Lets Trade This Deficit for That One
So, maybe the debt and budget deficit are okay. Maybe we even need more debt. And maybe people really are saving. But there are other headline-making, panic-inducing deficits giving investors frights—principally the trade and current account deficits. The current account deficit consists mainly of the trade deficit, so let's focus on the trade deficit first. The trade deficit was $717 billion14 in 2005 (EGAD! Infinite gazillion bajillions!). Freaks folks out—particularly those fearful of a weak dollar. Disapproval of the trade deficit and a desire to reverse it is exceptionally widely and passionately held. You don't read anywhere that you shouldn't worry about it at all. Suggest that in public and you will be widely ridiculed. That is always a great time for a Question One. Is it true trade deficits are bad for our economy, stock market, and dollar? While we're at it, throw in a Question Two: Is it possible the trade deficit might be something good rather than bad? If so, how?
Again, here is an investing concern bred seemingly from common sense analysis, confirmation bias, and an inability to scale (all errors combatable via Question Three). A trade deficit seems to signal we spend more on imports than we garner on exports, and are bleeding money. Folks in a tizzy over the trade deficit see it like a gigantic zero sum game—if you have more minuses than pluses you lose. By that logic, a trade deficit is bad for the economy because it's unsustainable and bankrupting. If America were a gigantic hardware store, a sustained trade deficit could be bad. If everyone acts nuts, the money bolts out the door (nyuk, nyuk). You want your hardware store to sell more stuff (nuts, bolts, drill bits) than it buys (computers, employee time, Cheetos for the employee break room), else the hardware store would bolt to bankrupt.
Nonetheless, folks who think this way make several cognitive errors. First, as a general remedy, think globally. If you do, you realize trade deficit concerns are global nonsense. Note: No one worries whether Montana runs a trade deficit with the rest of America. Or California or New York for that matter. It's obviously impossible for the whole world to run a trade deficit or surplus—it balances. Among developed nations, trade deficits and surpluses aren't materially more important to the overall level of global stocks than the trade balance between Montana and New York. That's a bit hard to accept, but we'll get you there.
One key point in seeing this clearly is U.S. and developed foreign markets with whom we have deficits behave similarly. They tend to rise and fall together. Sometimes America does better. Sometimes other countries do. And that is true of countries with similar deficits and ones with surpluses. We have a big trade deficit, current account deficit, budget deficit, and debt. Some countries have none of those. Some run huge surpluses. If deficits are bad, the U.S. stock market and varying foreign markets should be zig-zagging all over the map. The United States should be down big when foreign is flat or up big. But it's not so.
Consider this—since 1926, there have been 47 years the U.S. market has been up and the foreign market has been up too. How many years has the U.S. market been down big—over 10 percent—and the foreign market positive? Not many—3 times. And in the past 25 years, when we've had our big trade and current account deficits? Never! Many decades ago the markets weren't as correlated but, in recent decades, while these deficits have increased massively, the markets have treated these different countries more similarly. When it comes to market direction, countries do a whole lot more of going the same way than not, which we can see in Figure 6.4.
Figure 6.4 clearly shows the U.S. and foreign markets moving—not iden-tically—but certainly in the same direction and sometimes the same darned magnitude.
Let's think of the logic of this for a second. Once you get in your bones the U.S. market may lead or lag the rest of the world but doesn't go a markedly different direction, you know trade balances don't matter to the global stock market. They just can't. If the deficits mattered, and we have a big deficit to the rest of the world, then why are our stock markets more correlated than not? If a U.S. trade deficit is bad for America and American stocks, then by default, a surplus should be good for America and American stocks. Fair enough? If a trade surplus is good for America and American stocks, then a trade surplus in another Western nation should be good for that country and its stocks. That means an American trade deficit, implying a foreign trade surplus, should be good for foreign stocks and the two would offset each other perfectly with no overall effect on global stocks. (Remember the U.S. market is almost exactly half the world stock market in total money value.) Make
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Figure 6.4 U.S. and Foreign Market Stock Market Movement. Source: Global Financial Data.
sense? People talk as if that's so. But if it were, U.S. and non-U.S. stocks would be negatively correlated, not positively.
That still assumes a trade deficit is bad for U.S. stocks, a point I'm unwilling to concede. I'm still on Question One. The logic falls apart as soon as you get to global markets. We can all agree globally, trade balances. To argue cogently a U.S. trade deficit causes the global market to fall, you must argue trade deficits are more negative than trade surpluses are positive. To date, no one has ever expressed such a notion publicly, must less the theoretical economic justification for such a notion. No one even thinks that far. They simply stop at "the sky is falling" before getting to the notion the world can't have a trade surplus or deficit.
