The Curme-udgeon Column:
Has the Tipping Point Arrived?
The
American economy has been uncommonly resilient of late, not in least measure
due to the machinations of Alan
Greenspan. Yet, underneath the calm surface of rosy economic
reports there are seismic economic tremors, warning of tidal swells of impending
economic doom. The US Trade Deficit
hit a record $66.1
billion in September as imports surged and exports slumped 2.1%, the largest
drop since September 2001. The trade
deficit hit a record 6.3%
of GDP in the second quarter, a level that has typically led to financial
crises in other countries with structural imbalances. This has led such notables
as Paul
Volcker, the Organization
for Economic Co-operation and Development, and the International
Monetary
Fund to warn that we face the risk of a dramatic drop in the dollar, sharply
higher interest rates, and a severe worldwide recession. As if that weren’t
enough,
the American consumer, the juggernaut of worldwide consumption
is suffering a double whammy from the price spikes in gasoline and natural gas,
which together are taking an annualized $140
billion out of the pockets of consumers. Consumers are so stretched, the
personal
savings rate has
turned negative for the last four months. This
hasn’t happened since the Great
Depression of the 1930’s. In addition to already higher short-term
interest
rates,
inflation
is
eroding
consumers’ purchasing
power, rising to
a 14 year high of 4.7% in
September. And there are signs that
the engine of consumer spending, increasing housing prices that allowed consumers
to pull $1.1
trillion of cash out of their housing equity through refinancings in 2003
and 2004, is finally drawing to a close as the housing
bubble bursts.
Are we at the Tipping Point, the apex of the financial roller coaster, about to plunge down into a gut wrenching economic decline? Let’s see.
Twin Deficits: Mary-Kate and Ashley?
What are the Twin Deficits anyway? Words so often seen in the business section, but quickly skipped over in pursuit of the comics. The Twin Deficits refer to two very separate things: the Government Deficit, and the Trade Deficit. Let’s take the easier one first.
The government deficit is simply the amount of money that the government spends in excess of its income. The trend over time is shown below:
Aside from a brief incursion into surplus territory during Clinton’s reign, but brought about by Greenspan’s stoking of the money supply and the resultant tech stock bubble, our government has been in chronic deficit for a generation. Each year’s deficit just adds to the total government debt, which as of today is just a little over $8 trillion. Big deal, so what? We’ll talk about future deficits later.
The trade deficit is more complicated. It represents the net of exports minus imports. Unlike the government deficit, this has been getting worse over time:
Again, why should we care that we’re importing $800 billion dollars more than we’re exporting this year? The answer is that our trade deficit absorbs 80% of the world’s savings. How? Well, let’s say I buy a T shirt that was made in China. Eventually the Chinese exporter gets paid for the T shirt, and he is paid in dollars. He has no use for dollars, so he goes to his bank, and converts the dollars to yuan. The bank has no use for dollars either, so it gives the Chinese government dollars and gets back yuan. The Chinese government likes dollars, because they add to its stock of foreign reserves, kind of a nest egg that increases its protection in the case that the IMF or World Bank ever try to savage its currency (as happened to other Asian countries during the Asian currency crisis of 1997). Now the Chinese government doesn’t want cash, it would prefer to own something that pays interest, so it uses its dollars to purchase US Government bills and bonds, or agency paper (Fannie or Freddie), or maybe even corporates or Unocal, but mostly US bonds. China holds $248 billion of US Treasuries, second only to Japan’s $684 billion. (For a breakdown of all foreign holdings of US assets, see Report of Foreign Portfolio Holdings of US Securities, page 16). Net net, the trade deficit increases the amount of US debt in foreign hands, and increases the chance that foreigners will sell that debt, causing a sharp rise in interest rates, dollar depreciation or both.
Aren’t These Concerns Just Theoretical Bunkum?
No, we’ve seen this movie before. In 1985 the US current account deficit (trade deficit plus net investment income) was 3.4% of GDP, and the newspapers were filled with warnings about the deficits. Between 1985 and 1987 the value of the US dollar versus the German mark and Japanese yen plunged by 50%. Yet the world didn’t end. American exports surged, and the three leading economies (US, Germany, Japan) grew between 1985 and 1990 by 3.4%, 4.9% and 3.1% respectively. The US current account declined to 1.4% of GDP in 1990.
