Tuesday, December 16, 2008

Our Nation: So where do we go from here? Part 2

U.S. Interest rates
Over the next two years, rates will be low by historical standards. This will be bad news for fixed income investors, and good news for borrowing costs. In the 5-10 year time frame, there will be pressure for U.S. interest rates to rise due to the size of the U.S. government budget deficit. In addition, as the economy rebounds (and trust me, it will rebound), then the Federal Reserve will raise interest rates to hold inflation in check.

So when the government spends more than it collects in taxes, who pays the difference? Today, the shortfall caused by taxes collected being less than government expenditures, has been funded by foreign government purchase of Treasury bonds of various durations. Indeed, of all of the "savings" in the world, the U.S. consumes 85% of it to finance its borrowing. Mind you, the shortfall could be funded by US citizens buying government bonds, and if investors become more risk averse over the next two decades, this may occur. But even if that happens, the U.S. government needs foreign purchase of bonds.

Quick aside: if private pensions invested more in U.S. Treasuries, safeguarding retirement contributions, we could solve two problems at once.

So let's examine this question of foreign ownership of U.S. Treasuries, and consider whether they will continue to buy them as they are today.

As in most things, there are two sides to this argument -- those who think foreign governments will not continue to buy U.S. Treasury Bonds, and those who think they will. I fall in the latter camp, but let's examine the former.

Some financial and economic observers say that foreign governments will stop supporting the U.S. government's issuance of debt. They argue that diversification theory promotes holding non-U.S. debt. They argue that the lower interest rates that are being offered are not sufficient (hence mid- to long-term interest rates should rise). They also suggest that foreign governments may "blackmail" the U.S. and threaten to stop purchases unless the U.S. does what they want geopolitically (say withdraw troops from Iraq).

On the other side, there is an argument that the "savings" in the rest of the world are driven by the sales of goods and services to the U.S. by its trading partners. For example, ask yourself, "where would China sell their goods if not to the U.S.?" The same is true for everyone. Yes, the U.S. is the 2nd largest producer of oil, but it still imports from Canada, Mexico and Venezuela (and a little bit from the Middle East, maybe 15% of the total). So the question becomes, "why would our trading partners harm their single largest customer?" The answer is, they will not. This is why the blackmail argument is spurious. Let me make certain that this point is clear -- the world builds and sells products which are sold in the USA. Without question, they sell the most profitable (e.g. highest margin) in the USA. The profit they reap from their sales of goods and services can either be repatriated (which causes an increase in both their money supply and inflation) or they can keep the profit in dollars. The way that do it is through the purchase of Treasury Bonds. If they stop buying them, they hurt their biggest customer, AND they run the risk of hyper-inflation at home.

Also supporting the argument that foreign investment will continue is the simple fact that the the U.S. government is without question the safest place to invest. Please review below all the reasons I articulated in Part 1 that make this true. The ability of the government to tax and collect; the ability to maintain law & order; and the raw assets available as collateral; all support the credit-worthy nature of the U.S.A. Where would you trust your money in lieu of the U.S.? Russia, China, India, Brazil? All have political risk. The UK, France, Germany? All have significantly lower levels of assets and a smaller tax base. Unlike our developed friends, the United States has the ability to grow. The economy is huge, but can still grow 2-3% because our population is growing; because we have space for new citizens; because we invest in education, research and development (especially with venture capital start-ups).

So will interest rates rise? Yes, they will, but more in response to the very low rates we have now. There will be pressure to fund the federal deficit, but remember, the Clinton Administration ran a surplus on the back of the Reagan/Bush/Clinton economic expansion after the last major recession (Carter). This too is possible in the next two decades.

The U.S. Dollar
Should the average citizen care whether the dollar buys more or less units of another currency? Probably not. Most Americans do not travel extensively abroad. Moreover, the travel industry is very competitive, and deals are always available. With that said, there are several reasons why the U.S. Dollar will fall over the next decade.

1. There will be higher relative growth rates in other parts of the world. In Europe, there is still considerable growth to be unlocked by the continuing elimination of national trade and competitive barriers. There will never be a "United States of Europe," but it is clear that there will be 2-3 Euro champions in each industry as opposed to the historical "national" champions (think banking, energy, aer0space & defense, consumer durables, autos, consumer perishables, fashion). Moving beyond Europe, the BRIC nations will grow faster than the U.S. in the future.

Word of caution -- the $ amount of growth that the U.S. will generate on a $13 trillion base at 2.5% growth is $325 billion per year!!! Notwithstanding, the dollar will still fall due to relative changes.

2. A lower dollar makes U.S. exports more competitive, and makes imports more expensive. This is a check upon the trade deficit. A weak dollar is one reason why oil rose so fast so far. It is denominated in dollars! Same is true of gold and other commodities. The dollar's weakness explained 20%+ of the rise in commodities in 2008.

3. The most important reason the dollar will fall from today's level, however, is that it makes the debt paid in the future cost less than paying it today. This has been a specific Bush Administration policy, and quite frankly, a good one.

To summarize, the interest rate is not the reason foregin governments buy U.S. Treasuries. They do it to maintain balance of payments for international trade and to support their biggest market. Domestic interest rates will rise but will do so for domestic economic and inflation reasons, but not to attract buyers of U.S. Treasuries. And finally, the U.S. dollar will fall again for global macroeconomic reasons, and it is not a bad thing for our nation.


Jack said...

I think you hit on a great point when you say "especially with venture capital start-ups"

America does have all of the hard asset / demographic advantages you put forth in part 1, but without continued technological advancements, we won't be the leaders forever. All of the conditions you enumerate in part 1 add up to make the US the most conducive environment for advancement and creation, but we must be careful to ensure that political and regulatory adjustments to not destroy that advantage.

We cannot afford to have the founders of the next Google's and Microsoft's move outside of our borders because "it's just too hard to do business in the US."

Jeff Bell said...

Agree 110% Jack! Thanks for commenting.

Bellringer said...

High five.