What we aim to do with everything we produce – whether it’s The Daily Reckoning, our books, or the documentary – is to show how everything you see in the financial news actually relates to you. Why it’s so important that you pay attention to all the noise in the headlines, because the falling dollar, the credit crisis…all of this affects each American. Below, Addison explains how the trade deficit has a very real effect on the U.S. dollar.
Most people can relate to the realities of how jobs and profits shift, and why. The idea that higher-wage manufacturing jobs are being lost and replaced by lower-wage retail jobs, for example, is a reality that working people understand. They get it. The same is not always true when we talk about trade deficits. Like the falling dollar itself, it’s worth asking the question: How does it affect you, the individual?
The trade deficit – the excess of imports over exports – has a direct and serious effect on the value of our dollars. As long as we continue having big trade deficits, it means we’re spending more money overseas than we’re making at home. Our manufacturing profits are lower than our consumption. If your family’s budget has a “trade deficit” of sorts, you’ll soon be in trouble. If your spouse spends $ 4,000 for every $2,000 you bring home, something eventually gives way. This is what is going on with the trade deficit.
In fact, the trade deficit is one of the most important trends in the economy, and the one most likely to affect the value of the dollar. Combined with our government’s big budget deficit, the trade deficit only accelerates the speed of decline in our dollar’s value.
Speaking in terms of spending power of the dollar, the trade deficit is the third rail of the economy. Here is what has been going on: The United States used to produce goods and sell them not only here at home, but throughout the world. We led the way, but not anymore. The shift away from dominance in the production of things people need has allowed other countries (most notably China and India, and with Colombia, Russia, Brazil, and Mexico not far behind) to pass us up, and now the U.S. consumer has become a buyer instead of a seller.
This international version of conspicuous consumption 1 is financed not from the profits of commerce, but from debt. Let’s think about this for a minute. If we were buying from domestic profits, the trade deficit wouldn’t be such a bad thing. It would mean we were spending money earned from domestic productivity. But this is not what is going on. We are going further and further into debt to buy goods from other countries. Our wealth is being transferred overseas and, at the same time, we are sinking deeper into debt. This is taking place individually as well as nationally. Consumer debt (you know: credit cards, mortgages, lines of credit) is growing to record levels, and the federal current account deficit is moving our multitrillion – dollar national debt into new high territory.
Sure, we should be concerned about retirement income from savings, investments, pension plans, and Social Security. But a bigger danger is that, even with a comfortable retirement nest egg by today’s standards, what if those dollars are worthless when we retire? What then?
The big question today is, how long can this debt-driven economy continue? If you quit your job and refinance your home, you could live for a while on the money. The higher your equity, the longer you would be able to spend, spend, spend. But then what?
This is precisely what is going on in the U.S. economy, and, at some point very soon, we are going to have to face up to it and change our ways. The trade deficit is the best way to track what’s going on. Returning to the analogy of quitting your job and living off of your home equity, you may stay home all day and order an endless array of electronics, furniture, toys, computers, and the like; in other words, you could consume goods in place of working. But remember, you didn’t win the lottery; you are financing this new plan with borrowed money. The lender will want that repaid. So this individual version of a trade deficit (the deficit between generating income and spending money) is what is happening on a national level in the United States.
This is the problem that is directly affecting the value of the dollar; and the situation is getting worse. We know that the dollar is in trouble because we see it depreciating against the floating currencies of other countries.
The United States has a lot of wealth, but that wealth is being consumed very quickly. History shows that no matter how rich you are, you can lose that wealth if you’re not productive. Meanwhile, the dollar’s value falls and – in spite of the Fed’s view that this is a good thing – it means our savings are worth less. Your spending power falls when the dollar falls, and as this continues, the consequences will be sobering.
The dollar’s plunge has taken many people, currency experts of banks included, by surprise. For many of them, it is still impossible to grasp. Some talking head on CNBC said that he was at a complete loss to understand how such weak economies as those seen in the European Union could have a strong currency. For American policy makers and most economists, the huge trade deficit is no problem.
They find it natural that fast-growing countries import money while slow-growing economies export money. At least, that is the recurring theme. So Americans traveling abroad may continue to complain that “it has become so expensive to travel in Europe” as though the problem were somehow the fault of the Europeans. But in fact, it is the declining spending power of the dollar that is to blame, and not just the French, the Italians, and the residents of the so-called chocolate-making countries.
