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When the last 20 year financial period is viewed through the prism of a longer term stock market history one key concept may stand out above all others: operating profit margins.
From the Great Depression to 1997, three fundamental factors have loomed large in stock price valuation: 1. Earnings, 2. Dividends and 3. Corporate net worth, or its more imprecise proxy; book value.
During the 1930’s post depression period and extending to about 20 years ago, stocks rarely sold above 21 times earnings or traded above 2.2 times book value. During that same period dividend yields averaged about 4% annually.
Circa 1996-1998 we began to see a fundamental change. Price earnings ratios began to exceed levels unseen in most of stock price history and dividend yields sank to between 1 and 2 %. The previous high point ratio of 2.2 times book value became a new low point.
What caused this new paradigm and what risks are inherent for the future?
The shift in stock valuation relative to investment metrics post 1997 has been primarily a result of a massive upward shift in multinational corporate profit margins. These new margins are, in large part, a direct function of the development of outsourcing.
There are many factors that brought about an increase in outsourcing and the resulting revolution in profit margins. These include, political and economic changes in the 1980’s, 90’s and 2000’s in China, Vietnam, India, Eastern Europe and other formerly socialist states. In addition, new efficiencies in mass container shipping and transportation provided easier access to foreign product component supply markets. The advent of the internet also made international business simpler in a multitude of ways.
Furthermore, the explosion of robotics and the growth of technology companies with their higher returns on invested capital have also made business more profitable. Compounding these factors has been the omnipresent reserve currency status of the U.S. dollar which has resulted in a higher relative dollar valuation than what should be economically justified by past and present U.S. current account and budget deficits. Reserve currency status and the higher dollar has enabled the U.S. to import manufacturing components, as well as fully assembled products at lower prices squeezing out domestic manufacturers. At the same time the relative higher currency made many U.S. exports non-competitive.
Individually, and as a whole, these factors have manifested in a once in a generation upward tilt in U.S. corporate profit margins. No single factor has done more to increase profit margins and expand investment metrics while lowering production costs than the growth of outsourcing to lower cost foreign production centers.
This trend began as a trickle. However, as word leaked out from first movers it wasn’t long before any company with the financial economies of scale to set up foreign operations was seeking to manufacture outside the United States. By the late 1980‘s outsourcing became a torrent, and by the mid to late 90’s American multinational corporations had fundamentally “discovered” the massive profit margin and cost dichotomy of manufacturing in China vs. the United States. The immediate beneficiary: the bottom line.
The stock market began to reflect this new paradigm in 1996 and 1997 and prices relative to age-old metrics rapidly fell by the wayside. By 1999, even in companies not strickly related to technology, stock prices relative to book values rose to the stratosphere. Annual dividends, which had historically at times exceeded 7% and averaged at least 4% for many decades, dropped as low as 1%. Notably, this drop in corporate dividends relative to stock price was far in excess of the sequential drop in overall interest rates. Prices relative to earnings, which for decades rarely exceeded 22 on average, exploded. Even price to sales ratios climbed dramatically as the return on equity and the rising operating margins from oursourcing justified new valuation levels.
In recent times the S&P 500 has traded at an extraordinary 10.6 times tangible book value. This is a significant elevation even when compared with its more recent 20-year average of 6.4 times tangible book.
This new platform of higher margins can be explained by pointing to U.S golf club manufacturers that used to make their products in the U.S. but now glue their imported golf grips onto their imported golf shafts and attach their imported golf heads but call it “manufacturing”. In reality, their components are manufactured for them in a foreign country and without the inconvenience and expense of vertical domestic smelters or pesky problems with the EPA, labor unions, litigation and regulations. The same result, which occurred in almost every industry, produced a rise in this “productivity from assembly.” Furthermore, it has mitigated the need for intensive domestic capital investment, which, in conjunction with excessive debt loads in most sectors of the economy, may also explain, in part, the recent slowdown in monetary velocity.
As the trend took hold, CEOs, whose compensation was tied to profits and stock options, immediately recognized the opportunities in outsourcing. In fact, GE’s Jack Welch built his reputation using the concept. In the aggregate, these factors have sent profit margins for U.S. multinational corporations on an upward tear for more than 20 years and increased returns from invested capital relative to U.S. returns on labor.
Unfortunately, the laws of unintended consequences have also come into play.The massive expansion of outsourcing from the U.S. has led to the wholesale termination of over 65,000 U.S. factories in the past several decades. These U.S. factories found they were not able to compete with the “pennies on the dollar” Chinese labor market or with subsidized imports to the U.S. or the reduced environmental and litigation costs generally found in those outsourced countries. The other not inconsiderable side effect was that the influx of cheap imports to the U.S. also resulted in an exploding U.S. trade deficit.
This concept of outsourcing so permeated the American multinational corporate structure that by the late 90’s, U.S. investment flowed to China in larger and larger quantities. The Chinese, overrun with American capital that threatened to boost the currency exchange value of the yuan and make Chinese exports less attractive, returned capital back to the U.S. through the acquisition of U.S. government bonds, real estate and other corporate securities.
The U.S. financial industry which was faced with declining growth in the U.S. manufacturing base and a relative paucity of manufacturing investment opportunities directed both U.S. and foreign capital to over-invest in U.S. real estate as well as real estate debt and equity securities from the early to the mid 2000’s.
