The Tycoon Report

Why the U.S. would declare "bankruptcy"...

Monday, November 27, 2006 | Dylan Jovine

PAUL VOLKER SOUNDED very upset.

Apparently, a group of economists, using the same techniques as those used on the set of “Jurassic Park” (as opposed to those used on the set of the movie “Sleeper”), recently thawed the former Chairman of the Federal Reserve from his amber-induced deep sleep.

After they finished splashing water on his face they gave him the news: We’ve flashed back to the 1970’s: the United States government is running large budget deficits, there’s been extremely loose monetary policy and we’re fighting a war with open-ended costs.  And just like the 1970’s, Washington is behind the Eight Ball. But it’s not a dream. It’s the year 2006.

Upon processing the information, Mr. Volker boldly predicted there would be a “75 percent chance of a currency crisis within the United States during the next five years.” 

Unfortunately for us this isn’t a movie. And, history tells us that Mr. Volker’s recent predictions are based on some pretty strong evidence.

During the past six months, a growing chorus of leading domestic and international economists have begun to sing the same tune. 

And now that the dollar is beginning to collapse, I think it’s time we listened.

The Calm Before the Storm?   

Why are these leading economists and thinkers beginning to see a currency crisis on the horizon? It’s certainly not based on the surface of the economic waters that look troubling. In fact, recent economic news has been rather promising: the economy has been growing nicely, signs of inflation have abated and of course the unemployment rate stays encouragingly low.
 
And who can forget about the stock market. Ever since it seemed likely that the Dems would win the midterm elections, the S & P 500 Index has been hitting new highs seemingly every day.

While there is no question that Wall Street was happy to see good, old-fashioned Washington gridlock, the markets sharp rise suggests a belief that the fundamentals are beginning to look more promising (as well as a belief that recently approved Treasury Secretary Paulson actually knows more about international finance then Mr. Snow knew about bushy eyebrows).

But Wall Street is a place where two types of big money co-exist: “smart money” and the “smarter money”. 

“Smart money” invests in the stock market. “Smarter money” invests in bonds and currencies.

“Smart money” tries to capitalize on stock prices in relation to long-term interest rates.

“Smarter money” sets long-term interest rates.

It’s the “Smarter money” that’s beginning to get nervous folks.

What Lies Beneath?

If you look beneath the surface of the positive news coming from the “smart money” on Wall Street, you will see that our economy indeed faces some big, possibly painful adjustments over the next year.

And these “adjustments” could have major implications for your portfolio.
 
By far the most striking has been the degree that the dollar has fallen since the mid-term elections. Since then, the greenback has dropped in heavy trading and this week hit new lows against the euro and several Asian currencies. It seems that foreign investors have had enough.

And rightfully so. Our current-account deficit, the net amount we borrow from foreign lenders each year, inched its way up to 6% of GDP last year – a level never seen in the U.S. before and reflective of third world nations in financial crisis.

But that’s not all.

The broadest measure of the amount the United States owes the rest of the world – the net international investment position or NIIP – has gone from negative $360 billion in 1997 to an astounding negative $2.65 trillion recently.

What’s really surprising is that this has never happened before. Our current-account deficit is in uncharted territory, both as a share of the economy and in terms of the share of foreign savings it soaks up.

Most economists have long argued that this imbalance must, at some point, be corrected.

It seems that the time is now upon us. 

How Did We Get Here?

Cut out all the clutter and its simple really: The United States has been spending more than it can afford to.

To spend the money, we borrow from foreign governments. The borrowing largely comes in the form of United States Treasury Bonds that we issue each month.

During the past several years the largest buyers of our bonds (investors lending us money), have been the leading governments in Asia.

They’ve been lending us between $1.5 - $2 billion per day.  

To date, the large (and rapidly growing) amount of external debt has not yet been much of a burden on our economy. We’ve had no problem borrowing more money, and interest rates haven’t been much of a burden to this point.

That’s likely to change, though.

Recent economic weakness in the U.S. suggests that the Federal Reserve will not only stop raising interest rates, but will actually be inclined to lower them some time next year.

Think about that for a moment: If the U.S. lowers interest rates, the foreign governments who have been buying our bonds will begin to buy bonds from other countries such as Germany or England or France where their interest rates will likely be higher.

