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Coryoth's Journal: Elephants in the Living Room 37

Journal by Coryoth

The United States is facing the possibility of a severe economic correction. Yet most of the causes of such a correction are, for the most part, being completely ignored in preference to partisan bickering. It is the proverbial elephant in the living room - except it is not just one, but several elephants that everyone is doing their best to ignore. While the likelihood that any of these issues could result in disaster is low, these are issues worth taking the time to discuss.

The first elephant is debt. There are 3 kinds of debt that are of concern: Household debt, the budget deficit, and the current account or trade deficit. Of those three, it is only the budget deficit that gets any real attention, and even then it is often brushed aside.

The current US budget deficit stands at $413,000,000,000 in the 2004 fiscal year. This is a record deficit. To put it in perspective, that's 3.6% of the Gross Domestic Product, almost a quarter of total federal spending, or 80% of the total receipts from Federal income taxes. Clearly such a situation is not good. But there are deeper implications for such a large fiscal gap. Some economists argue that such large deficits are detrimental to private investment. The deficit effectively soaks up a large portion of the US's savings, which would otherwise be invested back into the private sector. There is historical precedent for this - investment fell to record lows during the previous record budget deficits under President Reagan. But there is something else to consider as well. This debt is managed by selling Government bonds and securities. These securities can be, and often are, sold overseas.

Currently, the two largest foreign owners of US Government debt are Japan and China. Japan had an economic boom, but collapsed in the 90s and has been struggling since. The Japanese government is very conservative, and has been remarkably slow to introduce reforms that are seen by many as necessary to stimulate the Japanese economy. Recently however, the Japanese Prime Minister, Junichiro Koizumi, has been fighting to push through the necessary reforms, with some success. In the last couple of years the Japanese economy has shown signs of improvement. Meanwhile, the Chinese economy is strong, and only getting stronger. Why is this important? Because as both of these economies gear up there will be far less interest in investing overseas, and much greater emphasis in investing the the local growing economy. This would essentially amount to a mass sell off of US debt in the form of government bonds, something that would almost certainly fuel higher inflation in the US, putting pressure on the Federal Reserve to take action by increasing interest rates. That is to say, it would almost certainly lead to a large scale recession in the US.

The US current account deficit stood at $530,668,000,000 in 2003 and $313,341,000,000 for just the first two quarters of the 2004 financial year. That's a record figure for each of the first two quarters of 2004. This could represent a country living beyond its means, or it could represent an economic power attracting large amounts of foreign investment. Certainly as long as the US remains a significant economic powerhouse it can sustain high current account deficits. That is, as long as the US remains an attractive place for foreigners to invest, an imbalance is of limited concern. Whether such a high current account deficit is sustainable is a complicated issue affected by many factors. A reasonably coherent explanation of some of those factors can be found in a 2002 paper by Catherine Mann. In rough précis, the current account deficit is balanced by private savings, but widened by budget deficits, yet at the same time is driven by the attractiveness of US investments to foreigners. Should the current account grow too large, the perception of the ability of the US to repay the investment may decrease, causing an economic correction. In the conclusion of her paper Mann indicates that a change in trajectory (from growing to shrinking) is inevitable, and the concern is whether this will occur through slow structural and policy changes, or whether it will be caused by a sharp correction in overseas investment. Two of the major requirements she lists for structural change are greater fiscal discipline (resulting in budget surpluses) and increased personal savings. Since the paper was published in 2002 we have seen massive increases in the budget deficit, as just discussed. At the same time, the prospects for increased personal savings are very limited (which I will touch on in a moment). Add to that the beginnings of resurgent Asian economies attracting investment, and the risk of a sharp correction is certainly much greater. The consequences of a sudden shift in global investment away from the US would be extremely rapid depreciation of the US dollar, most certainly resulting in considerable economic hardship in the US.

