That Strange Cloud Over the Horizon

In a recent article ("The Curious Bush Recovery"), I suggested that several trends were creating a scary picture of our economic situation. The most significant concern was that our government’s manipulation of interest rates and the money supply was encouraging citizens and the government to engage in an irresponsible EZ credit spending spree (the purpose of this policy is to create an illusion of wealth before next November’s presidential election). This has, in turn, caused a mushrooming trade deficit which imperils the dollar’s value in overseas currency markets.

Over the past week or so, several flares have gone up that make one wonder if the downward spiral hasn’t really started in earnest.

Funny noises are coming from the engine room…and it doesn’t bode well for our ship of state.

First, is the trade deficit. In normal times, a plunging currency causes the deficit to shrink as imports become more expensive. But the numbers came in last week for January, and they reveal a record 43.1 billion dollar trade deficit. Essentially, Americans are spending money they don’t have on imports from overseas, despite the recent fall in the dollar. They are going wild with their credit cards and are raiding their home equity via get-rich-quick mortgage refinancing schemes. Saving has essentially ceased, as the average family is now saving a mere 1% of their monthly income (…a number which may overstate reality. If you look at the big picture, Americans may be spending each month more than they earn, and thus may have a negative savings rate).

The second flare was Alan Greenspan’s recent congressional testimony. In what was perhaps the first lucid thing that the man has said in the past 18 months, he noted that congress might want to trim back entitlements, since both Social Security and Medicare will be going bankrupt any time now.

Well, duh!

Perhaps someone should have inquired as to whether Al had passed this revelation on to President Bush. And, in the process, see if he’d asked Bush why he decided to add a multi-billion dollar prescription drug program onto the Medicare system when it was already taking on water.

But, alas…we already know why. As FDR once said, "Spend, spend, spend and elect, elect, elect."

And even more ominous is the price of oil. As I noted in that previous piece, one of the things that has enabled the Fed to wallpaper the world with dollars and not have our economy immediately tank is the fact that OPEC prices oil in dollars. Thus, if the dollar plunges, the price of oil here remains the same.

Well…it appears as though the Arabs have the knives out for President Bush. They have been systematically cutting back on oil production. This, along with unforeseen instability in various oil producing nations and problems with goofy environmental additives, is causing a spike in the price of gasoline (and if the unstable situation with Chavez in Venezuela boils over, we could be looking at $4 a gallon in a heartbeat).

This surge in oil’s price is concerning for a couple of reasons. First, and most obvious, it will cause an economic slowdown due to rising costs to businesses. These businesses are already reluctant to hire, and this could make them more so. Second, the increased cost of imported oil is making our trade deficit figures worse.

And here is the real danger. Any normal country with our gigantic budget and trade deficits would have experienced an economic debacle by now due to a plunge in its currency. But the unique status of the dollar as the reserve currency has enabled us to live beyond our means for quite some time. But this is not fool-proof. Anyone who thinks that we can continue on this path and not experience a profound currency shock is delusional. Sooner or later, foreigners are going to look at the balance sheet and realize that they shouldn’t loan us any more money. And God knows we can’t finance the deficit on our own, since we have essentially a zero domestic savings rate. When that happens, everyone will start to dump their dollars…and its value will plunge as interest rates skyrocket.

And with it, will plunge our standard of living. I’ve seen estimates that up to 1/3 of Americans’ standard of living derive not from productive activity, but rather from the status of the dollar as the world’s reserve currency.

This party will end.

Meanwhile, the masses of do-it-yourself investors (comprised of that segment of the American public that still has any savings at all) are pouring their money into the stock and bond markets as though summer will go on forever… despite worryingly high price-to-earnings ratios. They must know something that the insiders don’t. Warren Buffett, the legendary investor, has been signaling disaster ahead for months. He is keeping his investors’ money out of the markets while buying commodities and purchasing investments denominated in foreign currencies…for the first time ever.

But perhaps Warren is all wet. Maybe we really can have $500 billion budget deficits, $500 billion trade deficits, a deflating manufacturing sector, and no household savings.

Inevitably, I’ll get emails claiming that the deficits don’t matter because as our economy grows, the deficits get smaller relative to our GDP. To which I reply, "That may be true, but what if the GDP shrinks? Does anyone believe it will continue on its credit-fueled growth indefinitely? And what happens when the currency drops due to our trade deficit, causing interest rates to rise and forcing the government to roll over its short term bonds to ones with significantly higher interest rates?"

The national debt will explode relative to our GDP…even if we don’t borrow any more money. And our goose will be cooked. The "GDP argument" cuts both ways.

And what will happen to all of these folks who are taking out home equity loans based on the bubble-inflated "value" of their homes and using the money for consumer purchases? What will happen if their real estate values drop below their new loans’ balances (which will happen if interest rates spike)? They could end up owing significantly more in mortgage debt than the post-bubble market value of their homes.

I suppose they might do the old-fashioned thing and work hard, stash money, and pay the loans back anyway. Or…they’ll mail the keys in to their lender and walk away…touching off a banking crisis.

But alas, these are inconvenient questions that are better not asked.

So go ahead…buy that plasma TV…slap it on the ole’ credit card. And while you are at it, call your congressman and suggest a few more third world countries to invade. What the heck? It’s not like we’ll ever have to actually pay any of it back.

But way off in the horizon, I see a strange, dark cloud slowly churning its way in our direction. One can barely see its outline.

Where did it come from? What is it?

Could it be a giant flock of…chickens??

Yep…and they’re coming home to roost.

March 15, 2004

Steven LaTulippe [send him mail] is a physician currently practicing in Ohio. He was an officer in the United States Air Force for 13 years.

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