Consider our massive trade deficit and how it impacts life here. Is our trade deficit, in fact, bad for U.S. stocks and our economy? Here's where investors make another cognitive error in forgetting to scale a big number. Our trade deficit is big, but we have a massive economy too—the world's biggest. In Figure 6.5, we show the U.S. trade balance back to 1980 as a percent of GDP which is the right way to think about it. The United States has run a trade deficit the entire time—continuing irregularly to get both bigger and bigger as a percent of GDP.
- Figure 6.5 U.S. Trade Balance as Percentage of GDP. Source: U.S. Census Bureau.
It currently is about 5.8 percent.15 Now, a better question: Is that trade deficit too big and bad for our economy and stock market? Or, seeking a Question Two: Is a big trade deficit a symptom of a healthy economy and a sound financial system and not an indicator of future financial ruin?
Yes, our trade deficit has gotten remarkably wider since 1980. Over the past 25 years, the United States also had one of the world's healthiest economies, growing nearly the entire time. In fact, over those years our economy grew faster than almost all the developed world. Since we've been running a trade deficit consistently starting in 1980, we've enjoyed average annualized real GDP growth of 3 percent16 and annualized market total returns of 13 percent.17 If our trade deficit were bad, per se, our market returns should have been worse than average and our GDP growth shouldn't have been among the world's best. As such, we have an economy that is the very harsh envy of the developed world. Maybe not of privileged French students protesting in the streets for their inalienable rights to a lifelong, lackluster governmental career, but the French don't get Capitalism as evidenced by their slower, more lackluster economy over the past quarter century.
So maybe the trade deficit is something that happens as we do well. Can that be? Critics make several arguments. First, they say it hasn't hurt us yet but things haven't yet come home to roost and will, all at once, in a future big-bang financial crisis coming straight to your backyard soon. Well, fine, but at what level of trade deficit or cumulative trade deficit does that occur? To date, I've never heard such a trigger point articulated—nor, even more important, articulated with an underlying fundamental argument as to why that is where a trigger point should be. Second, some may concede the trade deficit hasn't done enough damage to make our growth negative or nonexistent—but they ask, how do we know what our growth would have been without the trade deficit? We might have had even more growth were it not for this damaging deficit.
For example, consider Britain. Their markets have done well. Their currency has been stronger than ours. In fact, arguably the pound sterling has been the world's strongest major developed currency in recent decades. Surely this is the proof in the pudding (the Brits love their pudding) that our trade deficits have hurt us relative to them.
This is very wrong. The U.K. is actually a litmus test for many of our own economic conditions because the U.K. has been in almost exactly the same economic situation in the same proportions in terms of deficits, trade balance—everything. They ran a trade deficit since the early 1980s in almost exactly the same size relative to their economy—which you see in Figure 6.6. Their current trade deficit (accounted for the same way as ours) is about 5.5 percent of their GDP18—a tiny fraction of a percent smaller than ours. And their economy and markets have been strong just like ours. The British stock market has averaged the same annualized 13 percent return since they started running a trade deficit in 1984.19 Coincidentally, their economy has also been healthy, annualizing 2.7 percent GDP growth per year over that time period— just a whisker lower than ours (see Figure 6.6).
Other British deficits as a percent of GDP are similar but their currency is stronger. What gives? What does that tell you about trade deficits? It tells you they don't impact currencies. If pound sterling has been strong, and trade deficits impact currencies, how can their trade deficit, which is comparable to ours, be good for the pound sterling but ours be bad for the dollar? Critics may say, "That's just this year's deficit." Look at the charts again. You see the progression is similar. What you can't eyeball is if you take America's cumulative trade deficit over all these years, you get $5.096 trillion. Divide it by our $13 trillion economy and you get 39.2 percent. Do the same for Britain relative to its economy and you get 38.8 percent—statistically identical. You simply can't argue the size of our trade deficit relative to our economy is too big causing the buck to fall here while arguing their almost exact same size trade deficit relative to their economy now and cumulatively over time has
Figure 6.6 U.K. Trade Balance as Percentage of GDP. Source: Thomson Financial Datastream.
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Figure 6.6 U.K. Trade Balance as Percentage of GDP. Source: Thomson Financial Datastream.
somehow allowed the pound to be strong. Only a fool would go there. Is something else causing the relative strength or weakness of our currencies? Sure—but that is for Chapter 7. This litmus test is never contemplated by grumpy trade deficit bears.
Let's Play the "Which Country Do You Want to Be?" Game
Think about this yet another way. If a trade deficit is bad and a trade surplus is good, we can settle the question just by looking at examples of developed countries with big deficits and big surpluses. Without analyzing anything further than which country you'd rather be, look at Figures 6.5 and 6.6 again, both showing countries running "big" and growing trade deficits. Would you rather be the U.S. and U.K. with big and growing trade deficits but robust GDP and strong market returns over the past quarter century? Or, would you rather be a country with a steady surplus? How about those clever Germans—responsible for driving machines par excellence and punctual trains. They have run a trade surplus for the past 25 years (see Figure 6.7).