This problem is pegged not to some speculative or fuzzy economic cause, even though the concept of currency exchange rates continues to mystify. A historically large trade deficit is at the core of the declining dollar. Somebody needs to get over the notion that our economy is strong and other economies are weak, merely because this is America. In the United States, the reason for the trade deficit is not a high rate of investment as we see in some other countries, but an abysmally low level of national savings. We are spending, not producing.
A second argument offered by some is that “capital flows from high-saving countries to low-saving countries, wanting to grow faster.” Under this reasoning, a deficit country, looking at both consumption and investment, is absorbing more than its own production. But whether this is good or bad for the economy depends on the source and use of foreign funds. Do those funds pay for the financing of consumption in excess of production (as in the United States) or for investment in excess of saving? That is the key question that ought to be asked in the first place about the huge U.S. capital imports.
To quote Joan Robinson, a well-known economist in the 1920s and 1930s close to John Maynard Keynes:
“If the capital inflows merely permit an excess of consumption over production, the economy is on the road to ruin. If they permit an excess of investment over home saving, the result depends on the nature of the investment.”
The huge U.S. capital inflows (economic jargon for money coming into the country), accounting now for more than 6 percent of gross domestic product (GDP), have not financed productive investment; in fact, they are financing more and more debt. Capital grew from 5 percent in 2005 to more than 6 percent in 2006, according to a report from the Bureau of Economic Analysis (BEA), “U.S. International Investment Position.” Our net investments are among the lowest in the world, meaning we prefer spending and borrowing over actual production and growth. The huge capital inflows have not helped finance a higher rate of investment. The United States has been selling its factories and financial assets to pay for consumption.
It’s helpful to use a real means for measuring economic strength. Money coming here from overseas finances higher personal consumption. The steep decline in personal saving is a symptom of our spending, and along with that habit we have lower capital investment and a growing federal budget deficit. In the third quarter of 2005, for the first time ever, the rate actually fell into negative territory – to – 1 percent.
The U.S. economy has for years been the strongest in the world, leading the rest of the countries. Our Daily Reckoning newsletter routinely gets reader responses saying, in effect, “How dare you impugn the superiority of the American economy! How dare you!” We’re rather thick-skinned, so the insults bounce off rather easily. But “facts are stubborn things.” The fact that the U.S. economy has outperformed the rest of the world in the past several years is easily explained: Our credit machine has been operating in overdrive nonstop. It is geared to accommodate unlimited credit for two purposes – consumption and financial speculation. Let’s look at these two things a little more deeply.
Credit is not the same thing as production, despite the fuzzy logic you get from the financial media. There is a severe imbalance between the huge amount of credit that goes into the economy and the minimal amount that goes into productive investment. Instead of moving to reign in these excesses and imbalances, under Greenspan, the Fed clearly opted to sustain and even to encourage them. I want to believe that under Bernanke, the Fed will do better, but so far, it is still customary to measure economic strength by simply comparing recent real GDP growth rates. It is pointed to as proof and applauded by U.S. economists when U.S. economic growth outscores Europe – like some kind of dysfunctional futbol match.
Financial speculation is equally unproductive. An investor puts up capital to generate a sustained and long-term growth plan. For example, buying and holding stocks is a form of investment and a sign that the investor has faith in the management of that company. Speculators don’t care about long-term growth. They want to get in and out of positions as quickly as possible, make a profit, and repeat the process. So speculative profits – especially those paid for with borrowed money – tend to be churned over and over in further speculation and increased spending. None of that money goes into investment in the long-term sense. The speculator is invested in short-term profits, nothing more. Even so, the speculator is today’s cowboy, the risk-taking, living-on-the-edge market hero willing to take big chances. He is seen as a guy with big stones because he’s staring the prospect of loss right in the eye.
The Daily Reckoning
May 15, 2008
P.S. The essay above is an excerpt of the second edition of Addison’s bestseller.
Addison Wiggin is the editorial director and publisher of The Daily Reckoning, and executive publisher of Agora Financial, a multi-million dollar financial research firm and publishing group based in Baltimore, Maryland.