Why? Because like any of us, foreign governments hunt the globe for the highest returns they can find. And if they can invest $100 billion in Germany at 6% versus $100 billion in the U.S. at 3%, where do you think they’re going to go?

Danger’s My Middle Name ...    

On the monetary side, danger looks like this:

If foreign governments stop purchasing our bonds, our bond prices will decline; if bond prices decline, interest rates will rise.

Rising interest rates are never good for an economy; especially one that looks like it’s going to slow down next year - just ask somebody who has lived through the stagflation of the 1970’s.

On the fiscal side, the picture looks equally bleak:

If foreign governments decide to stop lending us money by purchasing our bonds, the U.S. government has to find an alternative way to finance our deficit.
 
There are three primary options the government has:  

The first option would be for the U.S. government to cut the amount we borrow. But to cut the amount we borrow means we have to cut our fiscal spending. Just a casual glance at the morons on both sides of the aisle in Washington shows how unlikely that prospect is.

The second option would be for consumers to spend less, thus increasing the savings rate. This could happen if the Fed were to aggressively raise interest rates, or if consumers bought fewer goods from foreign countries (yes, this means you).

But, as always, the Fed is doing a delicate balancing act with interest rates. If it raises them too quickly, it may stunt the already inconsistent growth of our economy.

And consumers buying fewer goods? Alas, look deep into your own heart for the truth. Getting 250 million Americans to spend less would be like herding a roomful of cats - a nearly impossible task.

The “Third Rail” Option

On the fiscal side (I’m on a roll here folks), the third and final option would be for the U.S. to “default” on its debt ...

Not default in the way you and I understand it.

Default in a way that only the most powerful government in the world could.

Let me explain. When we issue bonds, we borrow in our own currency. Therefore, by letting the dollar drop, trillions of dollars would be wiped off of the value of our lenders assets.

In other words, we would owe the foreign governments who lent us the money trillions of dollars less than the amount we actually borrowed.

To put this in perspective, if the U.S. dollar loses 40 percent in value, this would amount to the biggest “stealth default” in world history.

And you know it’s going to keep on falling, because it’s the easiest way out (for the U.S.) to begin to rectify its imbalanced finance-based economy.

Back to the Future

That brings us back to Mr. Volker and the 1970’s.

As you can see, the real question is not whether the dollar will fall, but how drastic the economic effects of its fall will be. In the mid-1980s, the greenback's trade-weighted value declined by 40% with few ill effects noted in America. The world economy absorbed the shock reasonably well.

Unfortunately, many economists like Mr. Volker see more parallels today with the dollar's collapse in the 1970s, when the Bretton Woods system broke down. As I mentioned before, the 1970’s was a time of large budget deficits, loose monetary policy and high oil prices, and America faced open-ended costs to pay for a war.

We’re facing the same situation today, but in addition, the combined costs of fighting in Iraq and maintaining security at home could easily match the cumulative 12% of GDP that the Vietnam War cost.

There is therefore a risk that the global economic consequences might be as severe as those which followed the demise of Bretton Woods, with the ultimate consequence being “stagflation” – stagnant economic growth inflation. 

Some of my more popular contemporaries believe that the only way that this would happen is if the buyers of government bonds began selling them in a panic-style rush.

I think they’re missing the whole point.

The problem isn’t that foreigners are going to rush to sell the dollar denominated assets. The problem, as Mr. Greenspan himself recently pointed out, is that “foreign lenders will eventually resist lending more money to the United States, causing the dollar to drop further.”

Mr. Greenspan is right – they’re simply going to stop lending us money.

And for them (or anybody else for that matter) to start lending us money again, they’re going to have to get a lot more in return.

In other words, they won’t buy bonds unless they’re getting paid an interest rate to match their risk. 

Let’s hope that rising interest rates are the only result of the current economic situation. Because if the dollar happens to decline more rapidly than we would like, and if interest rates shoot up faster than we would like, our economy will, at best, be in for a very hard landing. 

At worst, it could be a case of déjà vu all over again ...

