Do Trade Deficits Matter?

For the past four weeks we have looked at two rather remarkable books with very different conclusions. Charles and Louis-Vincent Gave and Anatole Kalestsky suggest in their book "Our Brave New World" that given the new financial era trade deficits do not matter, that debt is not a problem and that the long-term future of the US is particularly bright (although elsewhere they think the US will see an economic slowdown next year).

Bill Bonner and Addison Wiggin have the opposite argument staked out in their new book "Empire of Debt." They subscribe to the Austrian economic view that booms should come from savings and investment and that production and sales of goods are the driver for true economic prosperity. They think the rise in all kinds of debt in America combined with a lack of savings is producing a false boom. Further, as we borrow from abroad to finance our consumption, we will find we no longer owe ourselves but foreign nations who will require payment.

Today we start what will be at least two weeks of my response to these books. I have been taking notes and thinking about these letters for over a month. There is much more required than a simple one week response. Understanding this debate is one of the more important topics we will discuss this year. Ultimately, the value of nearly every investment you make is linked in one way or another to these questions.

But first, this note from my daughter and business associate (I must plead guilty that one of the great pleasures of my life is to have my daughter work with me).

"I have a confession to make. I didn't finish all of Dad's last book, Bull's Eye Investing.

"Motivated by a tiny bit of guilt, I took his new book, Just One Thing, to the gym this week. (I have learned from my Dad during our "working lunches" that it IS possible to read and walk on a treadmill at the same time!!!)

"Where to start? Do I read Dad's chapter first, Bill Bonner's (as I love to read his thoughts), or maybe Mark Finn (to look smart if someone is looking over my shoulder)?

"I settled on the tried and true, start-at-the-beginning philosophy with chapter one, Andy Kessler on Signposts in the Fog. Just a few pages in, I found myself nodding with his point as it applies to investment theory, but then sideswiped with an "aha" moment when it became clear I could apply it to other areas in my life. I live for those kinds of moments! "I got my Just One Thing (thanks Andy) and I have only read the first chapter! While Dad is finishing up this week's e-letter across the hall, my copy of Just One Thing is about to accompany me to the gym so I can read Chapter 2!

"There is still time for you to give an "aha" moment as a Christmas gift, or when the Holiday rush calms down and the new gadgets you received start running low on batteries, it will be there to provide some inspiration for the new year."

You can order Just One Thing by going to www.amazon.com/justonething.

Where Do We Go From Here?

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.

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.

Betting the Farm

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 which will save us from ourselves? Does the massive debt we are accumulating, both internally and abroad, matter?

I have been getting a lot of mail about this series. One Greg Payne writes: "You dismiss the possibility of gold reemerging as real money: 'does anyone really think a major central bank or government would so hobble itself? At least willingly?'

"Of course not. But do you really think that a central bank or government who have come to believe the solution to every type of ill is printing more money will be able to achieve their desired ends for ever? That is do you - not the central bank - believe that printing money is in fact a solution and will help the economy 'muddle through' to use a favorite phrase of yours? The greater the debt balances that are allowed to build without allowing natural cyclical and structural forces to work through the global economy, the less likely it is that your scenario of muddle through will play out.

"You dismiss the ideas of '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' as apparent fantasies. But where is the real fantasy here? Isn't the real fantasy an economy that can be healthy even while borrowing increasing amounts to deliver increasingly meager GDP gains? Isn't the fantasy to imagine that a society can become wealthy through borrowing to fund consumption? Isn't the fantasy a 'sustainable and productive' American (and Western) economy that is increasingly engaged in nothing but retail, housing and financial paper games?

No, Greg, 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 by prosper. That is not to diminish the pain felt by many during those crises, or the losses in investment portfolios.

There will be plenty of problems in the future, but there will also be lots of opportunities. I am looking at two new private ventures right now which I think have real potential. I am sure I will find more as the years go on. We need to remember that the world will not end even as we discuss the problems we face during what will be an uncomfortable period of rebalancing for many people. The trick will be to insulate yourself as much as possible from the effects of a future crisis.

