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The Federal Deficit, The Trade Deficit and The Weak Dollar:  Are You Concerned Yet?

 Richard W. Miller, Ph.D.

I don’t know about you, but I for one am tired of hearing the gloom and doom chanting of a biased press or newsletter writer that’s trying to sell us his advice.  We’re continually barraged by statements headlines like:

 

Don’t Get Crushed by the Falling Buck     Business Week, 12/06/04

Drooping U.S. Dollar—Medicine or Poison?   Wall Street Journal, 12/16/04

Why the Dollar is Giving Way       Business Week, 12/06/04

 

“If lots of people (foreigners) try to leave market, we’ll have chaos because they won’t get through the door.” So says Warren Buffet, the world’s most visible dollar bear and someone who has bet $20 billion dollars against the dollar.

Forbes, 1/10/05

“Because Americans don’t save enough, the U.S. relies on foreigners to fund the shortfall.”

Wall Street Journal, 1/03/05

 

In fact, run google searches for “weak dollar” and “2004” and get 140,000 hits; for “trade deficit” and “2004” and get 126,000 hits; for “federal deficit” and “2004” and get 99,100 hits.  There has been lots of writing about these subjects last year.

 

Stock traders and investors need understand these macroeconomic forces because they impact both market psychology and market reaction.  You might think things bad enough to remain on the sidelines and miss a big move, or you might ignore economic announcements all together and be swept downstream in a responsive market move.  Though we're all interested in picking good stocks, understanding macroeconomic conditions that move the market is even more important. Perhaps as much as 75 percent of a stock's movement is due to the combination of sector and general market strength.

 

Consider first the value of the dollar.  In a free market, the value of the dollar changes with its supply and demand, just like the value of any other commodity does.  If there’s increased demand, the dollar strengthens.  When foreigners convert their euros to dollars to invest in U.S. markets (stocks, corporate bonds, treasuries, real estate), the increased demand for the dollar strengthens it and, at the same time, weakens the euro.  Conversely, when there are excess dollars or less demand for them, the value of the dollar falls. 

 

The Fed strengthens the dollar by increasing interest rates or by soaking up excess dollars—decreasing the money supply--by selling notes from their portfolio.  The first draws money into the United States as foreigners must first trade or exchange for dollars--thereby increasing the dollar’s strength--before entering the U.S. market; the second obviously decreases supply.

 

Some currency statistics:  On Dec. 31, Europe’s common currency, the euro, traded at $1.3567 compared with $1.2579 a year earlier (a 7.9 percent weakening of the dollar); the yen at $0.00976 compared with $0.00931 (a 4.8 percent weakening).  In fact, this past year the dollar hit its lowest level since the euro’s 1999 debut and a five-year low against the yen.  A weakening dollar congers up bad images, but is it really bad for the U.S. economy?

  

Though its sounds bad, a weak dollar is both a good and a bad thing.  On the one hand, it makes U.S. exports cheaper in foreign lands, and that benefits U.S. exporting companies, both increasing their profits and creating new jobs.  It also can decrease the U.S. trade deficit if its foreign trade partners have strong enough economies themselves.  U.S. goods become less expensive in foreign lands, while their goods become more expensive in the U.S.  Of course, in the U.S. we read the Chicken Little cry from our press: “The sky is falling,” because what’s good for the U.S. is not necessarily good for the rest of the world.  Understand, the U.S. is the economic engine of the world.

 

On the other hand, a weak dollar can reach a point where foreigners prefer to take payment and hold currencies other than the dollar.  Since they now hold $1.7 trillion (largely in U.S. treasury notes) that would increase supply and thereby weaken the dollar further.  In the extreme, the Fed would be forced to step in and raise interest rates both faster and to a greater extent than they otherwise would have.  And that would throw water on our burning economy and, in the process, deflate the stock market.

 

But dollar flight is not very probable. No matter what you read.  Money takes the path of safest, most positive return: it goes where the economy is brightest.  And, the U.S. economic growth is much stronger than most other major regions.  Bank of America projects U.S. gross domestic product (GDP), the most comprehensive measure of a country's economic health, will increase by 3.8 percent in 2005.  Compare that to 1.7 percent growth in the euro zone, 1.2 percent for Japan, and 2.1 percent for Britain.  Instead of shying away from the U.S., foreign investors focus on the U.S. economy, the U.S.'s steady political system, faith in the U.S. Federal Reserve, and the transparent corporate structure and market exchanges. 

