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Tuesday, August 09, 2005

Trade Deficit Debunking

Trade always balances. Until we start interplanetary trade, a trade surplus of some countries is offset by a trade deficit of other countries. The global economy is the only fully closed economy in this trading system. Why then do some people worry so much about the U.S. trade or current account deficit? I think it is lack of understanding. Historically, the global financial system was much more limited in its' ability to handle the capital flows needed to accomodate large trade deficits. If it makes you feel better just think about the large capital account surplus we are running (we are)!

Another worry is that a trade deficit might indicate that we are living beyond our means. We may be, but I don't think so. We are huge exporters of intellectual property, much of which is uncounted or undercounted in industrial age trade statistics. This IP is the foundation of many high profit margin businesses in this country. The low profit margin manufacturing businesses overseas take some of the fruits of the IP, slap together a finished product and ship it back to the U.S. This makes the reported trade numbers look bad but it is just an artifact of a more efficient global division of labor. Scale and elasticity are key here in technology and IP - prices down, volumes up, new applications and on we go even with high margins...

I remember reading a Peter Drucker article a number of years ago that included a list of only a handful of business activites which he considered to be high value added. Design and marketing were on the list, manufacturing was not. We should probably strive to hold on to and create more of the highest end manufacturing but the more commoditized it is the more we should let it go. We are still the worlds' largest manufacturers even it only employs 20% of our population.

Don Luskin deals with some of the nonsense here.

Yet the notion of debt is always evoked when the trade deficit is discussed. The very term deficit implies debt. It's as though by talking in terms of debt the trade deficit can be portrayed as some kind of overhanging Sword of Damocles -- some inescapable doom that inevitably awaits us, as though it were a debt that can never be repaid and will throw us into moral if not literal bankruptcy. But stop and think for a moment. What's the worst thing that can happen? All that can happen is: all that unspent money overseas will eventually be spent on US goods. And what's wrong with that? Isn't that what the trade deficit catastrophists are complaining should be happening now? If it's what they want to happen now, why are they afraid that it will happen in the future?

If the invocation of the sin of debt isn't enough, the catastrophists can trot out this idea that when foreigners buy our productive assets -- our companies or our real estate -- rather than buy our goods, we are sacrificing all future benefits from those assets. This argument relies on an utter misunderstanding of how such assets are priced in an efficient market. If a share of stock in a company entitles its owner to a future flow of dividends and other benefits, then today's price reflects the market's appraisal of that flow. If you take money today in exchange for that share of stock, you have captured the present value of all its future benefits. In essence, an asset's price make you indifferent between holding the price in cash and holding the asset.

John Tamny takes a shot at the naysayers here.

That they’re not shows the glaring flaw in the arguments made by trade-deficit worriers. Since it’s an empirical fact that our trade deficits are driven by massive inflows of foreign capital, it must from there be deduced that money doesn’t flow here because the world loves us (the Left says they hate us), but because the worldwide investment community still sees U.S. economic policies that embrace low taxation and low regulation as ones that will yield the best returns.

In short, we can reduce the trade deficit, but only if we pursue the kinds of high-tax, tariff, and regulatory policies that would impoverish us. Because of that, Americans should beware of those offering solutions to our supposed balance-of-trade problem. The cure is much worse than the unambiguously positive symptom.
The 1990 recession brought us close to a trade balance - do you really want that??

Andy Kessler does a terrific job of explaining all of this in his two most recent books which I highly reccomend. One chapter of Running Money is titled "Why it is imperative that you drive a beemer, tote a toshiba laptop and watch a big-ass sony tv." He want foreigners to have the dollars to invest here but also to buy the products arising from our intellectual property. This is an example of our high margin...

Over the last year, two things have happened. First, Apple has increased their sales by over a third, almost all of it from increased sales of iPods – those 2 million of them at $265 each last quarter and another 100 million songs sold via their iTunes service. An iPod is just the combination some Apple software, cheap disk drives and a $12 chip a Silicon Valley company named PortalPlayer. I calculated that Apple pays $200 each per iPod to Chinese assembler Inventec to slap it all together. Even with cheap labor, Inventec has almost no profits, I’d bet under $10, probably more like $4. PortalPlayer, by the way, emails their design to Taiwan to be fabricated, with profits of some $5 per chip.