US household debt stood at $8,454,400,000,000 in 2002, and has grown since. A quick look at the associated chart shows just how serious the upward trend in household debt is. This debt is driven both by mortgages, and by credit card debt in an increasingly consumerist society. Do you recall the "Shop for America" campaigns following September 11? It is exactly that kind of thinking that helps to drive the consumer society even further into debt. In 2004 household debt increased 4 times faster than the economy, and average credit card debt for households with at least 1 credit card increased 300%, to over $9000. Of course this is not necessarily crippling, as a recent speech by Alan Greenspan points out. It is, however, trending in the wrong direction, and getting worse fast. It is certainly far from the increase in household and personal savings required to help curb the current account deficit.

The concern about debt for the US is, in the end, quite simple. US debt, in all three forms, is huge, and it is only getting larger. All three forms of debt, while different, are connected in that both household debt and government debt have a significant influence of the sustainability of such a large (and growing) current account deficit. At the same time, either the current account deficit or the budget deficit, if they continue to grow, could easily trigger a rapid and severe depreciation of the US dollar. Which brings us to our next elephant.

The second elephant is the US Dollar. At the time of writing, the US Dollar is running at about 0.77 Euros to the Dollar. One could claim that this is simply due to a strong Euro, but in reality most world currencies, including the Japanese yen and the Great British pound are trading strongly against the US Dollar. A quick look at the historical record of the US Dollar against the Euro, the yen, and the pound shows a distinct downward trend over the last two years in all cases. Of course this need not be seen as a bad thing, certainly it is beneficial to US exports, an increase in which would be highly beneficial for the current account deficit. There are potential issues however. The US dollar has, to some extent, remained as strong as it has due its position as the de facto global currency, in which most major commodities, including oil and gold, are traded. The Federal Reserve estimated that in 2003 around $400 billion of the $680 billion US dollars in circulation were held outside the United States. This high demand for US Dollars overseas is an effective prop for the US Dollar, meaning it is unlikely to ever fall too low too quickly. This prop could, however, disappear. The possibility of the Euro becoming a new alternative global currency is increasing.

In 2001 Alan Greenspan gave a cogent speech on the possibilities of the Euro as a global currency. The first salient point is the fact that a global currency tends toward a natural monopoly - as use increases, it becomes an increasingly attractive currency to hold, while the decreasing liquidity of competing currencies makes them less and less desirable as a global currency. Transitions can of course be slow, for example the transition from the Pound Sterling to the US Dollar between the world wars, but once it begins it becomes inevitable. Greenspan then notes that, at least on the surface, the Euro possesses all the traits required of a global currency (a stable currency based in a strong economy with a well developed financial system and deep, liquid financial markets). Greenspan continues by discussing reasons why the US Dollar remained so dominant after the introduction of the Euro. He cites the strength of the US Dollar against the Euro (the Euro depreciated against the US Dollar in its first two years after introduction), the strength of the US economy on comparison to the EU, and the Euro's apparent inability to expand into foreign equity markets. As already noted, the strength of the US dollar against the Euro, and in fact most world currencies, has been in decline. On the other hand, while the relative strength of the EU economy to that of the US has increased during the US recession, the US economy is beginning to show signs of increasing growth. Lastly, however, the Euro is now beginning to extend into foreign equity markets, most notably oil. An increasing amount of Middle Eastern oil is being traded in Euros, and while the US Dollar remains dominant, both Iran and Saudi Arabia have flirted with the idea of completely converting to Euros. Equally significantly, Russia, the second largest oil producer in the world, has expressed serious interest in trading their oil in Euros instead of US Dollars, though it has not yet embarked on such an en masse conversion. For now the US dollar comfortably remains the dominant player, but there are enough signs for concern, and as Alan Greenspan pointed out, a transition will have a tipping point, after which it will be carried by its own momentum.

The threat to the US economy is that this transition, if it occurs, may not be slow. Because the strength of the US dollar is currently supported in part by its position as a global currency, a shift toward the Euro could trigger further collapse of a weakening dollar initiating a panic driven feedback cycle resulting in an almost complete collapse of the US dollar from its current point of strength. Such a collapse will only be compounded by the fact that the US currently repays its debt in US Dollars - the only country in the world that is granted the privilege of paying off debt in its home currency. Should the US Dollar destabilise significantly (or the Euro establish itself as the global currency) many debt holders could choose to request payment in Euros. This would force the US to purchase Euros (at a markup) to service its debt, both reinforcing the Euro as global currency, an inflating US debt. Such a situation would only serve to exacerbate the US Dollar's collapse.

