GOOD DEBT, BAD DEBT
by Lynn Carpenter
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.
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.
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.
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.
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...
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.
Regards,
Lynn Carpenter
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. |
