US living on borrowed time - and money

By Julian Delasantellis

http://www.atimes.com/atimes/Global_Economy/HC24Dj01.html

03/28/06 In 1987, Yale historian Paul Kennedy published The Rise and Fall of the Great Powers, in which he argued that "military overstretch" - where conquering nations engaged in more foreign military adventures than their economic resources could support - led to the eventual decline and fall of empires.

So far, the US attempt at dominion that commenced in 2001 has not been threatened in this manner because, in essence, the

nation has been able to borrow the costs simultaneously to maintain both its new empire and its avaricious middle-class consumerist lifestyle.

But the times, they are a-changing. Buried deep in the arcanum of some recently released economic statistics are indications that the world is tiring of its role as America's charge card.

So far the United States has easily financed its endeavors in Iraq, as well as undiminished levels of domestic social-welfare spending, not by the traditional solution of raising taxes (in fact, taxes have been cut numerous times since 2001, an occurrence unheard of during previous wars) but by running huge budget deficits, such as fiscal year 2006's projected shortfall of US$423 billion.

Accompanying the federal budget deficit is the huge US trade deficit, burgeoning out of control as more and more of previously domestically produced consumption items are outsourced to foreign, mostly Chinese, manufacture. The stimulative US budget fiscal position assures that Americans will have all the money needed to buy them.

Standard economic theory since the adoption of floating foreign exchange rates in 1973 states that big trade deficits auto-correct by having the currency of the profligate nation depreciate. Thus if Brazil is buying more from, say, South Korea than South Korea is buying from Brazil, there will be more South Koreans with Brazilian reals (earned from the exports to Brazilians ) than there will be Brazilians with won.

In most cases, this would lead to selling of the currency of the deficit country, since there will be a surplus of the deficit country's currency in these foreigners' hands. The selling will drive down the value of the deficit currency; that will eventually make consumption of the shiny foreign goodies too expensive, and eventually the trade deficit will equalize.

This has traditionally not happened with foreigners holding US dollars. The United States dollar is what is called a "reserve currency", ie, foreigners are willing to hold dollars even though they can't easily use them as the domestic currency in their home markets. Without the selling that would accompany all the exporters to the United States trading their dollars for their home currencies, the US dollar stays higher than the economic fundamentals would theorize it should, and the great American global shopping spree can continue.

The ledger of how much more capital the US sucks in to finance its consumption as compared with how much it sends out to invest is called the current account deficit. The money that foreign exporters hold in US dollars and then invest in US government or private bonds, stocks or short-term bills is entered in the minus column on the current account. As the US domestic savings rate is so pitifully low, the United States must import a huge amount of foreign capital just to finance that huge federal government budget deficit.

From an even then huge $531 billion in 2003, the current-account deficit has been rising in recent years by more than 20% a year, last year's was $805 billion, and the projection for 2006 is more than $975 billion - that's almost 7% of gross domestic product. In other words, America's spending addiction, from DVD players to destroyers, means that the nation consumes 7% more than it produces.

But until very recently, financing this hunger wasn't all that much of a problem.

The most important US government economic statistical report that you've never heard of is called the Treasury International Capital (TIC) report. The current-account data report how much the US needs to finance its lifestyle; the monthly TIC data report what it actually gets.

Thus in 2003, the current-account deficit meant that the US needed to entice $531 billion from the rest of the world. TIC data reported that what it actually got was $747 billion. For 2004, the need was $666 billion; it actually got $915 billion. For 2005, the need was $801 billion; $1.025 trillion was actually received. Many economic commentators believe that as this excess foreign capital started sloshing around and through the US banking and financial system, it kept US interest rates low and thus fired the tremendous rallies in real-estate and stock-equity prices that have occurred in the past few years.

But nothing good lasts forever. From reaching a high of $117.2 billion in August 2005, the TIC reports are showing a steady decline in foreign inflows, down to $74 billion in December, and $78 billion for January, the last month for which data are available. The nasty thing about this is that with a projected $975 billion current-account deficit for this year, the US is no longer getting what it needs from the world to maintain its lifestyle. The foreign-capital food supply is dwindling just as the hunger increases.

True, the actual shortfall is not yet very large, right now less than $5 billion a month. But I see the salient fact here as not being the current-account deficit minus TIC-inflow shortfall right now, but the rather significant 35% absolute reduction in inflows since last summer. As the US political system shows absolutely no indication of being either desirous or even able to deal with its fiscal profligacy (the recent congressional farce surrounding the increase in the debt ceiling being an example), the current-account deficit will only rise; unless US households are willing to increase their savings rates massively (very unlikely, since I haven't seen any "going out of business" signs on Best Buy or Circuit City lately) or the declining-TIC-inflow trend reverses, there's trouble ahead for the latest US experiment in cut-rate conquest.

There are many ways this trouble could manifest itself. Since much of this foreign-capital inflow finds its way into long-term US Treasury securities, it's hardly surprising that, with the recent shortfall in TIC inflows, Treasury interest rates are rising to their highest levels in two years. If demand is falling, then the market is marking down prices, and the basic rule of bond markets is that yields move in inverse directions to prices. Rising mortgage rates will put the US real-estate boom in real jeopardy, and it has been US homeowners pulling spendable cash out of the inflated values of their homes that has generated much of the consumption component of recent US growth.

It is also possible that this could lead to a sharp selloff in the US dollar, as has been happening in the dollar-euro market since November. If foreigners with export earnings from the US do not put it back into US assets, they will not just keep it stuffed in their mattresses; they will look around for interest-bearing instruments denominated in euros, sterling, yen, or a dozen other currencies.

This will cause these currencies to appreciate in value, and the dollar to fall. If you've ever looked at the back page of The Economist magazine you'll have seen the huge foreign-exchange reserves being built by countries that have recently been the winners in the global trading game. As of December, the International Monetary Fund lists Japan's reserves at $847 billion, China's at $819 billion, Taiwan's at $253 billion, South Korea's at $210 billion, Russia's at $194 billion, and India's at $137 billion. These reserves, held overwhelmingly as US dollars, are the potential gasoline just waiting for the match to set alight a huge global economic conflagration.

If somebody starts selling his dollar reserves, even if it's only a portion of his dollar portfolio, other countries could be forced into panic selling of their huge dollar reserves. The foreign-exchange markets are the biggest and most liquid in the world, but whether they would be able to absorb the amount of selling that could emerge from portfolio adjustments this large is a very open question.

More likely there would be a sharp overshoot in the dollar-selling, leading to a perhaps 20-30% decline in dollar values within a very short time. For the US, this would mean a sharp rise in the prices of everything it imports, especially crude oil. That would mean inflation, with the Federal Reserve raising interest rates to contain it, or maybe the economy would bypass the intermediate inflationary phase and head straight into deep recession or depression.

Either way, the great run of US prosperity would be over. Worldwide, along with the global contractionary effects of US economic growth suddenly stopping or going into reverse, the effect of an almost instantaneous 20% haircut in the value of the world's financial reserves would be no picnic, either.

On the first day of class, business teachers like me love to introduce our sleepy students to the concept of TANSTAAFL - there ain't no such thing as a free lunch. The United States may soon be introduced to the concept of TANSTAAFE - there ain't no such thing as a free empire. Specifically, will the nation still think it's so important to control the sands of Samarra, or the streets of Fallujah, or, for that matter, those of Baghdad if, like the signs say in US doctors' offices, "payment is expected at the time of service"?

Julian Delasantellis is a management consultant, private investor and professor of international business in the US states of Washington.

(Copyright 2006 Julian Delasantellis.)