Of course ideally such a collapse would be halted by the closing current account deficit as the price of imports skyrockets, and US exports become ever more attractive. The US populace is, however, a heavily addicted consumer, more than willing to spend its way into increasing household debt (as already noted). Worse still, US exports have been on the decline despite the recent weakness of the US dollar. Increasingly, the US is importing goods from China, and services from India. Which leads us to another elephant.

The third elephant is the rise of India and China. Both the Indian and Chinese economies are growing very rapidly. These are the two most populous nations on earth, so they should not be taken lightly. Both countries are filled with young and talented people eager to make the most of their education and climb the global economic ladder. In the case of India this has taken the form of, for example, outsourced IT jobs from the US. Increasingly US companies are importing their IT service from India, where there is a vast pool of highly capable people who do not face the vast cost of living that their counterparts in the US do. In many ways this can simply be seen as globalization and free trade beginning to more evenly distribute the wealth of the world, and is not a threat as long as the US continues to innovate and create new industries for itself. There is a question as to whether this actually occurring however.

The most common statistic for measuring economic strength, Gross Domestic Product (GDP), shows the US economy to be in good shape. Current US GDP is between 10 and 11 trillion US dollars depending on whether you measure by Purchasing Power Parity (PPP) or Current Exchange Rate (CER). GDP does have problems, the most important to consider here being its ability to include work that produces no net gain, and its lack of consideration for negative externalities. It is worth considering how much work in the US is included in the GDP that has very minimal net gain. For those familiar with the SCO Group versus IBM court case, its worth noting that tens of millions of dollars have been spent, all counted toward GDP, and yet most observers would point out that, in comparison to the money spent, the gains are negligible if they exist at all. This is common to a surprisingly large number of other court cases in an increasingly litigious country. All of it counts toward GDP, much of it returns little if any gain. A more debatable issue is the current costs of management, particularly in larger corporations that have exceptionally high salaries for the many tiers of upper management - is the net gain provided by management actually comparable to the money being spent. It is certain that management provides significant value, what is unclear is exactly how much value, and how that compares to the salaries involved. As stated, this is a point for debate. The fear is that if, in fact, US GDP is inflated by such issues, the economy could find itself hollow when it comes time to compete in earnest.

Currently India is exporting low and mid level IT services to the US, but given current Indian growth, it is only a matter of time before India is in a position to cease selling its services piecemeal, and instead sell complete packages. At present, while a certain amount of work is being outsourced to India as their economy grows, management and the corporations have remained in the US. Given the growing number of capable and experienced IT workers in India however, it is inevitable that new companies will arise in India taking advantage of the considerably lower cost of living to compete head to head with US corporations for complete solutions. Again we have to question the ability of the US to forge ahead into new industries. It could be argued that ambition for education, science, and research is lower for the current youth of the US than for their would be competitors in India, China, Korea and Japan. While there is involvement from the US in the very ambitious fusion reactor project, it will most likely be sited in Europe, and if not there, then Japan. On the other hand it was a US based company, Scaled Composites, that recently won the Ansari X-Prize and looks to be at the forefront of commercial spaceflight. The future remains uncertain, but this is certainly an issue for concern.

Finally, the rapid growth in India and China is having other visible effects. China, in particular, with its rapidly growing manufacturing sector, has had an an equally rapid increase in its demand for oil, adding a new element to the global oil market. While China is currently trying to slow its economic growth to more sustainable levels, the growth in its hunger for oil is not expected to be similarly dampened. Oil prices are already being driven ever higher, and unlike the crises in the 1970's, it is not due to disruptions in supply, but instead simply due to demand. That this is detrimental to the worlds largest oil user, the US, is obvious. Of more concern is that with increasing Chinese oil needs stretching current oil production capacity to its limits, a disruption in supply now could be catastrophic. This issue is discussed in detail in an article by Paul Krugman. In the wake of ever higher oil prices, alternative energy sources may prove to be one of the most significant new industries in the coming decade. With this in mind, the question must be asked: Which countries are going to be at the leading edge of research in alternative energy sources?

