DEFICITS AND DOLLARS
Uncle Sam the International Beggar
Neither a Borrower Nor a Lender Be
A few years ago I went to dinner in Los Angeles with a group of close friends and a couple whom we had recently met. Because some people had very expensive meals with cocktails while others consumed very little, we decided not to divide the bill equally, but rather to each pay for our own consumption. When the bill came we all pitched in what we felt was our fair share (or so we thought).
We came up about $40 short of the tab. Since I had eaten a very modest dinner consisting of a turkey burger and a diet coke, I was pretty sure that I had not made a major mistake in calculating my share; nevertheless I pitched in an extra $5. So did most everyone else, and we paid the bill.
A few days later we revisited the embarrassing shortfall, and we began to piece together the puzzle. Because we were all good friends, we soon figured out that the new couple had consumed the most extravagant meals and had drunk the fancy cocktails yet had contributed almost nothing to the bill. We thus labeled the man "Cheapskate" (he had "paid" for the couple's dinner).
We resolved that in future interactions, we would not allow Cheapskate to take advantage of us. We even practiced confronting Cheapskate over the bill. "I had the turkey burger, what did you have?" Even though such displays are deeply embarrassing, we found them preferable to having Cheapskate take us for more money.
Our role-playing was never put to use with Cheapskate because he met a fate similar to Elvis. He died on the toilet from a heart attack just weeks after shorting us on the bill. After his death, his girlfriend discovered that she had a big mess to clean up—Cheapskate owed money conversion to almost every single person he knew.
A small-scale con artist with a drug dependency, Cheapskate had put "the touch" on everyone by borrowing money and never repaying it. Interestingly, although he owed many people money, his total debt was only a few thousand dollars. People were quick to cut him off. Just as he was never going to get more than $5 from me, others were not willing to make repeated loans.
A lesson from Cheapskate's life is that it is hard to be a perennial borrower. People are built with instincts that prevent and limit exploitation. When we loan money, we expect repayment and stop lending to deadbeats.
The same is true of countries. Those that consume more than they produce must return the favor or get cut off. The "current account" describes whether a country is consuming more or less than it is producing. Countries with current account surpluses, like Japan , are producing more than they consume. The excess Japanese production is being sent to other countries in return for IOUs in the form of money. The current account is the broadest measure of a country's consumption and includes everything from cars to movies, legal services, and investment income. Thus the current account includes the trade deficit and all other international transfers.
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As shown in Figure 6.1, unlike Japan , the United States has a large current account deficit. We've had a deficit for so long that we show the negative current account deficit as positive numbers. Because we can't imagine a world where the United States consumes less than it produces, we measure the amount of profligacy, not its existence. Residents in the United States consume far more than they produce. In return for Saudi oil, Japanese cars, and Canadian lumber, the United States sends the producers IOUs to the tune of about $500 billion a year.
How big is $500 billion a year? The short answer is: the biggest current account deficit in history. The longer answer is: The current account deficit is about 5% of the size of the U.S. economy, which still makes it one of the biggest current account deficits in history. How did we get here?
Current account imbalances are influenced by currency values. When Canadian lumber is made cheap by a strong dollar, for example, we import more logs from Saskatchewan . To understand the U.S. current account deficit we begin by looking at exchange rates.
When I was first learning about money, the British pound was always worth about $2.50. What I didn't realize then was that currency prices were fixed by agreement between governments. Thus the $2.50 was a government-mandated price, not a market price.
In 1944, governments decided that exchange rates were too important to be left to market irrationality. Economists put part of the blame for the Great Depression of the 1930s on wild fluctuations in the value of currencies. Toward the end of World War II, the major economic powers met in Bretton Woods and fixed the value of their currencies. The governments wanted to make sure that the excesses that led to global economic collapse would not reappear. 1
In 1971, Richard Nixon devalued the dollar and destroyed the Bretton Woods pact. Freed from its fixed price, the dollar was free to fluctuate between irrationally low and high values, and to create current account imbalances. As seen in Figure 6.1, from the 1980s until now the dollar's value has led to large and growing U.S. current account deficits.
Current account deficits are a form of borrowing. There's nothing inherently evil about borrowing in general nor in running a current account deficit. College students borrow to further their education, companies borrow to expand factories, and countries borrow to undertake projects that may take years to repay.
For example, the Hoover Dam outside Las Vegas was built in the 1930s and now generates very low cost hydroelectric power. Only a curmudgeon would argue against borrowing for the Hoover Dam on financial grounds (there are, of course, legitimate environmental arguments against dams). Borrowing to develop something is often better than the alternative of no borrowing and no development.
While IOUs are nice, and loans can be good, eventually the piper must be paid. Notice that Wimpy in the Popeye cartoon says, "I'd gladly pay you Tuesday for a hamburger today." He doesn't say I'd gladly eat a hamburger on Tuesday for a hamburger today.
"Neither a borrower nor a lender be" says Polonius to his son Laertes in Hamlet. While this advice appears sound, many scholars think Shakespeare wrote it as an example of a father droning on with obvious and unsolicited comments. In the case of borrowing, the advice is essentially empty. Debts must be repaid, so borrowing and lending are just different phases, not permanent states. It is impossible to go through life as a borrower (although I suppose Cheapskate did).
