From Know-How to Nowhere
The U.S. economy is plagued by an array of growth inhibiting imbalances: the trade deficit, the federal budget deficit, household indebtedness, record-low national saving rates, asset price bubbles, and of course, record-high consumer spending. Addison Wiggin explains how ignoring these problems will ultimately lead to the demise of the U.S. economy…
A weakened U.S. economy shouldn’t surprise anyone. It is a direct result of the questionable nature of the so-called economic recovery. Any other country faced with these many imbalances would have collapsed long ago. But the U.S. dollar was spared this fate when Asian central banks began accumulating the dollars needed to avoid rises in their currencies.
Both the United States and China practice credit excess, but with a crucial difference: In the United States, the credit excesses went into higher asset prices and, more notably, into personal consumption.
In Asia, credit excesses went into capital investment and production. The result is an odd disparity between the two economies: Americans borrow and consume, and the Asians produce. This symbiosis plays out in the trade gap. Ironically, this ever growing problem is ignored on the national level and plays virtually no role in U.S. economic policy or analysis. In the second quarter of 2004, the increase in the trade gap subtracted 1.37 percentage points from GDP (based on domestic demand growth). In comparison, during the 1980s, policy makers and economists worried about the harm that trade deficits were causing in U.S. manufacturing.
In a September 1985 move orchestrated by James Baker, the U.S. Treasury secretary, the finance ministers of the G-5 nations agreed to drive the dollar sharply down in concerted action. By the mid-1990s U.S. policy makers decided that trade deficits were beneficial for the U.S. economy and its financial markets.
Cheap imports were playing an important role in preventing inflation and, as a result, higher interest rates. Had the decision been to allow interest rates to rise, it would have had the effect of slowing down consumer spending. Instead, spending is out of control and the trade gap is the consequence. Ultimately, the victim in all of this is going to be the U.S. dollar.
The economic cycle involving inflation, higher interest rates, monetary tightening, recession, and recovery has a predictable postwar pattern in America and in the rest of the world. But we’ve taken a departure from this for the first time. A critic might argue that now the United States is enjoying a prolonged period of strong economic growth with low inflation and low interest rates. What could be bad about that?
Well, what’s bad about that is the fact that we are not experiencing strong economic growth. U.S. net business investment has fallen to all-time postwar lows, under 2 percent of GDP in recent years. At the same time, net financial investment is running at about 6 percent of GDP. In other words, the counterpart to foreign investment in the U.S. economy has been higher private and public consumption, accompanied by lower saving and investment.
Official opinion in America says that the huge U.S. trade gap is mainly the fault of foreigners, for two reasons. One is the eagerness of foreign investors to acquire U.S. assets with higher returns than in the rest of the world; the other is supposed to be weaker economic growth in the rest of the world. In this view, the trade gap directly results from foreign investment because it provides the dollars that the foreign investors need.
The first thing to realize about a deficit in foreign trade is that, by definition, it reflects an excess of domestic spending over domestic output. But such spending excess is actually caused by overly liberal credit at home, and not really by cheaper goods produced elsewhere.
Just as shaky is the second argument, ascribing the trade gap to higher U.S. economic growth. Asian economies, in particular China, have much higher rates of economic growth than the United States. Yet they all run a chronic trade surplus, which is caused by high savings rates. This is the crucial variable concerning trade surplus or trade deficit.
The diversion of U.S. domestic spending to foreign producers is, in effect, a loss of revenue for businesses and consumers in the United States. Is this important? Yes. The loss is higher than $500 billion per year. This is America’s income and profit killer, and it can’t be fixed with more credit and more consumption. This serious drag of the growing trade gap on U.S. domestic incomes and profits would have bred slower economic growth, if not recession, long ago. This has so far been delayed by the Fed’s extreme monetary looseness, creating artificial domestic demand growth through credit expansion. The need for ever-greater credit and debt creation just to offset the income losses caused by the trade gap is one of our big problems.
An equally big problem is a distortion of the numbers. We are officially in great shape, but the numbers don’t support this belief. Personal consumption in the past few years has increased real GDP at the expense of savings, while business investment has grown only moderately.
This can only end badly. Normally, tight money forces consumers and businesses to unwind their excesses during recessions. But in the latest round, the Fed’s loose monetary stance has stepped up consumers’ spending excesses. Our weight trainer is feeding us Big Macs. If we were to measure economic health by credit expansion, the United States has the worst inflation in history. And still our experts are puzzled by a soaring import surplus.
The problem here is that American policy makers and economists fail to understand the significance of the damage that is being caused by monetary excess and the growing trade gap. The trade gap is hailed as a sign of superior economic growth, while the hyperinflation in stock and house prices is hailed as wealth creation.
Until the late 1960s, total international reserves of central banks hovered below $100 billion. At the end of 2003, they exceeded $3 trillion, of which two-thirds was held in dollars. By far the steepest jump in these reserves, of $907 billion, occurred in the years 2000-2002. With China and Japan as the main buyers, Asian central banks bought virtually the whole amount.