Though lower inflation initially seemed like a positive knock-on consequence from the abundance of inexpensive imports, in reality this relative restraint on inflation provided the Federal Reserve far greater cover for greater monetary accommodation and declining standards in the housing market. This additional accommodation compounded Wall Street’s errors of capital misallocation and all of the foregoing ultimately contributed to the 2007-2010 financial crisis.
So what might cause a change in operating profit margins in the future?
The hollowing out of the American industrial base and middle class relative to population growth resulted in the election of Donald Trump who believed that after decades of large current account and trade deficits the day was drawing nearer when the U.S. would no longer be able to rely on the kindness of strangers or even its reserve currency status to avert calamity. Mr. Trump and members of his administration have made clear that they believe that large long term current account deficits will eventually place the dollar at grave risk.
The standard retort among some economists is that the current account deficit is small relative to nominal GDP. Though true, it is primarily because of their erroneous definition of GDP.
When we compare the dollar value of pure U.S. industrial production, (production that is non-assembly and non-service based), against the dollar value of our imports of manufactured products and components, the real relative size of our imports indicate a stark and precarious danger to our currency over the long term. It is important to note that the problem with the current definition of GDP for purposes of evaluating the sheer size of trade deficits is that conventional definitions don’t exclude that part of our GDP that is incapable of producing export earnings.
This is important because, though tennis lessons, travel agents and gambling casinos putatively rank alongside Boeing aircraft production in GDP parameters, they are really not the same and as a result many service industries should not be valued on the same basis as the fundamental manufacturing of high value products. To be of real value to the real trade economy, service industries need to have the potential to create export earnings. Casinos and tennis lessons, for example, have little potential to create export earnings. Often they are simply the internal movement of money.
It is clear that outsourcing has drawn off U.S. export earnings as well as large numbers of American higher paying jobs. Our relative financial position has become more tenuous as a result. If you don’t have products that other countries want to buy at your price then your primary mechanism for paying for imports is the export of paper currency and IOUs. This is clearly exemplified in the amazing and rapidly declining U.S. Net International Investment Position.
It is critical that Americans not ignore the key long term immutable law of economics: If you import a great deal more than you export, or borrow a lot more than you lend, in the long term the end result will be that you will inevitably pay a lot more for everything as a dire consequence of the loss of our reserve currency status, a further decline in our per capita manufacturing capability and the deterioration in the foreign exchange buying power of the dollar.
Empirically and historically in country after country it has always been, just a matter of time.
President Trump now seems determined to reduce outsourcing and close the trade gap. His actions may illustrate Herb Stein’s valued insight that; “Something that can’t go on forever, probably won’t.” and we are already starting to see this play out in rising costs for steel and its impact on companies such as Caterpillar, Ford and others. In addition, manufacturing inputs in China and other emerging countries are now rising and as a result the heretofore beneficial cost differentials are shifting. Moreover, without a comprehensive change in Chinese trade policies, many U.S. tariffs may remain a large part of the Trump trade equation. Prognostications are historically unreliable and it can often take many years for equilibrium to manifest itself from long term disequilibrium. However, the size and time length of the U.S. trade deficit are unprecedented in world history and as such we may see unexpected upheavals over the next 1 to five years.
Mr. Trump really has few choices. Let the U.S. continue on with huge current account deficits with disaster waiting at the end or act now to bring the U.S. back into better balance on our own terms.
Nevertheless, if Mr. Trump perseveres, especially through tariffs, it will most certainly result in an increase in costs and a probable knee jerk contraction in multinational corporate margins and investors should be aware that if operating margins were to regress to the mean or pre-1996 levels the impact on stock market parameters could be significant.
Positive outcomes may also emerge from Trump’s pressure to establish fairness in trade and some trade barriers could result in a mitigation of subsidized, below cost foreign products that are exported to the U.S. solely for the purposes of gaining market share and decimating our manufacturing capability. Additionally, a slowdown in imports and a pick up in exports could also result in more middle class manufacturing jobs thereby giving rise to a larger base of American customers for domestic products.
Ironically, robotics may also narrow the foreign wage differential. Our robots should be as good as their robots and this could draw more manufacturing back to the U.S. along with at least some factory technology jobs where before their growth was limited. Ultimately, we might also be forced to live a bit closer to our means and perhaps stave off some very possible undesirable outcomes such as a further decline in our manufacturing base, a collapsing currency and world hegemony by an authoritarian regime.
In recent months, stock market volatility has broken out of a long deep slumber though some of it has been due to a recapitalization of all investment markets as a function of volatile interest rates, slowing world economic growth and a decreasing expansion in central bank liquidity. But it may also be, in part, a recognition that the years of expanding operating margins derived from U.S. multinational outsourcing is drawing to a close.
Rising stock market volatility may mean that after 25 years U.S. investors are inching closer to anticipating that the free lunch game of more low cost imports, excessively high U.S. trade deficits and fewer high paying U.S. manufacturing jobs is perhaps about to change.
