Fair-Weather Flows

Several years ago, Alan Greenspan defended the Federal Reserve’s economic forecasts, observing that “the fact that they have been wrong for 14 straight quarters does not mean they will be wrong in the 15th quarter.” The comment was not only funny, it was true…and the same might be said about trying to forecast the path of the dollar and trends in international finance. Nevertheless, what follows is an analysis of how the U.S. has been able to finance its current account deficit to date, and why it may be more difficult in the months and years to come.

To start, we should head off any possible misconception about how the U.S. dollar might get its comeuppance. It’s not as if a large group of foreign investors will wake up one morning and decide not to invest in the United States of America anymore. Financial flows do not turn around so quickly – barring a major crisis, that is. What can change, however, is the price paid for U.S. assets at the margin. At the macro level, the easiest adjustment is through the currency exchange rate, which in this case is the value of the dollar.

Today, the structure of international money flows suggests further downside risk for the dollar. This is a flavor-of- the-month assertion, to be sure, but we hope to shed some light on the underlying data that support it.

Dollar Correction: Balancing Inflows and Outflows

Despite warnings to the contrary (including our own), the growing current account deficit failed to incite dollar weakness in years past. However, we long doubted that this relationship – largely a bubble phenomenon – could hold, and now it has started to break down. That is not to say that there should be an inverse relationship between the dollar and the current account deficit. At any particular deficit level, the foreign exchange market will balance inflows and outflows. But the expanding size of the deficit makes it harder to clear the market at a particular exchange rate, and the cumulative build-up of liabilities only adds to the difficulties.

In the four quarters ended September 2002, the current account deficit was $462 billion. To finance this Everest of debt, foreign investors purchased $418 billion in U.S. assets. The difference was made up by foreign central banks’ increasing their reserves of dollar-denominated assets by an estimated $66 billion. (The numbers do not sum due to statistical discrepancies in the reported data and our own small rounding error. But the discrepancy does not eliminate the major trends we are highlighting.)

At first glance, the foreign central banks’ actions in recent quarters might suggest that there is, in a sense, a shortfall in available financing. We wouldn’t go quite that far. Flows from central banks are as good as any other form of deficit financing in any particular period. But if we consider the nature of these flows, along with the fact that the U.S. is reliant on an historically high level of foreign investment to finance its deficit, we might conclude that the ability of the United States to attract such financing is diminishing. The $66 billion of increased reserves at foreign central banks is the “swing factor” that is helping to offset the U.S. current account deficit. From the U.S. point of view, this is the “balance-of-payments deficit”, or the payments gap that remains after accounting for non-official foreign purchases of U.S. assets. It is this gap that official reserve transactions must cover.

To be sure, there is good reason for foreign central bankers to increase their dollar holdings. For one thing, by buying dollars, foreign banks help to weaken their own currencies, which, in turn, helps their export industries. The decision to try to prop up the export industry is usually an easy political call, because the trade-offs involved – notably, higher prices for consumers – can be blamed on other factors.

Dollar Correction: No Smoking Gun

There is no historical relationship in the post-gold- standard era between balance-of-payments deficits and a weak dollar. So the recent increase in the deficit is not, in itself, a smoking gun in terms of financing problems. But by the same token, there aren’t many examples in financial history of a major debtor country running a deficit the size of America’s under a fiat currency regime. So the potential for a significant dollar correction can’t be ruled out, either.

Central banks around the world are not likely to dump their dollar holdings. But we do think that, at the margin, the U.S. will find it more difficult to obtain financing from both private and official sources. Despite the potential reasons for acquiring dollar assets, we would presume that, other things being equal, central banks would prefer not to hold depreciating assets. As history shows, there is a limit to foreign central banks’ willingness to finance America’s “deficit without tears,” as a French official once called it.

But the real “hot money” comes from private sources. In one sense, it would be better if the U.S. current account were financed completely by private, “non-official” purchases rather than by official ones. It would at least serve as an implicit vote of confidence in U.S. productivity (and even if the vote were a wrong one, it would be subject to market discipline). However, it would also mean that current account financing was subject to the whims of self- interested investors. It would be better still if the deficit were financed by direct investment or privately- floated securities, rather than by government obligations. Direct investment is not so easily repatriated. Also, government bonds are far less likely to finance something that is productive in the economic sense. James Grant, writing recently in Grant’s Interest Rate Observer, noted that, “in recent years, foreign dollar holders have shied away from direct investment in this country, favoring instead Treasury securities and federal agency obligations. They have switched their focus from investing in American enterprise to funding the housing market and the U.S. government.”