Think before you invest,





Dylan Jovine
Contributing Editor
The Tycoon Report


Mark Your Economic Calendar: What's ahead for the week of November 27, 2006
MARK YOUR ECONOMIC CALENDAR – What’s ahead for the week of November 27th.

Tuesday, November 28th, 2006
8:30                Durable Orders: Consensus -4.5%
Big Picture: Strong 2006 growth is based on flush corporate balance sheets, high capacity use and rising exports which add to underlying business demand.   The measure is volatile given the large costs of the goods included -- planes, capital goods and defense provisions.   But now business confidence plays a larger role as the economy slows and business investment slows with it.  Capital investment and the manufacturing it employs is a larger piece of the economic growth as consumer spending slows.  Lower energy prices aid continued strong growth but the need to invest slims with the slower economy.  

10:00                Consumer Confidence: Consensus 106.5
Big Picture: The index reached new 4 year highs in January, March and April 2006.   Energy prices, interest rates and the slowed economy have left a -5% decline since April.  The index has been extremely volatile over the last year.  Mini 'cyclettes' (and large monthly volatility) are evident in the modest upward trend.   Conference Board's survey is far larger and more business heavy than the household-heavy Michigan sentiment index.  The index is presumed to provide an early read on consumer spending which is far better previewed through interest rates and income growth.

10:00                Existing Home Sales: Consensus 6.20M
Big Picture: Higher mortgage rates and reduced demand have severely softened the housing market after the record high of June resales.  30-yr mortgage rates reached a 6.8% high in June and have fallen off considerably since, but as the huge amount of unsold inventory needs to be worked down before prices end their deceleration and now yoy declines.  The downward trend hasn't been overly severe given the years of record growth preceeding it as now falling long term mortgage rates, lower prices and improving employment and income growth provide support.  Strong price gains has fallen to yoy declines for the first time since mid 1995. 

Wednesday, November 29th, 2006
8:30                GDP-Prel.: Consensus 1.8%
Big Picture: Economic growth is slowing as the interest sensitive consumer sectors and the housing correction provide the swing.  The forward risk is that lowered business confidence slows the strong pace of capital investment and the manufacturing sector.  Lower energy prices will aid Q4 growth if they hold at these levels.   2006 growth will be based on moderating consumer spending (the Fed's intention) as business investment moderates but continues to provide a lift to the economy and manufacturing sector.  The drag from the trade deficit is expected to moderate as inventory rebuilding shouldn't provide much of a swing.  Stimulative fiscal policy now contrasts with restrictive monetary policy as economic growth has softened but remains self-sustained.  Inflation risk remains but the slowing economy should help quell the pressures.  Little slack in the economy, a weak housing market and the remaining inflation risks are the Fed's concerns.

8:30                Chain Deflator-Prel.: Consensus 1.8%
Big Picture: Economic growth is slowing as the interest sensitive consumer sectors and the housing correction provide the swing.  The forward risk is that lowered business confidence slows the strong pace of capital investment and the manufacturing sector.  Lower energy prices will aid Q4 growth if they hold at these levels.   2006 growth will be based on moderating consumer spending (the Fed's intention) as business investment moderates but continues to provide a lift to the economy and manufacturing sector.  The drag from the trade deficit is expected to moderate as inventory rebuilding shouldn't provide much of a swing.  Stimulative fiscal policy now contrasts with restrictive monetary policy as economic growth has softened but remains self-sustained.  Inflation risk remains but the slowing economy should help quell the pressures.  Little slack in the economy, a weak housing market and the remaining inflation risks are the Fed's concerns.

10:00                New Home Sales: Consensus 1045K
Big Picture: New home sales have fallen a sharp -21% from the July 2005 peak.  Speculative investment has disappeared as median prices have fallen -10% from a year ago.  The market will continue to fade given high inventory (homes for sale) despite the lower levels of fixed term mortgage rates.   The 30-year mortgage rate has fallen off the mid June 6.8% high as lower rates and lower prices will help moderate the decline.  Speculative buying in some locations leave a stronger risk of larger price declines (in those specific locations) as the trend in national and regional prices will reflect the size of the increase over the last few years.  

