Where do we go from here?
Today we have the final installment of the debate between the folks at GaveKal and our own Bill Bonner. John Mauldin has heard from both sides, and now it’s time for him to contribute his thoughts on whether or not trade deficits do matter…
"I don’t know whether change will come with a bang or a whimper, whether sooner or later. But as things stand now, it is more likely than not that it will be a financial crisis rather than a policy foresight that will force change." – Paul Volker
How long can the United States continue with an ever rising trade deficit? How far can debt rise? Will it end, as Paul Volker, former Chairman of the Fed stated above, in a financial crisis? Will it end as a soft depression as Bill Bonner suggests or is it, as the team at GaveKal projects, different this time?
Over the next ten to twelve years, we will see three recessions that will slowly move the average price-to-earnings ratio of stocks to historic lows. Rising oil and energy prices will be a main culprit of both the slowdown in the economy and an increase in inflation. Ever-increasing monetary inflation will, in fact, trigger a huge increase in all commodity prices, as well as a decline in bonds. Asset inflation will show up in the housing markets as home values continue to skyrocket. The dollar will continue to weaken against major foreign currencies. The current war will become increasingly unpopular, and the next administration will be forced to withdraw troops, under the guise of declaring victory. The American voting public will be split as never before, with major patterns in voting habits making a generational change. The newspapers will continue to write about how an Asian country will dominate the world economically in less than a few decades.
Following this period of malaise, there will be an amazing cycle of new technical innovation that will spark yet another major bull market. The new technologies will change the world in ways that simply cannot now be imagined and will lead to whole new industries, putting amazing new power and abilities into the hands of individuals and governments.
Trade Deficit Debate: 1970
The preceding scenario would, in fact, all come to pass. Except that the year was 1970 and not today. The forces that have changed the world in the decades following 1970 were only written about in science fiction and a few obscure books and journals. Who dreamed of the Internet in 1970? Who could envision that the Berlin Wall would come down in 1989? That Japan would not, in fact, dominate the world of economics and overwhelm the United States? Or that the China of Mao would become a capitalistic growth machine and that the USSR would break up? A personal computer on every desk and more computing power in an automobile than existed in the largest computers of the time? A globalized world economy? The prospect that a falling population (and not overcrowding) would be a problem, or that a Green Revolution would mean enough food for all (except where governments kept out a free market)?
In the 1970s, the mood of the country was decidedly negative. Japan was eroding our manufacturing base and unemployment was increasing. Reagan spoke of the Misery Index in his race against Jimmy Carter, which was a combination of inflation and unemployment.
And yet it all changed. In fact, the one constant in the modern world is that the pace of change is accelerating.
The above section comes from the beginning of my personal chapter in Just One Thing called The Millennium Wave, but it makes a good introduction to today’s topic as well.
In the late 70’s and early 80’s, there was a concerted sense of doom and gloom pervading the markets. Many urged that we stock food and emergency supplies, buy gold and silver and sell stocks. We had watched as Japan eroded our manufacturing base. Millions of jobs went offshore never to return. "Where," many asked, "would the jobs of the future come from?" America was in decline.
The correct answer then, as it is today, was "I don’t know from where they jobs will come, but they will." And come they did, as American entrepreneurs created whole new industries.
But that was then. Where are the economic miracles today that will save us from ourselves? Does the massive debt we are accumulating; both internally and abroad, matter?
Trade Deficit Debate: There Will Be a Rebalancing
I don’t believe that we can borrow our way to prosperity. Ultimately, as I will try to make clear, and I think I have stated consistently over the past few years, there will be a rebalancing. But I do not think it will lead to a depression, soft or otherwise. It will be Muddle Through. And after that period of rebalancing, I think we will see another great boom, probably starting then middle of the next decade.
Also, while it appears that ‘a machine at the Fed which simply grew the money supply at a reasonable rate of growth, coupled with a federal government that ran slight surpluses’ is indeed a fantasy, given today’s reality, it is my personal one. Would that it were so. But we invest in reality, not what we wish were true.
Now, let’s be clear. Muddle Through will not necessarily be fun. The 70’s were times of Muddle Through. Few would willingly revisit those economic times. And things changed dramatically from 1970 until 1990, and even faster after that. I think the next period of change will happen at a much faster pace.
