Wednesday, February 5, 2014

A Lousy Investment

The current account balance of a nation is akin to phenomena like trans fats, water-boarding and West Nile Virus in the fact all have entered the popular lexicon, very few people know exactly what they are, but most are pretty sure that experiencing any of them would be quite unpleasant. Despite the well-documented risk of consuming more than one can produce domestically, the United States has chronically rung up a deficit in its current account since the early 1980s. The country has gotten a “pass” on this profligacy from creditors given it is home to the world’s largest economy, its transparent and liquid financial markets, and the dollar’s status as the de-facto global reserve currency. As evidenced by recent events in Turkey, emerging economies are not so fortunate, with financial markets eventually punishing countries that are perpetually in the red. Yet the great economic axiom of there is no free lunch holds true; there is genuine risk should the U.S. fail to address its imbalances.

A Quick and Dirty Lesson in International Economics
A most basic definition of a nation’s current account is that it measures the goods and services a country buys from abroad versus those it exports. A country which buys more than it sells will run a current accounts deficit (yes there are additional buckets that comprise the current account tally, but as to not bludgeon the reader with national account minutia, those will be ignored for now). In the past generation, the U.S. has transitioned from a creditor nation to the world’s largest debtor. One reason for this is the country’s dependence on foreign oil. While the U.S. is still one of the world’s top producers of crude, the energy required to fuel its suburban-living, SUV-driving lifestyle means it has had to import approximately half of its oil needs, although the number is presently on a downward trend thanks to the Greenies’ favorite bugaboo: hydraulic fracturing. Not coincidentally, America’s persistent current-account deficits has roughly coincided with the country becoming a net crude importer.

Another contributing factor has been the relocation of massive amounts of manufacturing capacity to low-wage, namely Asian, countries.  In one of the most blatant ironies in modern economic history, the revenues generated by foreign (and domestic) firms hawking a range of cheaply built products were funneled back into U.S. financial markets for safe keeping, which in turn helped keep interest rates low (high demand and subsequent high bond prices push yields lower), thus spurring additional credit-fueled consumption.

On The Flip Side
Even less known than the nuts and bolts of the current account is that there is a (mostly) offsetting account measuring capital flows into a country. If a country consumes more than it produces, it must borrow the funds from abroad to pay for the difference. This is especially true in the United States, which, when including government accounts, doesn’t bother with anything as trivial as building up savings. Without a national piggy bank to dip into, and with consumption far outpacing domestic production, the U.S. must make up the difference with funds loaned from our buds in Beijing, Tokyo, Riyadh and Dubai.

Fortunately for spendthrift policy makers….and their overindulgent constituents….the U.S. remains atop the list of the most attractive destinations for risk-adjusted investment returns. Despite many shortcomings including sluggish GDP growth, chronic joblessness, an uptick in regulations, lousy coffee and a mediocre national soccer team, the country still has liquid, well-regulated capital markets, the rule of law and the reputation for paying its bills.

“You Spent It on What??”
Just like with consumers and businesses, financing certain purchases at times can be prudent for a country. It all depends upon how the borrowed funds are spent. If they are used for investing in high value-added endeavors such as modernized infrastructure, increased industrial capacity and education, then the return on investment could merit the financing costs. This is a reason why many….not all….emerging markets get a free pass for temporarily running current-account deficits. In order for a country to upgrade from goat herding, strip mining and small-arms manufacturing to a more complex, value-added product based economy, it must first import the capital goods necessary to retool its medieval industrial capacity. That entails running deficits until the high-margin exports start flowing.

So how has the United States invested its bounty of foreign inflows? Clearly not in infrastructure, given the nation’s crowded freeways and crumbling bridges, nor in education as evidenced by the country’s steady slide down global science and math rankings. It is true that the U.S. is home to a number of hyper-efficient, cutting-edge factories, but the manufacturing sector has contracted over the years to the point that it no longer provides the pop to the overall economy when output is buzzing. Nope, instead the country has gone on a binge of buying financial assets and speculative real estate in crappy locales such as  Las Vegas, mosquito-ridden coastal towns and down-market ex-burbs.