So Will the Dollar Decline by 50%?
History rhymes, but doesn’t repeat. The US dollar fell 40% against the euro between 2002 and 2005:
However, the dollar’s trade deficit only got worse. Part of the reason is that China fixes the value of its yuan against the dollar, and the 2.1% increase in the value of the yuan against the dollar earlier this year had little effect on the US/China trade deficit, which is on track to reach $90 billion this year. And the dollar has strengthened against the euro over the past six months. Why would the dollar strengthen if the trade deficit is so miserable?
Perhaps the dollar responds more to
interest rates than trade deficits.
As seen in this “Shifting View” chart, the dollar cratered when US interest rates fell dramatically below European rates in 2001. And the dollar recovered this year as US rates rose above European rates. Both Japan and Germany have strengthening economies that are likely to lead to increased interest rates. But as long as the US raises rates ahead of the rest of the world, the dollar is likely to remain relatively strong.
What About Debt Trap Dynamics?
What’s a debt trap? It’s when the interest rate on a country’s debt exceeds the country’s growth rate. Over time, the country’s debt will grow and grow and eventually spiral out of control. With $8 trillion in government debt, and 4-5% interest rates, some think the US debt could soon spiral out of control. But that’s a little extreme. For one thing, the US government itself owns $3.4 trillion of its own debt as an “investment” to pay for things like Social Security. But nobody in America thinks our government can pay Social Security to all the baby boomers, so you can ignore that debt. If you look at the US 2006 Budget, you can see that interest on the government debt in 2004 was $160 billion, only 7% of government outlays in 2004. (http://www.gpoaccess.gov/usbudget/fy06/pdf/hist.pdf, page 56)
Subtract out the interest the government paid itself, and interest on the government debt drops to $92 billion. That’s less than 25% of the $455 billion the US spends on the DoD, and only 6% of the $1,455 billion the US spends on “Human Resources” (Social Security, Medicaid, transfer payments) which are more easily reduced in times of need. Even if interest rates double or triple the US debt service, it’s chump change compared to lots of discretionary budget cuts. After looking at these numbers, I don’t worry about a depreciating dollar, or whether the US will pay me Social Security.
Should I Worry About the US Economy?
The US economy is one thing I do worry about. Consumer borrowing surpassed government borrowing in 1999. While the government can increase taxes or cut services, the US consumer has fewer options as interest rates go up.
Credit card and car debt is dwarfed by housing debt, which has increased 42% since 2001. Again, we can thank Alan Greenspan and his low rates for encouraging the housing bubble. Nobody really knows how much longer the housing bubble can continue. However, I wouldn’t count on increasing housing prices for much longer. Increasing long and short interest rates are quickly raising mortgage servicing costs. As much as 50% of the new mortgage debt accumulated over the past year in such hot markets as California has been adjustable rate, or interest only. As higher rates, inflation, and higher energy bills start to pinch consumers’ pockets, they will be disinclined to stretch for that extra big mortgage. This will, in turn, cut consumer spending since enormous sums ($640 billion last year) of mortgage debts were cash outs. And consumer spending is the foundation of this economy. 70% of America’s GDP is attributable to consumer spending, the highest factor ever recorded by a major industrialized economy. With a negative savings rate and a faltering housing bubble, it looks like this economy is in trouble.
Fortunately, reduced consumer spending is just what the doctor ordered with respect to our trade deficit! In a bad economy with higher interest rates, consumers will be more prone to save than spend, thus driving the savings rate from negative territory toward the 7.5% of GDP average over the past 40 years. There may be other good news: America consumes 25% of the world’s oil. A strong recession may cut oil consumption, thus moderating energy prices. The US government is not likely to suffer unduly in a recession. Peruse the budget tables (page 25) and you’ll see that even during severe recessions, government receipts seldom drop by more than 10%. Finally, the conventional wisdom is that if the US sneezes, the rest of the world will catch cold. However, Germany and Japan are growing in part due to healthy trade with China, which has been growing a 9-10% rate for years. And with the US/China trade gap of only $90 billion this year versus a US trade deficit of $800 billion, a slowing US may only moderate growth in rest of world. So let’s tip a glass and celebrate the strength of the US dollar, as our trade deficit moderates and our economy tips over.
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Ollie Curme
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