| February 6, 2014 | | | | |  | | | Trade, Fracking and Speculative Capital | | | - December's trade numbers... why the trade deficit was a nonissue as recently as 40 years ago… and Kurt Richebacher on its unsustainability...
- How the U.S. "shale gale" has helped close the gap to 2002 levels… It's hardly a "robust recovery," but hey, we'll take it...
- Plus, Greg Canavan on the speculative flows from the dollar into emerging market currencies... how the greenback gets its value... and more!
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Today, December's trade numbers were posted -- giving economists and traders alike an additional sense of purpose. Yesterday they made their "expert" forecasts, today they missed the mark -- the trade gap widened to $38.7 billion -- and tomorrow, they'll drone on about what it means.
But until 40-some years ago, you never heard about the trade deficit -- the amount by which imports exceed exports.
It was around the 1980s when it started making weekly headlines as Americans couldn't get enough Japanese cars and electronics while "good manufacturing jobs" in America became harder and harder to come by. It made headlines again in the early 2000s as Americans couldn't get enough cheap Chinese… whatever. Foreigners' desire for American-made goods was nowhere near as ardent.
Under a gold standard -- even one as imperfect as the Bretton Woods system from 1944-71 -- trade deficits were small and brief. As were trade surpluses. Debtor nations had to settle up in gold with creditor nations. And no nation wanted to part with large quantities of gold indefinitely. So the system maintained a constant state of equilibrium.
That all ended when President Nixon "closed the gold window" in 1971 and dollars held by foreigners were no longer redeemable in gold. As you see nearby, the United States has run an annual trade deficit every year since the mid-'70s. "America has, in fact, run trade deficits large enough to wipe out its gold hoard under the old rules of the game," wrote Jim Rickards in his book Currency Wars.
So where do we stand now? Let's take the chart and zoom in on the last 15 years with a view of the monthly trade deficit -- the blue line. "Such a large deficit used to be unthinkable," Dr. Richebacher said in late 2005 as the numbers approached their nadir -- "absolutely unsustainable for any length of time."
The Federal Reserve created enough new credit to keep the game going until the Panic of 2008. Then it was game over and Americans stopped buying imported stuff they didn't need and couldn't afford. Helping matters was an oil price that crashed from $147 a barrel to $33 in mere months.
The trade deficit started growing again as the "official" recession wound down. More recently, it's been shrinking the last two years; as we go to press, the number is no worse than it was in 2002.
And look at how petroleum's contribution to the trade deficit is so much less now than it used to be. American consumption of crude oil is about 2 million barrels per day less than before the 2008 crisis, thanks to a persistently weak economy and more fuel-efficient vehicles. Meanwhile, American crude production is about 2 million barrels per day more thanks to the "fracking" boom.
It's hard to overstate the impact of the shifting energy picture on the trade deficit. The Fed's endless credit creation hollowed out the U.S. manufacturing sector during the early 2000s, which only goaded the Fed to create more credit. "The credit expansion implemented to compensate for the trade losses in manufacturing," Dr. Richebacher explained in 2005, "creates job gains in different trade sectors: construction, financial services, temporary help services, education, leisure and hospitality and government.
| In some cases, it no longer makes sense to manufacture something in China | "In other words, manufacturing contracts while services proliferate. On the surface, this exchange may seem irrelevant. In reality, it progressively downsizes the economy's production structure. Manufacturing is the sector in the economy with the highest capital formation, the highest productivity and the highest wages. Most service jobs are rock bottom in all these respects."
But energy available closer to home is changing the calculus for many American firms, hence the "re-shoring" phenomenon in the 2010s that's reversing the "offshoring" phenomenon of the 2000s.
In some cases, it no longer makes sense to manufacture something in China and pay for expensive bunker fuel to ship it to the U.S. If your customers are mostly Americans, better to manufacture it at home -- especially if you can use robotic techniques that require a few highly skilled employees, not a factory full of low-skilled ones.
No, it's not the recipe for a "robust recovery." But without all that U.S. energy, the situation would be that much worse... | | | | | | | | | The Book the White House and Wall Street Don't Want You to See
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Click here to discover what it has to say. | | | | | | | | The Daily Reckoning Presents: The ebb and flow of trade deficits/surpluses is the natural consequence of a floating currency system. If you have the world's reserve currency, like the U.S. does, however, you can keep running deficits without ruffling too many feathers. In turn, the capital flows from trade affect the currency's value. Greg Canavan explores in full below...
****************************** | | | | Trade and Speculative Capital | | | | by Greg Canavan | | |  Since May of last year, financial news has latched onto the taper with full force. Don't worry, we would not going to discuss it at any great length here… we only mention it because we've been thinking about the dollar and currencies in general, and what determines the value of a currency.
You see, we think the whole taper story is a con. The line you're being, errr, 'fed' is that the US economy is improving and that, as a result, interest rates must 'normalize'.
What's helping to reinforce this notion is the strengthening dollar. Investors see the dollar rising against a range of other currencies and think it represents a preference for US assets because of the health of their economy.
We think it's a lot more complicated than that.