The second change since a year ago is that Apple’s stock has gone from $21 to $64. Pretty cool, capitalism at its best. Why? Because Apple keeps $65 per iPod - money chases profits! If you assume the stock increase is all due to the iPod (it is), then that business is worth some $15 billion. Add in PortalPlayer’s market value of almost $1 billion and you start to get a feel for how the world works. A $1.5 billion trade deficit increases wealth in the U.S. by some $16 billion – I’ll take that trade any day. So will all the holders of the retirement accounts at Vanguard and Fidelity and Janus and Lord Abbett who own Apple’s stock. Why am I caring about deficits again?

Trade deficits are just an economic construct, and lowering the dollar won’t solve a thing. We are already moving low margin, low paying jobs overseas, but fortunately, are left with high margin, high paying intellectual property jobs. Would you rather own Apple making a margin of $65 or Invetec with $4, on the same product? Me too. We may have trade deficits of $550 billion this year and, but we enjoy a huge margin surplus.

This deals with the global financial system and other elements of a global economy driven by the force of U.S. intellectual property.

With flexible exchange rates and relatively free trade in post-WWII (and to be fair, post the Bretton Woods gold standard), low margin tasks and low paying jobs moved out of the U.S. Displaced workers and union rhetoric screamed for something to be done about “lost jobs” but it probably was the best thing to happen to the U.S. since it allowed for high wages in the U.S. for high margin tasks. The stock market rewards high margin companies with high values, lowering their cost of capital. They can sell fewer and fewer shares to raise money instead of borrowing money from banks. High wages are taxed, to pay for social services, not the least of which is a military to protect the U.S. AND its trading partners.

Gold just gets in the way of the flow of funds.

You see, a new twist has been added to this system. Since the birth of the personal computer and the horizontalization of the industry, companies could focus on thin slices of intellectual property, which could have very, very high margins. Software, microprocessor architectures, semiconductors, network architectures, optical components, cell phone components, and databases are all pieces of intellectual property that could be licensed to others to build end products.

In fact, the U.S. is a huge exporter of these pieces of intellectual property, although these exports are hard to measure. Often, an entire architecture of a chip, valued at a billion dollars, can be emailed to a factory in Taiwan, without a cash register ringing or a commerce department employee around to measure the export. That chip and other intellectual property are then combined, using low cost labor with other low margin components, like a power supply and some plastic and turned into a laptop or DVD player. Oddly, this “margin surplus” run by the U.S. is the way to run an economy with declining price products. Gold won’t help. Instead, it requires a stock market to balance out world trade. Fortunately, we’ve got one of those! The money that leaves the country to buy those laptops and BMWs and Sony TVs comes back and invests in our high margin companies.

So after all that, what I am trying to say about gold? The British had no choice. They and the rest of the world needed a “hard currency” - something rare like gold as a baseline to base their own paper currency on. The Brits were certainly not going to take French or German paper currency and trust them not to devalue it by just printing more of it. So gold was necessary.

Fine. But the classical gold standard was a huge mistake. They held the wrong thing constant. Wages were never going to go down without more than a few pissed off laborers. It was currency rates that should have floated instead of wages and domestic prices. But that would have required rooms filled with computers, human or electronic, neither of which really existed in great numbers.

But they do now!

Currency rates do float. And there are 100,000 or more computer screens on Wall Street and around the world armed by bond and currency traders that keep countries honest. Countries caught cheating see their currencies plummet, their interest rates pop and their economies slow. It is a tightly wound system.

But banks are still a problem. They profit from lending, but there is no decent mechanism to keep them from overlending. Banks are as dead as gold. Neither is any good anymore at allocating capital. Stock markets, on the other hand, are quite good at providing access to capital for great companies and starving those that have dim prospects. Banks still loan to son-in-laws!

Ask the Japanese still burdened by non-performing loans. Some argue that half of Chinese bank loans are non-performing. We don’t have to ship gold around anymore, yet gold is still considered a currency in modern international commerce. Gold is no longer the reserve of central banks, it is dollars.

And these export economies have too much dollars. They have to give it back to us (investing in our high margin companies via the stock market) else they over lend. I know it sounds crazy, but it’s the new classical “insert your species” standard. When things heat up at home, you’ve got to ship out your species, in this case dollars, and they are all going to naturally flow back into the U.S. The Japanese periodically intervene and ship dollars back here to keep the yen down. The Chinese have a peg, so excess dollars go to banks, with awful results. The Europeans are just figuring out that $1.30 to the yen doesn’t do them any good, and they need to start intervening to get the euro down. This is the new economy, gold doesn’t flow, but dollars need to, in order to keep them away from dumb bankers. On the margin, it will invest in high margin companies in the U.S., that is our margin surplus. And I’d like to get in the way of that flow!

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