A good starting place this week is the legislation introduced in the Senate (SB.1586) to add a 27.5% tariff to Chinese goods unless they allow their currency to float. This is bi-partisan idiocy of the first order, sponsored by three Democrats (Senators Schumer, Bayh, and Durbin) and three Republicans (Senators Bunning, Graham, and Dole). It is legislation like this that sometimes makes me despair for the future of the Republic. It is pandering of the worst sort.
As an aside, if legislators want to pander, I suggest they pass a Weather Equalization Act to mandate that the temperature in Texas during July and August average 75 degrees (that is 24 degrees centigrade in the rest of the world). They could pay for the costs of such legislation by passing a Windfall Savings Tax whereby Texans would pay half the savings in their air conditioning bills as a tax to offset the costs for weather controls. If we were to ship our excess heat to the Southern hemisphere via a new hemispheric tunnel, we could even make a profit! Plus, think of all the jobs such a project would create.
Since everyone in southern California would come to Texas were our weather more like San Diego, our home values would rise. Local property taxes would then increase, solving our various current local budget crises. Business would boom, generating increased sales tax. Summer tourism would increase. Tempers would fall, as would the summer murder rate. I can think of no one against a cooler summer in Texas, except the power companies, who would see sales go down. I suppose we could pass some law to help those poor utilities so they would not have to lay off employees and spoil the otherwise perfect plan.
Trying to legislate the value of the Chinese yuan is about as silly. Exactly what is this evil thing that the Chinese have done to warrant the attention of the Senate?
First, they fixed their exchange rate in 1994, and have not changed it since. How sinister to want a stable currency by fixing it to the dollar. Of course, it did not seem to help Argentina, but that's another story.
Second, they sell us goods at a price not only less than we can find elsewhere, but at one which we freely agree to pay. No nuclear threat. No economic blackmail. A simple free market transaction. In short, the Chinese are behaving like capitalists. I suppose the senators would like them to return to their communist economy? They were certainly no economic threat to southern manufacturing with Mao running the show. (All the Republican sponsors are from the south.)
Third, they have taken the dollars we have given them and actually had the temerity to invest it in US government treasuries, rather than buying our companies and real estate. They actually seem to trust the Fed a lot more than many of my readers. They take our largest single export item, an electronic dollar, which has dropped 40% against the euro, and give us all manner of goods. Somehow, Wal-Mart is now part of that vast Chinese capitalistic conspiracy, as that company alone sells $15 billion of Chinese goods a year. How cunning these Chinese are!
Last year, over $56 billion dollars was invested by non-Chinese companies (mostly Western) into China to outsource manufacturing. Their exports have tripled to $365 billion in less than ten years. Over two-thirds of that is because of foreign investment. How dare they create economic conditions which force companies all over the world to invest tens of billions? Using competitive advantage is clearly something that only western nations can do in the eyes of these senators.
It would be helpful to remember at this point that while China is significant and growing, it is not all that large on the world economic scene, at least not yet. The US trade imbalance with China is about 1% of our GDP. Their entire foreign sales are less than 4% of US GDP.
Workers of the world, unite!
And the US senate is watching jobs move offshore. The data shows that August was more of a problem than we thought, and studies last week showed the 3,000,000 or so jobs we lost are not coming back. We are going to have to create whole new industries if we want to see large growth in unemployment.
What's a Senator to do? We have to show we care. Let's blame someone besides ourselves. Instead of getting rid of laws which hinder job growth, capital formation and entrepreneurs, let's see if we can destroy the economy of the world.
In 1930, two well-meaning US legislators named Smoot and Hawley persuaded Republican President Hoover to pass the Smoot-Hawley Act, which raised tariffs on foreign goods in order to protect American jobs. It started a world-wide trade war and turned a normal business cycle recession into a world-wide depression and led to the ripe conditions for WW II. The law of unintended consequences was never more harmful. Protecting a few American jobs ultimately cost millions of lives, both American and all over the world. There are certain aspects of US history I expect US senators (at a minimum the Republican versions) to know and religiously avoid. Starting a global trade war is one. Elizabeth Dole, ask your husband about international trade before you take such dangerous actions. Senators Graham and Bunning, you know better. Shame on you!
