Good Debt, Bad Debt
Scientists have rats. Economists don’t.
We’re the rats.
Scientists know exactly how many ultraviolet rays it takes to burn a rat. Economists are still waiting to find out how many imports it will take before holders of U.S. dollars get burned.
America imports more than it exports. The current account deficit is a dollar rendering of our trade imbalance. To be accurate, the trade imbalance concerns only goods, and the current account takes in financial transactions as well as services. I’ll just refer to the CA deficit to avoid repeating “current account deficit” from now on.
Find a large CA deficit, and you will find deep worries. But the very word “deficit” leads people astray in this case. It is easy for the “America first” types to create the illusion that when the current account is in deficit, America is losing its way.
What happens when a current account goes too far in deficit? Currency devaluation. Not gentle slides…meltdowns, erosions, devastation. Foreigners don’t like to hold excessive amounts of other people’s currencies, and that’s what they have when their trading partners are far in deficit. And if the trade imbalance reflects a weakness in the country’s productivity or ability to trade, foreigners can unload a currency faster than you can say “Thai baht.” But…there’s always a but.
CA Deficits: 90% of Global Trades
In America’s case, the currency in question happens to be the most widely used one in the world. It is involved in 90% of global trades. It denominates all oil trades. And in a rough world, it is very stable. Yes, there’s a lot in the news about the dollar sliding this past year. But that’s a slide from overvaluation. For the previous seven years, the dollar had risen 40% against major world currencies. Just over a year ago, businesses and farm groups were traveling to Washington pleading for help to weaken the dollar, as it was hurting trade.
But even if large CA deficits cause problems eventually, they don’t necessarily cause problems immediately. Countries begin to have currency problems at different levels. For an emerging economy, a CA deficit of even 3-4% of GDP tends to cause problems. But remember, those are small and easily disrupted economies, and their currencies have provisional stature. For major developed countries, the limit seems to be higher, about 4%, up to 4.5% for brief periods.
But the United States has been able to sustain deficits of 4.5% and higher for long periods without serious currency devaluations. The economy here is huge, resilient and backed with a currency everyone is still willing to accept.
The problem is that no one knows how far we might go, or for how long. We’ve never been this far out of balance before. In mid-2002, the U.S. CA deficit reached $127.6 billion, just over 5% of GDP. By September, it had backed off only to $127 billion, and it may rise again. There’s genuine fear that this deficit is headed for 6%, and that probably is too far.
When we look at this as investors, it’s important to pay attention to trends that affect the dollar’s value. After all, our stocks are priced in dollars. A declining stock market, for instance, can undermine confidence. So can foreign policy that other countries don’t like, or increasing strength in other areas (Asia for instance) can lead the dollar lower. And overvaluation can be corrected. These influences can come and go quickly.
CA Deficits: A Worrisome Slide
But in the longer run, a continuing high CA deficit is very important. It can lead to a worrisome slide, the kind that the dollar suffered in the late 1980s. And that can hurt your investments, even if you are a dollar-based investor with only American companies in your portfolio.
We Americans cannot simply assume that the dollar will be eternally popular, even if it is widely used. Maybe someone is always willing to marry Elizabeth Taylor despite her track record, but the dollar doesn’t have violet eyes. In the last year, the dollar has fallen 15% against the euro. If you owned a European business that collected millions of dollars by selling goodies to the United States and those dollars were worth fewer euros every day, what would you do?
Of course you would unload them.
Fortunately, much of the CA deficit is not dollars in European hands. It is in Asian hands. Steve Hanke, a currency expert at Johns Hopkins University, notes that 67% of the deficit is with Asian countries. They are apt to continue liking dollar investments. Both Chinese investors and Asian central banks remain fond of collecting dollars, Hanke points out. Still, we must worry if the deficit widens or stays so huge and Asian economies improve so heartily that the dollar no longer looks as attractive compared to Asian currencies.
The world should pare back the price of the dollar. Some. But if the world grows skeptical of dollars quickly, there’s trouble. The dollar’s value would continue to slide and its global purchasing power would melt like cheap ice cream.
Ironically, a fast devaluation can cure a big CA deficit. The trouble is, nobody likes the results.
CA Deficits: Thailand, 1997
That’s what happened in Thailand, 1997. Thailand’s CA deficit reached 8% of GDP. It got that high because the government kept intervening to support the currency to keep it close to 25 baht per dollar as trade soured. Speculators attacked a system overdue to explode. When the baht broke down, it not only lost half its value overnight, the wreckage spread.
Realize that Thailand is a very small economy, yet…even so, the effect was felt around the world. Thai companies that might have sold their exports more easily since the baht was now cheaper couldn’t get credit to take advantage of the opportunity; Japanese banks lost billions on loans to Thailand. Other Asian currency crashed as a result. But, just a couple of months later, the current account was in surplus, as desired.