But free markets and entrepreneurs adapt to new conditions. That is what happened in the 70’s and 80’s and 90’s, and what will happen in the future financial crisis that Volker speaks of. And I believe he is right. There will be a series of crises. But I think we have had a number of crises over the past 35 years and somehow we seem not only to survive, but also prosper. That is not to diminish the pain felt by many during those crises, or the losses in investment portfolios.
The argument that Bonner, Marc Faber, Steve Roach et al make is that the United States is living off of the kindness of strangers. It is the savings of the rest of the world, and primarily Asia, which finances our massive trade deficit. I argue that it works both ways, as they have become dependent upon the U.S. consumer to buy their products and keep their factories humming. It is this symbiotic relationship that has allowed the United States to run such massive deficits without a collapse of the dollar.
I wrote almost three (or maybe four) years ago that no country had ever seen their trade deficit rise to over 5% of GDP without a 30% revaluation of their currency. This was (and still is) a great part of my bearish stance on the dollar. Yet today we now run a trade deficit of almost 7%. The trade deficit is growing much faster than GDP. This is clearly an unsustainable trend. But how long can it last?
Many analysts, including me, correctly point out that it is in the best interests of the various nations to take dollars to keep their factories going. Further, dollars are not worthless. They can buy a lot of things like stock, homes, factories and assets in the United States, arguably one of the safest places in the world. Further, U.S. assets are growing faster than our liabilities. On a balance sheet basis we are in a good shape.
But Bonner correctly points out that at some point many nations of the world (read Asia) will start to wonder what they should do with all those dollars in their vaults. Those foreign dollars are now growing at $700 billion plus a year. At the rate of $69 billion last October (latest month data) it is well on its way to over $800 billion. Is there not a limit? The answer is "of course there is." (Though I should note that foreigners bought $107 billion of U.S. securities in October, an all-time high. Whatever the limit is, it seems we are yet a long way off.)
I wrote last year that various (primarily Asian) countries want to keep their currencies cheap relative to the dollar so they can be more competitive than their neighbors. It is competitive currency devaluation, plain and simple. Yet, each country’s central bank knows that ultimately those dollars are going to fall at some point. I pointed out it is like the children’s card game Old Maid. No one wants to get stuck with it at the end of the game.
Trade Deficit Debate: Do They Matter?
So, bottom line. Do trade deficits matter? Yes, in the long run, but probably not next year or the year after that. And they primarily matter to currency valuations. Please note that currencies fluctuated up and down 30% or more in the 80’s and 90’s and the large majority of the country did not notice. Has Europe wilted because the euro is down 40% or so? So "matter" is a relative term. But it should be positive for the gold bug crowd.
Because it is in the best interest of all parties concerned, the U.S. trade deficit is going to last a lot longer than most people think. The Asian countries hope that they can create their own consumer classes and slowly wean themselves from the U.S. consumer, allowing the dollar to fall gradually.
Gradually is probably not in the cards. It will be in fits and starts, with some long rallies to scare the dollar bears, like we have seen recently. I hope Volker is wrong. It would be a nice world if policy could manage a smooth transition. I strongly suspect he is right. It will be a series of financial crises that will push the dollar lower coupled with a Muddle Through Economy. During these crises and recessions, we will see consumer spending slow and savings increase which together will bring down the deficit.
for The Daily Reckoning
December 20, 2005
John Mauldin is the creative force behind the Millennium Wave investment theory, author of the weekly economic e-mail Thoughts from the Frontline, JohnMauldin.com, and a private letter for accredited investors. As well as being a frequent contributor to Capital & Crisis and Strategic Investment, Mr. Mauldin is a New York Times best-selling author with a unique ability to present complex financial topics and make them understandable to the lay reader with insights into the current economy and hedge fund industry. His latest book, Just One Thing, is due out in December.
"I started selling these lots much too cheap," began a neighbor in Nicaragua. "I was letting these beachfront lots go for $30,000 to $50,000. But that was before this big boom in America got underway. I built condos on the ocean, too, and sold them for $150,000. That was only three years ago…no, only two years ago. But I resold one of them last week for $279,000."
Property buyers in Nicaragua – as in Florida and California – seem to have spent too much time in the sun. They’ve become feverish.
