In the 1980s, the U.S. began posting large, chronic trade deficits. Pundits at the time warned that the trend was unsustainable and that an economic day of reckoning was coming. Tapping the era's negative zeitgeist on trade were books like Clyde Prestowitz's widely read Trading Places: How We Allowed Japan to Take the Lead.
Twenty years on, no one worries that the perennially ailing Japanese economy is a threat to America. Meanwhile, the U.S. trade deficit has continued rising, but without stunting America's growth. The imbalance of late dwarfs the levels considered dangerous in the 1980s. For 2005, the U.S. trade gap was a staggering $716 billion--five-fold more than the biggest annual deficit in the 80s. By last year's third quarter, the red ink hit another all-time high in dollar terms--equal to nearly 7 percent of the U.S. economy.
Much to the chagrin of the pessimists, the American economy has chugged ahead quite nicely in recent years despite the deficit's surge. But the pessimists don't give up easily. China has replaced Japan as the new trade demon, and some analysts warn that America's rising deficit is an even bigger ticking time bomb. Such thinking resonates with some powerful allies in the new Democratic Congress, where populist-styled talk of trade barriers and tariffs is on the rise again.
But is it really different this time? Is the trade deficit finally poised to wreak havoc on the U.S. economy and reorder the investment landscape? Or is the renewed anxiety one more case of misplaced worry?
As always, the outlook depends on the analyst. The main schools of thought fall into two camps. Optimists argue that a trade deficit, even one as elevated as America's, isn't worrisome because it reflects economic strength. Imports exceed exports because the U.S. economy is growing.
So says Daniel Griswold, director of the Center for Trade Policy Studies at the Cato Institute, a free trade-oriented think tank in Washington, D.C. He insists that deficits or surpluses in trade are neither inherently bad nor good. Japan has had a trade surplus for many years, he points out, but that hasn't immunized its economy from recession, deflation and other ills. Much more important are the underlying economic forces that created the deficit or surplus. "Investors should be looking at 20 other indicators before considering the trade deficit as some kind of indicator of where they should be investing their money," Griswold advises.
On the opposing side are those who warn that a rising trade deficit is a symptom, if not a cause of America's declining competitiveness and increasing dependence on foreign capital. The Economic Policy Institute, another Washington think tank and one that focuses on American workers, has published reports in recent years warning of the detrimental effects--such as job losses--thrown off by America's trade deficit and globalization in general.
No one disputes that America relies more than ever on foreign economies for capital and goods. But all's well, as long as China and others are willing and able to finance the U.S. trade and government budget deficits and sell wares here at relatively low prices. Or so it seems. But the cozy relationship can't last forever, some pundits say. One day, China and other nations sitting on hefty trade surpluses will be less willing to provide inexpensive financing and manufactured items.
If and when that day comes, the U.S. will face a less forgiving global economic climate. The dollar will fall relative to other currencies, bringing the flip side of globalization to America: Higher interest rates, higher prices for imports and perhaps a general decline in the standard of living for U.S. citizens. That, at least, is one theory that's receiving more lip service these days and inspiring an expanding array of mutual funds and ETFs intent on profiting from the expected stumble in the greenback.
The problem with predicting America's economic future by way of its trade deficit is that there's not much precedent for review. Great nations harboring the world's reserve currency are a rare breed, and so the historical sample is thin. The closest parallel in modern times is the Great Britain of a century ago.
The British experience in the early 20th century is said by some to offer a preview of America's in the 21st, and by that standard the outlook isn't pretty. The Empire's economic supremacy was beyond question in the years before World War I. The pound sterling was then the world's reserve currency because Britain was the center of international trade. Like the dollar today, the pound then was a natural destination for parking money, in part because so much of the world's leading commodities were priced in British currency.
But as England's preeminence began to fade after World War I, the country's net-creditor status slipped to net debtor. Sound familiar?
Among the benefits that come with printing the world's reserve currency is the luxury of spending beyond the host country's income. Indeed, credit is routinely extended to the U.S. in part because the dollar is the globe's primary medium of exchange. If and when the dollar loses its reserve-currency status, or materially begins sharing that rank with other currencies, a downward realignment in American living standards may emerge.