Another point to consider is the rise of imports into the U.S. Every time we buy something from a foreign country, the seller gets our dollars. Indeed, there are a lot of U.S. dollars living outside the United States. But to imagine that imports only debilitate our economy is wildly uninformed. Imports also spark our domestic economy.
In 2000, for every $1.2 to $1.3 trillion of imports, our economy grew another $2 trillion – because of those imports. In fact, Daniel Griswold at Cato Institute discovered that in years when the U.S. CA deficit was rising, GDP went up an average 3.5% annually. In years when it was shrinking, GDP rose only 2.6% on average.
Some imports are raw goods that get value added to them in the manufacturing process. But the rest comes from our domestic economy with its many layers. An importer buys a candlestick from Taiwan for 50 cents. He sells it to a distributor for $1. The distributor sells it to a retailer for $1.25. And you pay the retailer $1.75 at the end of the chain. Fifty cents went to someone in Taiwan, $1.25 went to businesses in the United States. And that’s not even including the money other companies make on shipping, advertising or packaging. The money made at home on such markups after foreign goods hit our shores comes to about 20% of our GDP.
We most certainly do not want a sudden drop in imports. Yet most commentary reads as though we Americans are either inept overspenders or being duped by wily foreigners every time we import goods. Not so. We are using those imports productively.
There is another element in our CA deficit that has similarly mixed implications. Not all of this importing and exporting is in goods and services. Much of the deficit comes from foreigners who are buying U.S. financial assets – T-bills and bonds as well as corporate and muni bonds.
CA Deficits: Low-Lying Fogs
Which brings me to another mis-impression the media foster. Alarmists always see the sky falling. Well, friend, the sky generally stays on top where it belongs, although the media do sometimes get lost in low-lying fogs.
Just because Sven and Igor and Hiro and Mustafa and Nigel own a lot of dollars instead of Billy Bob, Joe and Jack doesn’t mean they’re going to trade them in immediately. For what? Yet almost all the coverage I’ve read on the CA deficit makes it sound as though this were some kind of 90- day loan that has to be repaid. It is not.
Let me put it this way: If a software millionaire buys $2,000 worth of potatoes from the farmer next door and the farmer only buys $20 worth of the millionaire’s software, the millionaire is still a millionaire. And the farmer is still a farmer. The farmer is not superior to the millionaire because he spent less. Nobody owes anybody anything. The account is “settled” when the transactions are paid in cash. The current account balance is not an IOU, it’s a tally…a record of who sold the most. The current account balance of the millionaire may be a $1,980 trade deficit with the farmer. But the millionaire doesn’t owe the farmer money. He’s already paid. And the farmer isn’t going to demand he get his potatoes back because they’re uneven, either.
It is the same with the CA deficit. Nobody wants his potatoes back. The currencies do tend to get exchanged back to home currencies by corporations. A German axle maker will have a limit on how many dollars it wants to hold instead of euros. But there’s more to trade than axles. The flows in financial assets are strongly geared to dollars. By choice. Much of it comes from investors, including central banks, buying U.S. Treasuries, stocks and bonds.
There is a follow-on outflow of dollars with this financial trade. Interest payments. But the larger risk comes not from that. It comes from worry that this foreign liking for U.S. assets and dollars should change suddenly.
So…for us investors, here’s the first part of the problem that may directly affect us. Should the U.S. stock and bond markets badly lag those of competing countries, money could rush out. This would happen even if there were no CA deficit. Investors aren’t staying where the results are bad. But with the deficit so large already, such a big move would be disastrous for the dollar.
But to fix it…The CA deficit is one area that is best left alone to fix itself. We must hope that it is allowed to. Political and deliberate monetary policy cures are likely to do much harm. The most likely knee-jerk reaction to this imbalance, if the politicians get it in their teeth, is to restrict trade and raise tariffs.
I am opposed to that in theory and it has yet to have any enduring value. All we ever got from protecting the steel industry for so many years, to give one outstanding example, is a broken industry that finally couldn’t even support itself on oxygen.
Tariffs are a stupid solution. That is especially so when they’re levied on things no one needs to survive. And that includes most things for sale apart from oil. If bananas are too expensive, we’ll eat grapes. If two pairs of shoes are too much, we’ll only buy one pair. Or maybe skip it. If steel and cement cost too much, building slows down.
But world currency traders are doing a nice job. Already, the dollar is adjusting downward. It has dropped against the euro in the past year and may drop more.
But there’s another way that the CA deficit can be turned without causing inflation. Savings. Money saved at home reduces the money sent abroad buying imports without competing with the incoming foreign money for U.S. assets. It takes the pressure off demand. What’s more, it provides a pool for further capital investment.
