econ outlook 2005

Folks,

Here is a fascinating summary by a man who shoould know, and does, and after a
few days I want to take his article apart section by section with my review of
what it means for us at the small business level.

As we start the new year, I'll say it again, being self-employed is about
supporting your chosen lifestyle... doing well and doing good. And by
lifestyle I am thinking along the lines of Maslow's heirarchy rather than some
particular orientation.

Anyway, here we go,,,

THE MISSING LINK
by Dr. Kurt Richebächer

The badly flawed consensus thinking about the implications of sustained large
U.S. capital inflow starts with the error that U.S. assets are uniquely
attractive to foreign investors. The reality is that U.S. investors are earning
far higher returns on their assets in Europe and Asia than foreign investors do
on their U.S. assets. European firms and investors who invested heavily in the
United States during the "new paradigm" years in the late 1990s are still
smarting from horrendous losses. The DaimlerChrysler disaster is by no means an
isolated case.

As to U.S. bond yields, they are just marginally above euro yields, but
considerably below the yields obtainable in emerging countries. What is more,
after inflation, they are the lowest in the world. A falling dollar is, of
course, a virtually prohibitive deterrent to foreign bond purchases. In fact, it
might induce selling.

This leaves the central banks of Asian surplus countries as the potential buyers
of last resort for the dollar, unwanted by private investors. They did heavy
dollar buying in 2003 and in early 2004, but never forget, the dollar purchases
by the central banks have a heavy price in turning healthy economies into sickly
bubble economies.

The sustainability of the U.S. capital inflows is, actually, the totally wrong
question to ask from the American point-of-view. Far more important is another
question, concerning the effects of the trade deficit on the U.S. economy, in
particular on employment and income creation. We find that the dogmatic belief
in the mutual benefit of foreign trade has stifled any reasonable discussion in
this respect.

The benefits for the surplus countries are obvious. Exports in excess of imports
create higher employment, higher profits and higher incomes. But what are the
benefits to the United States? Frankly speaking, we do not see any true benefit
of a trade deficit. What the American "mutual-benefit" apostles fail to see is
that a balance in benefits essentially presupposes a balance in the underlying
trade.

Yet there is a widespread view that the flood of cheap imports, by keeping a lid
on U.S. inflation and wage pressures, fosters lower interest rates, which tend
to spur economic growth.

For us, both effects are not beneficial at all, because the imports implicitly
distort both inflation rates and interest rates to the downside. In essence, the
lower inflation rates allow a looser monetary policy than domestic conditions
justify. For Greenspan and many others wanting the loosest possible monetary
policy, this was certainly a highly esteemed effect of the trade deficit. For
us, it is insane.

Nobody seems to realize the enormous damages that the egregious trade deficit
has inflicted on the U.S. economy. Indisputably, it diverts U.S. demand from
domestic producers to foreign producers, and this implies an equivalent
diversion of employment and associated income creation from the United States to
these countries. That is the manifest direct damage of the trade deficit to the
U.S. economy, the obvious main victim being the manufacturing sector, with
horrendous job and income losses.

Blinded by the dogma of compelling mutual benefits; policymakers, economists,
investors and the American public flatly refuse to see this disastrous causal
connection. The alternative explanation is that America's extremely poor job
performance has its main cause in the highly desirable high rate of productivity
growth.

It is a convenient, but foolish explanation, reminding us of the early days of
industrialization, when people destroyed machinery for fear of unemployment. For
us, productivity growth that destroys millions of jobs is definitely suspect as
a mirage. Historically, strong productivity growth has always coincided with
strong capital investment involving, in turn, strong employment growth in the
capital goods industries.

That is presently, of course, precisely the missing link in the U.S. economic
recovery. (As an aside, in a healthy economy with adequate savings, cutting
labor costs generally takes place through investment, not through firing.)

