|Ominous: The US deficit vs the
By Jack Crooks
"Doublethink means the power of
holding two contradictory beliefs in one's mind
simultaneously, and accepting both of them." -
US deficit is good, because it stimulates US demand and
Asian exports. The deficit is bad because it has created
a massive global financial imbalance that will one day
need to be balanced. I think that qualifies as
I am guilty of doublethink more
often than I care to admit. But as I examine the
financial "realities" and the implications of the US
current-account deficit, the word "ominous" is the only
thought that seeps into my mind. And though the timing
is anyone's guess, the US dollar is poised to be
overwhelmed by the deficit.
Peter G Peterson,
chairman of the Council on Foreign Relations, the
Institute of International Economics, and the Blackstone
Group, had this to say in the September/October edition
of Foreign Affairs magazine:
The United States is now borrowing about
$540 billion per year from the rest of the world to
pay for the overall deficit funding Americans'
consumption of goods and services and US foreign
transfers. This unprecedented current-account deficit
is paid through direct lending and the net sales of US
assets to foreign business or persons: everything from
stocks and bonds to corporations and real estate. The
United States imports roughly $4 billion of foreign
capital each day, half of that to cover the
current-account deficit and the other half to finance
investments abroad. At 5.4% of GDP [gross domestic
product] in the first quarter of 2004, the deficit is
substantially higher than its previous record (3.5% of
GDP) in 1987, when the dollar fell by a third and the
stock market took its "Black Monday"
I think Peterson does an excellent job of explaining
the deficit problem and its relationship to the dollar.
The deficit truly is the common thread binding dollar
bears. Here's a look at what they are seeing:
The chart above shows the
deficit rose to a whopping US$166.2 billion for the
second quarter of 2004. Annualized, that's $664.8
billion, or approaching 6.5% of US gross domestic
product. As bad as this seems, it will probably get
worse before it gets better.
We are locked into
a set of "daunting arithmetic", says Richard Berner, an
economist with Morgan Stanley. He says, "The daunting
arithmetic locks the current-account gap into a vicious
circle that is hard to escape." Berner cites several
reasons he thinks the deficit will get worse:
Imports of goods, services and income are 40% bigger
than exports. And this ratio is on the rise again.
Higher US interest rates will increase debt payments to
foreign debt holders.
3) Iraq war and
4) Slowdown in global growth,
especially in Asia.
5) Soaring cost of imported oil.
Economics 101 teaches that if a country's
currency depreciates, that depreciation will allow for
an increase in exports, the theory being that the cost
of its goods become cheaper, or more competitive, in
international markets. But as one would expect, there is
a lag time between the time a currency depreciates and
its benefits begin to accrue in terms of trade. This
means the deficit will first get worse then better as
the currency declines in value. Economists refer to this
as the J-curve.
Import prices rise immediately
as a currency depreciates, but because the volume of
trade is not as sensitive to price changes, it can take
from one to two years for a positive impact to show up
in the terms of trade and improving the current account.
Take a look at the chart above, which compares
the US current account deficit to the trade-weighted US
dollar from 1972 through the second quarter of 2004. I
have tried to identify the last time the J-curve worked.
It's represented by the rectangular area, highlighted on
the chart. The dollar peaked in 1985 (red line). It then
fell in value until 1988 before the current account
deficit (blue line) began to improve. This also shows
the fall in the dollar Peterson was referring to. Many
believe it was a major catalyst for the 1987
history is utterly devoid of examples of current account
adjustments that are not accompanied by significantly
weaker currencies." - Stephen Roach, Morgan
I was thinking
about the historical parallels in the economic
environment now compared with then - during the time of
the last dollar crisis. Here's what I came up with:
But as bad as it seemed back then, the global
financial system now appears much more unbalanced. The
United States and China seem to be the sole economic
engines of growth in the world. And the deficit is in
historically uncharted territory and lurching from one
fresh all-time record to another.
|Go-go '60s stock-market boom
||'90s stock-market boom (Internet
|Vietnam quagmire & communist
||Iraq quagmire & "war on
|Soaring budget deficit
||Soaring budget deficit
|Rising interest rates to stem
||Rising interest rates to
"normalize" the Fed funds
|Soaring commodities prices
||Rising commodities prices (for now,
fell approximately 42% from its peak in 1985 to its
trough in November of 1990 before the current-account
balance turned positive again (when the deficit was 3.5%
of GDP). This is the "adjustment" Roach is referring to.
And it's why Roach believes a dollar crisis could "soon"
be upon us.
