America's Huge, Ugly Twins

Twin #1

The balance of trade or balance of payments deficit is officially described as:

The balance between all payments out of a country within a given period and all payments into the country, an outgrowth of the mercantilist theory of balance of trade. Balance of payments includes all payments between a country and its trading partners and is made up of the balance of trade, private foreign loans and their interest, loans and grants by governments or international organizations, and movements of gold (capital account).

Simply put, the balance of trade deficit is the bottom line when the total of all the money the US owes to all the other nations — for all the goods and services we bought from them, plus all the money we give to other countries in foreign aid — is subtracted from the total of all the money for goods and services the rest of the world bought from us. It has been a negative number pretty consistently since the 1950s.

At the time of this writing, the Bureau of Economic Analysis at the US Department of Commerce tells us the current account deficit "increased to $144.9 billion (preliminary) in the first quarter of 2004 from $127.0 billion (revised) in the fourth quarter of 2003."

Some simple math shows a yearly deficit at this rate comes to a tad more than $586 billion. Yes, billion. Every day, the US goes into debt to the rest of the world to the tune of more than $1.6 billion. If you like smaller numbers, it breaks down to just over $1.1 million per minute. While we don't get foreign aid as such from other countries, this massive infusion of credit from the rest of the world certainly aids our country in maintaining the lifestyle to which we have become accustomed. And that's just the deficit from twin 1.

Twin #2

The government budget deficit (GBD) is the bottom line difference between what the US spends in excess of what it takes in. After the government goes through all the billions it collects in taxes, plus the fines, penalties, rents, and fees, it doesn't stop spending. The resulting GBD is the amount the government spends above and beyond what it has collected.

This GBD is financed by government debt certificates (US bonds, US notes, and so forth), which are bought by individuals — as in savings bonds — by institutions, other branches of our own government (referred to as monetizing the debt), and the governments of foreign nations. This deficit grows not only from what the US government spends and gives away, but from the interest generated by this large and growing debt.

The White House put out the following information a couple of days before I started this article:

This Mid-Session Review of the Budget revises the estimates of receipts, outlays, and the deficit to reflect economic, legislative, and other developments since February. The deficit for 2003 is now estimated at $455 billion, up from the $304 billion deficit estimated in February.

At one time earlier in 2004 the estimate grew to $521 billion, so $455 billion almost seems like a bargain. This huge, ugly twin is nearly $1.25 billion per day of an additional burden on the citizens, current and future, of the US. This $455 billion comes to about $1,600 for every American man, woman, and child. A glance at reality quickly shows that it means a great deal more than $1,600 out of each working person's paycheck, because it doesn't take much to divine that there are a bunch of folks these days who are out of work.

Remember, the $455 billion in discussion is just the amount of dollars added to the national debt for the current fiscal year! The total national debt is around $7 trillion. That's trillion, a seven with 12 zeroes. You don't want to know your share.

Okay, it's a tad under $25,000 for every living soul inside our borders. As of May 2004, there were about 131,224,000 jobs in the US and somewhere around 290 million people. The numbers are fuzzy at best, but the national debt now comes to about $53,000 owed for every job — from car washer to chief executive officer — in the US. If you still aren't concerned, you haven't been paying attention.

Changes in attitudes

In the 1940s and the 1950s, everywhere you went there were movie stars on billboards and signs on the sidewalks with a picture of Uncle Sam pointing his finger at you, all with the admonition, "Buy bonds!" In those days, we did. We the people bought our country's debt. It was the patriotic thing to do. This was a time when Americans recognized the dangers of easy credit, and the increased cost that interest payments added to any purchase. Saving money was very much in vogue. The Great Depression and the severe rationing of World War II were still fresh in our minds. During that period, people bought bonds to save the US and also to save money for future purchases, future vacations, college for their kids, and/or their own retirement.

Today, savings of any kind seems not to be broadly practiced, particularly not by buying bonds, and with good reason. The interest paid on bonds by the government today does not begin to keep up with the official rate of inflation, let alone the real inflation numbers. Coupled with that there's the added percentage lost in taxes, which must be paid on even the minuscule amount of return the bonds provide. The combination of low interest rates, and the taxes on that interest, makes investing in bonds a guaranteed loss of buying power. It's a straightforward equation: buy bonds, lose money. It took about a decade for Americans to figure that out, but most now have a firm grasp of the concept.