We need to anticipate these potential changes and to be competitive and create products at a price and quality that the world wants. To do so the U.S. will need to further reduce personal and corporate taxes and regulations, mitigate ubiquitous tort actions, strengthen private property rights, lower entitlements, protect intellectual property from international theft and importantly reduce debt levels in all sectors. Undoubtedly, this will be a tall order. Some say that failure is an option but as Ernest Hemingway queried in the Sun Also Rises; “How did you go broke?” – the answer, “Two ways; gradually and then suddenly.”
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In 1965,when we imported less, manufacturing employed 24% of the U.S.workforce. By 2015, substantial portions of our manufacturing base had moved overseas, and domestic manufacturing had shrunk to just 9% of employment.
The U.S. has now run a trade deficit for 40 years, and at present levels our annual current-account deficit of $400 billion to $500 billion will aggregate additional deficits of $4 trillion to $5 trillion in only 10 years. However, despite the largest cumulative current-account deficit in world history and a plunge in manufacturing as a share of our economy, the U.S. seemingly persevered without a definitive penalty.
So, do trade and balance-of-payments deficits really matter? Not according to U.S. Sen. Ron Johnson, Congressman Ron Beyer, and many other U.S. politicians. However, history will attest that no country has incurred perennial trade deficits, imported and borrowed more than it exported or lent, and seen its currency live to tell about it.
Much of the demand for U.S. dollars is derived from its reserve-currency status, since the U.S. dollar is commonly held as a means of exchange and lending between independent third parties and not as much for claims on actual U.S. production. Therefore, Americans get the benefit of a higher value for their dollar, and this results in an ability to borrow capital and buy foreign products at lower prices, thus incurring trade deficits. Because reserve-currency status can prevail only alongside confidence in our dollar, the longer U.S. trade deficits go on, the greater the crisis when they cease, voluntarily or involuntarily. Consequences of imprudence often occur when least expected. The 2008 housing crisis is a case in point.
The approaching danger is that in one year or five, we will experience one $40 billion monthly current-account deficit too many, resulting in a decline in the dollar that extends in greater duration and magnitude than the economic climate might dictate. Economists will be mystified, but we will be catching up and paying penance for long decades of trade and budget deficits. On that day, nothing will save the dollar, not the corporate profits offshore, not more Japanese purchases of U.S. Treasuries, not presidential jawboning. Nothing.
At the outset, the degree of upward pricing in imports will overwhelm even the best of optimists. The Toyota, once closely priced to the Chevy, will double, and the U.S. consumer will rapidly devour all outstanding inventories of Chevys. However, enhanced foreign purchasing power will then bid up for domestic U.S. production, and the U.S. buyer will be priced out. Foreign investors will also buy up U.S. farmland, mines, and other industries on the cheap.
Understandably, it is hard to imagine such a scenario in today’s disinflationary economy. Nevertheless, unable to afford imported goods, Americans will seek to buy shoes, only to find they aren’t made in America. They will search for televisions, only to find they aren’t made in America. They will ruefully realize that the same applies to Rawlings baseballs, Gerber baby food, Etch A Sketches, Converse sneakers, stainless-steel rebar, Mattel toys, minivans, vending machines, Levi jeans, Radio Flyer wagons, cellphones, railroad turnouts, Dell computers, canned sardines, knives, forks, spoons, and light bulbs.
Americans will wistfully wonder where their manufacturing base went and how they lost more than 63,000 factories just since the year 2000.
The U.S. urgently needs a plan that will mitigate future long-term trade and budget deficits, an overall blueprint where everyone is better off, including our trading partners. Therefore, I propose that when the U.S. runs a trade deficit with any country for five years, an automatic import limit comes into play in the sixth year, mandating a reduction in the trade deficit with that specific country by 20%. A 10% increase in U.S. exports and a 10% decrease in imports relative to that country would fit the bill, but either way, an additional 20% annually mandated reduction in the trade deficit would continue for four more years until trade is balanced. Then, the law would go into hibernation for five years, allowing free trade with that country to resume. No tariffs, just a country-specific trade-deficit limit to act as a current-account safety mechanism to reduce the dangers of de-industrialization.
This gradualist method would also ensure that our trading partners’ interests would be aligned with ours, providing them with a strong incentive to buy more U.S. products. As a result, they would bring to bear innovative solutions on how to import more of our products so that they could export more of theirs. Ultimately, this would be a much firmer foundation for world trade.
However, modifications in our trade policy aren’t the only changes required for the U.S. economy to improve. We need a return to fundamentals that mandate significant reductions in corporate and personal income taxes, as well as government spending and entitlements. A flat tax of 22% at the federal level with a maximum combined state and local income tax of 4% would revive U.S. fortunes better than any single factor. It is no coincidence that Hong Kong, with a maximum 16% income-tax rate, has over the long term been one of the world’s best-performing economies. These fundamental changes would result in greater prosperity by increasing aggregate savings, investment, and demand.
If we fail to mitigate our long-term trade deficits alongside our cumulative budget deficits, we will eventually destroy many of our remaining industries, as well as our military.
Forty years of trade deficits might lead one to agree with what we are told; that trade deficits, like budget deficits, don’t really matter. However, as international economist Rudiger Dornbusch warned,“In economics, things take longer to happen than you think they will, and then they happen much faster than you thought they could.”
