Deficits Do Matter

The Daily Reckoning PRESENTS: For the last month or so, we’ve been involved in a debate with a few different analysts about whether or not deficits matter to a growing economy. Today, Dr. Marc Faber gives us his point-of-view on the topic…


I can easily see that one cannot argue a priori that a trade surplus is “good” and a trade deficit is “bad.” Much will depend on a country’s composition of imports. If a rapidly growing economy imports principally capital goods for the production of goods or pays patent fees for the application of some inventions, I suppose that a trade deficit can be justified as it relates to capital formation, which leads to investment-driven sound growth and, eventually, boosts households’ real earnings and their standard of living.

However, when the trade deficit is linked to a sharp loss of competitiveness, over consumption and relates principally to the importation of consumer goods, I doubt that such a deficit will lead to a rising standard of living in the long term.

Temporarily, and in theory, there could be a rise in the standard of living when import prices decline sharply and allow households to buy a larger basket of goods, while the loss of employment in some industries may be immediately offset by employment in other industries that pay the same or even higher wages. But this doesn’t seem to be the case in the Western industrialized countries and the United States where the median real household income has declined by 4% since 1999. This seems also to be supported by data from the Bureau of Labor Statistics and by a survey commissioned by the AFLCIO.

According to this survey, which was carried out by Peter D. Hart Research Associates Inc. who polled 805 working Americans and which has a margin of error of 3.5%, only 11% of the respondents – concentrated among families with annual incomes of US$75,000 or more – consider their family income to be rising faster than the cost of living. And among the 53% of workers who said that their incomes were falling behind, less than a third reported doing better than their parents at the same point in life.

However, it is still possible that standards of living have been rising even though median real household income is down, as evidenced by rising debt levels, which have created asset inflation and the illusion of wealth. Since 1995, total U.S. credit market debt is up by more than 100% to US$37.3 trillion, or over 300% of GDP, while consumer debts have soared by more than 120% to US$10.7 trillion, or to more than 120% of personal disposable income

However, if standards of living have been rising as a result of higher debts leading to soaring household wealth, two points ought to be considered. The gains in household wealth have been unevenly distributed. Between 1983 and 2001, the top 20% of households in terms of wealth received 89% of total growth in net worth, while the remaining 80% of households accounted for only 11% of the growth in net worth. In fact, I would argue that the central problem of monetary inflation is that it distorts the entire market mechanism. When monetary inflation leads to consumer price increases, it doesn’t lift all prices by an equal amount; some prices soar, while others languish.

Similarly, when monetary inflation shows up in asset prices, not all households benefit to the same extent. Therefore, asset inflation usually leads to an enormous widening of wealth and income inequity (unless fiscal policy is designed to redistribute wealth, which then creates new maladjustments).

I think it should be obvious even to a non-economist that when production and investments shift to a region, it creates employment in that region and, through various forms of multiple effects, leads to rising incomes and standards of living. It should not be forgotten, also, that when a manufacturer shifts its production to Asia or any other emerging economy, it is accompanied by a transfer of technology, knowledge, and ancillary services, which then boosts the educational and skill levels of the local population and brings numerous other benefits. An example of ancillary services also moving to Asia is the shift of warehousing functions to China and other Asian locations.

According to the Financial Times (November 7, 2005), “U.S. manufacturers and retailers are increasingly shifting warehouses and distribution facilities to China as part of efforts to make their supply chains more efficient. Until recently, China made goods typically passed through U.S. warehouses en route to their final destination. But that has begun to change, as a growing proportion of goods are sorted, packaged, and labeled before leaving China. Once they arrive in America, the goods are delivered direct to the retailer or consumer, bypassing U.S. warehouses.”

According to the article, most U.S. companies don’t build their own warehouses but use the facilities provided by logistics partners such as UPS and DHL. UPS is expected to have 50 warehouses in China by the end of this year and plans to open another ten next year. Red Wing, a U.S. shoemaker, the Financial Times reports, has shifted some work from its main U.S. warehouse in Salt Lake City to a UPS facility in Yantian.

According to its director of marketing, “We were doing the same thing [in Utah] with more people taking longer to get it done at a higher cost.” (Here you have the reality about the great U.S. productivity miracle.) Moreover, according to SJ Consulting, a transport consultancy, a warehouse worker in China costs about US$2 per hour compared with $14-$15 in the United States. (But note that US$2 per hour in China is considered a very good salary.) The shift of warehousing and distribution to China isn’t positive for Hong Kong, either!

