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from: http://www.gold-eagle.com/editorials_00/blanchard103000.html The Forgotten Deficit

The federal budget deficit may be fast disappearing, but the "other" deficit is growing bigger than ever before. America's huge and growing trade/current account deficit could soon spoil the "Goldilocks" economy-and few in Washington and on Wall Street even want to admit that there is a problem.

What is a Trade Deficit?

America runs a trade deficit when U.S. exports are less than imports. In other words, the rest of the world-especially Japan, Communist China, and OPEC (Organization of Petroleum Exporting Countries) members-ship us more real goods and services than we ship them. The "current account" deficit is the broadest measure of America's international economic position. It includes investment income in addition to goods and services. For the purposes of this article, we will use the term "trade deficit" to refer to this total picture.

Foreign countries benefit from this deficit because we ship them financial assets (dollar-denominated securities) in return for their goods. Simply put, America is borrowing from foreigners. This form of borrowing is often referred to as "dissaving." A trade deficit is, simply put, borrowing from abroad. The market value of foreign owned U.S. assets now exceeds the value of U.S. owned foreign assets by some $1.4 trillion-an increase of more than $1 trillion since Bill Clinton took office. To put it into perspective, the U.S. is now in debt to the rest of the world to the tune of about $5,000 for every man, woman and child in America.

As we shall see, borrowing huge amounts from foreigners is filled with potential pitfalls. So far, foreigners have been happy to take our dollars and help lower U.S. interest rates and drive our stock market higher. But what happens if foreigners no longer want to hold dollars? Our huge foreign debt poses the threat of a sudden, major weakening of the U.S. dollar if foreign holders become pessimistic about the American economy.

This rising indebtedness is due to America's mushrooming trade deficit. Between 1992 and 1998, the trade deficit grew from $39 billion (0.6% of GDP) to $202 billion (2.3% of GDP). It grew even larger during 1999 to a whopping $347 billion.

Is There A Problem?

Some economists and public policy observers claim that the trade deficit is really not a problem. In fact, they even celebrate it as a by product of a strong economy and America's role as marketplace for the world.

The potential negative implications of the trade deficit are underestimated in Washington, on Wall Street and in academic circles. The persistent and growing trade deficit shows that our economy, especially our manufacturing sector, is increasingly being dominated by foreigners. That deficit means that thousands of American jobs are being given away to foreign countries. Unless action is taken to correct this situation, there could be a protectionist backlash which could derail the world economy and financial markets.

What Caused the Problem?

What has caused the U.S. trade deficit to balloon out of control? There are many theories, yet no consensus. Some observers point to the paltry domestic savings rate that causes us to borrow from abroad. Others celebrate the deficit as a consequence of strong U.S. growth relative to other world economies.

But there is another explanation: it has become clear that our deficit is being influenced by Japanese, Chinese and other foreign governments' purchases of U.S. government securities. They want to keep the dollar propped up to make their goods and services cheaper relative to American goods and services. This is pure market manipulation separate and apart from U.S. fiscal and monetary policy or domestic savings and investment trends.

This foreign accumulation of U.S. government securities is an alarming economic development. As Dr. Ernest H. Preeg of The Hudson Institute (www.hudson.org) points out in his new book, The Trade Deficit, The Dollar, and The U.S. National Interest, these massive holdings make America vulnerable in trade policy and even national security:

"Foreign governments increased official dollar holdings from $432 billion in 1989 to about one trillion dollars in 1999C At some future point, large dollar holders, such as Japan and China, could threaten to sell dollars, or shift them into euros and other currencies, as bargaining leverage against the United States related to trade or national security issues. One Japanese prime minister has publicly spoken of the temptation to sell dollars, and Chinese military strategists have published studies about integrated warfare with the United States, including in financial markets."

What does Dr. Preeg mean by "leverage?" Well, if either Japan or China decided to sell their Treasuries, the result would be a financial crisis rivaling the 1973-74 episode that was characterized by "stagflation" and a 45% drop in the U.S. stock market. By dumping Treasury bonds, foreigners would force U.S. interest rates higher (when bond prices fall, interest rates rise). This would send the bond market into the proverbial tank and it wouldn't do the stock market much good either.

In the short term, the trade deficit and foreign holdings of U.S. government bonds may have little impact on U.S. financial markets. But as the situation progresses, tensions between America and her trading partners are bound to flare. The U.S. and Japan have come close to an all-out trade war twice in the 1990s over everything from rice to luxury cars and consumer electronics. With oil prices skyrocketing and U.S. oil imports on the rise, tensions with OPEC could surface, especially if Saddam Hussein decides to cut production. Finally, Communist Red China considers the U.S. its number one enemy. We have a lot of disagreements with them over issues like Chinese proliferation of ballistic missiles and weapons of mass destruction and their expansionist aims with regard to Taiwan and the rest of the Pacific Rim. Don't think for a second that they would hesitate to use their $105 billion in Treasuries as leverage in a crisis.

Is There a Cost From the Trade Deficit?