In a speech given in Berlin in 2004, Alan Greenspan was amazingly frank about the "increasingly less tenable U.S. current account deficit," suggesting that foreign investors would eventually reach a limit in their desire to finance the deficit and diversify into other currencies or demand higher U.S. interest rates. He expressed the new consensus view in America that the dollar has to bear the brunt of reducing the U.S. federal budget deficit.
American policy makers seem to want a lower dollar, apparently believing (or hoping) that this will take care of the U.S. trade deficit, and they appear to regard this as an easy solution to this problem.
But this will not solve the problem at all. The premise is wrongly based on the assumption that an overvalued dollar has caused of the U.S. trade deficit – an entirely unsupported view.
It is widely assumed that rising stock and house prices will keep American consumers both willing and able to spend, spend, spend their way to wealth – indefinitely. But the transfer of U.S. net worth to interests overseas is alarming, and it endangers U.S. economic and political health. Warren Buffett, who kept his vast fortune invested at home for more than 70 years, decided in 2002 to invest in foreign currencies for the first time. Buffett and management of Berkshire Hathaway believe the dollar is going to continue its decline. We should not need confirmation such as this to recognize the inevitable; but it bolsters the argument that the dollar is, in fact, in serious trouble, and that this trouble is likely to continue.
In addition to debt problems at home, Buffett made his decision based at least partially on the ever-growing trade deficit. He warned:
"We were taught in Economics 101 that countries could not for long sustain large, ever-growing trade deficits. At a point, so it was claimed, the spree of the consumption-happy nation would be braked by currency-rate adjustments and by the unwillingness of creditor countries to accept an endless flow of IOUs from the big spenders. And that’s the way it has indeed worked for the rest of the world, as we can see by the abrupt shutoffs of credit that many profligate nations have suffered in recent decades. The U.S., however, enjoys special status. In effect, we can behave today as we wish because our past financial behavior was so exemplary – and because we are so rich.
Buffett is especially concerned about the transfer of wealth to outside interests. He notes:
"Foreign ownership of our assets will grow at about $500 billion per year at the present trade-deficit level, which means that the deficit will be adding about one percentage point annually to foreigners’ net ownership of our national wealth. As that ownership grows, so will the annual net investment income flowing out of this country. That will leave us paying ever-increasing dividends and interest to the world rather than being a net receiver of them, as in the past. We have entered the world of negative compounding – goodbye pleasure, hello pain."
The Daily Reckoning
Editor’s Note: Addison Wiggin is the editorial director and publisher of The Daily Reckoning. Mr. Wiggin is also the author, with Bill Bonner, of the international bestseller Financial Reckoning Day and the upcoming thriller Empire of Debt. Mr. Wiggin is frequent guest on national radio and television programs.
The above essay was taken from Mr. Wiggin’s newly-released book, The Demise of the Dollar…and Why It’s Great for Your Investments. To order your copy, please see here:
"Which Western economy has both a budget surplus as well as a current account surplus?" asks Fred Jones of Jutland Capital Management. "Or, what country has the world’s second-largest oil reserves?"
The answer to both questions is the same. It’s that land north of the 48th parallel.
How Canada got such vast quantities of Mother Nature’s gifts we don’t know. Canada not only has oil reserves second only to Saudi Arabia, she also has what Saudi Arabia and California both lack – water, as well as immense supplies of other natural resources.
If you believe, as we do, that the coming decade or two are likely to be kind to raw materials but cruel to paper assets, that alone should make Americans want to take a look across the border at what Canada has to offer.
But it is not just the works of nature that interest us there; we also like how man has played his part. And we particularly like one thing the Canucks did – they resisted temptation, while Americans gave into it.
We drift back a few years. The Reagan administration, faced with the perennial choice of whether to raise taxes or cut spending decided to do neither. Instead, it cut taxes and borrowed – giving itself and its citizens more money to spend. The spending spree currently reaching its zenith in the United States can be traced back to those years…among others. What it has wrought takes our breath away each and every day. The U.S. economy stands behind no other when it comes to spending and to debt. It is numero uno.
But where is the Canadian economy?
"When we examine what happened when Canada faced a similar situation in the mid-1980s," writes Jones, "…we see that the government chose to make some very difficult and unpopular choices. Starting in the mid-1980s, the Canadian government resisted the politically expedient temptation to cut taxes. In fact, the Tory government of Brian Mulroney actually introduced a new federal tax, the goods and serves tax (GST). It was a consumption-based tax modeled after a similar tax in New Zealand."
Thus did the Canadians tighten the screws on both their government and their citizens. Neither was given much rope; neither hanged himself.
"Of all the G7 countries," notes Harold Chorney, "only Canada remains obsessed with balanced budgets and avoiding deficits."
Readers might consider replacing their U.S. dollars with the Canadian brand. Both are emitted by English-speaking countries in the North America. Both are made of paper. But one comes from the world’s largest debtor – now desperately dependent on imported energy and imported capital. The other comes from a country that is an exporter of both. The former has not enough energy and capital. The latter has so much it can share with its neighbor – particularly its giant neighbor to the south.
Our guess is that the sharing will go on…but the terms will change. Canada is likely to want more dollars for its exports. The Canadian dollar – also known as the ‘Loonie," because it has a picture of a bird on it, rather than a dead president – will likely go up.
