In the past week, I have been in the car coming home late from work, with the presidential debates are on the radio. It is very discouraging to listen to what passes for economic literacy among the candidates. In reality, many candidates are espousing policies that are quite dangerous at worst, or simply misleading at best. Far too many in both parties tell a frustrated America what it wants to hear, rather than the economic reality. The Republicans have some of the worst offenders.

So, today we will look at some economic reality. We tackle trade deficits, the dollar, taxes (the "Fair Tax"), how should we stimulate the economy as we slip into recession, and global trade. I think we will cover enough that I can just about guarantee to offend most of my readers at some point. But the main point I want you to take away from all this is that the simple one-line answers given at these debates might work to fool most of the voters and tell them what they want to hear, but they are not based in economic reality. While this is of more interest to US citizens, the principles apply across borders. So, let's jump right in.

The Reality of Trade Deficits

The trade deficit jumped this month by almost 10%, to $63 billion. To hear the candidates talk, we can lower the deficit by forcing China to allow its currency to rise, increase our exports because of a lower dollar, stop our dependence on high-priced foreign oil, etc. Whatever the problems are, they are not of our making.

Let's look at the reality. I asked my friends at Plexus to create a few charts for me. First, let's see if a lower dollar will have a major impact on the deficit. The deficit is in red, and the numbers for the dollar index are on the right. Notice that from 1992 until 2002 the dollar got stronger and the trade deficit rose. Of course, there was the period from the end of '93 until '95 where the dollar dropped almost 20% and had seemingly very little effect on the trade deficit.

Now notice that from 2002 until the present the dollar has gone down and the trade deficit has exploded. If a weaker dollar were the answer, then one would expect the trade deficit to improve. Yet, the deficit has roughly doubled since 2002 while the dollar has dropped by more than a third. Using a trade-weighted dollar index would produce the same visual results, although the trade-weighted dollar has dropped by "only" 25%.

As I have maintained for years, I expect the Chinese to allow their currency to rise slowly. By the time the next president can have a foreign policy team in place to focus on the issue, the Chinese will have allowed the yuan to rise another 15% or so. This will bring it very close to the 30% increase in valuation that the China hawks in Congress have been wanting. The reality will be that the Chinese will have done almost all the heavy lifting within 18 months.

What will be the result? It means that the $325 billion in goods and services that we buy from China will cost us 10-15% more than it does now. Will we buy 15% less? Not if that is how we want to spend our money. And that brings us to the next chart. While there is not an exact correlation, the trade deficit rises as consumer spending rises, which makes sense if you think about it.

Want to see the real problem at the root cause of the trade deficit? The one that candidates absolutely cannot mention from the debate podiums? Look at the next chart:

No, the simple answer is that the trade deficit is not going to come down until the US starts to save more and spend less. In 1992, consumer spending was a little over 65% of GDP. It is now closer to 72%. Savings are down from 8% in that time, to barely above zero. If US consumers simply saved 5%, as we did 10 years ago, the trade deficit would come down by a lot.

But it would not go away, because we, like all developed countries, are addicted to energy consumption, and for now that means oil. We imported $34 billion in petroleum products in November, a jump of 10% over the next highest month on record. (By the way, you can get 47 pages of small-print numbers on all aspects of trade at the main web site at the US Census Bureau at http://www.census.gov/foreign-trade/Press-Release/current_press_release/press.html. The data I cite is from there.)

In large part, that is because of soaring oil prices. But it may get worse. We actually imported less oil in November in terms of barrels of oil than the average for the last year, but the price was up from an average of $72 in October to almost $80 in November. Oil at $95 has not yet made it into the actual price. Another $15 a barrel could add as much as $50 billion to the annual trade deficit.

That means oil alone will soon be more than 60% of our trade deficit, if oil stays above $90 a barrel. Hard to cut the deficit with a lower dollar if we keep buying expensive oil.

Some random items from pages 21-22 of the report. We imported $193 billion in autos for the first 11 months of the year. $618 million in sugar. $118 billion in TV's, VCR's and other electronic gadgets. We imported $219 billion just in crude oil.

Quick: who's our biggest trading partner? Canada, by a wide margin. We import almost the same from Canada as we do from China ($289 billion to $295 billion), but we also send them $229 billion. Yes, we ran a trade deficit with Canada of $59 billion for the first 11 months of the year. ($67 billion with Mexico.) The rapidly rising Canadian dollar has barely made a dent in the deficit. Yet Senators Schumer and Graham (bipartisan economic illiterates) think a rising Chinese currency will lower the trade deficit with China when it has done no such thing with Canada, and dropped the $112 billion deficit with Europe by just 10%, almost entirely composed of lower imports and only a little by increased exports.

And yes, our deficit with China is going to be in the $260 billion (annualized) range. Dropping that by 10% would not change the deficit that much. You reduce the trade deficit by spending less and exporting more.