I am only mildly concerned that such legislation would violate all sorts of international trade treaties. I am significantly concerned that such an action would precipitate another world wide trade war. I have noted on a few occasions that a move on the part of the world economic powers to protectionism would quickly abort a Muddle Through Economy. Nothing could trigger a true and lasting Depression faster than the action suggested by Republicans Bunning, Graham and Dole.
What does such action say to third world countries that are coming to the next round of free trade talks in Cancun? Are we for free trade or not? Is free trade with the US ok, as long as you are not too successful? Is it OK for everyone else to change, just as long as the US does not have to? That it is ok to be protectionist when it is local jobs?
The steel tariffs that Bush '43 passed last year have cost the US far more jobs than the few thousand they have saved. US citizens pay far more for cars and other items which contain steel than the few dollars we get in tariff income. You do not mess with the free market without cost.
What the senators are saying is that they oppose a strong dollar. Of course, their press relations personnel would deny this. They would note they simply want a stronger yuan. But given the direct link between the Chinese currency and the rest of Asia because of competitive currency devaluation, when the Chinese allow their currency to float, the rest of Asia will rise and fall along with it.
What these senators also are saying is that they want the US consumer to pay more for their foreign goods. They want prices to rise and life-styles to diminish. They want to protect their voters from the forces of change. Why don't we outlaw tractors? We could create lots of jobs if we had to plow fields behind a mule. Let's legislate no more change in the US.
To my foreign readers who wonder about such things, let me explain this action. It is called pandering to the voters. Like my mythical Texas weather bill, each of these Senators knows there is no chance in hades of Bush signing such a bill, nor of it even getting to the Senate floor. But since their local manufacturing companies are losing jobs to China, this is a way to "show they care." They get local favor without having any real consequence attached to their actions.
Even if somehow they were to get such legislation passed, it would make no difference (apart from creating a Depression). As Stephen Roach of Morgan Stanley notes, if it were not the Chinese, it would be some other country with whom we have the deficits. Do we pass legislation against those dastardly MBAs and phone workers from India next?
The US is running a monster federal deficit. Someone has to buy that debt. Either US citizens must save enough to do so, or we must buy lots of "stuff" from overseas from countries who will buy our debt. The equation between national savings and national debt must balance. That is a basic economic fact. I am working on the last chapter in my book which tries to explain this equation in simple terms, and I will give you a summary when I get it done. The upshot is that we cannot continue to see our twin deficits grow ad infinitum without real consequences. There will be an end to this trend, and no legislation, short of a balanced budget, will be able to avoid the consequences.
Who Really Owns the Debt?
Today, we read in the Financial Times that foreign countries now own 46% of US foreign debt not owned by the Fed. The US trade deficit over the next two years will be over $1 trillion dollars, so foreign debt holding must rise to even greater proportion. The "good news" is that since the US federal deficit seems to be rising faster than our trade deficit, there will be plenty of US treasury bonds for the Chinese and the rest of Asia to buy.
As long as Asian nations continue to buy US debt the dollar will remain roughly where it is today in regards to those currencies. Each individual nation believes it is in its own national interest to buy dollars, even though they know they are worth intrinsically less as we export more of them. Why do they do so? Because they want to keep selling goods and services to us to support their own economies. They clearly believe (or at least the politicians and those who control them do) that they would be worse off if they were to sell less to the US, even if the dollars are one day going to be worth less. It is a national equivalent of the "burning match theorem."
They all fear to let their currencies rise as long as their international "competitors" for the US consumer do not let their currencies rise as well.
This makes goods and services in those foreign nations cheap in terms of our dollars, and thus we see jobs leave the US. Thus the Senate angst and the target of their concern: those mean foreign nations who buy our government debt.
Why not target the Japanese, who are actively manipulating the yen? The Chinese merely maintain a ten year status quo, after all.
It is what Robert Alan Feldman (Morgan Stanley in Tokyo) calls a "sub-optimal Nash Equilibirum." This is in reference to a theorem by John Nash (which he termed his most trivial), which won him the Nobel Prize. The recent movie, A Beautiful Mind , was made about Nash. (Rent it if you have not seen it.)
A Nash equilibrium, is a set of strategies, one for each player, such that no player has incentive to unilaterally change her action. Players are in equilibrium if a change in strategies by any one of them would lead that player to earn less than if she remained with her current strategy.