Figure 6.7 Germany Trade Balance as Percentage of GDP. Source: Thomson Financial Datastream.
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Figure 6.7 Germany Trade Balance as Percentage of GDP. Source: Thomson Financial Datastream.
Unfortunately, their vaunted trade surplus has been paralleled by a notoriously sluggish economy and a stock market that has slightly lagged the world's average. And poor Japan! Their big trade surplus over the past 25 years hasn't helped at all in getting their economy or their market to do as well as global averages (see Figure 6.8).
So, who do you want to be? Would you rather be the countries with the trade deficits and the zipping economies and above-average market returns? Or do you want to boast a trade surplus and desolate growth rates? All but the irrational would opt for the deficit and growth. Again, our trade deficit is a symptom of our economic vigor and rapid growth, not a political problem to be tackled. Those who think otherwise are ignorant.
Circle back to the current account deficit, which as we said earlier, includes and is largely comprised by the trade deficit. If you can't worry about the trade deficit driving stocks and the economy down, you really can't worry about the current account deficit either. But people will.
Most of the logic we used for trade deficits applies equally—there can be no global current account deficit. What's more, by definition, the current
- Figure 6.8 Japan Trade Balance as Percentage of GDP. Source: Thomson Financial Datastream.
account deficit is self-financing. The current account deficit is the complement of the capital account surplus. Much of the confusion over the current account deficit is because the cause and effect of balance of payments are often wrongly reversed. The current account doesn't drive the capital account. America doesn't "import" capital to "fund" the trade deficit. Rather, foreigners voluntarily (yes, voluntarily) choose to invest in U.S. securities and other forms of direct investment (because of our above-average growth and abundant opportunities compared to most of the rest of the developed world). This capital inflow invested in America and American securities, caused by foreigners, on balance perceiving better investment opportunities here than abroad, caused America to spend on overseas goods and services, adding to the trade deficit and creating the other side of the current account deficit. This allows you, me, and Joe Sixpack to buy more foreign products— creating the offsetting current account deficit. It balances, and there is nothing alarming to worry about here. The scary part is how few can see the simple beauty in this.
Mercantilists Are Darned Near as Bad as Commies— And I Hate Commies!
Note the real problem: the trade surpluses in Germany and Japan and many European nations. Why do they have them and why is it a problem? It must be a problem because the countries with trade surpluses have had markedly slower growing economies than the countries with trade deficits. Why? Before capitalism evolved in America and Britain as a dominant means of the creation of goods and services, mercantilism preceded it. People forget about mercantilism. Find a basic economic history text and read about it. My personal favorite fast read on all this is Douglas C. North's, Growth and Welfare in America's Past (Prentice Hall, 1966), but from his references you can find many other sources. Real capitalism first reared its head just as America was birthing. Recall Adam Smith's legendary The Wealth of Nations, the very most seminal book on capitalism, was published in the year of our nation's birth.
Mercantilism operated then to a more extreme extent but much as Japan and Germany do now. They deploy government-based economic throttles to purposefully create trade surpluses on the theory surpluses should help their economy. They think just like those who think our trade deficits are bad. They think trade surpluses help and deficits hurt, so they purposefully manufacture trade surpluses by constricting consumption governmentally and pushing exports. But forcing policy through an economy to create anything at the expense of freer markets and purer capitalism leads to sub-optimization and slower growth. Always! Why? To maximize growth, you must let capitalism run wild. Positively amok! That is the basic economic lesson of the past 200 years. Deficit bears are too clever by half with their views of good and bad and can't get the beneficence of Adam Smith's invisible hand. They want to interfere—with a policy hand that gets in the way and simply stifles growth. Bet on capitalism and growth, not on mercantilism and trade surpluses. Our growth creates the capital flows sustaining our trade deficits; as long as we continue to grow rapidly, our current account and trade deficits will remain high and we will remain happy. If our growth slows or ends, our twin deficits will too. That is all there is to it.
Summing up, in using Question One with a Question Two follow-up, we've learned debt and the triple deficits—the budget, trade, and current ac-count—aren't the negatives most people would have you believe. There is no actual evidence, other than mythological babble based on wrong-headed thinking, to support assertions deficits and debt will impale our world. In fact, nowhere will you hear or read a good trigger-based explanation of what the various deficits and debt are too high in relation to. When you hear drumbeats warning of market decline and worse because of a "too large" or "unsustainable" deficit or debt or both, know that fear of a falsehood is bullish—always. You can bet against it driving the market down. Keep that in mind, because deficits and debt frequently recycle as reasons for bearishness.
You should fear any effort to force a reversal in these deficits a la mercan-tilism—usually from senators. And you should fear surpluses. Repeat after me, "I would prefer not to see budget, current account, and trade surpluses in America. I would prefer to see rapid growth and deficits." Say that at your next cocktail party, and someone may throw a drink in your face. First, that reaction tells you this truth still has power and legs. Second, hey, free drink!
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