However, we would have to grow exports by 90% to balance the trade deficit. Exports are up by 12% over a year ago, and most categories are up, but it is simply not realistic to think we can grow our way out of the trade deficit.

The heavy lifting on reducing the deficit is going to be by a reduction in spending. And that is only going to happen when people realize they have not saved enough for retirement and their homes are not a piggy bank that can be cashed out for retirement. And reduced consumer spending will not happen on just imports. It will be across the board and a drag on the economy. Wishing for a lower trade deficit may bring along problems that are not mentioned in the debates.

Yes, if we can develop coal-to-natural-gas technologies (there is considerable hope on that front), bio-fuels (not ethanol, which is a really bad idea, unless you grow corn) and a conversion to electric-based cars, the developed world can rid itself of oil addiction. But that is going to be at least 10 years down the road, if not a lot longer.

So, the next time some candidate says we have to lower the trade deficit, ask him how he plans to do that. Exactly what policy is going to make a difference, unless we erect trade barriers? See if the candidate says we need to spend less.

Fair Tax Nonsense

The only candidate I will specifically mention is Mike Huckabee. His espousal of the Fair Tax demonstrates his lack of understanding of reality and economics. Basically, Fair Tax proponents want a 23% sales tax to replace every type of government tax. No more income, corporate, social security, or Medicare taxes. And everyone gets a $5,000 or so "prebate" which covers the taxes up to the poverty level. What could be simpler or more fair?

No one would like to get rid of the IRS more than I. I spend way too much on accounting for taxes and such. But this is not the way to do it.

First of all, the 23% they talk about is really 30%. Under the proposal, if an item sells for $100, then $23 of that would go to the government (said to be tax-inclusive). That means the item really costs $77 and the tax is an additional $23 or about 30% (said to be the tax-exclusive rate). Add an average 7% for state sales tax and we are now up to 37%. But wait, it gets worse.

That 23% number simply won't produce the revenues they suggest. That assumes the government will pay the tax, so the budget has to go up. It also assumes that there is 100% compliance and everyone pays that 37% (yeah, right - just like they do the income tax). Bruce Bartlett writes this week in the Wall Street Journal:

"A 2000 estimate by Congress's Joint Committee on Taxation found the tax-inclusive rate would have to be 36% and the tax-exclusive rate would be 57%. In 2005, the U.S. Treasury Department calculated that a tax-exclusive rate of 34% would be needed just to replace the income tax, leaving the payroll tax in place. But if evasion were high then the rate might have to rise to 49%. If the Fair Tax were only able to cover the limited sales tax base of a typical state, then a rate of 64% would be required (89% with high evasion)."

44 states have income taxes. They would have to repeal their income taxes and raise their sales taxes in order for individuals not to have to file annual income tax returns.

Do you really want to add 30% to the cost of a new home? And pay an extra 30% in interest on the borrowing price? 30-40% more for your legal services? Do you want your rents to go up 30%? Do you really think that massive evasion would not follow? We would move back to a black market cash economy so fast it would take all of Ben Bernanke's printing presses working overtime to create enough cash for the black market economy.

Yes, in theory it would mean that exports would be priced more competitively, as corporate taxes are removed. The idea as theory is not entirely without merit, but every independent study I have read suggests the number for the tax when combined with state taxes would be north of 40% and maybe more like 50%.

Further, this is a tax hike on the middle class. If you make less than $15,000 you win. If you make more than $200,000 you win, because you actually save more and spend less of your income. This is a nice populist proposal which sounds good but is economically challenged. It only works on someone who has not read about the problems.

Let me give you two links if you want to read more. One is to Bartlett's article and the other is to the people at Fact Check (a very good site for lots of facts on a lot of things) http://opinionjournal.com/extra/?id=110010523 and http://www.factcheck.org/taxes/unspinning_the_fairtax.html.

What would I do about tax reform? Dick Armey had it right: flat and low and simple. It seems like every ex-communist country has it figured out. It is just we capitalists that can't get it right.

How to Create an Immigration Depression

The call by Huckabee and others to deport 12,000,000 illegal immigrants is simply economic suicide. It would create a depression (not just a minor recession) in short order. Let's reduce productivity by 10-15%. Let's reduce consumer spending by 7-8%. Shut down hundreds of thousands of businesses who could not get workers they need. Who will pick the crops? Or do any of a hundred jobs that Americans don't want to do? It would drive up labor costs and create inflation. It would be a disaster of Biblical proportions.

Now, I am all for controlling the border. I want to know who is coming in. But we have to deal with reality, and the reality is that we need those workers who are here. The economy simply will not function without them. You can't send them home and then tell them to apply and hope they can get back in, and then expect business to function as usual. It will take years for a bureaucracy to handle the paperwork.

Go ahead. Close the borders. Find out who is here illegally and make sure they do not have a criminal record. If so, they go. The rest need to get documented, and we need to radically increase the number of immigrants we allow (after we control the borders!), especially educated workers who can help us build our knowledge economy.