There remains one significant issue to discuss: the domino effect. This is the fact that the three major issues so far discussed are all interconnected. Increasing strength in the Chinese and Indian economies, providing goods and services to consumption addicted Americans willing to go into personal debt to maintain their standard of living, could easily lead to a widening of the US current account deficit. If the current account deficit grows too large it could easily trigger significant depreciation of the US Dollar. Should the US Dollar start too look too volatile, or become a significant financial risk to hold (due to depreciation), global markets could easily start to embrace the far more stable Euro, potentially sending the US Dollar into free fall. During a period of such extreme uncertainty in the US Dollar, foreign investors may well seek to diversify their investments away from the US towards rapidly growing countries such as India or China. That is to say, any one of these issues could trigger the others, to a devastating end.

Much of what has been discussed is speculative. Far from being probable, the potentially disastrous outcomes outlined are somewhat unlikely. Furthermore, even if the worst did come to pass the US would rebound, and may well come back stronger than ever. The reason to consider these issues, despite the low probabilities, despite the eventual recovery, is that the possible effects could be so pernicious during the time required for such an economic correction to shake itself out. The severity of the possible outcome demands our attention. These are issues that US politicians should be discussing instead of quoting the standard divisive talking points about the usual false dichotomies. You won't hear these issues raised, however, because with these issues politicians can't give a soundbite as to how they'll spend some money, or make a law that will fix the problem. Ignoring the problem won't make it go away, and just because there are no easy solutions doesn't mean that nothing can be done. What is certain is that nothing will be done if people aren't aware of the problems.

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Elephants in the Living Room

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  • Having read every word from beginning to end, I see you have clearly research all of the topics presented extensively. Thanks for enlightening me further on such interesting topics.

    --
    Stephen
  • by MsGeek (162936)
    Damn good essay...you should be writing professionally. I'm linking to this on my blog.
  • Paul Krugman [mit.edu] did a excellent commentary [marketplace.org] on this subject. It's pretty grim.

    BTW, great journal entry.

  • Terrific entry. Ive been talking with people about these issues for some time, but this brings things together very clearly -- kudos.

    If such an even DOES occur, how would a person defend his personal finances against it? Or even take advantage of the situtation?

    Invest in euros? Gold? Resources etc?

    If a quick adjustment of the US dollar does occur, what will both provide a safeguard and/or a personal-financial advantage (profit)?
    • Realistically your best option at this stage is just diversifying your investments, particularly any long term savings. For instance, find a mutual fund, or other investment, that has most of their money sunk into interests outside the US, or other means to juggle their money to avoid the US Dollar. In the end it is better to let the professionals do any currency speculation wherever possible.

      To try to take advantage of the situation involves large gambles - you have to bet that bad things will happen.
    • Holding some gold is an excellent hedge against a dollar collapse. I have found that e-gold [e-gold.com] is a low-cost solution. And for the truly paranoid/wise, a little bullion buried in the back yard is smart insurance.

      Another alternative is foreign currencies - especially from countries who are getting rich exporting commodities to Asia. You can buy CDs denominated in several different currencies from Everbank [everbank.com]. As a plus, many currencies are paying higher interest rates than you can get on dollars.

      For the brav
      • You have to be careful about using gold as a hedge. Realize that if you're not in physical possession of the gold, you're leaving yourself open to the possibility of getting burned. If you're buying gold shares, you have to be careful that the fund has a sacrosanct policy where they can physically back the complete value of their shares with gold. Some of them are "cheating" on that policy. Perfectly legal; the federal gov't doesn't even back their paper (the dollar) with any precious metals.

        Also, rea

  • Most of these concerns are actually irrelevant. World-wide consumption of petroleum products continues to grow but no new reserves are being found. Once production peaks, we will see a world-wide economic collapse that will make the Great Depression seem like a down day on Wall Street. Gasoline will be unaffordable for consumers; some form of rationing will have to be instituted for essential transportation of food, but then food production will also start to fall to 1880 levels. Large portions of the U
    • We're still a ways from hitting peak oil consumption, and already there is considerable research into alternative energy sources, and downstream dvices to make use of those new sources (and do so increasingly efficiently). Predicting disaster when remedies are being worked on, and the horizon is still distant is perhaps a little foolhardy.