Thursday, November 30th, 2006
8:30                 Initial Claims: Consensus NA
Big Picture: Remarkable stability as the 4-week average holds in a low and tight 12K range (306-318K) since early June.  Continued claims showed a five year low in the 4-week average in mid May and stands only slightly higher today.  The continued low levels reflect the thin available labor supply which make a qualified hire difficult to find and therefore leaving less layoffs.  A good read on the labor market as net hiring slows with the economy.

8:30                 Personal Income: Consensus 0.5%
Big Picture: Consumer spending is softening under the weigtht of interest rates as a boost from lower energy prices is expected in Q4.  While we expect spending to run at a more moderate pace it will be the key element of slowing in overall economic growth given its dominant weight (70%) in GDP.   Strong employment and improving income growth provide underlying support as wages and salaries have jumped 8% yoy.  The Fed's favored core PCE price index rose to a new cyclical and 11 year high of 2.5% yoy in August but fell off to 2.4% in September -- that 2.5% yoy rate may be the peak.

8:30                 Personal Spending: Consensus 0.1%
Big Picture: Consumer spending is softening under the weigtht of interest rates as a boost from lower energy prices is expected in Q4.  While we expect spending to run at a more moderate pace it will be the key element of slowing in overall economic growth given its dominant weight (70%) in GDP.   Strong employment and improving income growth provide underlying support as wages and salaries have jumped 8% yoy.  The Fed's favored core PCE price index rose to a new cyclical and 11 year high of 2.5% yoy in August but fell off to 2.4% in September -- that 2.5% yoy rate may be the peak.

10:00                 Chicago PMI: Consensus 54.5
Big Picture: The index rose to an annual high in September then rebounded to an annual low in October.  A volatile measure with a 57.6 average over the last 3 months.  Briefing.com expects manufacturing demand and production to soften in the 4th quarter given the decline in business confidence which will presumably carry in to investment orders.   Inventories have been drawn down to satisfy near term demand as rebuilding shouldn't be expected to provide much of a lift.  The manufacturing sector moves in sharper cycles than the overall economy and the regional measures move in even shorter, more volatile patterns.  Business investment has strong fundamentals of flush corporate balance sheets and high capacity use as confidence in the economy continues to risk weaker order growth than we expect.

Friday, December 1st, 2006
00:00                 Auto Sales: Consensus 5.2M
Big Picture: Buying incentives have provided a bouncy path for vehicle sales over the last few years and drive the monthly pace of domestic sales.  High gasoline prices provide the advantage to fuel efficient imports and domestic autos but SUV sales have not shown a strong decline given the larger discounts awarded.  Reduced discounting has softening the pace of 2006 sales to a 12.9 mln average pace from 13.2 mln in 2005.  With a 25% weight in retail sales, autos provide the monthly swing to consumer spending.

00:00                 Truck Sales: Consensus 7.3M
Big Picture: Buying incentives have provided a bouncy path for vehicle sales over the last few years and drive the monthly pace of domestic sales.  High gasoline prices provide the advantage to fuel efficient imports and domestic autos but SUV sales have not shown a strong decline given the larger discounts awarded.  Reduced discounting has softening the pace of 2006 sales to a 12.9 mln average pace from 13.2 mln in 2005.  With a 25% weight in retail sales, autos provide the monthly swing to consumer spending.

10:00                 Construction Spending: Consensus -0.2%
Big Picture: Vastly different factors driving the 3 components of construction spending:  residential, business and public spending.  Business structural investment has surged over the last half year and leads the components by a large margin in yoy growth.  Residential spending is plunging and stands -7% lower than a year ago.  Public spending is motoring along at 12% yoy.  Residential provides more than half the weight in the index and leaves slowing despite the near 20% yoy growth in business spending.

10:00                 ISM Index: Consensus 52.0
Big Picture: Business capital investment drives manufacturing orders and production.  Business confidence is a concern given its forward read on investment spending and the resulting slow down in manufacturing production.  New orders provide the forward read on production and have fallen to 52.1 in October.  Strong business activity, flush corporate balance sheets and large capacity useage may not be enough to offset the weakening in business confidence and the resulting softening in investment.  While we don't expect a sub 50 level, its drawing close at 51.2 in October.
(Source: www.Briefing.com)