FRANK BERLAGE is the CEO of Multilateral Partners Global Advisory Group, a private-equity firm based in La Jolla, Calif.
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Prior to this election season Americans used to pay about as much attention to trade and current account deficits as they did to picking potato chips, and with good reason. Economists have been warning for years that America's trade issues would come back and bite us in the keister, but so far, nothing seriously detrimental has occurred. In fact, the U.S. current account deficit declined to to $125.3 billion or 2.8% of GDP in the final quarter of 2015. Notwithstanding the sheer nominal dollar size of that deficit, 2.8% of GDP is less than many other countries and significantly smaller than 2006 when we reached a run rate of 6% of GDP. (1)
In 1965, when we imported much less, manufacturing accounted for 53 percent of the U.S. economy. By 2015, substantial portions of our manufacturing base had moved overseas and domestic manufacturing had shrunk to just 12 percent and only 9 percent of employment. Since 1976, despite 10.6 trillion dollars of the largest cumulative balance of payment deficit in world history and a plunge in manufacturing as a share of our economy, we have seemingly persevered without a definitive penalty. So, do trade and balance of payments deficits really matter?
Yes, they matter immeasurably.
In the long run, no country that has run perennial trade deficits, imported and borrowed more than it exported or lent, has seen its currency live to tell about it. In fact, before the Roman Empire fell, the Roman Senate sneered at criticism that carts brought Rome imported goods from all over the world but departed with only manure.
For the past 30 years, the primary objective in the reduction of trade barriers has been to boost the standard of living for billions across the globe. This has worked particularly well for China, Southeast Asia, India and Mexico, among others. The motivating principal was that when restrictions are reduced and each nation's comparative advantage augments international trade, we see an efficiency of production resulting in increased consumption along with lower prices. One country more efficient at making cars and another more efficient at making pharmaceuticals are both better off when they trade. As a result, their economies grow more.
As an ardent free trade, free enterprise and open markets advocate I have found it difficult to entertain any thoughts contrary to these principles. However, every once in a great while there comes a time to recognize an exception, a time when economic facts dictate considering solutions that may be against these strongly held beliefs.
The U.S. has now run a current account deficit for 40 years and recently its net international investment position has also deteriorated from a negative 1.4 trillion in 2008 to a negative 7.3 trillion in 2015, or close to 40% of GDP. (2)
Nevertheless, many analysts often focus only on the latest quarter's trade deficits and disregard the fact that an annual current account deficit of $400-500 billion dollars becomes a cumulative deficit of 4-5 trillion in only 10 years. It is the cumulative aspects of trade deficits that matter, the long forgotten trade deficits of 1988, 2006, 2015 and everything in between.
Herbert Stein correctly noted, "If something cannot go on forever, it will stop." But many following U.S., trade and current account deficits believe they may be the living example of Keyne's time proven adage "In the long run we are all dead." Nevertheless, the approaching danger is that the longer America's trade deficits go on, the greater the crisis when they cease, voluntarily or involuntarily. History has repeated shown that the ramifications of a prolifically in imprudence often occur when least expected. The 2008 housing crisis is a case in point.
To comprehend the potential plight of the U.S. dollar we must understand its relationship to our status as the world's primary reserve currency. Despite losing 97% of its purchasing power since the creation of the Federal Reserve, the U.S. dollar today is still the world's leading currency. More countries use the dollar for reserves than any other currency. It is also the most likely choice as an alternative or substitute currency. Furthermore, the U.S. is unique in that more than 50% of its currency is distributed throughout the world for functions unrelated to claims on U.S. production or trade.(3) The euro, the pound and the yen are distant competitors.
This grandeur bestows wide ranging privileges on the American people, privileges that would not be available under similar circumstances or with similar trade deficits for, say, the Argentines, Poles, Brazilians or any other country whose currency is not considered a reserve. The dollar's exalted position in world finance provides Americans with benefits that extend well past its role as a financial reserve, it translates directly into available hard consumable products for the U.S. public at artificially low prices.
Because the U.S. dollar is commonly held as a means of exchange and lending between independent third parties, and not as much as a claim on U.S. production, Americans get the benefit of the float. This results in an ability to borrow because of an artificial demand for dollars that keeps its relative price far higher than it should be, certainly given 40 years of trade deficits. Lower import prices on a wide range of goods inhibits domestic manufacturing but it affords the American public imported goods in large quantities. Regrettably, given the relative decline in U.S. manufacturing, this reserve status now relies more on America's historical post war supremacy, the dollar's standing ubiquity and the absence of a substitute currency, rather than its current industrial might. Like Blanche Dubois, the U.S. dollar has become a currency dependent on the kindness of strangers, though they may not always be so kind.
Reserve currency status can also short-circuit the natural laws of trade. Under conventional circumstances when a country runs a trade deficit for a long time, other countries begin to liquidate that currency because they can reasonably envision that the trade deficit country will have to print more money to pay for its imports. They correctly anticipate that the excess supply of money will reduce the purchasing and exchange value of the trade debtor's currency. Thus, as the currency declines in relative value, the higher price for imported products usually means that the trade debtor country will have limits in the number of imports it can afford. However, all things being equal, it also means that the trade debtor's now lower priced currency should increase demand for its exports and rectify problem trade deficits through a natural self-correcting mechanism.