“One market bubble may be an accident;” begins an article in the Financial Times, “two in the space of a decade begins to look like carelessness.”
In our view, the bubbles in housing and debt were the result of neither accident nor carelessness. They were the result of Fed policy.
The Fed thinks it has two mandates: to preserve the value of the U.S. dollar…and to maintain full employment. The two are as incompatible as a sanctimonious governor and the Emperor’s Club. At some point, you have to choose. What’re you going to be – a governor or an emperor?
Fed governors chose the easy path – they chose to try to boost up the economy…and let the dollar go to hell. That’s why the greenback has lost half its value against major foreign currencies since the beginning of this century. And it’s why we have had two major, related asset bubbles so far this decade – one in housing and the other in housing debt. And it’s why we have also had a credit crisis…from which we now seem to be emerging.
People are beginning to put two and two together – to make the connection between the Fed’s aggressive attempts to put more money and credit in circulation and the asset bubbles. And now that they’ve got their slide rules out…they’re wondering about the oil price too…and gold…and food…and consumer prices…
…and now, in this moment of high anxiety, the whole world turns its weary eyes to Paul Volcker. Like France recalling the old Hero of Verdun – Marshal Petain – in ’42, the press goes to Volcker and asks his opinion.
The latest Bloomberg report:
“Volcker, who engineered a surge in interest rates to 20 percent when battling consumer price gains 18 years ago, said ‘there is some resemblance to where we are now in the inflation picture to the early 1970s.’ The Fed failed to contain a pickup in prices at that time, spurring the acceleration of inflation later that decade, he said.
“‘If we lose confidence in the ability and the willingness of the Federal Reserve to deal with inflationary pressures’ and buttress the dollar, ‘we will be in real trouble,’ Volcker said. ‘That has to be very much in the forefront of our thinking. If we lose that we are back in the 1970s or worse.’
“Consumer prices rose 3.9 percent in April from a year before, compared with an average rate of 2.7 percent over the past decade, a Commerce Department report showed today. Volcker said there’s ‘a lot more inflation’ than reflected in government figures.”
Yes, dear reader, the battle between inflation and deflation has been noisy and indecisive. But the real cost of this war hasn’t even begun to register. Unbeknownst to most observers, almost a whole generation of wealth building has been wiped out. Wages are back to levels of the ’70s. Stocks have gone nowhere in 10 years. And houses are headed back to levels of the mid-’90s.
On this last item, we have some news headlines. Foreclosure filings rose 65% in April, from the year before. In California, foreclosures hit a new record high. And land prices in Las Vegas, away from The Strip, are down 24% from a year earlier.
Toll Bros. (NYSE:TOL) says its sales will go down 30% in this quarter. Mortgage fraud cases are up 31%, says the FBI. And in England, realtors say the market is the worse they’ve seen in 30 years.
How cometh these things to pass? Fed governors have been enjoying their own emperors’ club, if you know what we mean. They’ve had their cake – and eaten it too. Until now, they could cut rates and increase the money supply, and still hold their heads up look Americans in the eye: “Do you see any inflation? We don’t see any inflation.”
Alas, the rumors are out…the receipts are turning up…and people are appalled. They’re turning on Alan Greenspan, in particular. We opined years ago that Greenspan’s reputation was inversely correlated to the price of gold. As gold rose, Greenspan’s stock went down. As you will see, below, this trend probably has further to go.
Even Ben Bernanke has disavowed his former boss – saying that the Fed can and should spot bubbles and lance them before they get too bad. But while Bernanke talks tough…he has shown himself unwilling to make Volcker’s tough choice. Between protecting the dollar and keeping the bubble pumped up, Bernanke has chosen the pump, not the lance.
*** Yesterday, we mentioned the oil market. Today, we slide in deeper.
You’ll recall, dear reader, some time ago we guessed that the feds’ efforts to keep consumers consuming were essentially inflationary…and that the inflation they caused would tend to go more into gold and oil than into economic growth or asset prices.
Since then, the price of oil has shot up over $100. Yesterday, it hit a new record at over $126, before falling back to $124. Gold, meanwhile, has traded above $1,000 – and now is correcting in the mid-800s.