Some observers claim that the trade deficit is a benign deficit with no real negative effects. Others disagree. The Economic Strategy Institute (www.econstrat.org) has quantified the effects of the trade deficit. The trade deficit results in lower GDP (Gross Domestic Product) because it forces employment and investment away from U.S. export activities, as well as domestic business activities that have to compete with cheap foreign goods and services. The Institute estimates that eliminating the trade deficit would increase real GDP by some $44 billion per year.

U.S. companies have to match the import competition, but will do so at a cost. Profits have to be shaved to compete with cheaper foreign goods. Lower profits have an effect on the stock market, because investors don't like low earnings.

Meanwhile, with rising oil prices and our growing dependence on foreign oil, the trade picture could get even worse-perhaps much worse.

Implications for the U.S. Dollar

Absent a protectionist backlash in the United States or a massive foreign liquidation of U.S. Treasury bonds, there is still another major concern surrounding the trade deficit: the dollar may be set for a major decline. A strong dollar makes U.S. goods more expensive overseas and foreign goods cheaper here. That means a strong dollar adds to the trade deficit. A weak dollar, with all of its negative implications, would lower the trade deficit. Alan Blinder of The Brookings Institution (www.brookings.org) and Princeton University warned of a coming fall in the dollar due to the trade deficit during testimony on December 10, 1999, before the U.S. Trade Deficit Review Commission:

"Another concern is that we may be setting up the dollar for a very big fall, and that brings me to my third and final point. I believe that a lower dollar, indeed a much lower dollar, will ultimately play a major role, indeed the major role, in whittling our trade deficit down, not to zero, but to a manageable size. I think the problem for public policy is simply to cope with the sinking dollar as it sinks."

A sinking dollar is not just a problem for public policymakers. It is a problem for investors as well. A rapidly sinking dollar has never been kind to the stock and bond markets, however, gold is probably the single most negatively correlated asset to the U.S. dollar. It will be one of the few asset classes that can protect investors from a collapse of the dollar.

Potential Effects for Investors to Ponder

Eventually, these chickens will come home to roost. There will be a price to pay for continuing large trade deficits and a huge foreign debt. Three potential scenarios exist. All have negative consequences for the financial markets:

1. Protectionist Backlash. We've already seen the roots of protectionism in last year's violent protests at the World Trade Organization meeting in Seattle. Should that sentiment spread to the halls of power in Washington, D.C., we could see tariffs and embargoes spring up overnight around the world. Such a scenario would destroy whole corporations and eliminate jobs. In short, the U.S. and world economy would be crippled, much like what happened during the protectionist backlash of the 1930s. It would not be an exaggeration to say that the financial markets would collapse. Fortunately, this scenario does not seem likely.

2. Foreign Dumping of U.S. Treasury Bonds. Should foreigners sell U.S. Treasury bonds-or even cease purchases of U.S. Treasury bonds-the result would be a possibly steep rise in interest rates and the concurrent fall in stock and bond prices. Unfortunately, this scenario is a real possibility.

3. A Decline in the U.S. Dollar. A rapidly sinking dollar would more than likely mean inflation in the United States and a decline in our stock and bond markets. This scenario should be considered likely.

Gold: Financial Insurance

The potential effects of America's huge and growing trade deficit should prompt investors to include gold investments in their overall financial plan. Investors have had the luxury of ignoring risk during the "Goldilocks" economy of the 1990s, but they should not assume that this luxury will continue indefinitely. Gold is one of the few assets-perhaps the only asset-suited to providing a degree of capital preservation during any of the potential scenarios likely to arise due to our trade deficit.

Gold is negatively correlated to the U.S. dollar, so when the dollar falls, the price of gold usually rises. This is exactly what happened in 1982-83 when the dollar fell and the price of gold increased from $294 an ounce to $514 an ounce in just 9 months--an increase of 74%. Once again from 1985-87 when the dollar fell again and the price of gold increased, this time from $282 to $502 over 21 months--an increase of 78%.

Stocks and bonds are no longer negatively correlated with one another, but they are both negatively correlated with gold. So, should stock and bond prices fall under the pressure of a falling dollar, mass sales of U.S. Treasuries, or other negative economic and political events, gold will be useful as a portfolio diversifier.

It is best if investors do not wait for the trade deficit to begin taking its toll on the financial markets to acquire their financial insurance in the form of gold. By then, it may be too late to buy gold at attractive prices. Today gold is trading at under $275 per ounce-just above a 20-year low. And $275 gold is lower than the annual peak in each of the past 20 years. In fact, $275 per ounce gold is cheaper than the average annual price of gold in each of the past 20 years. There has never been a better time to buy gold for less.

October 26, 2000

Blanchard Economic Research
http://www.blanchardonline.com

-- (perry@ofuzzy1.com), November 01, 2000

Answers

If things get bad enough for countries to start selling dollars for euros, and Japan or china demanding euros only as payment for "dollar denominated securities", the bottom will fall out of the dollar, other nations will forclose aginst the U.S., come and take our infrastructure home with them and gold will have little value in a fourth world United States. The way I understand international finance ,debts can be forgiven but not bankrupt. Isn't this the standard we have set.

-- Lee Blocher (cblocher@northernway.net), November 01, 2000.