      The US has immediate concerns in the here and now. Let me provide you a few links:

      BBC US Dollar movement:
      Decline begins [bbc.co.uk]
      Slide getting serious 10 Nov [bbc.co.uk]
      New low 17 No [bbc.co.uk]
      • The WSJ feels that our (national) debt is not a huge concern, as when you figure it as a percentage of GDP it's still fairly low. They ran a story lately comparing it to several European countries and our ratio is apparently significantly better. That said, they would like to see more being done to address the problem (in the form of reduced government spending). The export deficit they see as not a problem owing to our status as the biggest industial economy: they expect that when China and India catch
        • by Coryoth (254751)
          It is indeed a big game of chicken in many ways. China has their currency artificially pegged to the US Dollar. The more the US Dollar falls the more pressure there is on China because their currency is further deformed from its true market value. To try and remedy that China, and actually even more so Japan, have been buying up large on US bonds and securities, artificially propping up the value of the Dollar, and alleviating pressure while allowing them to keep a low relative currency and hence have a
          • Way way late in the game on this response.. but perhaps the weakening of the USD is on purpose?

            We have let our dollar fall from one of the strongest positions in many years to the lowest in a matter of 3 years. I think the US is trying to break the Chinese to stop devaluing their currency so as to even out trade deficits. As long as China pegs against the Dollar we can't close the gap easily.

            America has always been masterful at using its economy to defeat others. I recently worked at a large US corpora
            • Way way late in the game on this response.. but perhaps the weakening of the USD is on purpose?

              Certainly there is a certain amount of purpose in letting the Dollar fall, as you say it outs pressure on the Chinese to stop pegging their currency, and it eases the current account deficit. The problem is, as outlined, if the US Dollar alides too much it could break some of the props that have been holding it up. Right now the US is running a current account deficit of 6% of GDP, and it has been steadily in
    • Large portions of the U.S. will suffer malnutrition

      I'm sorry, but how is this a problem? Aren't many Americans already malnourished? And isn't the carb-reserves in America more than enough to last for at least a year of crisis? I mean if you lived off french fries you'd only need to ewat a few to get all the calories you need for a day. I just don't see Ethiopia happening in the states. Not trolling , just curious. IANADietician.

      • Did you see the movie, "Supersize Me"? First, you need more than calories, you need nutrition: vitamins, minerals, etc. A year's supply of One-A-Days would help, but once they're gone... Second, there's the transportation of the food. A year's supply of french fries aren't going to do you much good if they are rotting in a warehouse 500 miles away.

        I've seen estimates that without petroleum, the food-producing capacity of the US is only enough for 200 million people. The population today is 290 million

        • That's what the drugs are for, man.

          When the food gets scarce, you make sure there are drugs available for people as an alternative. Crack is especially good in this regard. After only a few uses, people will choose it over food anyway.
    • Maybe on ethenol or bio-diesel, maybe space-based power satellites.

      Scratch ethanol or bio-diesel. They're not self-sustaining methods of generating fuel. The big thing about "peak oil" is not that there won't be fuel for food transport. The big thing about "peak oil" is that we use A LOT of petroleum in order to generate the fertilizers & pesticides to create our technological crop yields. No petroleum, no ethanol.

      Me, I'm building an off-grid "vacation" home 3 hours driving time from the nea

      • Scratch ethanol or bio-diesel. They're not self-sustaining methods of generating fuel. The big thing about "peak oil" is not that there won't be fuel for food transport. The big thing about "peak oil" is that we use A LOT of petroleum in order to generate the fertilizers & pesticides to create our technological crop yields. No petroleum, no ethanol.

        Both of our assertions are true. First, ethanol production doesn't have to be "self-sustaining" for ethanol to be useful. The production of batteries isn'

  • The huge federal deficits are not purely accidental. There's actually a method to the madness. There is a wing of the Republican party that believes in a strategy known as 'starve the beast'. This approach seeks to limit government programs by producing large deficits that make it impossible for the federal government to do anything but engage in little more than essential services.