Yesteryear's mindset of assuming the liability for the future has become backward thinking in today's "Buy now, pay later (or not)" mentality. Back when Americans bought a lot of bonds, the lion's share of the GBD we owed to ourselves. America both owed and owned its national debt. As inflation grew and wiped out the saving aspect of savings bonds, most citizens wised up and abandoned bonds in an attempt to fight inflation in the stock market. Even though a new line of savings bonds was introduced roughly tying the interest paid on the bonds to the official inflation rate, there never was the renewed "Buy bonds" mentality needed to sustain our government's burgeoning spending habits.

More aid via twin #2

Over the past couple years, somewhere between 40-50% of the debt certificates issued to pay for our US budget deficit have been purchased by foreign governments. While Americans still owe the entire debt, we are now buying just over half of it. This is another form of the massive indirect foreign aid.

However, over the past several months foreign governments, especially the major holders of our bonds, China and Japan, have been seriously cutting back on the amount of our debt they are willing to finance. This is good news short term, but bad news long term. Here's why.

The good news is that foreign governments are buying less of our government-issued debt instruments, and therefore less control of our destiny. The bad news is that because of the declining value of our US dollars over the past two years, combined with the very low interest rate on our US debt certificates, the Asian countries are buying less of the bonds we need to refill the coffers for the spending that takes place in Capitol Hill.

The sting

Nations who have invested in our US government bonds and notes can be stung in two ways. First is the loss of profit they accept by investing in US debt instead of investing in the debt of countries that pay higher returns. Second is the gamble they take on the strength of our currency. The interest they receive is paid in dollars. If the dollar continues in its current long-term downtrend, their interest rate loss will be compounded by being paid in dollars that are worth less and less. In truth, the dollar could level off, or even increase in value, which would mitigate their losses to some extent, but in view of current circumstances, that may not be a prudent bet.

Betting on the buck

While betting on a stronger dollar might seem like a fairly sound wager, a couple of caveats need to be taken into consideration. First among these is the persistency of dollar trends. As a rule, the dollar trends generally last from four to seven years. Uptrends and the subsequent downtrends often have a similar life expectancy. The last major dollar uptrend lasted about six years, and we are about two and a half years into the current major downtrend.

Exacerbating the likelihood of an extended overall downtrend is the significant role a weaker dollar plays in resolving the huge balance of payments. As the dollar loses buying power, oil, fancy cars, plasma TV sets, shoes, furniture, steel, and everything else imported from overseas becomes more expensive. The more expen sive offshore products become, the less likely the US consumer will buy them, which helps in reducing the uglier of the twins.

In addition, as other currencies gain purchasing power, foreign buyers tend to buy more of what is "Made in the USA." Taken to its most positive spin, if the dollar gets weak enough, the ugly CAD twin would get an extreme makeover. With that kind of benefit available to improve the looks of twin 1, it is difficult to see why the powers that be would work with much vigor to strengthen the dollar.

Lastly but not leastly, the politicians on the Potomac may not have total control over the situation. Should the world's nations in general, and China and Japan specifically, decide that they do not want to invest further, they could cease their altruistic $1.6 billion-a-day donations to Uncle Sam. Without those sustained donations, the dollar's losses would take a dive that, by way of comparison, would make the flailing Seattle Mariners look as though they were having a good season.

How to get rid of the twins:

Inside-the-box solutions

There is no doubt these ever-larger fellows cannot hang around indefinitely. The manner of their leaving is open to speculation. Raising interest rates might stabilize the dollar for a while, but there is no guarantee of that. The combination of a possibly stronger dollar and a higher return on government debt could prolong foreign investment in our bonds, but would mean the GBD twin would continue to balloon. Not only that; most everyone by now has heard of the devastation that can be brought on by higher interest rates.

If the interest rates were lowered, almost no sane person would continue to invest in our government debt, except, of course, our own government. All of the debt would have to be "monetized" — a fancy word that means that the government printing presses would print money as fast as they could in order to continue spending. That could be a wonderful solution to the problem, except there is a horrendous downside to that approach: hyperinflation. Hyperinflation is very bad.

At its worst, hyperinflation means that those on fixed incomes are quickly destitute, the wealth of the rich is reduced to nothing, and the working class is paid every four hours, because at the end of the day what they were working for in the morning is now worth only half as much as it was when they earned it. Think of Weimar Germany. A loaf of bread at noon could cost about what you now pay for a car, and by nightfall that same loaf of bread could cost what you now pay for two cars. Even those with IQs short of genius may discern that this is not good.

Sir Plus to the rescue

The only viable route to getting rid of the GBD twin is for our government to begin generating a huge surplus. All pork-barrel legislation would have to disappear and many grants and entitlements would have to be cut, if not completely, at the least drastically. Hammers that cost $600 each would have to be replaced with more reasonably priced ones from Lowe's or Home Depot. Graft and corruption would have to be rooted out and billion-dollar contracts would have to go through a bidding process that rewards dollar value. Of the inside-the-box solutions, this solution gives the appearance of being the only one with a chance of success. That said, snowballs in Hades have a much better chance of survival than curtailing government waste.