And yes, this is amnesty. That is the cost of not controlling the border all these years. Nothing we can do about it, unless we want to shoot ourselves in both feet just to prove a point. Sounds rather dumb to me.

The great irony is that within ten years we are going to need even more immigrants to replace retiring boomers, as well as to pay into social security and Medicare programs. We are going to be competing with Europe for those immigrants. We need to get a head start.

And yes, it is a lot more complex than this quick analysis. But pandering to voters who for whatever reason want to stop illegal immigration by throwing out everyone who is here illegally is not the answer. Establish fines, require documents, whatever. But recognize reality and stop telling voters what they want to hear when your policies simply cannot work and will be destructive.

Stimulate the Economy by Cutting Spending?

In the Republican debate in South Carolina last night, the candidates were asked what they would do to stimulate the economy if it is rolling into recession. Nearly every candidate said "I would cut spending" as an answer.

I guess they skipped that class in Economics 101. Deficit spending is a stimulus in the short term. Cutting spending in the short term would be the opposite. I am a huge proponent of cutting spending, smaller government, balanced budgets, etc. But you don't stimulate an economy that is rolling into recession by cutting spending. Dumb answer, and those who are doing the questioning should call them on their economic garbage.

Tax Hikes to Help Us Grow?

The Democratic candidates agree that the Bush tax cuts needs to be repealed. So, in 2010 we face the largest tax increase in history if that is to be the case. Want to double the dividend and capital gain taxes? Vote for Hillary or Obama. Watch your stocks tank.

They want to "tax the rich" and make more for middle class tax cuts. Sounds nice, but let's look at the facts. The bottom half of taxpayers only pay 3% of the total income taxes collected, which is 1% less than before the Bush tax cuts. 44% of the US population, or 122 million people, pays no income tax at all.

The richest 1% of the country pay 39% of all taxes ($365,000 income and up), which is 3% more than before the Bush tax cuts, under the Clinton tax policy. The top 5% ($145,000) pay 60% of all taxes (up 5% from 1999); and the top 25%, with income over $62,000, pays paid 86% of all taxes. It seems to me that the rich are paying their fair share. Every category is paying more now than under Clinton, except the bottom 75%.

Under any Democratic plan, they would want more than 50% of US citizens to pay no income taxes. If you pay no taxes, why do you care if we run deficits? Polls clearly show that those who pay no taxes are overwhelmingly against tax cuts, as they think it will cut their entitlements and benefits. The plan is clearly to build a constituency of voters who will vote Democrat to increase taxes on someone else and spend the money on programs for them.

Any increase in taxes at the levels proposed by Democrats is by definition anti-growth. Government spending is not as efficient or productive as private spending. It will also be a large drag on the stock market. 2010 is now less than two years away. Congress is going to have to deal with tax policy in 2009 or risk a major economic setback. See how safe your job or business will be in a second recession within a few years, like we saw in 1980-82.

A repeal of the Bush tax cuts would raise taxes on the bottom 75% of the country, and cut taxes for the rich, as a percentage of total taxes paid.

I can go on, but I have probably offended enough readers for one weekend.

Europe, Phoenix, and My Conference in La Jolla

I am going to be in Phoenix February 9-10, speaking several times at the Cambridge House Resource Investment Conference. This is a large, free conference with an outstanding line-up of speakers, mostly focused on natural resources and gold. If you are in the area, or simply looking for more information on gold and natural resources, you should consider attending. As noted, the conference is free if you pre-register. You can find out more by going to: http://www.cambridgehouse.com/mauldin/access.html and clicking on "Phoenix."

I am off to Europe next Saturday for a week, and am now scheduled to go back April 16-18. I trust the weather will be better in April. Details to follow in a few weeks on the second trip.

We are finalizing plans for the Annual Strategic Investment Conference, co-hosted by Altegris Investments in La Jolla. It will be April 10-12, so save the dates. This is a very high-level conference with nationally known speakers and some of the best hedge fund managers I know. Attendees consistently rate it the best conference they attend all year.

The kids are now off and gone after being here for most of the holidays. The house is quiet and the tree is (finally) out, with all the decorations packed for another year. It is a great pleasure to watch them grow and mature, talking about decisions, anticipating graduation and new jobs. Abbi has been an intern for the Tulsa 66ers, a minor league basketball team, but she was recently hired on as paid staff, running floor operations. Clearly management there knows a good thing. Now if Mark Cuban can get the same vision, maybe Abbi can move closer to Dad.

There have been times when I thought seven kids was a little much, but now I realize I am a blessed man. Seven is just about the perfect number.

It is time once again to hit the send button. Have a great week.

Your working harder than he would like to analyst,

John Mauldin

P.S. If you like my letters, you'll love reading Over My Shoulder with serious economic analysis from my global network, at a surprisingly affordable price. Click here to learn more.

• Bruce Bartlett
• Fair Tax
• Immigration
• Taxes
• Trade Deficit

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