  • At first I thought you were stealing a story from Kuro5hin, but now I see you are the same guy, so its all good. But why link to your /. journal in your sig instead of the story on kuro5hin where there is an active discussion?
    • Oddly enough the Slashdot sig character limit. The lengths of links counts into that, and a Slashdot link saves me a lot of characters, which leaves more room for actual text.
  • by killjoe (766577) on Tuesday November 30, 2004 @12:58AM (#10950040)
    Dear Sir,

    My name is George W Bush. I wish to inform you that you are very wrong. There is nothing wrong with deficits, increased govt spending, or the decline of the dollar. How do I know? Because God told me so that's how. Now who you gonna believe? Some liberal bedwetter or God?

    God will take care of it in the end. He will make sure his chosen people are OK and really who cares about the rest.

    I gotta go now, toby keith is on the radio.

    Bye.
  • Overall I like your entry. I had a couple comments while reading it. When expressing national economic statistics, it is more expressive to show things in proportion to the country. So for debt (or other stats), don't say 'The US debt is $413,000,000,000!' since that is worthless if you don't know the size of the US economy. Yes the US debt is rising, but let's look at the numbers in the right perspective. I got all this data the Economist [economist.com] (go to each countries Profile-Economic Data). Here we go, Public deb

    • It's also worth noting that while a deficit of 3.6% is too high to join the European Union (as per Maastricht), it is not that much too high. The cut off was 3%. In other words, even *with* the war, we are still at roughly the same deficit as the UK was when they were trying to join the EU. Without the war, the deficit would be 2.9% or 3.0%, within the EU limits. Not to say that the US wants to join the EU, just that it isn't that far off from the qualifications.

      When based on GDP %, deficits don't look
      • Not to say that the US wants to join the EU, just that it isn't that far off from the qualifications.

        :o) There are many other qualifications that would be required if the US wanted to join the EU. Apart from relocating to Europe, there is a lot of legislation about social welfare and workers' rights that would be very unpalatable to the current US administration. Oh, and a certain degree of transference of sovereignty to Brussels.

  • One - look at Fannie Mae and Freddie Mac. Dodgy accounting, increasingly risky position taking.

    Two - look at the credit derivative markets. How many trillion dollars ?

    Three - guess what happens if a major bank or institution gets caught on the wrong side of big currency swing (USD/JPY or USD/Euro). Credit event. Credit derivative market goes ape. Fannie and Freddie, and a bunch of others, feel real pain.

    Money available to borrow (households, corps) - nil.

    US growth - negative.

    US jobs - negative.

    Po
  • Just to add some more praise - excellent job mate!
  • by fishbowl (7759)
    Whoever keeps lending money to a bankrupt deadbeat NEEDS TO STOP.

    If the US is even ABLE to incur debt, that reflects much more on the lender (SUCKER), than on the US.

    • Whoever keeps lending money to a bankrupt deadbeat NEEDS TO STOP.

      If the US is even ABLE to incur debt, that reflects much more on the lender (SUCKER), than on the US.


      For foreign countries Japan is the worst offender, with China a close second. They've been buying US debt because buy buying bonds and currency they can keep the US Dollar strong. As long as the US Dollar is strong they have cheap exports to the US. It's been working very well for them for the past many years. The problem is, if their bu

      • >So that sucker that needs to stop? That's YOU!

        Well, "borrowing" without express consent of the lender, is more correctly called something else.
        • I understand where you're coming from, but generally elections are considered to be the "consent" phase of the whole operation. Which, of course, is not to say that you consented, just that a majority of the population consented. Blame them.

          Jedidiah.
          • "Which, of course, is not to say that you consented, just that a majority of the population consented. Blame them."

            Ok. So either they are right, and it will all work out in the long run, or they are wrong, and the country is on the fasttrack to utter ruin.

            Either way, I'm satisfied. I know how to grow my own food, etc. Others can starve for all I care.

Facts are stubborn, but statistics are more pliable.

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