Supply and demand determine price. That’s true for peanuts and also for assets, like stocks and homes.
The aggregate demand for investment assets is total domestic savings plus imported savings, which is equal to the trade deficit. The aggregate supply of investment assets is all the houses we build, and new companies we fund, and new investment by existing companies, etc.
Supply of investment assets:
Since the 1980’s or even earlier, the US has needed about 10% of its GDP to be devoted to investments. It used to be higher when increases in our productivity were driven primarily by supplying workers with more and better machinery. Since we’ve become more focused on intellectual work, our productivity is enhanced most by education and knowledge and training in general. And that takes less capital.
Demand for investment assets (=savings):
Our trade deficit has been large for a long time, and increased significantly with China’s recent explosive economic growth. By 2007, this supply of savings from abroad looking for US assets amounted to about 5% of our GDP annually, or half of our entire annual supply of investment assets.
Whenever you have too much money chasing too few goods, you get inflation. And this mismatch between total savings and available domestic investment opportunities, driven by trade deficits and the lower need for traditional investment in our knowledge-driven economy, is at the heart of our asset bubbles. Until we deal with the causes of the mismatch, we will only be moving bubbles from one asset class to another, or re-inflating the ones that pop.
