Where do we go from here?

John Mauldin - Wed 21 Dec, 2005

"...The final instalment of the extended dinner date between the folks at GaveKal and our own Bill Bonner. John Mauldin was there...and now it's time to hear sense from the man in the middle..."

"I don't know whether change will come with a bang or a whimper, whether sooner or later. But as things stand now, it is more likely than not that it will be a financial crisis rather than a policy foresight that will force change."
 - Paul Volcker, former US Fed chairman

How long can the United States continue with an ever rising trade deficit? How far can debt rise? Will it end, as Paul Volcker, former Chairman of the Fed states, in a financial crisis? Will it end as a soft depression as Bill Bonner suggests? Or is it, as the team at GaveKal projects, different this time?

Well, over the next ten to twelve years, we will see three recessions that will slowly move the average price-to-earnings ratio of US stocks to historic lows. Rising oil and energy prices will be a main culprit of both the slowdown in the economy and an increase in inflation. Ever-increasing monetary inflation will, in fact, trigger a huge increase in all commodity prices, as well as a decline in bonds. Asset inflation will show up in the housing markets as home values continue to skyrocket. The dollar will continue to weaken against major foreign currencies. The current war will become increasingly unpopular, and the next US administration will be forced to withdraw troops, under the guise of declaring victory. The American voting public will be split as never before, with major patterns in voting habits making a generational change. The newspapers will continue to write about how an Asian country will dominate the world economically in less than a few decades.

Following this period of malaise, there will be an amazing cycle of new technical innovation that will spark yet another major bull market. The new technologies will change the world in ways that simply cannot now be imagined and will lead to whole new industries, putting amazing new power and abilities into the hands of individuals and governments.

The preceding scenario should, in fact, all come to pass. Except that the year was 1970 and not today. The forces that have changed the world in the decades following 1970 were only written about in science fiction and a few obscure books and journals.

Who dreamed of the Internet in 1970? Who could envision that the Berlin Wall would come down in 1989? That Japan would not, in fact, dominate the world of economics and overwhelm the United States? Or that the China of Mao would become a capitalistic growth machine and that the USSR would break up?

A personal computer on every desk and more computing power in a family car than existed in the largest computers of the time? A globalised world economy? The prospect that a falling population (and not overcrowding) would be a problem, or that a Green Revolution would mean enough food for all (except where governments kept out a free market)?

In the 1970s, the mood of the West was decidedly negative. Japan was eroding our manufacturing base and unemployment was increasing. Reagan spoke of the Misery Index in his race against Jimmy Carter, which was a combination of inflation and unemployment.

And yet it all changed. In fact, the one constant in the modern world is that the pace of change is accelerating.

The above section comes from the beginning of my personal chapter in 'Just One Thing' called The Millennium Wave, but it makes a good introduction to today's topic as well.

In the late '70s and early '80s, there was a concerted sense of doom and gloom pervading the markets. Many urged that we stock food and emergency supplies, buy gold and silver and sell stocks. We had watched as Japan eroded our manufacturing base. Millions of jobs went offshore never to return. "Where," many asked, "would the jobs of the future come from?" The West and most especially the US was in decline.

The correct answer then, as it is today, was "I don't know from where the jobs will come, but they will." And come they did, as American entrepreneurs created whole new industries.

But that was then. Where are the economic miracles today that will save us from ourselves? Does the massive debt we are accumulating; both internally and abroad, matter?

I don't believe that we can borrow our way to prosperity. Ultimately, as I will try to make clear, and I think I have stated consistently over the past few years, there will be a rebalancing. But I do not think it will lead to a depression, soft or otherwise. It will be Muddle Through. And after that period of rebalancing, I think we will see another great boom, probably starting the middle of the next decade.

It appears that "a machine at the Fed which simply grew the money supply at a reasonable rate of growth, coupled with a federal government that ran slight surpluses". But that is indeed a fantasy. Given today's reality, it is my personal one. Would that it were so. But we invest in reality, not what we wish were true.

Now, let's be clear. Muddle Through will not necessarily be fun. The '70s were times of Muddle Through. Few would willingly revisit those economic times. And things changed dramatically from 1970 until 1990, and even faster after that. I think the next period of change will happen at a much faster pace.

But free markets and entrepreneurs adapt to new conditions. That is what happened in the '70s and '80s and '90s, and what will happen in the future financial crisis that Volcker speaks of. And I believe he is right. There will be a series of crises. But I think we have had a number of crises over the past 35 years and somehow we seem not only to survive, but also prosper. That is not to diminish the pain felt by many during those crises, or the losses in investment portfolios.

The argument that Bonner, Marc Faber, Steve Roach et al make is that the United States is living off of the kindness of strangers. It is the savings of the rest of the world, and primarily Asia, which finances our massive trade deficit. I argue that it works both ways, as they have become dependent upon the US consumer to buy their products and keep their factories humming. It is this symbiotic relationship that has allowed the United States to run such massive deficits without a collapse of the dollar.

I wrote almost three (or maybe four) years ago that no country had ever seen their trade deficit rise to over 5% of GDP without a 30% revaluation of their currency. This was (and still is) a great part of my bearish stance on the dollar. Yet today the US now runs a trade deficit of almost 7%. The trade deficit is growing much faster than GDP. This is clearly an unsustainable trend. But how long can it last?

Many analysts, including me, correctly point out that it is in the best interests of the various nations to take dollars to keep their factories going. Further, dollars are not worthless. They can buy a lot of things like stock, homes, factories and assets in the United States, arguably one of the safest places in the world. Further, US assets are growing faster than our liabilities. On a balance sheet basis we are in a good shape.

But Bill Bonner correctly points out that at some point many nations of the world (read Asia) will start to wonder what they should do with all those dollars in their vaults. Those foreign dollars are now growing at $700 billion plus a year. At the rate of $69 billion last October (latest month data) it is well on its way to over $800 billion.

Is there not a limit? The answer is "of course there is", though I should note that foreigners bought $107 billion of US securities in October, an all-time high. Whatever the limit is, it seems we are yet a long way off.

I wrote last year that various (primarily Asian) countries want to keep their currencies cheap relative to the dollar so they can be more competitive than their neighbours. It is competitive currency devaluation, plain and simple. Yet, each country's central bank knows that ultimately those dollars are going to fall at some point. I pointed out it is like the children's card game Old Maid. No one wants to get stuck with it at the end of the game.

So, bottom line. Do trade deficits matter? Yes, in the long run, but probably not next year or the year after that. And they primarily matter to currency valuations. Please note that currencies fluctuated up and down by 30% or more in the '80s and '90s and the large majority of people did not notice. Has Europe wilted because the euro is down 40% or so? "Matter" is a relative term. But it should be positive for the gold bug crowd.

Because it is in the best interest of all parties concerned, the US trade deficit is going to last a lot longer than most people think. The Asian countries hope that they can create their own consumer classes and slowly wean themselves from the US consumer, allowing the dollar to fall gradually.

Gradually is probably not in the cards. It will be in fits and starts, with some long rallies to scare the dollar bears, like we have seen recently. I hope Volcker is wrong. It would be a nice world if policy could manage a smooth transition. I strongly suspect he is right.

It will be a series of financial crises that will push the dollar lower coupled with a Muddle Through Economy. During these crises and recessions, we will see consumer spending slow and savings increase which together will bring down the deficit.

Regards,

John Mauldin
for The Daily Reckoning