Unfortunately, in the case of the U.S. dollar, that process has been circumvented and we have sown the seeds of a time bomb. Because of its reserve currency status and the dollar's elevated value, U.S. exports are more expensive than they should be and as a result U.S. production jobs are exported to low wage countries from industrial states like Pennsylvania, Indiana, Ohio, Michigan, Wisconsin and Illinois. This results in higher unemployment and lower wages for American industrial workers and potential political turmoil.
The current U.S. election cycle has demonstrated that some things have truly changed. The American worker now sees the ramifications in the rapid arbitrage of international wages and world trade and he believes it has put him out of work. He now feels, and not unreasonably so, that one way or another too many of our international trading partners are not playing fair. These competitors use their wage rate advantage to readily export to an open U.S. market and then compound that advantage by also instituting byzantine currency and regulatory methods to restrain U.S. exports.
Fair competition between near equals in wage compensation can result in a drive to innovate with new processes and systems that improve productivity in production. For example, arbitraging a U.S. hourly wage of $30 (U.S.) with a Canadian wage rate of $25 dollars (U.S.) can force improvement to American efficiency. However, some differentials are just too difficult to overcome. It becomes almost impossible to retain domestic U.S. manufacturers that must pay a Delphi Auto Parts worker $49.00 an hour while at the same time competitors are outsourcing to Vietnamese workers paid .96 cents/hr (4). If enough high-paying industry jobs move offshore, the mitigated wages paid by the remaining employers such as Radio Shack and McDonalds and others can mean lower aggregate demand, mitigated savings and investment and ultimately a weaker economy.
Don't misunderstand, international competition, be it in wages or products, is generally a good thing. It pushes countries to focus on their comparative advantages and therefore improve production. If the Japanese auto industry had not put such an emphasis on quality, Detroit might still be designing cars with planned obsolescence or even now Detroit might be making cars that are "unsafe at any speed." The problem is that many U.S. trading partners have taken clandestine and inequitable competition to a new level and for the more open U.S. markets the resulting trade deficits have become a sucker's game. Many American companies have found that they are disadvantaged in competing against foreign countries that don't require safety or environmental regulations. Many competitors also under price their currencies, free companies from health care costs through their own government paid health programs, provide subsidies for investment in land, buildings, energy, equipment, grant tax holidays and rebates, provide subsidized financing or pay their workers subsistence wages that would be illegal in the United States.The end result is that America is de-industrializing a sizable part of the manufacturing base that it has painstakingly built over the past 150 years.
America now produces fewer real products and imports more per capita because investment and capital are not welcome here anymore. Regulations, taxes, litigation, labor for value costs, poor educational skills, entitlements and ridiculous healthcare costs have chased manufacturing out and foreign locales with less of each have welcomed it in. This corporate and capital flight has diminished the number of quality investment and job opportunities which has exacerbated income inequality, weakened consumer credit and mitigated aggregate demand. Ironically, all of this has provoked calls from more radical candidates for even more of the same socialist prescriptions of higher taxes and more regulation that precipitated the problem in the first place. Clearly, we are forgetting that the ramifications of a prolifically in imprudence often occur when least expected. The 2008 housing crisis is a case in point.
A large portion of the U.S. trade deficits are now with China and since 1995, China has also consistently recorded trade surpluses with the rest of the world. Since just 2009, China's trade surpluses have increased more than 10 fold.(5) Consequently, when some economists grumble about an undervalued Chinese yuan, they do so with the valid assertion that, over the long term, the Chinese currency has not risen proportionally to China's growth in per capita wealth, GDP or trade surplus.
Despite the relative decline in manufacturing, some argue that the U.S. balance of payments deficit at 2.8% of GDP is not excessive and therefore there is not really an urgent reason to act. However, the real problem is not the calculation of trade relative to GDP. It is the definition of U.S. GDP. When services are the lion's share of an economy as they are in the U.S., the trade imbalance in real products matters much more. In fact, many "services" are not particularly accretive to the real U.S. economy and bring little in the way of hard currency to balance the red ink when compared to more manufacturing based economies like Japan, Germany and China. For example, tennis lessons, nail salons and casinos are not really a sign of a productive economy but more an indication that the U.S. is simply moving money around. Consequently, when calculating our balance of payments deficit relative to our GDP, we need to subtract those portions of the economy that fail to add real value and see our real dependence on externally manufactured products for what it is, a much more menacing proposition.
The big danger is that in one year or five, we will experience just one 40 billion dollar monthly current account deficit too many, one that culminates in a dollar collapse. Can we predict that date or the precipitating factor? Not likely.
Perhaps it will stem from yet another QE because, for the umpteenth time, our debt, regulatory, tax burden or declining monetary velocity has again deflated the U.S. economy. Perhaps there will be precipitous defaults in some sectors of the world\’s massive debt structure or in the multitude of new covenant-lite corporate debt, or possibly fallout from defaults in the student loan market. Maybe it will simply derive from an unexpected transformation in psychology rather than an economic event.