The nations of Asia and the US are in a weird sort of equilibrium. None of them seem to feel they have an incentive to act first to change their policies. Yet the stand-off means that foreign nations take more dollars which will ultimately buy them far less than what it will today. And the US sees jobs go to foreign soil. This does not seem to be an optimum
Actually, if the Senators really thought further than their next election (which may be asking too much from some of them), they might require the Chinese to maintain their currency controls. Quoting Feldman:
"My own epiphany came from a chat with a Chinese economics professor a few weeks ago. When I brought up the issue of ending the RMB peg, he astonished me by saying that ending the peg would cause a massive RMB De valuation. Why? Because people in central Chinese provinces in particular would rush to buy dollars. While simple comparisons may not be valid, it is important to remember that about 50% of deposits in Hong Kong are in US dollars, and a similar level in Taiwan. The levels of such deposits in China are currently estimated to be about 10%. At the least, these figures require us to take my professor friend's hypothesis seriously."
Let's look at yet another aspect. Most commentators, myself included, assume that when the Chinese revalue their currency, the dollar will drop significantly. But what if, as they float their currency, they also allow Chinese citizens to invest overseas? Might prudent investors wish to diversify? Would they buy US government Treasuries? Very doubtful. Or would they buy actual income producing property and businesses, just as businesses and investors all over the world do? Would they seek outlets they control in the US for their products?
Far-fetched? Outrageous? Think Japan and 1969. We laughed then. Detroit, among other industries, is no longer laughing.
There is always an end to every trend. We cannot grow our government and trade deficits at the current pace for too many more years. The stock market cannot grow faster than GDP plus inflation over long periods. At some point, one of the participants in what Greg Weldon calls the Competitive Currency Devaluation Raceway will exit the track. The dance to find a new equilibrium begins. The longer this takes to come about, the more difficult it will be to find an equilibrium which will make for a smooth transition. Indeed, I fear we are already past that point.
The real race is between this "new equilibrium" and continuing employment declines to see which triggers our next recession.
A Single Flight of Planes
As I read the moving words written everywhere on 9/11, I was struck by the quotes that Art Cashin brought to my attention written by E.B. White more than 50 years ago for the New Yorker. It was written as the UN building was rising and the threat of nuclear war was first making its way into our national psyche.
"The subtlest change in New York is something people don't much speak about that is in everyone's mind. The city, for the first time in its long history is destructible. A single flight of planes no bigger than a wedge of geese can quickly end this island fantasy, burn the towers, crumble the bridges, turn the underground passages into lethal chambers, cremate the millions. The intimation of mortality is part of New York now; in the sound of jets overhead, in the black headlines of the latest edition.
"All dwellers in cities must live with the stubborn fact of annihilation; in New York the fact is more concentrated because of the concentration of the city itself, and because, of all targets, New York has a certain clear priority. In the mind of whatever perverted dreamer might loose the lightning, New York must hold a steady, irresistible charm.
"....New York is not a capital city - it is not a national capital or a state capital. But it is by way of becoming the capital of the world....This race - the race between the destroying planes and the struggling Parliament of Man - it sticks in all our heads."
"The city at last perfectly illustrates both the universal dilemma and the general solution, this riddle in steel and stone that is at once the perfect target and the perfect demonstration of nonviolence, of racial brotherhood, this lofty target, scraping the skies and meeting the destroying planes halfway, home of all people and all nations. Capital of everything, housing those deliberations by which the planes were to be stayed and their errand forestalled."
A Question for my non-US Readers
I started putting the letter onto the internet with a few thousand readers back in the fall of 2000. Today, we are pushing 2,000,000 weekly readers. Essentially, the letter is my way to discipline myself to focus on what I think are the more important themes from the several hundreds articles, letters, and various publications I read each week. That is also why the topics are so varied.
My policy is that the letter is free, and anyone can use it however they like, quote it freely to their heart's content, as long as they mention the website. Scores of readers have asked to use it on their sites or on private bulletin boards. Larger publishers use the letter (or parts of it) to send to their lists, adding advertising or simply as a service.
I note with some amazement the growing number of non-US readers. I am told that beginning in a few weeks, my letter will be translated into Greek and available on a major Greek investment web site. I find my letters sometimes translated into Russian (thanks, Dmitri) and on well-trafficked Swiss and German sites as well as other international portals. Go figure. It is all somewhat humbling, and a lot of fun.
Now I want to briefly ask my non-US readers for some help.