The unbalanced twin

As enormous as the government deficit twin is, the unbalanced payment twin is even more titanic. Even with only inside-the-box options being considered, a miracle or two is needed to help with this one.

First of all, interest rates, and the taxation of interest on savings, would have to be changed dramatically to convince US to change back to a nation of savers. Saving would need to be rewarded in much the same way as it is now punished. For instance, there should be a rule that specified the minimum interest paid by any institution must be at least half of the maximum interest it charged. If a bank charged 21% on its credit cards, then it would have to pay a passbook rate of 10.5%. The first $2,000 of all interest and dividends would be free of any and all taxation, just for starters. To jumpstart bonds, the first $5,000 of interest on government bonds and notes would be free of tax.

Second, "Made in America" would have to stand for lower prices/better values on enough products that we could actually sell about $2 billion of goods more per day than what we buy from the rest of the world. While we may still be able to build some better mousetraps here, it becomes more difficult by the minute to improve on the quality of countries that also have an excellent labor force, and one that will work for pennies on the dollar compared to the cost of US workers. The majority of the world's labor force has no idea what an XBox is and wouldn't know a Hummer if it ran over them.

Third, the US dollar would have to be greatly devalued. Not a little devaluation like the one in 1971, but something serious. Cutting the dollar's value in half would be a good start. That would cause pain to the majority of Americans, but nothing like the agony of hyperinflation.

In the normal course of human events, it would be difficult to envision anything in the last several paragraphs coming to fruition. All the routes out of the current situation seem to be on exceedingly narrow and uncharted roads along immense walls of worry, through valleys of depression, and by way of some dangerous territories where the possibility of corruption lurks just behind each corporate edifice, and fiscal terror is hiding around each twist and curve along the way.

How to get rid of the twins:

Outside-the-box solutions

One of the problems with the situation that the US is in is that it is very difficult to come up with outside-the-box ideas that are not pure fantasy. There will be no little green alien to descend from the mothership and push the "New Game" button.

In the history of the world, several nations have gotten themselves into similar, though not identical, financial predicaments. Alas, not one of those nations ever got back to square one without some painful and distasteful consequences. Everyone knows what comes after pride, and we have been very proud of our accomplishments until now. It would be wonderful beyond words were we to be the first nation in the history of the world to find the solution to overcome these huge, ugly twins and do so with a happy ending. Does anyone know an Einstein of finance?

The upcoming reality show

Unfortunately, the future will be less like "While You Were Out" and more like "Fear Factor Meets Survivor." Knowing when the show will start, and/or what will start it, would be an advantage, seeing as how we are all unwilling participants. So far, however, none of that information has been made publicly available.

One last thing

There are still some high officials — Federal Bank governors for instance — who continue to voice the opinion that inflation is preferable to deflation. In plainer English, it is better that we always pay more for the same thing than less. There are others who say our country is so large and powerful that these deficits just do not matter. Time will tell.

Bruce Faber may be reached at BFaber@Traders.com.

Current and past articles from Working Money, The Investors' Magazine, can be found at Working-Money.com.

Suggested reading

• Bankruptcy
  www.uscourts.gov/Press_Releases/fy03bk.pdf
• Current account deficit 6/18/04
  http://www.bea.doc.gov/bea/newsrelarchive/2004/trans104_fax.pdf
• Mid-session review of the budget 8/11/04
  http://www.whitehouse.gov/omb/budget/fy2004/summary.html
• $521 billion forecast for this year 7/30/04
  http://money.cnn.com/2004/07/30/news/economy/bush_budget.reut
• Jobs in the US as of May was 131 million 6/17/04
  http://www.briefing.com/GeneralContent/Silver/Active/ArticlePopup/ArticlePopup.aspx?ArticleId=NS20040617091717TheBigPicture
• 7 trillion
  http://abcnews.go.com/wire/US/reuters20040218_441.html
• Graph
  http://www.die.net/musings/national_debt
• Bureau of public debt
  http://www.publicdebt.treas.gov/
• Graph of U S Federal debt
  http://www.geocities.com/capitolhill/4834/pic.htm
• IMF
  http://www.imf.org/external/Pubs/NFT/Op/227/#fig2
• Deficit doesn't matter-Gramlich June 24, 2004
  http://www.federalreserve.gov/boarddocs/speeches/2004 /20040624/default.htm