[Shadow_Group] Fw: Ominous: The US deficit vs the dollar

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Ominous: The US deficit vs the dollar
By Jack Crooks 

"Doublethink means the power of holding two contradictory beliefs in
one's mind simultaneously, and accepting both of them." - George Orwell 

The 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 doublethink. 

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" plunge.
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:
1) Imports of goods, services and income are 40% bigger than exports. And
this ratio is on the rise again.
2) Higher US interest rates will increase debt payments to foreign debt
holders.
3) Iraq war and redevelopment.
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 stock-market crash. 

Ominous parallels
"Economic history is utterly devoid of examples of current account
adjustments that are not accompanied by significantly weaker currencies."
- Stephen Roach, Morgan Stanley 

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: 

Then
 Now
 
Go-go '60s stock-market boom (conglomerates craze) '90s stock-market boom
(Internet craze)  
Vietnam quagmire & communist dominoes  Iraq quagmire & "war on terror" 
Soaring budget deficit  Soaring budget deficit  
Rising energy prices Rising energy prices 
Rising interest rates to stem inflation Rising interest rates to
"normalize" the Fed funds rate 
Soaring commodities prices (inflation driven) Rising commodities prices
(for now, supply/demand imbalance) 
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. 

The dollar 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 hunt 
"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. 

There 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: 

First of 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 now
exists. 

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 dollar. 

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). 

US policymakers are depending heavily on a Chinese revaluation and a
corresponding improvement in the balance of trade with China. But that
dog might not hunt. 

The dollar's Achilles' heel
"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 Crashes 

Causa romota: An explosion of credit from bank lending and fixed
investment pouring into China. 

Causa proxima: A hard landing in China. 

"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 the buck. 

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. 

There 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 tone.

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. 

These 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.  

Timing it right

Here's an indicator that may help us with the timing of a fall in the
dollar (taken from Black Swan Currency Currents, October 7): 

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.

 
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