In fact, it is wishful – if not arrogant – thinking to assume tha tall engineers, scientists, and inventors will be stationed in the West and that the “uneducated” Asians will be employed in low paying manufacturing and low-value added service jobs. Rather, my view would be that, in future, research and development centres will follow the migration of manufacturing to Asia, since the benefits – the cost advantages aside – of the proximity of manufacturing and product development would seem to be obvious. For example, IBM has just announced that it has signed an agreement establishing an Indian outsourcing company, HCL Technologies, as the first Power Architecture design centre outside of the company’s own facilities. The design centre is based in Chennai (formerly Madras) and has 25 employees, but according to company executives it could grow into a 1,000-employee operation in two years.

Given that, in 2004, China graduated around 500,000 engineers and India 200,000, compared to 70,000 in the United States, and since a company can hire five chemists in China or 11 engineers in India for the cost of one engineer or one chemist in the United States, it is only a matter of time until most R&D will be carried out in Asia.

The notion that the Western world has a huge technological advantage over Asia would also seem to be negated by the findings of ipIQ, an intellectual property consulting and service company based in Chicago. Using a proprietary patent database that goes back 30 years, ipIQ’s technology rating model tracks patent details and ownership transactions, and ranks companies based on the number of patents granted, including the number of previous-year patents and growth of patents year-over-year. In particular, it also evaluates the impact of patents by looking at the frequency with which they are cited in scientific papers and by producing a science linkage index.

In 2005, ipIQ ranked the following ten companies as having the highest-quality patents, based on the innovations’ impact on industry and scientific significance:

1. IBM, 2. Micron Technology, 3. Hitachi, 4. Intel, 5. Hewlett Packard, 6. Samsung, 7. Canon, 8. Matsushita Electrical Industrial 9. Toshiba, 10. Fujitsu. And while this ranking may be debatable, it nevertheless shows that six out of the ten top-ranked companies are based in Asia and supports the view that the technological and scientific advantages of the United States and Europe are waning.

There is one more point I wish to make about the belief that “advanced” nations produce high profit intellectual property and services and have outsourced low profit manufacturing to the developing economies. While the United States still has a surplus in its balance on service, this surplus has in recent years been declining – suggesting a loss of competitiveness even in high-profit intellectual property and services. Moreover, the surplus in the United States balance on services is tiny and shrinking as a percentage of GDP when compared to the bulging and (as a percentage of GDP) increasing deficit in the balance on goods.

Economists may contend that the U.S. trade and current account deficits are sustainable ad infinitum, which in my view they are not, but very clearly it doesn’t take much economic background to see that the decline in the U.S. balance on services and the explosion in the country’s deficit in its balance on goods indicates very clearly a loss of international competitiveness. This is best documented by a figure that Bridgewater Associates has compiled and which we have published previously, which shows how the United States has lost market share of export markets.

When a company loses market share, it affects its profitability in the long term and can threaten its survival (witness General Motors), while when a country loses market share in export markets and has growing external deficits it will have a negative impact on standards of living and on its financial strength in the long term. I do, however, concede that temporary standards of living can be maintained or even boosted if such an economy goes deeper into debt, as is clearly the case for the United States.


Marc Faber
for The Daily Reckoning
January 4, 2006

Editor’s note: Dr. Marc Faber is the editor of The Gloom, Boom and Doom Report and author of Tomorrow’s Gold, one of the best investment books on the market.

Headquartered in Hong Kong for 20 years and now based in northern Thailand, Dr. Faber has long specialized in Asian markets and advised major clients seeking bargains with hidden value, unknown to the average investing public.

Our advice at the beginning of last year was the same as the advice we gave the year before…and the year before that:

“Buy gold.”

Happily, gold was the year’s top performing sector, for which we claim no distinction nor ask for any thanks. We have only one virtue here at The Daily Reckoning headquarters: humility. And we are even insincere about that. But even false modesty is a great advantage in the forecasting business…that, and not watching television.

Nobody knows what will happen. The worst thing you can do is to listen to other forecasters. The New Year brings them out like a new moon brings out werewolves. All tend to howl the same thing: next year will be more or less like the last. How do they know? They read it in the paper!

If you follow the consensus view, you are doomed to mediocrity. You will make the same investments everyone else makes and get the same returns that everyone else gets. That is not only a dull and cowardly way to do things, it practically guarantees that you will eventually be looking for coins under cushions and asking your brother-in-law for a loan. Over time, the great mass of investors loses money. Every bull market is followed by a bear market. Every bubble pops. Every great company fails. G.M. lost half its value last year. Fannie Mae fell 31%. The typical investor merely goes along; he follows the trends up, and back down. All the while he is paying Wall Street’s costs. For long periods of time, he thinks he is smart. The last bull trend in stocks began in 1982. It lasted for 18 years. All an investor had to do was to follow the consensus view and buy stocks ‘for the long run.’ Even now, five years after the peak, he still thinks he will get rich in stocks if he waits long enough. But the typical bear market lasts about as long as the bull market that preceded it. And it wipes out most or all of the gain. By the time it is finally over – perhaps in 2015 – the Dow will probably be back below 5,000 and the average investor will be underwater, because he bought when the newspapers, experts and forecasters told him to: when the Dow was over 5,000.