Whatever the factor, the first symptom is apt to be a decline in the dollar that extends in greater duration and magnitude than the economic climate would dictate. Economists will be mystified. Multivariate regressions and inference algorithms will fail to explain the abrupt drop because we will be catching up, paying penance for those long decades of trade and budget deficits. It will suddenly become clear that the dollar\’s post World War II ubiquity is retracing.
In fact, on that day the dollar will bear more than just a passing resemblance to Wile E. Coyote who, having run out of road, alternates between contemplation of his audience and the canyon far below. On that day, nothing will save the dollar, not the corporate profits offshore, not more Japanese purchases of U.S. Treasuries, not presidential jawboning, nothing. The Federal Reserve will also be powerless because in a weak economy the difficultly of subtracting dollars from the system will pale in comparison to the ease of adding them.
At the outset, the degree of upward pricing will overwhelm even the best of optimists and there will be a substantial increase in the price of imported products across the board. Faced with a loss of his favorite German, Japanese, Korean, Chinese and Vietnamese products, the American consumer will now turn from the significantly higher priced imports to domestically manufactured products. The Toyota that was close in price to the Chevy will double and as a result the U.S. consumer will rapidly devour all outstanding inventories of Chevys. Unfortunately, when prices rise more, the U.S. consumer will become the low tender. Enhanced foreign purchasing power due to a declining dollar will bid up for U.S. products and the American buyer will be priced out of his own production. Overall inflation for most products will then soar and demand from both Americans and foreigners will overrun supply. Additionally, foreign investors will now buy up U.S. farmland, mines and other industries on the cheap. Understandably, it is hard to imagine such a scenario in today's deflationary economy.
Nevertheless, unable to afford imported good, Americans will seek shoes only to find they are not made in America. They will search for televisions, only to find, they are not made in America. They will ruefully realize that the same applies to Rawlings baseballs, Gerber Baby Food, Etch a Sketch's, Converse Shoes, stainless steel rebar, dress shirts, Mattel toys, minivans, vending machines, Levi Jeans, Radio Flyer's red wagon, cell phones, railroad turnouts, Dell Computers, canned sardines, forks, spoons and knives, incandescent light bulbs..... Americans will wistfully wonder where their manufacturing base went and how they lost over 63,000 factories just since the year 2000. (6)
Our consolation: waste product and waste paper will continue as our largest export and we will sell more of it. It won't be Roman manure but you won't be able to tell the difference.
In attempting to borrow and increase production, American producers will find they have too much debt from too many stock buybacks. Making matters worse, producers only expand production and add supply if the return on their invested capital is higher than their cost of capital. It won't be. Exogenously derived inflation and commensurately higher interest rates, all in conjunction with higher dollar priced raw materials and commodities will cause costs to exceed those potential ROIs restraining new supply. In addition, the vast majority of foreign made machine tools will be economically unaffordable to many U.S. producers. In turn, foreign lenders, anticipating an even further dollar decline, will demand an expanding rate premium over inflation. Investors will seek refuge in gold and other currencies rather than production. In conjunction with the need to print money to ameliorate debt, there will be a mad dash to salvage any remnants of one's purchasing power and that will supplant any proclivity to invest. America will be boxed-in.
Therefore, America needs a plan now that will mitigate future long-term trade and budget deficits, an overall blueprint where everyone is better off, including our trading partners.
Part I - Balancing Trade
I propose that when the U.S. runs a trade deficit with any country for five years, an automatic import limit comes into play in the sixth year mandating a reduction in the trade deficit with that specific country by 20%. A 10% increase in American exports and a 10% decrease in imports relative to that country would fit the bill, but either way, an additional 20% annually mandated reduction in the trade deficit would continue for four more years until trade is balanced. Then, the law would again go into hibernation for five years allowing free trade with that country to resume. No tariffs, just a country specific trade deficit limit that acts as a current account safety mechanism that reduces the dangers of de-industrialization.
This gradualist method would also insure that our trading partner's interests would now be aligned with ours, providing them with a strong incentive to buy more American products. As a result, they would bring to bear innovative solutions on how to import more of our products so that they could export more of theirs. Ultimately, this would be a much firmer foundation for world trade.
Part II - Return to Fundamentals
Modifications in our trade policy are not the only changes needed for the U.S. economy to improve. The second part of a comprehensive plan would require significant reductions in corporate and personal income taxes, government spending and entitlements. A flat tax of 22% at the Federal level with a maximum combined state and local income tax of 4% would revive U.S. fortunes better than any single factor. It is no coincidence that Hong Kong, with a maximum 16% income tax rate, has over the long term consistently been one of the world\’s best performing economies.
Furthermore, there would need to be significant mitigations in the regulatory and environmental stranglehold on industry and we would also need to closely monitor unreasonable and spurious demands from U.S. labor so that we don't engender more outcomes like the City of Detroit when U.S. manufacturing revives. On balance, controls on crony capitalism and corporate lobbying would also need palliations. In the end though, rising U.S. high value factory production would increase the number of higher paying jobs and U.S. workers would again become become consumers of tangible U.S. made products. This would result in improved aggregate demand, savings, and investment resulting in greater prosperity for the U.S. economy.
It is clear that if we fail to take these actions, our long-term trade deficits alongside our cumulative budget deficits will eventually destroy many of our remaining industries as well as our military.