Measured on a rolling four-quarter basis, foreigners’ purchases of U.S. assets have declined from over $1 trillion in early 2001 to $647 billion in the latest four quarters. A subcategory, foreign direct investment, has withered from over $300 billion in 2001 to $46 billion in the latest four quarters. Part of the reason this contraction hasn’t made the U.S. funding problem even more severe is the increase in foreign official reserves noted above, coupled with the repatriation of overseas assets by U.S. investors.

Dollar Correction: The Cumulative Impact of Deficits

Should either trend reverse, the dollar would have to fall, unless an offsetting increase were to appear somewhere else.

Most readers of the Daily Reckoning have some idea of the size of the current account deficit. Rarely mentioned, however, is the cumulative impact of all these deficits. At the end of 2001, the net result was that foreigners owned $2.3 trillion more in U.S. assets than U.S. investors owned abroad, which produced a negative net asset position for us Americans, equivalent to more than 20% of U.S. GDP.

The trend may seem alarming, although we might exaggerate its importance. As author and economic commentator Andrew Smithers pointed out recently on Breakingviews.com, “In a world of massive disequilibria, the threat that foreigners will, on current trends, own 12% of the U.S. capital stock by the next decade is hardly worth half a pint in a gloom merchants’ saloon bar.” Perhaps. Yet it seems to us that foreigners might become increasingly concerned about the risk of currency depreciation as debts continue to rise.

The increase in liabilities also has a direct impact on investment income. Martin Wolf noted in a recent column in the Financial Times that, despite the negative net asset position of the U.S. in 2001, the country ran a small surplus in investment income – it received more in income than it paid out. The U.S. earned an average of 4.1% on its assets in 2001, while paying out 2.9% on its liabilities. This favorable difference is nothing new for the U.S., and Wolf concludes that “foreigners are stupid investors”. Maybe so, but perhaps they are no “stupider” than their U.S. counterparts.

Delving into this phenomenon, we calculated the returns, based on income payments and receipts, going back to 1982,the earliest available estimates for this particular measure. The U.S. advantage has occurred every year since then, but both U.S. and foreign returns have been in a fairly steady decline. America’s consistent relative advantage is clearly the result of its perceived safety vis-à-vis non-U.S. financial markets, hence the lower returns. Because the U.S. net asset position continues to deteriorate, however, the absolute amount of the investment income surplus has been in an uneven, downtrend.

Dollar Correction: Another Source Drying Up

In other words, the sheer weight of liabilities, along with the declining income returns, is countering the apparent advantage of U.S. investors. Importantly, the peak surplus of $36 billion registered in 1983 covered nearly all of the annual deficit for that year. By stark contrast, 2001’s $14-billion surplus covered about 3% of the U.S. current account deficit over the last 12 months. Since there is little reason to expect the U.S. net asset position to improve in the near future (and even if it did, it would take a while for the turnaround to have an impact), here is yet another source of financing that appears to be drying up.

Another problem for the U.S. current account is the return of fiscal deficits. As the fiscal deficit expands, the current account deficit will likely follow suit, thus putting even more pressure on the dollar by increasing the severity of the financing problem. If the U.S. private sector moves toward financial balance, a fiscal deficit necessitates a current account deficit, because the government needs to borrow from foreign investors. Stephen L. Jen of Morgan Stanley predicts that the “twin deficits” problem will become so severe in the coming two years that “it will overwhelm other factors that may be USD-positive.”

Of course, it is difficult to predict to what degree the size of the deficit will impact the dollar, and to what degree a weaker dollar will narrow the deficit. Either way, though, unless net exports happen to increase substantially without any help from a weaker currency, a dollar correction seems like a logical consequence.