Not only does Canada have the winds of major economic trends at its back, it seems to have the good sense to trim its sails. While U.S. federal debt races ahead as if the ship of state had lost its rudder, its mind and its master…Canadian federal debt is actually in decline…and at least one province, Alberta, has paid off all its provincial debt.
Yes, all the Western nations are likely to lose ground against new Eastern competitors. But some will lose more than others. Canada, thanks to man and nature, may come out better than most.
Eric Fry, reporting from Laguna Beach, California…
"The price of Kinross Gold (NYSE: KGC) touched an all-time high yesterday; the price of gold did not. Maybe the price of Kinross has more to do with trends in the gold-mining industry than with trends in the gold trading pits."
For the rest of this story, and for more market insights, see today’s issue of The Rude Awakening
And more thoughts…
*** A note from Chris Mayer telling of something most have no idea about: labor shortages in China…
"I’ve written labor constraints in China. So, I was interested when a recent
Wall Street Journal article confirmed this idea of a shortage in skilled labor in China.
"The article quoted the head of a French consulting firm, which operates a business out of Guangdong in southern China, employing 500 people.
"’Eighty million people live in this province,’ he said. ‘When you see that, you think you can get anything you want. It’s just not true.’
"The problems: a weak educational system, not a lot of mid-level managerial talent and a cultural propensity to prefer local firms to Western ones. These are problems that are spread out among many other parts of China, not just Guangdong.
"Of the 1.3 billion people in China, only 5% or so have college degrees, compared with 25% of the U.S. population. Even among these college- educated, there are complaints that most of them are not prepared or comparably equipped as graduates from other nations. The Journal reports, citing a McKinsey & Co. study:
"’Even engineering students from the most prestigious universities in Beijing receive little practical training in projects or in working with a team. Few speak passable English. As a result, McKinsey estimates that only 160,000 engineering graduates a year are suitable to work in multinationals – a pool no larger than the U.K.’s.’
"Then there is a lot of turnover. It is common for companies to lose a third of their work force per year. Most firms are happy if they can limit turnover to about 15% per year.
"These forces are pushing up the price of Chinese skilled labor. Hewitt Associates says wages for experienced English speakers are rising 15% per year. Anecdotal evidence suggests the number is much higher.
"In any event, China is not a panacea for companies looking to cut costs. There are many obstacles and challenges on the road to success."
[Ed. Note: Chris Mayer, of Capital and Crisis fame, is excellent at nosing out profit-making opportunities where most see none. Take, for instance, something that everyone uses – and relies on – everyday, but never gives a second thought t water. Most investors don’t know water-related investments have already made silent fortunes for some of the world’s more savvy market players. Read his full report here:
*** Heroin production is up dramatically in Afghanistan.
From David Marks writing in ABC, Australia:
"The numbers are enormous. The United Nations Office on Drugs and Crime recently announced that this year’s opium harvest will be more than 6,000 tonnes.
"The Executive Director of the Office, Antonio Maria Costa, says that represents 92 per cent of the world’s supply and exceeds demand by 30 per cent.
"So how can farmers grow the raw product for heroin so abundantly in a country backed by the one of the world’s most strident anti-drug regimes – the United States?
"Professor William Maley, the author of Rescuing Afghanistan, was recently in the country and says the record crop can be traced back to the overthrow of the Taliban in 2003.
"William Maley: ‘The United States blocked the expansion beyond Kabul for nearly two years of the International Security Assistance Force. And this had the effect of creating a security problem off which the opium producers were then able to feed very effectively.’"
And with the opium came increasing corruption.
"Some provincial governors within Afghanistan have been very much under the thumb of drug barons, and that has compounded the problem of poor governance. The problem of course is that some of the drug barons have also been prepared to provide support to the Coalition forces with bits of intelligence about al-Qaeda. And so there’s been a reluctance thus far to hit where it really hurts in the production chain…"
And there you have the paradox of most government programs.
Bomb terrorists off the streets in Afghanistan and you get heroin…on the streets of Melbourne or Paris….
The idea, you’ll recall, was to invade the country…kick out the Taliban…and turn the place into a ‘Little America.’ This would give us a strong base of operations in the area…as well as show the whole Arab world what fine lives they could have if they only threw off those silly turbans, let their women out of those black bags and got with the program.
Well, now the Taliban have apparently gotten back in the country, and from reading the news reports it looks like they’re taking over. Which is bad news for heroin users…because the Taliban doesn’t like drugs. And, unlike American anti-drug programs, when they set out to get drugs off the streets, the drugs disappear.
The whole show in Afghanistan seems to be going bad. The peacekeepers are forgetting their lines. The Afghan government is missing the plot. The curtain seems ready to come down on a complete mess.
No one goes to war in that part of the world without later regretting it, we recall ourselves saying years ago. But it takes time for the public spectacle to run its course…from the original delusion that we can create a ‘Little America’ in the Hindu Kush…to the farce of putting in CIA operatives…handing out rich contracts to cronies…manipulating the news…organizing puppet governments…to the final tragedy of people getting blown up…the Taliban seeking revenge…death…destruction……