Thursday, September 17, 2009

The Economy – what’s next?

So I have this high-altitude narrative working. According to me, too much money found itself chasing too few goods, only the goods weren’t real goods, they were investment assets, and safe ones at that. The surge in demand for good paper came about because (i) our baby boomers increased their savings rate as their age went up and their risk tolerance went down, and (ii) our trading partners found nothing on our shelves that interested them.

Too much money chasing too few of anything causes the average price of that thing to rise. Most often, the increase in price is achieved through an increase in the actual selling price of the item. But other mechanisms can achieve the same result. Most notably, the product can be adulterated or counterfeited. In that case, the price can stay relatively stable as new “supply” appears to meet the new demand. And so it was with American mortgage debt. When we ran out of borrowers with real credit buying homes with real value, we started pretending that the homes were worth more than they were, and that the borrowers’ credit - which never really mattered in itself but did signal to the attentive that there would be no bigger fools available to buy the homes should the need arise – was better than it was. That way, the nominal yields stayed high (i.e., the nominal price of the instruments stayed low), and everybody was happy. Until the music stopped.

So now what? The boomers aren’t getting any younger, and their appetite for paper has only increased as they try to recoup what they lost in blue-chip stocks, mortgage-backed securities, and other “prudent” investments. We’re still importing oil and toys, and we haven’t achieved any new comparative advantages to support a boom in exports. So. too much money will again be (or is still is?) chasing too few good pieces of paper. But the fraud option is no longer viable. How does that play out?

The stubbornly low yield on Treasury paper, and the bull market in stocks, both in the face of a stagnant economy and a soaring Federal deficit, are the first natural consequences. The prices of these instruments have gone up because the investments are, for the most part, what they claim to be. And people have to put their money somewhere.

On that score, the Americans have little choice. We will pretty much buy American, although a lot of people certainly are loading up on Asian stocks. My two largest holdings – largest because they have done so well and not because I invested heavily in them - are a Chinese travel agency and an Australian mining equipment maker. But still, our major averages are up nicely since March, and the need for Americans to rebuild their savings seems to be driving that.

What, then, will the Chinese and OPEC countries do with their dollars? Remember the wag’s description of the Soviet economy? “We pretend to work, and they pretend to pay us.” Although we can no longer pretend that a dollar will buy anything, our trading partners can pretend otherwise, converting export dollars into local currency for use by the local economy to stay employed and to continue to grow. It doesn’t really matter that the yuan or rial is backed by dollars and the dollars are backed by nothing. If our currency can be backed by nothing, why can’t theirs? (Actually, all currency is backed by the issuing country's ability to offer things for sale - manufactured goods for China, oil for OPEC.)

The only thing our trading partners cannot do is refuse to export to us, until, that is, they don’t need us as an export market. And that’s the game we need to follow now. The risk we run is that the US will outlive its usefulness as an export market. We may experience a functional embargo, a “shortage” induced by everyone else turning to serve the Chinese market because, in the case of Chinese sellers, the domestic growth is a good thing, and, in the case of OPEC, the Chinese have something to sell in exchange for the oil they import. Why should the world’s leading exporters continue to deal with us if they can deal with China? Wouldn’t you rather export to a country that has stuff to sell than to one that doesn’t? Wouldn’t you rather sell to your neighbors for your own currency than to foreigners who have nothing to sell you for theirs?

Eventually, the growth of demand in Asia and elsewhere could bring about a renaissance of manufacturing here, as cheap foreign goods are no longer available. But, just as we need a floor on the price of oil to promote alternative energy, we need a floor on the price (or ceiling on the quantity) of foreign goods to promote investment in production here. That may sound like a trade barrier, but it won’t be one if the barred products aren’t coming anyway. But still, the counterintuitive nature of trade restrictions, and the reluctance of capitalists to rely on them, may augur a period of significant shortages here until we get the political will to stimulate our own production.

This will be a slow process, taking shape as the domestic Chinese (and Indian and Brazilian) economies continue to grow, fed, ironically, by the myth that US dollars represent wealth. That’s because, at the end of the day, those dollars are just an excuse for deciding who among the Chinese, Brazilians, and Indians deserves to be wealthy. Exports to America become a way of keeping score in the game of “Who Makes the Best Stuff.” Because our consumers are good judges of stuff, the stuff we buy the most of is the best stuff (in terms of marketability, not necessarily quality), and that’s the stuff that should be made available to the domestic markets - and the producers thereof made rich for their efforts. We have, for the nonce, a comparative advantage in consumerism – an ability, unique in all the world, to advertise, distribute, test, and validate the products brought to us. That’s a useful thing, and we will benefit from acting as judges of foreign stuff until our trading partners’ own consumers are able to to the job for themselves. Until, again, the music stops.

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