This is based on the view that capital flows through a currency, not into one. This idea is going to take a bit of explaining, but it's an interesting one so bear with us.
First, it helps if you understand the general flow of capital throughout the world. Grossly oversimplified, the US is the source of much of the world's liquidity and capital flow via its U.S. $500 billion per year trade deficits.
In other words, the US sucks in $500 billion more in goods and services than it sends out to the rest of the world, so it must pay for the excess in paper currency. Sort of. It actually pays for it by borrowing, and it does that by issuing Treasury bonds.
| The US sucks in $500 billion more in goods and services than it sends out to the rest of the world. | As a result, capital flows out through the dollar (and into, say, the Chinese yuan) to pay for the goods and services. But almost instantaneously the Chinese send the capital back through the dollar (to maintain its currency peg) into dollar-denominated assets like Treasury bonds.
It's this constant and equal flow that maintains the dollar's value. When a little more capital flows out than flows back in, the dollar weakens against whatever currency is not maintaining an equal flow. And when the inflow is greater than the outflow, the opposite happens.
So what you're seeing now is a general inflow back into dollar denominated assets. But as we said, it's more complex that just that. Here's what we think may be going on…
Capital flows based on international trade in goods and services are just one part of the equation. Financial 'speculative' capital flows also play a major role in determining currency values.
For example, the US government issues Treasury bonds to finance its deficit, which represents spending on real goods and services. These bonds, while ostensibly being a government IOU, are also a financial asset…one that the holder can 'borrow against' to speculate with.
That is, if you hold a Treasury bond you can use it as collateral to borrow dollars and then spend those dollars to get exposure to say, emerging markets. When QE was in full force and liquidity flowing, that was a pretty popular trade.
But now, with the market expecting the QE party to end, or at least to 'taper off' more, those speculative flows are reversing. Speculative capital is flowing back through the dollar in a hurry, pushing up its relative value against a whole host of currencies (especially emerging market currencies) as it does so.
So there are two capital flows to keep in mind here, one that concerns trade in real goods and services and one that relates to financial, speculative trade. | | | | | | |
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Click here to see how! | | | | | | | | Right now, we think the strength in the dollar relates more to what is going on at the speculative end of the market…the financial flows. And if we're right, it's actually masking some major structural weakness in the dollar.
Why?
Because of what's happening at the trade flow end of the spectrum. The US is still generating an annual trade deficit of around $500 billion (meaning an outflow of dollars to pay for the goods). In order for the dollar to remain stable (ignoring the financial side of things for the moment) foreigners must plug this gap by sending the capital back through the dollar to buy dollar denominated assets.
But right now, foreign creditors to the US are not doing that. The appetite for long term US assets, specifically Treasury bonds, is waning…big time. That's not a healthy development for the dollar, but right now a reversal of speculative capital flows back to the US (going through the dollar to get there) is masking this looming structural issue.
And the Fed's promise to taper is making things worse. Currently the Federal Reserve is buying about $35 billion a month in Treasury bonds, or $360 billion per year. This is more than enough to cover the trade deficit, but it's certainly not a good look to have your central bank finance 100% of your excess consumption.
In fact, it's downright dangerous. Because instead of foreigners doing it, which involves selling foreign currency to buy dollars, the Fed effectively creates more dollars to buy dollar denominated assets.
| When foreigners finance US deficits, it represents genuine demand for dollars. | That may sound confusing, so let us break it down. When foreigners finance US deficits, it represents genuine demand for dollars (or movement of capital through dollars). When the Federal Reserve does it, it represents an increase in dollars relative to foreign currencies. Not good for the dollars' long term value.
And all those 'dollars', or dollar-denominated assets, are still out there. 30-odd years of accumulated trade deficits sit in foreign central banks around the world in the form of US Treasury bonds. The stock of federal debt, held abroad, is enormous. In other words, there is a very large supply of dollar denominated debt sitting outside US borders.
As you probably know prices are set at the margin. The next seller (and buyer) of just one unit of the enormous dollar denominated stock sets the price.
So if some foreign holder wants to sell, and no other foreigner wants to buy, then chances are it will be the Fed who becomes the marginal buyer. Such a transaction is dollar negative, as it effectively creates a dollar to buy a dollar.
It will therefore ultimately be negative for the value of the greenback vis-a-vis US trade partners. In turn, this will increase the price of imports, which could push up the nominal value of the trade deficit and make matters worse. Or the US could pull its head in and consume less, which higher bond yields may force it to do.
Who knows? But what is becoming clearer are the intractable problems of too much debt moving around the international financial system. Tapering, speculative capital flows, rising bond yields and a reduction in foreign financing of the trade deficit are all intertwined.
The next few years will prove to be very interesting indeed. There are many scenarios that can still play out, but a sustainable US economic recovery is not one of them.
Regards, Greg Canavan
for The Daily Reckoning | | | | | | | | |  Greg Canavan is the editor of Sound Money, Sound Investments, a financial report devoted to unearthing great value investments amid today's "money illusion" of fiat currency. He is also a contributing editor to the Australian Daily Reckoning. | | | | | | | | | BE SURE TO ADD dr@dailyreckoning.com to your address book.
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