Forty years of trade deficits might lead one to agree with what we are told; that trade deficits, like budget deficits, don\’t really matter. But as Rudiger Dornbusch commented; "In economics, things take longer to happen than you think they will, and then they happen much faster than you thought they could."
Frank Berlage is the CEO of Multilateral Partners Global Advisory Group L.L.C., a private equity firm based in La Jolla, California.
America and much of the world suffers from the impediments of aberrant subpar economic growth and notable income disparity. Monetary and fiscal expansions along with extraordinary debt growth have failed to ameliorate these conditions and no one seems to have any real answers to the world’s declining economic growth rates.
Many believe that excess debt is the cause of our weak economy but perhaps debt is just a symptom. To define the real problem might we have to look to our political structure for a clear explanation of our predicament?
When Winston Churchill noted that "Democracy is the worst form of government, except all those others that have been tried"he outlined his general frustrations but failed to point out the specifics. Today we see that America, Europe, Japan and others suffer from what is most certainly the tragic flaw of modern democracy and one that conflicts directly with free enterprise and its natural product of prosperity. This is the construct of modern democratic politicians in their ubiquitous declarations;"Give us your votes and we will give you free stuff."….free stuff paid for with ever-increasing amounts of debt.
John Adams and Alexis deTocqueville described this flaw as a "tyranny of the majority"but could it be better described as a"tyranny of the minority", epitomized each day in the proclamations of those aspirational politicians before each election?
When Barney Frank wanted to offer up free stuff to unqualified homebuyers in 2003, he said,"I want to roll the dice a little bit more in this situation toward subsidized housing." However, in pressuring Fannie Mae and Freddie Mac to change their policies to give cheap mortgages to the constituency he probably did not realize the events he would set in motion or that the eventual outcome would be a debt crisis of epic proportions.
Churchill was right. Democracy is the best form of government. However, it is this gaping hole in our democracy’s design and structure that has inflicted us with a progressively worsening worldwide debt crisis and the greatest threat to our prosperity since the Industrial Revolution. If it is not permanently addressed soon, it will surely escalate toward another breaking point in the future.
According to the Mckinsey Global Institute’s Report "Debt and Deleveraging -Not Much",global debt loads have increased by $57 trillion to $199 trillion in just the last seven years. To keep this in perspective, the aggregate stock market capitalization of the entire S&P 500 is approximately $21 trillion; so every 30 months the world's economies are adding additional debt greater in sum and proportion than that manifested before the Great Depression and in an amount equal to the capitalization of all the companies in the S&P 500.
The Europeans, for their part have discovered that promising "stuff" to get elected is the easy part; not bankrupting the economy in the process is a bit more difficult. As people get more accustomed to free stuff or living off government handouts, their moral construct debilitates. Each day we move closer to an eventual outcry of "If I can get free welfare, why not free everything?"
The inherent attractiveness of free stuff and the benefits to the politicians that hand it out are destructively penetrating to free enterprise and prosperity. While any compassionate society should provide well for the 5-8% of the population that suffer from real genetic or physical disabilities, the demands of those who simply don't want to work are now inhibiting the ability of society to provide for those that actually have genuine physical disadvantages. In recent years when 90% of Long Island Railroad workers retired with a "disability" or when 82% of senior California State Troopers claimed they were "disabled" in their last year before retirement, the effect on the genuine needs of society and the truly deserving was radically compromised as a result. This fraudulent mis-allocation of resources does not even address the astonishing limitations such debt places on other scarce resources like education and infrastructure that are needed to promulgate a vibrant functioning system. However, we can be sure of is that those Long Island Railroad workers and California State Troopers promptly voted for whichever politician endorsed their benefits.
As New Jersey Governor Chris Cristie pointed out in his April 14th New Hampshire speech;
"In 1960, when John F. Kennedy was elected President, 26% of the federal budget was spent on payments to individuals. Today, that number is 71%. In the last 25 years, while our economy has grown by over 200%, Medicare has grown by 539%. Medicaid and related programs have grown by well over 800%. They are 9 times as big as they were 25 years ago and the U.S. economy is only 3 times as big. The share of working age Americans collecting disability has doubled in the last twenty years – from 2.3% to 4.6%. The disability rolls have increased by over 1.5 million just since January 2009, to more than 11 million people. This is up from just 2.7 million in 1986. This is not sustainable."
The bigger problem is that most government transfers to individuals fail to produce a productive long-term return to the economy and other critical needs go unmet. All of this short circuits the natural free enterprise system resulting in increasing income disparity. In essence, capital is consumed to give people fish and as a result there are no returns available for capital investment or to expand private sector employment as they might be if the funds were invested in the growth of, say, the fishing industry. The result is that the economy staggers along like a marathon runner with a backpack of rocks with no way to disperse the burden by lowering interest rates as it has in past years.
Presently, our accumulated debt and regulatory burdens like Dodd Frank leave little room for increasing credit growth, the lifeblood of a money-multiplied economy. Furthermore, when debt is increasing faster than the GDP, net productive economic returns are not available to service the larger debt load. This means that the burden of excess debt eventually becomes so precarious that policy makers are ultimately faced with a choice between deflationary defaults or a significant rise in inflation through direct monetizations.