The big opportunities – and big dangers – are all at the turning points. When the Dow turns down, for example, it is time to sell. When gold begins to take off, it is time to buy. But these turning points – these major market shifts – are never foreseen by the forecasters. They are ‘discontinuities.’ That is, they are breaks in the visible and usual patterns. You cannot see them coming by looking at what happened last year or the year before. You cannot predict them by guessing that things, next year, will be more or less as they were the last. They are the very time when things will not be as they have been.

They are the points at which new trends begin.

We are too ornery to follow the crowd, and too modest to think we know what the year ahead will bring. The best we can do is to follow hunches, instincts and old-fashioned theories. ‘You get what you’ve got coming,’ is one of them. ‘Buy low, sell high’ is another.

At $10 a barrel, they were practically giving away oil a few years ago. It hit $70 a barrel on September 1, 2005. Now it is around $60. Stocks were selling at only six times earnings in 1982; they were practically giving them away. Likewise, gold was so cheap in the early ’70s – at $41 an ounce – they were practically giving it away. Whenever people give away something valuable, we take it.

We’ve never regretted buying at give-away prices. It is what led us to buy buildings in Baltimore in the early 90s, our place in Nicaragua, and more recently, land in Argentina.

By the late 1990’s, gold was being given away again at under $300 an ounce. Then, with the Dow near 12,000, we announced our Trade of the Decade: buy gold, sell stocks. Half the decade has now gone by. Gold has doubled. Stocks have not yet broken down. But we will stick with our trade. They are not giving gold away anymore. Still, a major bull market in the yellow metal is underway. We are too humble to make a forecast, but we stay with our Trade of the Decade, just to see how it turns out.

More news from our currency counselor…

Bill Bonner, back in London with more opinions and thoughts on the New Year…

*** Yesterday, gold traded over $530 an ounce. It is beginning to look as thought we have had our last chance to buy at less than $500.

*** What’s the most overvalued property market in America? A new study says it’s Naples, Florida, where the typical house sells for $329,000, which is about 80% more than it should be. The median house price should be closer to $180,000 – based on supply, demand, costs, demographics and other factors, says the study.

On the other hand, if you want to live somewhere where property is cheap, move to Texas. The Lone Star State has houses that are under-priced, according to the same study. In El Paso, for example, you can buy a house for nearly 20% less than it is actually worth.

We lived in Mineral Wells, Texas, once. Your editor’s father was in the Army at the time; he didn’t have a choice. We don’t remember much about the place, but from what we’ve seen since, we don’t know if a 20% savings is enough to make it worth moving there. Still, a lot of people seem to like the place.

*** We spent New Year’s Eve with friends in Managua. While the older kids went out to a nightclub for the countdown, we were back in the hotel room with the younger boys by midnight. As the hour approached, Managua erupted with what sounded like small arms fire. For a moment we thought another revolution was underway. Then, looking out our window, we saw explosions all over town, and showers of red, white and yellow fireworks coming from every quartier. It seemed as though there was a fireworks display on every rooftop and in every backyard. We had never seen anything like it.

It is amazing how fast you adjust to new circumstances. Even with the sounds of World War III all around us, we fell quickly asleep and slept soundly, until we were awoken just after 5:00 am for the trip back to Miami and London.

*** “I don’t want to go to school. I’m terrible at school, and this school is too hard for me,” was Edward’s lament last night. The youngest of our sons is not a gifted student. In a family of bookworms, he is a perfectly normal butterfly. He cannot sit still and cannot pay attention. And yet, he is keenly aware of his class ranking and not very happy about it. French schools let students and parents know where they stand. Each child knows exactly who is in front of him and who is behind. Edward, in the very competitive French Lycee in London, finds many of his friends ahead of him…and few behind.

“I don’t have any friends at school, and the teachers don’t like me,” he went on.

After a two-week vacation running wild in the warm tropics, Edward is finding it hard to put on the cold chains of very formal education. The Nicaraguan beaches seemed to bring the boy to life. He played in the waves…he learned to surf. He climbed the hills, scampered about, and was pampered by the maids. With three older brothers to tease him and play with him, an endless supply of Christmas candy, no stone he couldn’t throw, and no book he couldn’t leave un-opened, Edward was a boy in his element.

Today, he has had to put on his uniform go back to his schoolroom cell. Poor boy.

“Don’t worry,” was his father’s advice. “There are times you play, and times you have to work. All you can do is to do your best at both of them. If you do your best, no one is going to complain.”

The Daily Reckoning