Many readers write and ask about specific investment recommendations. Frankly, most of what I do involves private offerings, hedge funds and other types of alternative investments, about which I can say nothing in a public forum like this. If you are an accredited investor (generally, individual net worth exceeding $1,000,000 ), you can go to www.accreditedinvestor.ws and sign up for my free letter on hedge funds and private offerings. Please read all the material on the site so you can understand the process, especially the part about the risks associated with investing in hedge funds. (I do not like to limit the letter based upon net worth, but there are very specific regulations about who can get information about and invest in private offerings. I always follow the rules.) (John Mauldin is a registered representative of the Williams Financial Group, an NASD member.)
The "problem" is that about 15-20% of those who ask for such information are not US citizens or residents, and the number of such requests is starting to become significant. As noted above, I am registered in the US with Williams Financial Group (an NASD member) as a broker. My firm, Millennium Wave Investments is registered as an investment advisor and as a CTA/CPO (Commodities Trading Advisor or Poll Operator) with the NFA/CFTC (National Futures Association/Commodities Futures Trading Commission). I expect to soon be an IB, or Introducing Broker (again, commodities). All of these registrations are necessary for me to legally be able to do business in the US. Trust me, you do not do so for the fun of it.
The problem is that I do not have any registrations outside of the US. If, for instance, a citizen of Brazil, Botswana, Bahrain or Belgium (to use the "B" countries) asked to see my accredited investor letter, I am not sure what the legal requirements in those nations are for me to send you information. Would I violate some local law? If I partnered up with a local firm to represent the funds I find of interest, what registrations, if any, would I need? Is it legal for me to give that name (with the reader's express permission) to a Swiss banker or other international brokerage firm in another country? In legal terms, would the authorities in a particular country deem me to be "holding myself out as an unregistered investment advisor" simply because I am on the internet and communicate with one of their citizens if they invest in a fund which I recommend? Is registration required in Bahrain or Botswana or Brazil (I know it is in Belgium, but not the details)? Or any of the multiple scores of other countries from whom I get requests?
There is no problem with my regular weekly letter, as it does not have information about specific private offerings, securities or investments with which I may have an association. The tricky part comes when I take off my journalist/analyst hat and actually try to make a living.
Most of the funds I work with have offshore (to the US) versions. Are there restrictions on such within your country? Does one have to have a certain level of net worth to invest in private funds? Is working with local partners sufficient? Do you need local partners or is it possible to communicate directly (and legally, of course) with you?
This has been brought to mind many times, as I get letters from non-US citizens asking me why I can't send them my letter on private funds and offerings? Some of you get more than a little irate, thinking I am some parochial US-centric analyst. What I really am is slightly paranoid.
I suppose I could set up an offshore brokerage firm, work with those of an international persuasion and ignore the rules in the various countries, as some firms do. The argument is that since a person from a particular country could contact my firm that would mean I did not do business in their country. Many attorneys make such arguments, if you transact your business in such and such a manner. I am not persuaded that local regulators would buy such an argument. I certainly would not want them complaining to any of the above groups which regulate me in the US that I was doing business illegally in their country.
So I ask the following questions: Does anyone know of a paper or document which details the rules in non-US countries? Do the local laws require that I must work with a local firm? Are their local firms within a country who would like access to my research and funds and with whom I could "partner up?" Which countries are "wide open" and have no securities laws and which have specific and strict rules? Do you know the rules in your country? Does a private fund have to register in your country to be sold to one of your citizens? Do you have private offering rules?
Thank you for sending me any information you have, and any such communications will be kept confidential.
As promised last week, here is a link to the web page for the New Orleans conference October 29 through November 1. Join me, Bill O'Reilly, Richard Russell and Jim Rogers, plus a host of excellent investment analysts at one of the more fun events I attend each year. http://www.neworleansconference.com/event/faculty2003.htm#mauldin
I will be in Chicago October 8 and New York around November 12. My bride informs me my presence is requested(!) in Puerto Vallarta in mid-October. My publisher informs me my book is due, I am way behind on the next accredited letter I mentioned above, I need to get into the gym more and my son tells me to stop writing and come home as it is time to go out. I see meat and movies in my very near future.
I just re-read this letter for the final time. I seemed to have let myself get a tad worked up. Life can't all be Muddle Through.
Your running as fast as my puppy dog legs will take me analyst,
Did someone forward this article to you?
Click here to get Thoughts from the Frontline in your inbox every Saturday.