During the boom, policy makers and business leaders alike thought they had stumbled upon the perpetual motion machine; cheap credit funds housing expansion, home-buyers demand even more gadgets to cram into their man caves and three-car garages, which in turn fattens the wallets of purveyors of those goods…along with  those of numerous housing-centric service providers…allowing them all to partake in the virtuous circle. But one can only buy so many flat-screen TVs. Once the sugar-buzz of a housing spurt wears off…which it inevitably does…if there is no underlying industry (ideally export-oriented) to pick up the slack, the…pardon the pun….house of cards collapses. As it did. A robust housing market should be the consequence of a strong economy, not the source of one.

The influx of foreign funds also flowed freely into U.S. financial markets. This lowered the cost of capital across the economy thanks to treasury purchases, goosing aggregate demand and driving corporate profits higher.  Some of this foreign money went directly into equities markets, joining domestic investors as they chased indices to record highs.

In theory, robust demand for shares can provide corporate boards with funds necessary to expand capacity and invest in new projects. This concept is one of the underpinnings of the Fed’s multiple iterations of quantitative easing. The only problem is that it hasn’t worked. Instead of building new factories in the borderline Soviet expectation that increased supply will somehow spur demand, firms have squirrelled away these funds and will likely not deploy them on any large scale until there is greater evidence that economic growth finally has hit the afterburners and demand for their products returns.

Capital Stock: The Missing Link
A key contributor to economic growth is increasing productivity. And a sure-fire way to increase productivity is to have glitzy new factories and cutting-edge technologies deployed across society.  While there are certainly such examples in America, over the past four decades investment in nonresidential fixed assets has been on a downward trend. Much of that is attributable to the transition to a service-based economy. One can argue that as the world leader in exporting services, the country does not need levels of investment required during an earlier era. The contrarian view, however, is that a country that makes stuff, value-added stuff and in large quantities, should have a bright future.

As seen in the chart below, the trend for investing in private sector equipment has steadily fallen over the decades. In the meantime, residential real estate went on a tear, far outpacing overall economic growth. As stated earlier, such gains proved ephemeral.  In a tragically fitting irony, yield-hungry investors, spurred by the Fed’s extraordinary monetary policy, made cash-investing in depressed real estate markets a borderline national pastime in the aftermath of the crisis, essentially, doubling down on a sector that does nothing to increase competitiveness.

Giving Trickle-Down Economics A Bad Name
So when it comes to preparing for the future, the U.S. is a lousy investor. What’s worse, rather than squandering its savings (it has none) on dud endeavors like real estate and stock speculation, it is borrowing money from abroad to do so. The safety of the country’s financial markets has been a strong competitive advantage versus even other developed economies. But eventually, if the return on investment is not there, foreign governments, sovereign wealth funds and private investors will find other, higher-yielding destinations.  Should that occur, the country’s ability to get away with consuming more than it produces would be threatened and any attempt to raise interest rates to win back foreign capital would add yet another headwind to this unprecedented era of sputtering growth.

Whether one is a supply-sider or not, it is evident that the concept of trickle-down economics only works when the titans of industry put their wealth to work by investing in factories and office space, hiring workers and increasing productivity.  Yet in the wake of the financial crisis and policy responses it triggered, there has been no wealth effect sending positive shockwaves through the economy as promised….unless one considers Aspen hoteliers, stock brokers and Manhattan real estate agents.  This backdrop of a recovery benefiting only the very few who have large amounts of paper assets makes the recent State of the Union speech, grumbling about income inequality, all the more laughable. This administration’s…and  the Fed’s…. misguided understanding of investment incentives and requirements for durable economic growth have only aggravated the income gap.

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