Andrew Kashdan,
for The Daily Reckoning
January 29, 2003

P.S. The dollar’s perpetual decline against real goods will continue; it has lost more than 94% of its purchasing power since the founding of the Federal Reserve in 1913. When it comes to exchange rates, however, the feeble alternatives among the world ‘s currencies – none of them backed by more than a friendly face – will guarantee that a dollar correction will only go so far.

Be that as it may, I believe the correction is just beginning.


No panic yet. But consumers are less confident than at any time in the last 9 years. And rumors are circulating that the Fed is considering yet another rate cute to try to boost consumers’ spirits.

The Fed has cut rates a dozen times. And yet, it still doesn’t seem to have found that magic number that turns excess indebtedness into a virtue. It will try again…what else can it do? If rates don’t go down, the economists at the Fed must think, the whole world economy might.

The whole world is getting worried; it counts on the American consumer like a liquor store depends on alcoholics. There are better customers, maybe, but none more reliable.

More borrowing and spending may not do the consumer much good, but exporting nations love it. China, for example, welcomes Americans’ weakness for consumption like the day’s first customer.

Americans increased spending in each of the last three years. But each year, U.S. business profits fell, even while businesses were cutting back expenses sharply. Where did the money go? We need hardly ask the question, dear reader, for you already know the answer: it went to boost overseas economies.

Fed governor Ben Bernanke notes that the U.S. “can produce as many dollars as it wishes at essentially no cost”. But the cost is higher than Bernanke imagines. Nothing destroys a man faster than free money. The poor fellow thinks he has found paradise. He stops working and takes up dissipation full-time. Before you know it, he’s as worthless as a congressman.

But who knows? Americans must cut back someday. Maybe this is the day – even if the Fed dangles another 25-point rate cut in front of them.

Over to you, Eric, for the latest Wall Street news:


Eric Fry, reporting from Wall Street…

– The stock market finally regained its footing, at least for a day. The Dow climbed 99 points to 8,089, while the Nasdaq added 1.3% to 1,342. The U.S. dollar also managed to regain its footing – at least for a day – by rising about half a percent to $1.082 per euro.

– But consumer confidence continues to stumble. The Conference Board’s confidence index dropped to a nine-year low in January – a victim of the sliding stock market and sliding job market. The index fell to 79 from 80.7 in December, which means that this gauge of consumer confidence has dropped in seven out of the last eight months. Clearly, the consumer is not feeling very chipper these days.

– We’re not surprised that the consumer is finally becoming more cautious; we’re just surprised that it took him so long. We were cautious – and occasionally terrified – even when stocks were going up every day. Now that the stock market and the economy are slumping in tandem, what financial phenomenon could possibly inspire confidence? And remember, if consumers don’t consume, corporate earnings don’t rise…and neither does the stock market…

– What’s this? The Pension Benefit Guaranty Corp. (PBGC) is running low on funds? Didn’t this very same federal agency, which safeguards the nation’s pension plans, assure the public last month that all was well? Yes, as a matter of fact, it did.

– In the December 12, 2002 issue of the Washington Times “Insight” magazine, PBGC spokesman, Jeffrey Speicher, said, “The PBGC is able to meet its commitment to pay benefits for the foreseeable future. We have been running a surplus, but, even if that should go away, we have the wherewithal to meet our commitments that we were set up to pay.”…Hmmm…we might define “wherewithal” a little differently that Mr. Speicher.

– Responding to Speicher’s assertion, your co-editor was quoted by “Insight” as saying, “While the PBGC has about a $4.8 billion surplus [currently], it had a $9 billion surplus two years ago. So this ample surplus…has been cut in half in the last two years, despite the fact that the wave of problems hasn’t yet hit. The number of pensioners receiving benefits from them is about 270,000, but they expect that to go to 400,000 by year’s end. It isn’t hard to imagine what this means. If you boost the number of recipients by 50 percent, and at the old number you eroded half of the surplus in two years, how long would the alleged surplus last?”

– “Not long,” is the unfortunate answer. Already, the PBGC’s surplus has disappeared and plummeted into deficit, which means that the PBGC has somewhat less “wherewithal” than it used to.