From the peak in this cycle,
February 2002, through September 2004, the dollar has
fallen only 23%. The current account is now approaching
twice what it was when it finally bottomed in 1988. So
if we use the current-account "adjustment" as a guide,
we should multiply the 42% decline by a factor of two to
determine just how far the dollar must fall before
solving the current-account problem - that's 84%!
It may seem silly to conceive of the world's
reserve currency, the US dollar, falling that much. But
if we consider there is little else on the horizon other
than a fall in the dollar to help rebalance this
situation, an 84% decline starts to look more plausible.
Chinese 'revaluation': That dog might not
"In some ways, the 19th-century version
of the global capitalist system was more stable than the
current one. It had a single currency, gold; today there
are three major currencies crashing against each other
like continental plates." - George Soros, The Crisis
of Global Capitalism
The three currencies Soros
was referring to are the US dollar, the euro and the
Japanese yen. And he is right. But the dollar's fate
will probably flow one way or another from China.
Now that you understand how deeply the United
States is entrenched in deficit, you can understand why
the US is pressuring China to "revalue" its currency.
The US does not have the political will to do what it
takes on the spending side of the equation to improve
its financial position.
"For the first time in
the post-World War II era, the United States faces a
future in which every major category of federal spending
is projected to grow at least as fast as, or faster
than, the economy for many years to come. That means not
just pension and health-care benefits for retiring 'baby
boomers', or increasing interest payments as deficits
and interest rates rise, but also appropriated or
'discretionary' spending for national defense, for
foreign aid, and for domestic homeland-security
programs," writes Peterson.
In a country where
voters know they can vote themselves the goodies and
have accepted the term "war on terror", it's highly
unlikely the US can get its fiscal side under control
for many years to come. Thus the howls for China to do
something with its currency grow louder.
is one major problem with the Chinese "revaluation"
scenario: There are no guarantees that once China allows
the dollar-yuan rate to move within a "more flexible
band" that its currency will appreciate against the
dollar or that it will significantly benefit US
manufacturers. Here are four reasons:
all, the chances of some type of big-bang revaluation in
the dollar-yuan rate are slim to none. Chinese
policymakers do not believe the yuan is overvalued. And
I believe the most they will do is slightly widen the
trading band around the 8.28-yuan-per-dollar rate that
Second, if China utilizes a
trade-weighted approach to calculating its trading band,
which is likely, because the US is the largest trading
partner, and because said band will move on a
trade-weighted value, not China's fundamentals, the
index will not fluctuate a great deal against the
Third, it's not necessarily a
differential in exchange rates that will solve the
competitive differences between China's exports and the
rest of the world. With China's abundant supply of very
cheap labor, state-of-the-art manufacturing capabilities
and world-class infrastructure, it will take much more
than a shift in exchange rates before the goods flow
comes into balance.
And finally, if financial
liberalization includes reducing capital controls, the
private sector has significant scope to raise its
foreign-currency holdings (of US dollars).
policymakers are depending heavily on a Chinese
revaluation and a corresponding improvement in the
balance of trade with China. But that dog might not
The dollar's Achilles'
"Causa remota of the crisis is
speculation and extended credit; causa proxima is
some incident which snaps the confidence of the system,
makes people think of the dangers of failure, and leads
them to move from commodities, stocks, real estate,
bills of exchange - whatever it may be - back into
cash." - Charles Kindleberger, Manias, Panics, and
Causa romota: An explosion of
credit from bank lending and fixed investment pouring
Causa proxima: A hard landing
"When the Asian financial crisis hit
in 1997-98, the US Federal Reserve tolerated a liquidity
boom that spawned the Internet bubble. When the Internet
bubble burst, the Fed tolerated another wave of
liquidity, which has led to the global property bubble,"
says Andy Xie of Morgan Stanley. I would say, "Bingo!"
The Economist magazine recently summed it up
this way: "China's boom is itself partly the product of
the Fed's super-lax monetary policy. With its currency
pegged to the dollar, China has been forced to import
America's easy monetary conditions. Its [China's] higher
interest rates have attracted large inflows of capital
that have inflated domestic liquidity, encouraging
excessive investment and bank lending in some sectors
which could lead to a bust."
With the Fed now in
a tightening mode, the music in China could soon end.