This is already a major adjustment. It comes along with a major adjustment in the purchasing power of the dollar, generally. Americans’ global purchasing power has been cut in half. The value of their assets – on the world market – are only half what they were during the Clinton years. And the value of their most precious asset – their time – has also been greatly reduced.
This is why you see so many Europeans in the United States…America is a cheap place to visit. It’s also why U.S. export industries are reviving; the country has become a low-cost producer for many things; it is now a place where richer nations can consider outsource production.
All of this has gone almost ‘according to plan’ – that is, it is pretty much what we guessed would happen.
But now, we have to ask: are these adjustments enough?
You’re expecting us to say ‘no,’ aren’t you? Instead, our answer is ‘maybe.’
In the case of America’s 50% pay cut, (the U.S. dollar is only worth about half as much as it was compared to other major currencies) we think it should do the trick. Now comes a long period in which people come to realize it and begin living not quite as large as before. They lose their houses. They cut back on their spending. They relearn an old word – thrift – and find they like it. They downsize their lives – with smaller houses, smaller cars, and littler expectations. The economy goes into a long slump – as 70 million people, facing retirement, begin to save money.
In the case of gold, our guess is “probably not.” Gold has still not come near the inflation-adjusted peak it set 28 years ago. Considering all that has happened during those years, we bet that there is another peak to come – even higher than the last. In 1980, the United States still had the residual financial integrity to stand up to inflation. Paul Volcker could push the yield on the 10-year Treasury note up to 16%; he caused a recession, but not a revolution. Most importantly, he protected the dollar. We don’t see any Volcker around now…and we don’t see how anyone – even Paul Volcker himself – could “pull a Volcker” now.
The country has twice as much debt per person. It has a hugely negative current account. It has the biggest government deficit ever (think what would happen to it in a real recession…the deficit would go to $1 trillion). No, we don’t think gold is in danger of a sudden attack of monetary propriety. Instead, we think the gold bull market has much further to go – probably above $2,500 an ounce, before the dollar-based financial system collapses completely.
Agree or disagree, dear reader…but you’ll want to take advantage of this dip in the gold price. Pad your portfolio with the yellow metal – for just one penny per ounce. You can beat that.
But it is oil we set out to reckon with today. And what we reckon is that oil is getting close to its near term peak. If we were holding major positions in oil, we would sell them.
Here’s why. While gold is nowhere near its record high – oil is above it. In today’s money, the top price ever paid for a barrel of oil, until recently, was only about $79. Today, oil seems to be headed to twice that level. And a few experts think it will go much higher. Goldman’s oil expert predicts $200 oil.
But why should it go so high? For all the talk about China’s insatiable demand, it is still true that prices and demand must worth themselves out. When the price goes up, people grumble…but they use less. We filled our tank in France last weekend. The total price came to more than $150. We had been thinking about driving down to the South of France next weekend. Instead, maybe we’ll take the train…the trip would have cost us more than $300 in gasoline alone.
Everything happens at the margin, said a dead economist. Americans alone probably drive millions of marginal miles – to places they really don’t really need to go…when they don’t really have to be there. At over $3.50 – they’ll drive less. Already, the Financial Times reports that U.S. demand is falling more than expected.
There’s so much shifting sand in the oil market – usage, new discoveries, distilling capacity, storage facilities, OPEC policy, inflation, drilling technology, emerging market developments, the dollar, U.S. economic growth – its impossible to know how big the dunes will get. But oil demand – and prices – should generally stay in line with GDP. The more growth, the more oil. Plus, if you measure GDP and oil in dollars you eliminate both inflation and currency depreciation as variables. Well, at $100, reports Martin Wolf in the Financial Times, “the annual value of world oil output would be close to $3,000 bn. That is 5% of world gross product. The only previous years in which it was higher than that were 1979 to 1982.”
Those were not good years to enter the oil business. The price subsequently collapsed.
Yes, you could make a lot of money in oil…many people already have. But sure as fleas come with stray cats, success leads to excess. As the price rises, more and more people imagine that it will keep going up. Some take measures to avoid using it. Some find substitutes. Some increase production. Markets still work, in other words. Every bubble eventually finds its pin. The day can’t be too far off when the price of oil will fall back under $100.
The Daily Reckoning