We at Casey Research like to take the
long-term view. As part of our ongoing research to understand current
investment options and stay abreast of long-term economic trends, we look at
how the economy fared under the previous stressful times of the Great
Depression. Are there any important similarities?
There are a number of important sub-models of
this investigation, but only one of them is featured here. Identifying a
number of the significant economic drivers of then and now, we will expand on
others in an upcoming International Speculator issue.
It is critical to get the real data for this
kind of analysis because even after seven decades, there are very differing
interpretations of the causes of the depression. Many who worry about the
parallels and see economic difficulty ahead are looking for similarities,
like the expansion of debt and the unusual rise in stocks. This piece
examines one of the most important imbalances of our time, an item that is
decidedly different from the 1920s: the Trade Deficit.
How Serious is the Trade Deficit?
Last weeks report from our Treasury on foreign
investment in the U.S. brings me to focus on the trade balance, related
foreign investment, our loss of manufacturing, and the long-term
implications.
I have been monitoring the big imbalances of
our economic system to determine if we are heading toward a big economic
convulsion that would change our investments and our lives. I have been
evaluating long-term historical measures of prosperity and economic movement,
comparing the last big depression to now to see if we face similar situations.
Some of the similarities look dangerous, like the large overall indebtedness
of then and now. Some of the differences do not show so serious a situation
today, such as the relatively stronger financial institutions that would
surely get government bail-out if liquidity became a problem. But there is
one difference that is much worse now: the trade deficit.
First, here is the trade balance as usually
reported, showing a big drop starting in the 1970s, as we began to buy more
than we sold abroad:
Accumulating the annual numbers above shows
the position of how much the U.S. owes or is owed by the world:
The question is what that means for our
financial system. Decades ago, the U.S. was smaller and dollars were worth
more, so we need a baseline to make the periods comparable. The method I use
is to calculate the ratio of trade deficit (or surplus) to GDP. The positive
position we enjoyed in the lead-up to the 1929 crash has eroded now to a
negative position.
The trade position of the U.S. was very strong
before and during the great depression. The dollar was devalued against gold
one time by Roosevelt, but was generally strong. In fact, we experienced
deflation, meaning the purchasing power of the dollar increased, as prices of
homes and other items crashed. The foreign situation of accumulated
international debt is exactly the opposite of what it was in the 1920s. This
important difference shows why the dollar then turned out to be strong, even
in the face of disastrous economic contraction that brought 25% unemployment.
Now, the accumulated trade deficit hangs over the dollar so that this time
looking forward, the opposite conclusion is more likely: the dollar will
succumb to decreasing purchasing power. Many commentators suggest that if we
are headed toward recession or, even worse, to depression, that will be
deflationary just like it was in the 1930s. I believe we are headed toward
serious financial times, but I do not see the deflation of that time
returning. Foreigners lending us $2.5B per day can’t continue forever.
When it fails, we will not see deflation but big inflation. Foreigners all
wanting to get out of dollar positions will drive the dollar down and prices
up as they bid for assets other than dollars.
We can look at today’s numbers from the
Treasury on foreign investment to see the size of foreign support by their
reinvestment of their trade surplus in our Treasuries, agencies, stocks and
bonds. I monitor the reinvestment as an indicator of pressure on the dollar.
The data from today, averaged over the last 3 months, does not show a
problem. Foreigners are still investing in U.S. financial assets, despite
pronouncements from the Chinese and other central banks that they want to
divest some of their U.S. holdings. In aggregate they are continuing to
invest. The reinvestment by foreigners is equal to the trade deficit, so
imbalances have escalated together as shown in the chart below:
The underlying data from today show this
source of reinvestment may be more precarious than the surface shows. China
is the country we watch most closely because they hold the biggest hoard of foreign
currencies of $1 trillion. China still added to their U.S. dollar denominated
holdings, even if at a slower rate this month. The other two biggest
purchasers are London and Grand Cayman Islands. They are different because
they are money centers, and are passing through investments from other
countries from such sources as hedge funds and countries that prefer
anonymity, like oil countries. The surprise is the amazing size of the
investment from London:
Investing money centers are potentially able
to change their position on a whim, as seen in London’s negative move
in July. London’s investment of $47B is huge compared to the worldwide
net foreign purchase of $88B. This trade deficit and investment juggling act
has succeeded, and on the surface has held together. When you look at the
components, the underpinnings do not look so stable.
The other side of the trade deficit is that
foreign cheap labor has replaced manufacturing in the U.S., hollowing out our
lower and middle class incomes. The chart below shows U.S. manufacturing jobs
as % of total jobs. The expanding trade deficit matches the decreasing U.S. manufacturing
jobs. This is exactly as expected, but it is not good for the long-term
economic strength of the U.S.
The destruction of productive capacity will
decrease our long-term wealth creation. With U.S. production decline, there
is less need for investment in that productive capacity. Investment, which is
the basis for future growth, has moved to Asia. U.S. corporations seeking to
increase profits by cutting costs actively supported these moves. That means
less wealth for the U.S. because we are not producing as much. The economy
will weaken because we are not paying our workers to make the things we
import, so they will have less to spend. Foreigners have put off the problem
in the short term by lending us the money to buy their exports and maintain
our lifestyle. But this can only continue until foreigners fear that they may
lose by holding too many dollar investments that start to decrease in
purchasing value.
So in conclusion, the trade deficit is very
serious, especially in the long term. It is part of the hollowing out of
American production and wealth creation. As a consequence of borrowing to buy
those foreign goods, we have sold off some of our future profits as we have
to pay interest on Treasuries and dividends on stock holdings, with the
result that the dollar will weaken. Foreigners have continued with the deadly
embrace of extending more credit to us, so we appear wealthier than we are.
But should they try to extricate themselves from their dollar holdings, the
consequence will be a devaluing dollar. Even if we head toward a massive
economic slowdown 1929-style, a serious deflation is unlikely because of the
negative position of our trade deficit. A weakening dollar will be supportive
to gold and precious metals in the long term.
Bud Conrad
www.caseyresearch.com
In future editions of the International Speculator,
we will comment on other important economic movers such as the stock market,
debt, housing and gold--comparing how they interacted then and now with the
unfolding economic scenario.
Bud Conrad holds a Bachelor of Engineering degree
from Yale University and an MBA from Harvard.
Among others, he has held positions with IBM, CDC and Amdahl. Currently he
serves as a local board member of the National Association of Business
Economics and teaches graduate courses in investing at Golden Gate University.
His data and analysis regularly appears in the pages
of Doug Casey's International Speculator, which is dedicated
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