The job losses from the soaring trade deficit have always been there. But they
did not show up in the aggregate for many years because the booming economy -
driven by extremely loose monetary policy - created sufficient alternative jobs.
But this alternative job creation has drastically abated since 2000, and the
soaring trade deficit's damage to manufacturing is now surfacing in full force.

Having said this, we hasten to add that the U.S. trade deficit must be seen as
one imbalance among several others, whether zero or even negative national
savings, a soaring budget deficit, record-low net capital investment or sky-high
consumer debt. They all derive from the same underlying key cause: Unprecedented
credit excesses that have boosted consumption for years at the expense of
capital formation.

What governs the U.S. trade deficit is not the law of "comparative advantages,"
but the careless depletion of domestic saving and investment resources though
policies that have recklessly bolstered consumption. Essentially, employment
creation through capital investment is out. Putting it bluntly, the U.S. trade
deficit, like all other imbalances, reflects a grossly skewed resource
allocation toward consumption.

To American economists, this idea that over time, excessive consumer spending
leads to recession and worse, by crowding out capital investment may seem
preposterous. Widely unknown, it happens to be the central idea that F.A. von
Hayek developed in his famous lectures at the London School of Economics in
1931.

In essence, he explained in great detail that an increase in consumer demand at
the expense of saving will inevitably lead to a scarcity of capital, which
forces a "shortening in the process of production," and so causes depression.
Putting it in simpler parlance: Excessive consumption inevitably crowds out
business investment. As a share of GDP, consumption in the United States is
presently excessive as never before. And it keeps worsening.

Assessing the U.S. economy's prospects, it also has to be realized that the
bubble-driven consumer-spending boom represents artificial, unsustainable
demand. Apocalypse will follow when the housing bubble bursts - which is sure to
happen in the near future.

As the Boston Herald recently reported: "[Stephen] Roach met select groups of
fund managers downtown last week, including a group at Fidelity. His prediction:
America has no better than a 10% chance of avoiding economic 'Armageddon'...
Roach's argument is that America's record trade deficit means the dollar will
keep falling. To keep foreigners buying T-bills and prevent a resulting rise in
inflation, Federal Reserve Chairman Alan Greenspan will be forced to raise
interest rates further and faster than he wants. The result: U.S. consumers, in
debt up to their eyeballs, will get pounded."

We could not agree more. Our particular nightmare is that the huge carry trade
bubble in bonds will inevitably burst in this process. A fire sale of bonds in
unimaginable proportions would begin, with bond prices crashing and yields
soaring. With the prices of housing, stocks and bonds crashing, the entire U.S.
financial system would be at risk.

It is typically argued that the U.S. economy is importing too much in comparison
to exports. Superficially, that is true. Yet on closer look, it is a mistaken
perception. Compared to other industrialized countries, U.S. imports are very
low as a ratio of GDP. The true key problem is abysmally low goods exports,
accounting lately for barely 7% of nominal GDP. This compares, by the way, with
a German goods export ratio of 35% of GDP.

The next implicit question is the cause or causes of this extremely low U.S.
export ratio. The answer is strikingly obvious. It is precisely the same cause
that chokes productive capital investment - the progressive shift in the
allocation of available domestic resources away from capital formation through
saving and investment in plants and equipment, and toward immediate consumption.

That is the supply-side problem. Yet there is a demand-side problem, too.
Greenspan and others like to boast that America is creating growing demand for
the rest of the world. The ugly truth, rather, is that U.S. monetary policy has
been excessively loose in relation to potential domestic output, because
Greenspan has wanted maximum economic growth for years. But lacking domestic
output capacity to meet the soaring domestic demand, an increasing share of the
demand creation from monetary excess exited to foreign producers, resulting in
the huge U.S. trade deficit.

It is a flagrant policy failure that has created a monstrous, unsustainable
imbalance, both domestically in the United States and globally. However, for
years, American policymakers and economists have glorified this deficit as
America's great contribution to world economic growth. But the day of reckoning
is rapidly approaching.

Regards,

Kurt Richebächer
for The Daily Reckoning

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