– “The federal agency that insures the pensions of 44 million Americans has been pounded by a succession of big corporate bankruptcies and has burned through its entire $8 billion surplus in one year,” the New York Times reports. “Though it can continue to make its current payments, the agency is expected to disclose a deficit of $1 billion to $2 billion at the end of this month. Its soundness is likely to deteriorate further in the coming months.”

– Since the PBGC’s deficit calculation rests upon various assumptions about future income and liabilities, “deficit” does not exactly mean bankruptcy (Of course, neither does it exactly mean solvency). The PBGC, like the federal government itself, can, and does, operate for years in deficit.

– Nevertheless, the PBGC’s Icarus-like descent from surplus to deficit highlights the many vulnerabilities of our post- bubble economy. Like the “foolish maidens” of the New Testament parable, the PBGC did not “fill its lamp with oil” when it had the chance. The PBGC did not raise sufficient insurance premiums during the fat-income, bubble years to adequately safeguard pensions during the lean years in which we now find ourselves. As a consequence, the PBGC may soon be forced to raise insurance premiums, which would amount to yet one more assault on corporate profitability.

– “Some 35,000 insured pension plans participate in the PBGC,” Insight magazine explains, “paying a flat $19 per employee per year, plus additional variable rates paid by the underfunded plans.” Obviously, $19 per employee per year will not begin to cover the looming liabilities.

– “Some possible palliatives for the PBGC’s current situation,” says Reuters, “would involve charging businesses higher premiums.” Of course, what is the PBGC’s palliative is corporate America’s poison. But U.S. companies have far greater pension-plan worries than the size of the insurance premiums they pay to the PBGC.

– As Apogee Research has been highlighting for months, the $323 billion plain-vanilla pension shortfall amassed by the S&P 500 companies is only half the story…literally. “Other post-employment benefits,” or OPEBs, which includes things like medical care for retirees, has become a whopping $317 billion liability for the S&P 500 companies, according to CFO Magazine.

– The S&P’s $323 billion pension liability, coupled with its $317 billion OPEB liability, totes to a cool $640 billion liability – or more than two years worth of the entire S&P 500’s net income! That money has to come from somewhere. Net-net, we would repeat what Apogee Research first observed last October 25th: “Companies could end up working for their retirees instead of their shareholders.”

– Forecast that, Abby!


Back in Paris…

*** The International Labor Organization says there are more unemployed people around the globe than ever before – 180 million of them. In Argentina, for example, unemployment is up to 22% of the labor force. The number of people who either have no jobs or earn less than $1 per day has risen to 730 million, says the ILO. Gosh, what will happen when Americans stop buying?

*** In 2002, equity mutual funds had their first year of net outflows in 14 years. $5.5 billion went out of stock funds in December.

*** Every conversation seems to turn to war… “War, war, war… If I hear the word war one more time I shall leave the room and never talk to any of you the rest of the evening…”

Scarlet O’Hara didn’t like it when men’s attention turned from her to other subjects. But men are so much more at ease in front of an enemy army than they are in front of a beautiful woman. The stakes are so much lower. And so they turn to war for safety.

*** “I just can’t believe the way you Americans are so eager to go to war against Iraq,” Sylvie began last night’s French lesson. “You know, I give lessons at the American embassy, too. I don’t like to talk politics with my students, but the subject came up with a woman there. We were reading a newspaper article which asked, “should the inspections continue?” She didn’t think for a moment. ‘No way,’ said she. ‘The inspectors should get out of there right away so we can get on with the war.’ I mean…Isn’t this very strange? Sometimes people have to go to war. Sometimes they have no choice. But this woman wanted war….I never would have imagined it possible.”

“But, Scarlet…I mean Sylvie…” your editor began his explanation. “French military history is nothing but a series of debacles ever since Waterloo. The war with Prussia in 1870…WWI…WWII…each one was a disaster. Even Algeria was a disaster. And every war ‘hero’ in France – Napoéon…Pétain…DeGaulle – is loathed by at least half the population. No wonder the French would rather make cheese than make war.

“Americans,” he continued, “have an entirely different history. It is so much simpler. Each time we faced an enemy we won…with modest casualties (excepting the War Between the States) and got richer doing it. Besides, the guys who fought in WWII, and remember how awful a war can be, are either retired or dead….”

The Daily Reckoning