One warning sign that the U.S. risks such a future is the sliding value of the dollar so far in the 21st century. At the end of 2006, the U.S. Dollar Index (a trade-weighted benchmark of the greenback based in foreign currencies) had tumbled by nearly one-third during the previous five years. By some accounts, the fall is only a prelude for what awaits the battered buck.
A growing number of ETFs and mutual funds are banking on a bear market in the dollar. But while it's easy to bet on the fall and decline of the world's reserve currency, is it prudent? Yes, says Axel Merk, portfolio manager of Merk Hard Currency. The two-year-old mutual fund was created to exploit the anticipated decline in the greenback by holding foreign currency-denominated money market accounts peppered with positions in a gold ETF.
Dave Wilder, a CFP and executive vice president of Financial Management Group in Cincinnati, tells Wealth Manager that he recently put as much as 6 percent of client portfolios into Merk Hard Currency. Another 6 percent was in the share class of Pimco Foreign Bond Fund that doesn't hedge foreign-currency exposure.
"We see 2007 as being a challenging market environment, which will be the result of a slowing U.S. economy," says Wilder. "As a result, China and Japan--the largest purchasers of U.S. debt--will likely allocate to other areas of the world that are doing better, such as Europe...or to reinvesting in their own economies."
The greenback's fate may increasingly depend on decisions made in Beijing, Tokyo and other capitals that hold the bulk of foreign dollar reserves born of surging exports to America. China alone recently topped $1 trillion in foreign reserves, according to Brad Setser, an economist with Roubini Global Economics in New York. But international trade isn't a one-way street. America's profligacy may be extraordinary, but so, too, is the world's excess savings. Deficit and glut are two sides of the same coin, and each has found a willing partner. Dramatically changing the relationship would bring repercussions all around, leading some to predict that China, Japan and others won't do anything to rock the boat.
Asia's export-heavy economies draw enormous benefits from America's consumption driven deficits, and so there's a strong incentive to maintain the status quo. China's mercantilist agenda is powered by the People's Bank of China's strategy of keeping the renminbi abnormally weak against the dollar. In turn, the currency peg promotes exports by keeping Chinese products relatively inexpensive in dollar terms.
What does China do with its escalating pile of dollar reserves born of exports? Most of it--as much as 70 percent, Setser estimates--is invested in high-quality U.S. bonds. In fact, one recent study calculates that the overall foreign purchases of U.S. fixed-income securities lowers American interest rates by around 100 basis points.
Nonetheless, pressure for change is building in Washington. Based on the economics, China's currency deserves to strengthen against the dollar.
The danger is that a rebalancing takes on a life of its own and unfolds faster and delivers more pain than officials would prefer. And while a lower dollar will reduce prices of American exports, a cheaper dollar implies higher prices for imports into the U.S.
If there's one point that all sides agree on, it's that the current climate can't continue forever. The trade trends at some point must reverse, or at least stabilize. The bigger question is one of timing and magnitude: When will the shift begin, how long will it last, and how much pain will it unleash?
The predictions are all over the map, ranging from a gradual transition to one with severe aftershocks. Cato Institute's Griswold expects a "mild evolution."
But while he isn't worried about a rebalancing per se, he is concerned about a political "solution" in the form of a protectionist backlash that breeds new hostility to foreign investment. "If that happens, it'll not only hurt domestic investors, but it will discourage foreign investors, which would drive away foreign capital to other markets, causing a weakening of the dollar."
But if the imbalances are allowed to adjust on their own, Griswold says the transition can be smooth. He reminds that the U.S. ran trade deficits for most of its history up until World War I. "Those deficits unwound without a hard landing."
Will history repeat? Again, much depends on how America reacts. "Serious economic mismanagement would lead to the substitution of other reserve currencies for the dollar," warned Barry Eichengreen, an economics professor at the University of California, Berkeley, who studies international trade issues, in a 2005 speech to the Economic History Society. Allowing the trade deficit to persist is one example which could eventually result in higher inflation and a drop in the dollar, he counseled.
But history, Eichengreen emphasized, isn't fate. With enlightened policies, the U.S. can transition from being the lone economic superpower to a first among equals.
Nonetheless, prudence suggests hedging one's bets by diversifying globally across equities, bonds and beyond. When it comes to confidence about the future, politics loses against asset allocation every time.
James Picerno (jpicerno@highlinemedia.com) is senior writer at Wealth Manager.
