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October 28, 2004

Current Account Deficit Woes Fuel Gold
by Michael Swanson

This past Monday gold pulled back off its 16-year resistance level of 430. At the same time while dollar is now only inches away from making a new yearly low. The fundamentals and technical action are suggesting that gold is on track to launch 'wave two' of its bull market before the year is over. Few people see this coming, but few people truly understand the fundamentals behind these markets. In fact, there is a lot of confusing rhetoric flying about. And it all has to do with the current account deficit.

An account deficit is the difference between a nation's savings and expenditures. If the current account deficit is positive it means that a portion of a nation's savings is being invested abroad; if it is negative it means that a portion of domestic investment is being financed by the savings of foreigners.

When a country runs large budget and trade deficit, the deficit is funded by foreign money coming into the country. For instance if a country imports more goods than it exports it will pay for those imports with loans coming from other countries.

The United States has the largest budget, trade, and current account deficits in its history. Historically other nation's have experienced some sort of currency crisis once their current account deficit passes 5% of GDP. The United States surpassed this level almost a year ago.

In effect, we're depending on foreign money to sustain our own economic growth.

Bloated current account deficits lead to a crisis. Once they get too large, investors lose faith that the country will ever be able to completely finance it. In order to protect themselves, the investors begin to sell assets in the currency, an act which snowballs and eventually causes interest rates to spike and the economy of the indebted country to collapse.

Worries About the US Dollar

Many commentators believe that the current account deficit of the United States has approached unsustainable levels and will eventually lead to a serious financial problem. Legendary investor Warren Buffett announced last year that he took positions against the United States dollar, which he described as being "massive," in the expectation that we are headed to such a crisis.

"Our country's net worth so to speak, is now being transferred abroad at an alarming rate," he said. "In effect," he warned, "our country has been behaving like an extraordinary rich family that possesses an immense farm. In order to consume 4% more than we produce - that's the trade deficit - we have day by day, been both selling pieces of the farm and increase the mortgage on what we still own."

The head of the Dallas Federal Reserve, Robert McTeer, shares this position. In a speech on October 7, he said that there were only two ways to address the unsustainable current account deficit. Either US incomes would have to shrink so that consumers will buy less foreign imports or else the dollar would have to weaken. "Over time, there is only one direction for the dollar to go - lower," he said.

However, some people do not think the deficit is a problem. Permabull FOX News financial commentator Tobin Smith says that the deficit is actually a sign of the strength for the US economy and is so huge because the US economy is the biggest economy in the world.

"We run a current account deficit as a country because we consume so many more goods than other countries. Remember, we have 5% of world's population, 33% of the world's GDP, and more than 50% of the corporate and personal income earned. The market cap of our stock and bond markets are 75% of the entire world," Smith writes.

"In the context of our exaggerated rate of consumption vis-à-vis the other countries in the world, there is $88 trillion of corporate and household wealth vs. less than $20 trillion for the rest of the world," Smith continues.

According to Smith, "running a trade imbalance of less than 5% of our GDP is actually LOW on a percentage adjusted basis."

"There is no precedent for a trade balance that is unsustainable for a country that produces and consumes such a disproportionate amount of the world's goods and owns such a disproportionate amount of the world's wealth," Smith concludes.

I have two responses to this. First, the trade imbalance is not low; it is taking a toll on our economy and endangering our national security. It is stripping our manufacturing base and turning the economy into a credit card, debt-driven, consumption machine, which will ultimately collapse like a house of cards. The US trade deficit is growing and is now over $600 billion. Some 2.6 million manufacturing jobs have been lost in the past 4 years and replaced with lower paying "service" jobs.

It is false to say that we have had a "jobless recovery" in the past few years as Presidential candidate John Kerry has charged. We have created millions in slave-wage jobs in China thanks to a $150 billion dollar a year trade deficit with China. What we buy from China here in the United States amounts to 40% of their exports and 10% of their entire GDP.

Secondly, there are precedents for world leading economies to have crisis-level deficits. Great Britain had one in the 1920's which just happened to lead to the collapse of the gold standard and helped spur the Great Depression. In the United States, we reached a current account deficit right under 5% of GDP in the 1970's thanks to a decade of 'guns and butter' deficit spending, which led to a crisis of foreigners selling the dollar and draining the United States of its gold reserve. To escape a full-blown currency crisis, Richard Nixon abandoned the Bretton Woods system and canceled our commitments to redeem dollars for gold, an act that changed the global monetary system and started the imbalances that have grown since.

People who claim that there is no precedent for today's situation simply don't know history. And history shows that a current account deficit that grows like ours has been growing will result in some sort of crisis.

Smith also argues that our current account deficit is a good thing, because it represents foreign money investing in the United States. "The countries that produce capital surpluses typically have such low return on investment performance that their capital owners WANT to invest their surplus capital where they feel it will be best rewarded vs. the risk they are willing to take with that capital," he writes.

With this reasoning Smith is saying that our current account deficit is so big, because the Unite States offers the best potential of risk to reward in the whole world. This fuzzy logic turns the fundamental reasons for the current account and trade deficits upside down.

The Real Story

In reality, the deficits are making the United States a less attractive place for investment. That is why the dollar is dropping and one of the reasons that the stock market is under pressure.

Just a few days ago the US Treasury reported that the net capital inflows from the rest of the world into the United States fell for the 6th month in a row. Private from abroad fell to $34.7 billion in August and from $72.9 billion in July. Asian central banks made up for the shortfall. If they hadn't, the current account deficit would have exploded.

The NY Times quoted Ashraf Laidi, a currency analyst at MG Financial Group as saying, "foreign central banks saved the dollar from disaster. The stability of the bond market is at the mercy of Asian purchases of US Treasuries."

The current account deficit has grown so large the foreign investment coming into the United States is no longer creating economic growth. Although the United States is taking in 80% of the world's surplus savings it is all being used to finance the deficits.

According to Stephen Roach, the head economist of Morgan Stanley, the deficits are growing so large that by the end of the year America's indebtedness to other countries will reach 28% of GDP.

That would bring the US indebtedness to a level of 300% of exports. Argentina and Brazil were at 400% right before they collapsed in the 1990's.

In short, the current account deficit will soon reach the point at which it will become a problem that even bullish prognosticators like Tobin Smith won't be able to deny.

During August, foreign investors were net sellers of US equities. It was the intervention by foreign central banks that prevented a run on the dollar. We may be starting to see the first signs of a brewing crisis. If the current trend continues then the US financial markets will eventually come under intense pressure, the dollar will continue to drop, and investors from all over the world will flock into gold.

Gold just tested 430 yesterday, a level that has been resistance for gold all year. Gold is likely to pullback or consolidate before it breaks 430. This would give us a consolidation period in gold stocks and, more than likely, a final buying opportunity. This scenario is also in line with the dollar bouncing off of 84 support for a few weeks. The action in the gold stocks is giving us important clues to which stocks are likely to go up the most during the next gold bull run."

To find out what gold stocks Mike Swanson holds and plans on buying subscribe to his free Weekly Gold Report at http://wallstreetwindow.com/weeklygold.htm

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Michael Swanson,
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