FROM KNOW-HOW TO NOWHERE

A weakened U.S. economy shouldn't surprise anyone. It is a direct result of the questionable nature of the so-called economic recovery. Any other country faced with these many imbalances would have collapsed long ago. But the U.S. dollar was spared this fate when Asian central banks began accumulating the dollars needed to avoid rises in their currencies.

Both the United States and China practice credit excess, but with a crucial difference: In the United States, the credit excesses went into higher asset prices and, more notably, into personal consumption.

In Asia, credit excesses went into capital investment and production. The result is an odd disparity between the two economies: Americans borrow and consume, and the Asians produce. This symbiosis plays out in the trade gap. Ironically, this ever growing problem is ignored on the national level and plays virtually no role in U.S. economic policy or analysis. In the second quarter of 2004, the increase in the trade gap subtracted 1.37 percentage points from GDP (based on domestic demand growth). In comparison, during the 1980s, policy makers and economists worried about the harm that trade deficits were causing in U.S. manufacturing.

In a September 1985 move orchestrated by James Baker, the U.S. Treasury secretary, the finance ministers of the G-5 nations agreed to drive the dollar sharply down in concerted action. By the mid-1990s U.S. policy makers decided that trade deficits were beneficial for the U.S. economy and its financial markets.

Cheap imports were playing an important role in preventing inflation and, as a result, higher interest rates. Had the decision been to allow interest rates to rise, it would have had the effect of slowing down consumer spending. Instead, spending is out of control and the trade gap is the consequence. Ultimately, the victim in all of this is going to be the U.S. dollar.

The economic cycle involving inflation, higher interest rates, monetary tightening, recession, and recovery has a predictable postwar pattern in America and in the rest of the world. But we've taken a departure from this for the first time. A critic might argue that now the United States is enjoying a prolonged period of strong economic growth with low inflation and low interest rates. What could be bad about that?

Well, what's bad about that is the fact that we are not experiencing strong economic growth. U.S. net business investment has fallen to all-time postwar lows, under 2 percent of GDP in recent years. At the same time, net financial investment is running at about 6 percent of GDP. In other words, the counterpart to foreign investment in the U.S. economy has been higher private and public consumption, accompanied by lower saving and investment.

Official opinion in America says that the huge U.S. trade gap is mainly the fault of foreigners, for two reasons. One is the eagerness of foreign investors to acquire U.S. assets with higher returns than in the rest of the world; the other is supposed to be weaker economic growth in the rest of the world. In this view, the trade gap directly results from foreign investment because it provides the dollars that the foreign investors need.

The first thing to realize about a deficit in foreign trade is that, by definition, it reflects an excess of domestic spending over domestic output. But such spending excess is actually caused by overly liberal credit at home, and not really by cheaper goods produced elsewhere.

Just as shaky is the second argument, ascribing the trade gap to higher U.S. economic growth. Asian economies, in particular China, have much higher rates of economic growth than the United States. Yet they all run a chronic trade surplus, which is caused by high savings rates. This is the crucial variable concerning trade surplus or trade deficit.

The diversion of U.S. domestic spending to foreign producers is, in effect, a loss of revenue for businesses and consumers in the United States. Is this important? Yes. The loss is higher than $500 billion per year. This is America's income and profit killer, and it can't be fixed with more credit and more consumption. This serious drag of the growing trade gap on U.S. domestic incomes and profits would have bred slower economic growth, if not recession, long ago. This has so far been delayed by the Fed's extreme monetary looseness, creating artificial domestic demand growth through credit expansion. The need for ever-greater credit and debt creation just to offset the income losses caused by the trade gap is one of our big problems.

An equally big problem is a distortion of the numbers. We are officially in great shape, but the numbers don't support this belief. Personal consumption in the past few years has increased real GDP at the expense of savings, while business investment has grown only moderately.

This can only end badly. Normally, tight money forces consumers and businesses to unwind their excesses during recessions. But in the latest round, the Fed's loose monetary stance has stepped up consumers' spending excesses. Our weight trainer is feeding us Big Macs. If we were to measure economic health by credit expansion, the United States has the worst inflation in history. And still our experts are puzzled by a soaring import surplus.

The problem here is that American policy makers and economists fail to understand the significance of the damage that is being caused by monetary excess and the growing trade gap. The trade gap is hailed as a sign of superior economic growth, while the hyperinflation in stock and house prices is hailed as wealth creation.

Until the late 1960s, total international reserves of central banks hovered below $100 billion. At the end of 2003, they exceeded $3 trillion, of which two-thirds was held in dollars. By far the steepest jump in these reserves, of $907 billion, occurred in the years 2000-2002. With China and Japan as the main buyers, Asian central banks bought virtually the whole amount.

In a speech given in Berlin in 2004, Alan Greenspan was amazingly frank about the "increasingly less tenable U.S. current account deficit," suggesting that foreign investors would eventually reach a limit in their desire to finance the deficit and diversify into other currencies or demand higher U.S. interest rates. He expressed the new consensus view in America that the dollar has to bear the brunt of reducing the U.S. federal budget deficit.

American policy makers seem to want a lower dollar, apparently believing (or hoping) that this will take care of the U.S. trade deficit, and they appear to regard this as an easy solution to this problem.

But this will not solve the problem at all. The premise is wrongly based on the assumption that an overvalued dollar has caused of the U.S. trade deficit - an entirely unsupported view.

It is widely assumed that rising stock and house prices will keep American consumers both willing and able to spend, spend, spend their way to wealth - indefinitely. But the transfer of U.S. net worth to interests overseas is alarming, and it endangers U.S. economic and political health. Warren Buffett, who kept his vast fortune invested at home for more than 70 years, decided in 2002 to invest in foreign currencies for the first time. Buffett and management of Berkshire Hathaway believe the dollar is going to continue its decline. We should not need confirmation such as this to recognize the inevitable; but it bolsters the argument that the dollar is, in fact, in serious trouble, and that this trouble is likely to continue.

In addition to debt problems at home, Buffett made his decision based at least partially on the ever-growing trade deficit. He warned:

"We were taught in Economics 101 that countries could not for long sustain large, ever-growing trade deficits. At a point, so it was claimed, the spree of the consumption-happy nation would be braked by currency-rate adjustments and by the unwillingness of creditor countries to accept an endless flow of IOUs from the big spenders. And that's the way it has indeed worked for the rest of the world, as we can see by the abrupt shutoffs of credit that many profligate nations have suffered in recent decades. The U.S., however, enjoys special status. In effect, we can behave today as we wish because our past financial behavior was so exemplary - and because we are so rich.

Buffett is especially concerned about the transfer of wealth to outside interests. He notes:

"Foreign ownership of our assets will grow at about $500 billion per year at the present trade-deficit level, which means that the deficit will be adding about one percentage point annually to foreigners' net ownership of our national wealth. As that ownership grows, so will the annual net investment income flowing out of this country. That will leave us paying ever-increasing dividends and interest to the world rather than being a net receiver of them, as in the past. We have entered the world of negative compounding - goodbye pleasure, hello pain."

Addison Wiggin

The Daily Reckoning

Addison Wiggin is the editorial director and publisher of The Daily Reckoning. Mr. Wiggin is also the author, with Bill Bonner, of the international bestseller Financial Reckoning Day and the upcoming thriller Empire of Debt. Mr. Wiggin is frequent guest on national radio and television programs.

The above essay was taken from Mr. Wiggin's newly-released book, The Demise of the Dollar...and Why It's Great for Your Investments.