The implications are clear. Countries with current account deficits must at some point swing to surplus. Thus the United States , currently the world's biggest net consumer from other countries, will become a net producer. In the coming years we will be discussing the size of the U.S. current account surplus. Because the U.S. current account deficit is huge, the inevitable adjustment to surplus will have profound effects on the world's economy and on individuals' investments. Let's look at how this is likely to play out and the implications.
A Euro for Your Thoughts
Investing in stock market, online stock trading, hot stock , buy stock system, trade forex, futuresIn November 2002 my wife and I visited Milan . Walking along the famous shopping street of Via Montenapolean, Barbara spotted a Bottega Veneta purse for the price of 700 euros. At the time, one dollar bought just over one euro so this purse was being offered at the price of about $680.
Both Barbara and I found this $680 purse price to be ridiculous but for different reasons. "Don't you realize that I saw this same purse on sale in New York for over $800!" she said. Biting my lip and suppressing my horror, I said, "I think you should snap it up." On our way back from Europe we flew out of the airport in Cologne . A young German woman about 23 years old was working the customs desk. She said, "You have declared an item worth 700 euros; may I see it?" I showed her the purse, and she gasped, "That's it?" "Yes, isn't it a ridiculous value?" I replied. We returned to the United States with Barbara's beautiful bargain, thereby contributing $680 to the U.S. current account deficit.
Were we to go to Europe in 2004 we would find that purses costing 700 euros translate to a dollar-cost of $850. Costs to U.S. consumers have increased dramatically because the dollar has lost value relative to the euro. Currency devaluations change people's purchasing decisions. Add up enough 700 euro purses not purchased, throw in a few Mercedes that Americans don't buy, and pretty soon a falling dollar leads to a smaller current account deficit.
A current account deficit means that a country is consuming more than it is producing. A simple way to cut back is to raise the price of consumption. This can be accomplished almost magically by changing the value of the currency. Against the euro, the U.S. dollar has lost almost a third of its value over the last few years. As compared to the Japanese yen, the U.S. dollar has been in decline for decades. Thus without any change in dollar wealth, U.S. consumers are now much poorer than we were a few years ago. This weakening of the dollar works to make us consume less from abroad. It also makes the American products cheaper, thus boosting purchases by foreigners.
A cheaper dollar decreases imports and increases exports, reducing the current account deficit.
Real and Nominal Exchange Rates
While exchange rates are a bit abstract for many people, for others they are of visceral importance. I learned this during a 1992 visit to Victoria Falls . I was staying in Zimbabwe across the Zambezi River from Zambia ( Zimbabwe used to be called Rhodesia , and Zambia was Northern Rhodesia ). One day I rented a bicycle and crossed a bridge into Zambia , intending to peddle a few miles to the museum in the town of Livingstone .
Two interesting things happened on the road to Livingstone. First, my bicycle got a flat tire. There was no place to fix the tire, so I decided to ride on the metal rim and pay the owner for any consequent damages. This meant that my already slow pace in the hot sun was further reduced.
Second, a group of Zambians descended on me. The Zambians were hungry to get their hands on some Zimbabwean currency. I found this interesting because I was able to get so much Zimbabwean currency for my U.S. dollars that I felt like a rich man in Victoria Falls . While the Zimbabwean currency was weak compared to the U.S. dollar, it was rock solid compared to the currency of Zambia . So motivated were these Zam- bians to get some "hard" currency that they chased after me for more than a mile—running beside my damaged bicycle in their street clothes and hard-soled shoes.
If one were to visit Victoria Falls today, the situation would be reversed. The Zimbabwean currency is now extremely weak compared to that of Zambia . What happened? The current inflation rate in Zimbabwe is over 640%. By comparison, the Zambian rate of 18.5% looks positively tame. 2 Because of the different inflation rates, the Zimbabwean currency is dropping on a daily basis. People who want to store their money in a stable currency are willing to work hard to avoid Zimbabwean currency.
Of the two currencies, the Zambian is now rock solid because of the difference in inflation rates. The lesson from this is that whenever we discuss exchange rates, we need to be sure to consider relative inflation rates. We care about the purchasing power of our money (the real exchange rate), not the number of bills we can get (the nominal exchange rate). The real exchange rate takes into account inflation rates.
With high inflation rates, the difference between nominal and real exchange rates can be enormous. In January 1913, one U.S. dollar converted into 4.2 German marks. In October 1923, the same dollar was worth over 25 billion German marks! Because German prices had risen even faster than the exchange rate, however, the purchasing power of these 25 billion marks was less than the 4.2 marks in 1913. 3 The nominal value of a U.S. dollar in marks had gone up astronomically while the real value actually fell.
Wouldn't it be nice if we could just ignore the difference between real and nominal exchange rates? Yes, and we will. Most of our discussion focuses on the three big currencies: the U.S. dollar, the euro, and the Japanese yen. All three regions have similarly low inflation rates these days.
If You Want Closure In Your Relationship, Start With Your Legs - Big BoomWhen countries have similar levels of inflation, it is okay to use nominal exchange rates.