"Even the ‘B’ lots – you know, those that aren’t on the beach – are selling. We’re almost out of them. And I’m amazed they would sell at all. It’s low land. And when it rains, the whole place is underwater. My tractors got stuck three times during this last rainy season. But the strangest thing was this guy who wanted to buy one of the back lots. He came during the rainy season, so I didn’t want to show it to him. Because it was under about a foot of water. Luis came to me and said he wanted to borrow the tractor. I asked what for. He told me the client wanted to see the back lot. We could only get in there on the tractor…and even then I was afraid it would get stuck. But he got on the tractor and went to look at the lot and bought it."
People occasionally make a mistake and buy a lot that is underwater. Sometimes they get conned or swindled and end up with a waterlogged lot. But a real bubble market turns swindlers into honest men. They can tell the truth and still make a sale; the customer swindles himself.
The bubble may be over in North America, Australia and Britain. But new trends reach the tropics slowly, as if by steam packet. For now, developers in Latin America are selling condos, houses and underwater lots without hardly trying.
And perhaps the buyers aren’t such fools, after all. Your editor bought a parcel down the coast a few months ago. The price was exorbitant by Nicaragua standards. But compared to the rest of the world, it was a bargain. Even $279,000 for an ocean front condo would leave change in a Miami-based buyer’s pocket. And, of course, other costs are lower too – cleaning, gardening, and dining out. Everyday that our family spends in London costs a fortune. We cannot go out to dinner without spending at least $100…usually more. We take a taxi across town and easily pay $40. A cup of coffee and a croissant sets us back $15.
But here…our wallets mildew from lack of use. There is nowhere to go…scarcely a thing to buy…and nothing to do that costs money. We can play in the surf…ride horses…sunbathe…play tennis…read…write…doze… none of it costs much money. We probably save $50 a day just by being here. In a month, we have saved nearly $1,500 – about enough to cover airfare.
More news, from our team at The Rude Awakening…
Eric Fry, reporting from a gridlocked Manhattan:
"We inquired…You replied. Last week, we asked you, the Rude Awakening readers, to identify gold mining companies that you believed would be attractive takeover candidates. You responded with a flood of emails."
Bill Bonner, with more miscellanies…
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*** We began building this house on the beach a couple of years ago. This is the first time the family has stayed here.
"What do you think?" we asked Elizabeth.
"I think it’s very nice," came the answer.
"But where’s the pool?" Edward, 12, wanted to know.
"We don’t need a pool. We have the ocean."
"Oh…but where’s the TV?"
"We don’t need a TV, we have books."
"Oh…but at least we have Internet, right?"
"Nope…we don’t need internet. We can write letters."
"Oh…I want to go home."
*** The boom in property prices in Latin America worries us. We like owning real estate in Nicaragua. But we like owning it because it has seemed under priced as well as underappreciated. When it becomes less under priced, it is less attractive to hold it and more attractive to sell it. But we’ve become attached to our Nicaraguan properties as if to an old pair of shoes; we hate to throw them out. Elizabeth even wants to buy more:
"We really should buy that lot next to us. Look, we’ve already invested a lot of money on our house. We want to be sure we can enjoy it, right? Well, why not try to buy up some extra lots around the house so we’ll be protected."
"But those lots are already twice as expensive as they were two years ago," we protest.
"Well, you should have bought them two years ago. Besides you’re always saying you can’t predict the future. For all you know they’ll double again in the next two years."
"Yes…we can’t predict the future…that’s why we insist on only buying things that are cheap."
"But how do you know when this is cheap? Even after doubling, this place is still not half…no, barely a 10th of prices in some areas of the United States, and it’s much more attractive. And it’s really not a question of money anyway. What’s the point of making money? It’s so you can live the way you want. After the children are all in college we’ll be able to spend more time down here. We won’t want to look out at the next-door lot and say to ourselves: if only we had bought that lot 5 years ago.
"And I’ll tell you something else…let’s say we change out minds. Well, we can always sell the lots later. But we can’t always buy them later."
"Maybe so…" we replied lamely, "maybe we could sell them later. But not necessarily for the same price."
"That’s right…maybe they’ll be less expensive. Maybe they’ll be more expensive. Since you don’t know either way, you have to ignore that point altogether. I don’t know why you brought it up…"