Compounding the issue given the interrelated nature of the world economy is that the debts of one country affect all countries. Without increasing credit growth on the part of their debt laden western customers, China, Korea, Vietnam and many other producers are forced to add more debt to assist their own slowing economies. Eventually, even non-democratic, more centrally planned economies are drawn into the same debt quandary.
So, how has the United States afforded the parabolic rise in entitlements and the resulting debt growth over the last 20-30 years without collapsing its economy? The answer lies in declining interest rates and their high inverse correlation coefficient with aggregate debt growth.
To better understand this concept compare the expansion of debt in U.S. economy overall to the expansion of debt for an investment in a house or real property. Holding other factors constant, such as the down payment and property taxes, a home buyer can generally get twice the mortgage or buy twice the house relative to his income at interest rates that are one half of their previous levels. Similarly, the U.S. economy currently supports public and private debt of 353% of GDP compared to only 170% of GDP in 1980. This has occurred, in part, because of declining interest rates that over the last 30 years has resulted in the real debt service burden relative to GDP declining while at the same time the actual aggregate gross debt itself has grown dramatically. In short, as debt to GDP has risen, interest rates have declined, thereby lightening the load. Lower rates have therefore performed the same function as they would for a home buyer and it seems clear that declining interest rates have in part, enabled a large part of our massive debt growth.
However, there is a rub for the future. The closer you get to zero rates, the harder it becomes to push rates below the zero bound to keep the debt service burden on the growing gross debt at a mitigated level. For example, when you have to pay your bank to hold your money, instead of the other way around, it creates a propensity to seek cash withdrawals that in turn inhibits rates dropping far enough below the zero mark to reduce the larger effective debt service burden on a larger gross debt. Therefore, future additional debt burdens that result from entitlements and other non-productive investments will go unmitigated by lower rates. At that point, accretions to debt begin to inhibit growth to an even greater degree, which might also begin to explain the weaker economy we see today.
What are the answers for us?
One thing is clear, additional fiscal stimulation through even more debt is not the answer. Japan spent 20 years patiently waiting for growth to re-emerge, all the while adding debt to their national accounts. Some believe that by waiting to monetize their debt and make structural changes, the Japanese only ended up with a bigger problem and eventually had to debase their currency anyway. In addition, many economists believe that the American public will soon tire of below trend growth and will demand quicker action to reduce the debt burden through a combination of inflation and higher GDP growth. However, the other problem is that increasing fiscal stimulation past a certain point inevitably results in a rapidly declining return of GDP growth for each fiscal dollar borrowed and spent by government.
But there are no perfect choices for treating excessive debt expansion and it often comes down to a choice between a 1930's type deflationary default with its associated obsolescence and decay on the one hand, or a 1980's monetary induced inflation on the other. Inflation at moderate levels does tend to do less physical economic harm than default because on a comparative basis the use of inflation will better maintain the manufacturing infrastructure for the bulk of the industrial base. However, the problem in selecting inflation as a solution is that one can never be sure it will be controlled once gets a little bit out of the box. On the other hand, without inflation, excessive or unserviceable debts frequently culminate in default alongside deflation and this usually produces a worse manufacturing and economic abyss similar to the 1930's, which turned out to be a deflation that was extremely difficult, if not impossible to climb out of until World War II came along.
While a combined growth and inflation rate of 6.8% would reduce real debt/GDP back to 1980 levels in roughly 10 years, it would not solve democracy's long-term problem of vote buying financed by debt. Moreover, it may be true that a gold standard might stop money printing by the central banks but it would not completely stop politicians from expanding nominal debt to buy votes. Certainly, the implied currency restraints of the Euro did little to stop excess borrowing and spending by countries such as Greece, Spain, Italy, France and many others.
In considering other answers, a restraint like sequestration has brought down the U.S. budget deficit over the last few years, but in the long term, it will likely only prove to be a short-term solution, one that is washed away at a moments notice on the whim of the legislature. Consequently, in the end, the only real answer is to take the capacity for excessive deficit spending out of the hands of the politicians. In the U.S. the best way to do that is with a constitutional amendment that limits excess debt growth and confines any debt/GDP expansion to periods of real emergency with strict instrumentalities to eliminate those exceptions once the emergency has passed.
Just because the next crisis has not yet arrived does not mean that we can continue to build a debt structure to the sky with no long-term control mechanisms in place. As Rudiger Dornbusch commented; "In economics, things take longer to happen than you think they will, and then they happen faster than you thought they could."
America needs to make a real concerted effort to live within its means and to eliminate the proclivity to hand out debt-financed goodies before each election. America needs to permanently fix this flaw of vote buying. It needs to reduce the size of government and end the government's blatant waste of the taxpayer's dollars. With a 20% flat personal income tax rate and the saving of much of its future debt service costs, America's economic potential could reawaken with a vengeance.
By contrast, in failing to control our debt growth, we are not just mortgaging our children’s future; we are running the real risks of another crisis, likely to be greater than the last and possibly sooner rather than later. Only by acting now to mandate predictable and prudent spending with limited debt, can free enterprise fulfill the promise of its potential and enable greater prosperity at all levels of society.
Frank Berlage is the CEO of Multilateral Partners Global Advisory Group L.L.C., a private equity firm based in La Jolla, California.
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