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Where are we going with the Current Account Deficit?Craig Harris Welcome to a continuing series of Q & A from Craig Harris. The questions can be found here. In this segment, we are discussing question 9. "Where are we going with the current account deficit? What is going to cause a sustainable equilibrium to develop and what will the impact be?" There is a lot to consider here. The first thing to consider is my discussion on equilibrium (Question 9A). That discussion explains why the jobs are leaving... particularly the jobs where people make things or where there is a real tangible output... things that the rest of the world wants to buy. The US government can play tricks, as they have recently done by reclassifying fast food jobs as "manufacturing jobs"... but does anyone other than the bean counters in Washington think that stacking the numbers will actually fix the problem? It's more like a cure for the criticism, not a cure for the problem. Building Blue-Collar Burgers?
I think the best hope for that tactic is to fool a few market participants in the short run and maybe encourage a few more dollars to erroneously flow into Mutual Funds. Wall street will go along with ideas like that... because it's frankly just good for business. In classic economics, there is this thing which I have discussed before called the J-Curve or the J-Curve effect. The "J curve" is a theory that says a country's trade deficit will initially worsen after its currency depreciates because higher prices on foreign imports will more than offset the reduced volume of imports in the short run. In other words, the long term regulation mechanism that is supposed to solve current account deficits and surpluses are changes in currency relationships. Back to my equilibrium discussion, when one country is importing too much relative to what they export, theory says that the currency should depreciate, and that at first the J Curve effect will worsen the problem but in the longer term the increased cost of imports and more competitive exports solve the problem. In this case, that's where the problem lies however... BECAUSE WHAT SOME PEOPLE REFER TO FINANCIAL ENGINEERING HAS CLOUDED AND DISTORTED IMPORTANT FINANCIAL RELATIONSHIPS TO MAINTAIN AN UNSUSTAINABLE STATUS QUO. Furthermore, the biggest importer to the US is China, and guess what? The Yuan is tied to the US dollar. So, as the US Dollar goes ever lower, Chinese imports retain their competitiveness. Furthermore, This is the way you have to look at it. First of all, understand that the Yuan is pegged to the dollar. As the dollar depreciates while the yuan holds it's peg it becomes more competitive against all other currencies since it's tied to the dollar and the dollar has depreciated vis a vis other currencies. So..for the Chinese, their currency is strengthening while pegged. This actually fits with the data that we've been seeing... although the US Dollar is off more than 30% from it's peak, the trade imbalance with China is increasing. That leaves you looking for another reason why the dollar decline will stop... it won't be due to a correction of the trade imbalance with China unless the Yuan is devalued, and the Chinese will be loathe to do that because frankly they don't have to and they have the upper hand. Why does China have the upper hand? One thing that you have to understand is something I've discussed over and over. First you have to ask yourself "what is the US exporting?". The US is exporting dollars. That's a problem in itself because these dollars that are being exported have lost their intrinsic value over the past 50 years. The only thing they're redeemable for is... more dollars (which can be created for free). They're created by the stroke of a pen. They're only worth what the Central Banks and market participants say they're worth by convention these days. The gigantic 40 billion plus monthly current account deficit is being maintained because the US is exporting dollars to make up the difference. In other words, that 40 billion per month has to be reinvested in US assets to maintain the status quo. As time passes, an increasing portion of the US national wealth is owned by foreigners like China and Japan. It's like slowly selling your business to a foreign entity. After enough time passes, that foreign entity owns your business, which in this case is the USA. China already owns several trillion dollars of US assets... and they're owning billions more with each month that passes. Mr Greenspan has testified that he isn't worried about this... and one can only wonder why? As both a market participant and an American citizen, I certainly am. But back to the question... what will solve the current account deficit? Again, the thing that is supposed to solve it is increasing competitiveness because of a falling currency. What we are seeing however is that the manufacturing jobs continue to flow overseas. Remember my equilibrium discussion (9A) ...since we are at an orders of magnitude disequilibrium, a 10 or 20 or 40% drop in the value of the US dollar isn't going to do the trick. What is going to do the trick? One thing that needs to be understood is how we got into this predicament in the first place. My best thinking is as follows. In the 1990's, a few people got the bright idea that US prosperity could be engineered to be higher, growth higher, the stock market higher, by talking up the US dollar. That was good politics and it was fine with most of our competitors, because they are exporters... they make their living making things to export and doing that as cheaply as possible. They bought into the notion that a cheap currency was good for them for that reason. So... the US dollar continued to climb. Exports continued to become cheaper. The US slowly converted from a competitive manufacturer to a simple demand engine. If you were an active consumer in the 1990's at some point you probably realized that most of the stuff you bought was coming from China. So what happened was that these cheap imports fueled the US consumers ability to consume, and the US became a big consumption engine... printing US dollars for free, and the rest of the world remained eager to snap up these dollars for their exports. In other words, a self reinforcing imbalance was created that isn't supposed to happen. As the dollar became more overvalued, it fueled a US consumption boom because of a broken relationship between the exports and the currency. The reason it happened this way is due to the fact that the US dollar is the pre eminent world fiat reserve currency. The ability to pay back that debt with more dollars never came into question. In other words, for most other countries, if their current account deficit became very skewed, the world would begin to question the creditworthiness of the currency that was being exported, and that currency would then be expected to lose value, correcting the imbalance. In the case of the US dollar in the 1990's however, that didn't happen. The main thing that was being manufactured in the US were misleading numbers and data and talk to maintain an artificial relationship. Markets are attempting to correct this imbalance now. The problem however as I've discussed above is that the imbalance has become so large, both in dollar terms, in % of GDP terms, and in wage and cost disparity terms that an instant correction would turn the global financial markets on it's ear... which is why we are seeing increased levels of financial engineering to maintain artificial and unsustainable relationships. So I'll sum up by stating what I think I know about this problem.
I wish I had better news. March 02, 2004 Mr Harris offers a free 30 day trial subscription to his daily market letter. For a free trial please contact bcharris@gate.net. The risk of trading commodity futures contracts can be substantial. You should therefore, carefully consider whether such trading is suitable for you in light of your circumstances and financial resources. If you choose to open an account with Harris Capital Management, a Risk Disclosure will be sent to you. Please read it carefully before you invest. ### Harris Capital Management, Inc. CTA is a futures broker and registered Commodity Trading Advisor, meeting the needs of futures traders worldwide. They provide a high level of personal service to discriminating clients around the world, while offering commission rates comparable to discount brokers. All clients are handled directly by Mr. Harris. Copyright ©1995-2004
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