Over the past 60 years America has tranformed from the world's largest creditor nation (we produced goods and sold them to the rest of the world) to the largest debtor nation (the rest of the world produces goods and we buy them).
In 2006 we bought $800 billion more in goods than we exported.
To provide an example, let's say we bought $1 trillion in oil from Saudi Arabia in order to take care of our energy needs. In exchange we sent them $200 billion in military products. The difference is $800 billion, which is called a trade deficit.
Saudi Arabia (or China, Japan, ect.) now have $800 billion in American dollars to spend. What did they do? In order to keep their currency artificially low, which in turn would boost their export driven economies, they turned around and invested the money right back into the United States.
In 2006 our total deficit was $160 billion. That means the government needed to borrow $160 billion in order to cover expenses. They do this by issuing I.O.U.'s called treasury bonds.
Foreign countries eagerly bought up these $160 billion in treasury bonds with their $800 billion in spending money. But that left them with another $640 billion to spend.
So they began to buy American mortgages, corporate bonds, and stocks, which added fuel to our already growing credit bubble. This bubble burst in 2008.
Fast forward to today:
We now only run a $500 billion trade deficit, but our annual budget deficit is now $1.5 trillion per year. So if foreign countries decide to reinvest 100% of their spending money back into America (which they don't have to do) then we will still have an annual gap of $1 trillion.
This is where the Federal Reserve steps in. The Fed has become the missing buyer to fill this gap.
So what would happen if the Fed stopped buying treasury bonds in June when QE 2 is scheduled to end?
Money would have to move out of stocks, corporate bonds, real estate, ect., to fill the gap needed to fund our deficit. Up until now, with the Fed purchasing the debt, investors have not had to make that choice.
As I have continued to say; the Fed has painted themselves into a corner. While I continue to believe we have one more major disinflationary shock to the markets ahead of us, the final outcome will be an inflationary depression for the United States as we move toward the Greece moment when the market runs on our debt.
Assets being bought today at ridiculous pie in the sky prices, such as commerical real estate, will go on sale at once in a lifetime bargains.