As it turns out, Americans are saving more now than they were two years ago. Almost as if they knew…
CA Deficits: Cautious Money
In its way, the now-burst tech stock bubble has helped the situation as well, although jerkily. There is no longer a three-headed boy in the carnival tent pulling foreign investment into the U.S. stock market. The foreign investment money that is here now is cautious money. It is here because nowhere else looked much better. Interest rates on safe investments are comparatively high here. Some of this money will wander off looking for sexier returns elsewhere.
As that money leaves, hopefully gradually, the dollar could drop in value. But a somewhat weaker dollar would be no big loss.
We had a similar situation in 1985-1986 when the dollar dropped in value without doing great harm to the U.S. economy. The magic formula in this puzzle is the nature of the U.S. economy. It is very nimble. Both its labor and capital are quite flexible. As a country, we don’t have massive problems laying off workers as the euro countries do because of their labor laws. Nor do we have great problems hiring up. And right now, we have a very low capacity utilization…
If you are going to have a bad capacity utilization number, the best time to have it is when the dollar is too strong, as it has been. As the dollar drops, exports become easier to sell and businesses can quickly gear up the selling simply by using their existing capacity more fully.
The effect on trade is obvious. We Americans with fistfuls of weak dollars won’t buy as many imported goods. Most of the world needs our trade to keep its own economies sound.
But the less obvious threat is the one to corporate balance sheets worldwide. A lot of seemingly healthy companies will show their cracks when their dollar assets lose value. Every foreign company that collects dollars for what it sells will see profits evaporate as those dollars they bank are translated into lower and lower figures in their own euros, rubles, and francs.
February 4, 2003
P.S. As investors, this all means something to us. It is good to diversify now. You will likely find the currency exchange rates work in your favor. However, there’s a limit to how much you can expect. It is not time to flee the dollar and all dollar-based investments. For one, there’s a dearth of choices outside Europe (still more economically challenged than the United States), Hong Kong and Japan.
But more important, you will not find other countries willingly allowing the dollar to slide too far. A very weak dollar is not good for people collecting dollars. And that’s most of the world.
As you know, dear reader, we’ve been waiting for the End- of-the-world-as-we-have-known-it, EOTWAWHKI for short.
The EOTWAWHKI hasn’t exactly made the headlines. Life goes on one day to the next pretty much as it always has. In today’s TIMES of London, for example, it is business as usual: Tony Blair wonders whether his support of an American war against Iraq will cost him the next election…Michael Jackson admits he sleeps with boys…and a naughty vicar has been charged with molesting male prisons and buggery.
With so much going on, who noticed the smell of something rotting?
“While the United States rules the waves as well as turf and sky, I’m not so sure that we are, or perhaps will be the economic powerhouse we once were,” writes PIMCO’s Bill Gross. “Three years of stock market declines, a 20% devaluation of the dollar over 10 months, and an inability to serve as the global economy’s locomotive despite massive monetary and fiscal stimulation suggests America’s ‘shining city on a hill’ may have lost some of its sheen of late. The US of A, it seems, is becoming less wealthy by the minute, as foreign investment is withheld and in some cases redirected to Chinese and other more attractive ports of call. Economically, we may have begun a process of hegemonic decay…”
Over the last 50 years, America’s net foreign trade position has gone from nearly 3% surplus to nearly 6% deficit. These are big numbers. The current deficit runs about $500 billion – that is the amount of foreign capital required to keep Americans living beyond their means.
And now cometh the Bush Administration with a $2.2 trillion budget. The central government proposes to seize and spend about one out of every four dollars its citizens make. It also proposes to run the biggest deficits in the history of organized government – more than $300 billion in 2003 – and a total of about a trillion dollars over the next 5 years.
This may not be the end of the world…but there’s a whiff of decay in the air. America’s consumer credit expansion is half-a-century old. Its continued credit needs…along with an aging population burdened by debt, military ambitions, a falling dollar, overpriced stocks…all of these things are going to force the consumer to cut back and scale down.
“While that may not qualify as a trip to the poor house,” Gross continues, “I have no doubt that such events signify to at least some Americans a trip to a poorer house. Many of us will have to adjust, either in the form of higher unemployment, an increased price for imported goods, or heavier indirect taxes in the form of higher inflation and interest rates. Investment strategies, both bond and equity, should put these secular reversals at the top of their A list when considering opportunities to make relative and absolute returns. Hegemonic decay will impose costs unimagined just 16 months ago during the innocent hours of September 10th, 2001.”
But let’s turn to Eric for the latest news from Wall Street…and then we’ll return to the EOTWAWHKI.