As I concluded in my chapter on The Millennium Wave:

"Albert Wang in an article in the 2001 Academy of Sciences Journal of Financial Intermediation shows us that a cautious optimism is the appropriate approach. Wang uses evolutionary game theory to study the population dynamics of a securities market. In his model, the growth rate of wealth accumulation drives the evolutionary process, and is endogenously determined (by that it means that only the data and not some outside factors influenced the determination of winners and losers). He finds that neither under-confident investors nor bearish sentiment can survive in the market. Massively overconfident or bullish investors are also incapable of long run survival. However, investors who are only moderately overconfident can actually come to dominate the market!

"In the world of our ancestors, overconfidence would get you killed. Lack of confidence would mean you sat around and starved. Cautious optimism was the right approach!

"And it still is.

"The Millennium Wave is also going to offer the greatest investment opportunities ever seen, as whole new companies and processes are created. Of course, this mean that what Schumpeter called 'creative destruction,' will be in full force, as many companies become the buggy whip manufacturers of the new century. Taking advantage of all these changes will require a nimbleness and an ability to make decisions, rather than passively investing in indexes, which will reflect the companies that have already become large or are getting ready to go the way of dinosaurs.

"Change. You'd better get to know and love it. It is coming. That is one thing that is for certain will not change."

The Kindness of Strangers

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 US consumer to buy their products and keep their factories humming. It is this symbiotic relationship that has allowed the US 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 US, arguably one of the safest places in the world. Further, US 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 their not a limit? The answer is "of course there is." (Though I should note that foreigners bought $107 billion of US 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.

We've Got "Yu" Under Our Skin

GaveKal would argue differently, that the dollar will get stronger. They agree with Andy Kessler that "we think, they sweat." And maybe to some extent that is true. But what does that have to do with the value of the dollar? It is a medium of exchange, nothing more. I cannot find some intellectual component to our currency. It is supply and demand. And when they get too much supply, the dollar will fall. That may be a long time, but as we read below, it will come.

I bring this latest bit of worrisome news about China (and the subheading) from a note from Dennis Gartman last Wednesday. A Mr. Yu Yongding, an official from the People's Bank of China commented on China's monetary reserves.

"Firstly, for example, Mr. Yu said regarding the need for China to reduce its holdings of US dollar reserves, 'in the first stage we must reduce accumulation, then later we should reduce our reserves.... [China and Asian countries] don't need that large an amount -more than $2 trillion- of foreign exchange reserves.... This is a very big problem and I think the Chinese government should take some action to reduce the growth rate of the accumulation of foreign exchange reserves as we're still facing the possibility of a big devaluation of the US dollar, so the capital losses will be huge. If that happens, it will be a tremendous hit to the Chinese economy.

"This is hardly the statement of a gentleman with a benign view toward the US dollar's valuation. It is instead a gentleman, in a position of authority, with a great deal of concern. He went on:

" 'The trouble is, with such a huge amount of foreign exchange reserves, that there is no way to spend it very quickly and there's no plan to sell it of course-- otherwise that inflicts damage on ourselves. You don't want to dump shares when the stock market has not collapsed yet and you are the biggest shareholder."

" "Then,' he said, 'all east Asian countries have tremendous foreign exchange reserves and they all want to get rid of them, but if you do this then you cause competitive devaluation, not of their own currencies, but of the US dollar. So we should do this in an orderly fashion. If Asian countries moved too fast, everyone would lose... It would be utterly unfortunate if Japan sells a proportion [of their reserves, for] that causes problems. Then China panics and China sells a proportion-- it would be very damaging."

"At this point," noted Dennis, "we were preparing to pour ourselves a double hemlock on the rocks, for the world looks bleak indeed, and we were glad simply to have covered our long dollar positions when we did. It then got worse still, for Mr. Yu suggested that the 'nicest possibility' for China, Japan and the US to escape this problem was for