The Current Account Diversion
Below is an extract from a commentary originally posted at www.speculative-investor.com on 25th January 2007.
We thought we'd weigh-in on a debate between Peter Schiff and Robert Murphy regarding the implications of the US's large and seemingly ever-expanding current account deficit (and corresponding capital account surplus since a deficit on the current account must be offset by an equivalent surplus on the capital account). Mr Schiff argues that the current account deficit is a major problem that virtually guarantees a much lower US$, whereas Mr Murphy argues that today's balance of payments situation is not necessarily a bad thing and does not point towards a weaker US$.
On this topic our views are much closer to those of Mr Murphy than those of Mr Schiff. A large current account deficit does not, in and of itself, constitute a problem. The fact is that it can be advantageous for some countries to run current account deficits and, at the same time, advantageous for other countries to run current account surpluses, just as it can be advantageous for two individuals to engage in a transaction whereby one individual provides goods or services to the other in exchange for the promise of a future return (an IOU or a stake in a business venture, for instance). Actually, the simplest way to see that neither a current account deficit nor a current account surplus is necessarily problematical is to reduce the issue to the individual level. After all, no country decides to run a current account deficit or surplus; rather, the balance of payments situation for any country is the net result of millions upon millions of individual transactions.
To make the point that neither a deficit nor a surplus on the current account is necessarily a bad thing Mr Murphy describes the hypothetical example of an American entrepreneur who can't afford to purchase the office equipment (computers, photocopiers, phone system, etc.) needed to get a new business off the ground. In exchange for a stake in the business, some Japanese investors send the American entrepreneur the required office equipment thus allowing him to begin the wealth creation process. If the business succeeds then both parties to the transaction -- the American entrepreneur and his Japanese investors -- will benefit. The US economy as a whole also stands to benefit despite the fact that the transaction adds to America's current account deficit.
Further to the above and as we've noted many times in previous commentaries, the US current account deficit is not a good reason, in itself, to be bearish on the US dollar. A large current account deficit can sometimes, however, be symptomatic of an inflation (money-supply growth) problem in that a relatively high inflation rate in a country will lead to a relatively large rise in the costs of doing business within that country, thus increasing the incentive to import goods rather than manufacture them locally. And a relatively high inflation rate IS a very good reason to be long-term bearish on a currency. In fact, a relatively high inflation rate is the ONLY good reason to be long-term bearish on a currency.
In general terms, what happens is that if the supply of Currency A consistently grows at a faster rate than the supply of Currency B then Currency A will end up losing its purchasing power at a quicker rate than Currency B; and if this happens then the A/B exchange rate will trend lower over the long-term. Under such circumstances Country A will most likely end up running a greater current account deficit than would otherwise have been the case, but it's critically important to realise that the problem lies in the inflation, not in the current account.
Which leads us to the question: Has the large US current account deficit stemmed from a relatively high US inflation rate?
We think the answer is yes; inflation has, over the past several years, been an important contributor to the widening of America's current account deficit. There are two reasons for thinking this way. First, the supply of US dollars increased at a relatively high rate during 1998-2002 and this inflation, like all inflations, undoubtedly resulted in misdirected investment and higher costs. Second, a substantial portion of the external demand for US dollars over the past 5 years has come from foreign central banks.
Expanding on the second of the aforementioned reasons, it seems that over the past 5 years private foreign investors, as a group, have not been overly impressed by the potential real investment returns on offer in the US. As a result, foreign central banks -- institutions that often have as their primary motivation something other than achieving a reasonable real return on investment -- have had to 'take up the slack'. As opposed to being comprised almost entirely of transactions of a similar nature to the one in the above-described hypothetical example, over the past 5 years a big chunk of the foreign investment demand for US dollars has been associated with the currency-management programs of foreign central banks. Specifically, foreign central banks have bought-up huge quantities of US dollars and funneled these dollars into the US bond market with the primary goal of preventing their own currencies from appreciating. Such dollar-support operations would never have been necessary had the large current account deficit not been an effect of rampant US$ inflation.
But that was then and this is now. Over the most recent 3-year period the US dollar's inflation rate has generally been lower than the inflation rates of its major fiat currency counterparts. Therefore, whereas it was an obvious choice for us to be long-term bearish on the Dollar Index back in 2000-2004, it is no longer a cinch that the US dollar's foreign exchange value will ultimately trade at much lower levels. This is not because the US dollar's fundamentals have improved, but because other currencies' fundamentals have worsened. (As an aside, the rapid simultaneous devaluation of all fiat currencies via inflation improves the long-term investment case for gold. Gold will eventually become widely recognised for what it already is: the only viable alternative to the dollar.)
In conclusion, the US$ bears whose bearish outlooks are primarily based on the current account deficit might end up being right about the dollar, but if so they will be right for the wrong reason. Specifically, they will only be right if the US$ inflation rate once again becomes relatively high. On the other hand, making a long-term bet against the US$ via currencies such as the euro, the British Pound and the Canadian Dollar -- a tactic that worked very well during 2002-2004 -- will result in losses if the relative inflation-rate trends of the past three years continue.