 

As Arthur B. Laffer, discoverer of the famous Laffer Curve which shows that reducing tax rates increases government revenues, recently published in WSJ (1/03/05) “Destination U.S.A.”  “Look around, Germany hasn’t had a growth spurt since the 1960s.  France still has mandated maximum workweek of 35 hours, maximum income tax rate of 58 percent, a 1.8 percent annual wealth tax, and government spending at over 50 percent of its GDP. Japan has had a stock market down by 70 percent from its high in 1989…So what’s not to like about the U.S.?  Whether you’re an American or foreigner the U.S. is the choice destination for capital.

 

The weak dollar benefits U.S. small businesses as well.  In a WSJ (1/20/05) article entitled “Weak Dollar, Strong Sales,” Timothy Aeppel described the increased manufacturing opportunities opened by the weak dollar in Europe for small business, citing new European orders for gas fittings producer, Superior Products, Inc., and couplings manufacturer, Ohio Screw Products, as examples.  Further, he cited Robert Lawrence, a professor of international trade and investment at Harvard University, who estimated that up to 750,000 U.S. factory jobs, many from small businesses, were lost in recent years due to the U.S.’s “strong” dollar policy.

 

In a Reuters article (12/29/04) “Broadway Takings Up as Weak Dollar Draws Tourists,” the benefits of increased U.S. tourism are cited, as foreigners can buy more dollars for their currency—things become suddenly cheaper in the U.S.  Foreign tourists, lured to the U.S. by the weak dollar, boosted Broadway takings by 3 percent in 2004 ($749 million, up from $725 million in 2003 and 1.2 million foreign visitors versus 650,000 the year before).  And these visitors do more than attend Broadway shows:  they rent hotel rooms, buy food and visit attractions.

 

Similarly, at the other end of the country, the Arizona Republic (1/27/05) reported in “Weak Dollar, a Strong Lure” that the international passenger count was up 11.1 percent at their Phoenix Sky Harbor International Airport through Oct. 2004.  And this foreign demand was making its way to Arizona resorts, parks, restaurants and shops.  Overall, the Travel Industry Association of America forecast total international arrivals to the U.S. rose almost 9 percent over 2003 to 43.8 million visitors in 2004.

 

China chooses not to allow the U.S. the trade advantages of the weaker dollar.  She has chosen instead, since 1994, to peg her currency, the renminbi, to the dollar (8.25 renminbi to $1).  Consequently, America keeps buying their blue jeans, and DVD players from China.  As a result China has become a large trade partner with the U.S. who ran a trade deficit against China of $147.7 million dollars over the first 11 months of 2004 (compared to $114.2 over the same period in 2003).  To peg their currency to the dollar, however, China has to maintain a reserve of dollars to step into the world market as needed and either buy or sell dollars against her renminbi (become its "market maker" of last resort if you will).  As of Nov. 2004, China holds $191.1 billion in U.S. Treasury Securities, second only to Japan’s $714.9 billion.  Of course, the Bush administration wants China to "float" its currency so as to solidly support U.S. businesses, while Congress considers a bill sponsored by Repulican Lindsay Graham and Democrat Charles Schumer to impose a 27.5 percent across-the -board tariff on Chinese goods if the Renminbi were not floated.

 

To be fair, the weak dollar has a flip side too:  it costs you more to make an international visit;  for some products, produced exclusively overseas, like French wines and black winter truffles, prices must rise in the U.S; imported commodity prices (oil, steel, plastic) rise as well.  So eventually, the weaker dollar can lead to price inflation here.  Often, prices don’t rise because the producer wants to maintain market share and not force the buyer to seek U.S. alternatives.

 

As Lawrence Kudlow reported in an IBD Perspective piece on 12/31/04, Critics of 'Hoover' Economy Now Attack Bush Prosperity: "U.S. GDP has been trending steadily around 4 percent for two years (half a percent above the nation's 3.5 percent long-run growth trend)...Meanwhile, the unemployment rate moved down from 6.3 percent to 5.4 percent indicating strong U.S. work conditions...The household survey shows 2.5 million jobs gain during Bush's first term...Corporate profits, without which businesses cannot create jobs, now stands at a  record $1.118 trillion--56 percent above the recession trough, 25 percent above the prior recovery peak of the late 1990s and at a near-record 9.5 percent of GDP.

 

All in all, things are much brighter than the press would lead you to believe.  In another segment I'll address the twin deficits: the U.S. trade and federal deficits.  One's a good thing and the other's improving.  Too, in the next report I'll address the following chart highlighting trade flow.