And the scramble "back into cash" from "commodities,
stocks, and real estate", as Kindleberger describes,
could soon begin. When it does, it's very bad news for
When the US financial markets cratered
in early 2000 after one of the biggest financial parties
in the history of mankind, the Fed quickly stepped in to
fill the void with liquidity. This is why the so-called
"emergency" Fed funds rate of 1.0% materialized. The Fed
made it clear to all it would err on the side of
creating global asset bubbles in stocks, bonds and real
estate to stave off the bogeyman of global deflation.
Well, the Fed succeeded beyond anyone's wildest
expectations at the time.
To get a sense of the
massive liquidity created by the Fed, consider that
Asian central banks are now sitting atop an estimated
$2.2 trillion in foreign-exchange reserves - double
their 2002 total. In other words, Asian banks were able
to recycle $1.1 trillion into US Treasury bonds -
driving yields lower and creating a virtuous circle for
US consumers - increasing US demand for Asian exports.
As Treasury bonds soared and US demand rose,
stocks revived. "It's the 1990s again," rattled the
talking heads on CNBC. But the big winner in this
liquidity game was global real estate. "The world is
sitting on top one of the biggest property bubbles in
history, with the biggest bits in China and the US, in
my view," says Xie.
is nothing new in what we are seeing in China. Massive lending
funneled into property and commodities speculation: it's the classic
boom-bust credit cycle. The late economist Ludwig
von Mises wrote:
The drop in interest rates falsifies the
businessman's calculation. Although the amount of
capital goods available did not increase, the
calculation employs figures that would be utilizable
only if such an increase had taken place. The result
of such calculations is therefore misleading. They
make some projects appear profitable and realizable,
which a correct calculation, based on an interest rate
not manipulated by credit expansion, would have shown
as unrealizable. Entrepreneurs embark upon the
execution of such projects. Business activities are
stimulated. A boom begins.Artificially low
interest rates in China have supercharged property
speculation. Entrepreneurs, savers, overseas Chinese
investors and international institutions have jumped
into this "easy" money-making game. It's reminiscent of
the "easy money" days trading the Nasdaq in 1999. The
human frenzy and delusion are similar in
Chinese government attempts to circumvent
the price system through central planning/rationing,
instead of market-based credit allocation through the
interest rate, are exacerbating the boom-bust cycle in
China. Inadvertently, they are sending the wrong
messages to the market.
"The boom can last only
as long as the credit expansion progresses at an
ever-accelerated pace," wrote von Mises. Fed tightening
is working its way through the global financial system.
Soaring crude oil prices are dampening growth prospects.
Property prices in Australia and the United Kingdom are
already falling. And policymakers are continuing to
apply the brakes in China where they can.
are the dynamics that scream for an eventual bust in
China. I believe this will be the catalyst for a dollar
crisis. It could be a wake-up call to US policymakers.
They may realize that ignorance is no longer strength
when it comes to the deficit. But by the time they act,
most of the damage will probably already be done.
Here's an indicator that may
help us with the timing of a fall in the dollar
(taken from Black Swan Currency Currents, October
US president Richard Nixon closed the
gold window in 1971, severing the link between the
dollar and gold once and for all. Robert Bartley,
the now-deceased longtime editor of the Wall
Street Journal and a brilliant man to boot, said
when the dollar went off the gold standard crude
oil went on the gold standard. He explained that
the oil crisis in 1973 was in reality a
foreign-exchange crisis (Money Bazaar,
Andrew Krieger). In other words, the Organization
of Petroleum Exporting Countries realized the
dollars it was receiving for its crude oil was
buying a lot less than it did before the gold link
with the buck was severed. Thus it was time for a
little price hike.
Okay, fast-forward. Oil
is still priced in dollars and now at an all-time
high, we all know that. But what is interesting is
that the real cost of oil, if we consider gold to
be the standard, is also close to an all-time high
(calculated by the number of barrels of oil one
ounce of gold will buy). This could have some
implications for the greenback.
Let's say you are in control of
the world's money supply. And you see that the
cost of oil is threatening global economic growth.
And let's also say that you keep an eye on gold
prices because you once wrote a paper extolling
the virtues of gold. And let us say your last name
starts with the letter G. Okay, the stage is set.
What do you do now?
Hmm, you're thinking:
if I can somehow get the dollar price of gold to
increase, it might take a lot of pressure off of
the global economy by reducing the real cost of
oil and clear the way for sustained economic
growth. If you're thinking that, then you're
thinking a weaker dollar.
Crooks has traded in global equity, fixed
income, commodity, and currency markets for more than 20
years. He is president of Black Swan Capital, a currency
advisory firm - BlackSwanTrading.com.
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