– Yesterday’s trading action on Wall Street featured Day II of a feeble “relief rally.” The Dow added modestly to last Friday’s 108-point gain by tacking on 56 points to 8,110. The Nasdaq inched ahead 3 points to 1,324.
– Meanwhile, gold continues to glisten. The yellow metal rallied $2.50 to $371.60 an ounce. Although gold’s months- long rally has been pretty impressive, platinum is the hottest precious metal these days. Yesterday, platinum prices soared $25 to $698 an ounce – their highest level in 23 years! A worldwide lack of supplies is spurring the price higher, along with threat of additional supply disruptions. Specifically, Russia’s Norilsk Nickel, the world’s fifth-largest producer of platinum, is battling modest labor unrest.
– Stock market investors are also growing a bit restless. “Investors are understandably gun-shy these days,” observes Morgan Stanley’s Stephen Roach. “Bear markets tend do that – especially this one. The hope is that the worst is over. But there are few willing to bet that a meaningful resurgence in the global economy is now at hand.” Roach says investors aren’t too worried anymore about the downside, but neither do they hold out much hope for the upside…On average, investors are perfectly ambivalent, and the latest mutual fund numbers tell the tale:
– “Investors took $50 million more out of stock funds than they put in last month,” USA Today reports. “While the exodus was relatively small, the fact that it happened at all is troubling, because investors normally resume funding retirement plans and put year-end bonuses to work in the market in January.”
– During the bubble years, the lumpeninvestoriat would routinely dump about $20 billion per month equity mutual funds. But after three straight losing years in the stock market, the lumps have little money left to dump.
– The few remaining folks who still have a spare dollar or two to their name are hesitant to try “catching the bottom” in tech stocks for the umpteenth time. Even the lumps can see that the tech sector’s “bottom” is likely to be as wide as a sumo wrestler’s. Global information-technology spending has stagnated and could easily remain stagnant for some time. And yet, many tech stocks still command very rich valuations.
– The World Semiconductor Trade Association announced yesterday that global chip sales fell 2.3% in December from the previous month. For the year, sales grew just 1.3% to $140.7 billion in 2002. All in all, not a very impressive performance.
– The semiconductor sector’s malaise typifies an American economy that is “reverting to the mean” from the excesses of the bubble era. Weakness – both in the economy and in the stock market – is the path of least resistance.
– But that doesn’t mean we won’t enjoy the occasional, spectacular bear-market rally. In 1992, three years after Japan’s Nikkei Index reached its peak, the Japanese stock market rallied about 40% before resuming its inexorable decline. That was ten years ago, and the Japanese stock market is still languishing.
– Michael Belkin thinks the U.S. stock market is on the verge of mounting a very similar sort of bear-market rally. Belkin is looking for a gain on the order of 40%, before the market rolls over and resumes its decline.
– “Mike’s reasoning draws heavily on his formative early experiences strategizing the Japanese market’s twists of fate,” writes Kate Welling of Welling@Weeden. “He was just starting out on his own back in 1992, when his charts and models started setting off alarums. Bearish calls on Japan at that point were a lynchpin of his reputation, but suddenly it looked to him like the Nikkei would rally, big.”
– Belkin was right, as it turned out. Now he sees – or thinks he sees – the setup for a similar rally in the U.S. market. “His major theme for trades,” Welling reports, “is that the markets, sectors and groups that have fallen the most, have the best bounce potential – that’s right, stuff like Nasdaq, TMT, utilities – while, conversely, all the usual suspect ‘safe havens’ won’t be.”
– “But careful who you call a ‘bull,’ says Welling. “Mike is adamant: ‘This is not a new bull market forecast, just a bounce in a long term downtrend. But 40% upside potential is substantial, too much to endure if you are an under- invested long-only manager or shortseller.'”
– Consider yourself forewarned…
Back in London…
*** Why would foreign investors continue to buy U.S. shares? Overseas stocks are cheaper than those in the U.S…and there is no dollar risk.
Forbes reports that London-based Cadbury Schweppes sells at only 9 times earnings, compared to Alanta-based Coke at 23 times.
Based on price to sales, Total Fina Elf is a third cheaper than Exxon. So is the Bank of Ireland compares to Wachovia. Lafarge is less than half the price of U.S.-based Vulcan Materials. And Unilever is only one-ninth the price of Kraft Foods.
*** But foreign investors are even more discouraged with their own economies than they are with America’s. German shoppers have “stopped spending,” says the BBC. Wages in Japan are falling…along with unemployment. European manufacturing is down for the 5th month in a row.
*** Investors who cannot stomach either U.S. equities or foreign ones are turning to gold. The yellow metal has a great advantage in tough times. Managed by no one…it cannot be mismanaged. Nor does it lie to creditors…or go broke in a crisis. And unlike Bernanke’s dollar, it cannot be inflated away when the managers feel the urge.