Fire Sale Time

Time Magazine is running a largely insightful article this week on the trade deficit and its costs. Only two things are missing... a discussion of how to end the bleeding (e.g. policies that would reduce the trade deficit) and a recognition that foreign governments have played a role in abetting and sustaining the imbalances. None the less, it makes some good points. The title: America's Coming Garage Sale.

The real cause of the trade deficit is that Americans spend too much and save too little. That's true for both the government, with its mammoth budget deficits, and the average consumer. American household debt reached $13.8 trillion at the end of 2007, or more than double the amount in 1999. This debt-financed consumption has led to a level of imports well beyond the nation's ability to pay for them. Americans have no one to blame but themselves.

Now toss on top of that unstable situation the current financial chaos. One effect has been to depress the value of American assets, such as shares and property. This alone is impoverishing the average American. Housing price futures are predicting a more than 20% decline in Los Angeles home prices over the next 12 months. Christopher Wood of brokerage house CLSA recently wrote that the financial meltdown will "produce the most devastating wealth destruction" in the U.S., "which conventional monetary policy will be powerless to prevent." Americans are already getting poorer by the day.

So is the U.S. vis-á-vis the rest of the world. The losses at American financial institutions and fears of a coming recession have eroded confidence in the U.S. economy and depressed the value of the dollar against other currencies. The dollar has hit record lows against the euro, and last week sank to its weakest level versus the yen since the mid-1990s. That means all of those imports that Americans buy – from oil to toys – are becoming increasingly expensive, eroding the average American's quality of life. "By pursuing a policy of diminishing the dollar," says Thailand-based investment analyst Marc Faber, Americans "impoverished themselves relative to the rest of the world."

It also means that those mounds of dollars held by central banks and investors from Tokyo to Kuwait City are also deteriorating in value by the day. Yet the world can't just dump its dollars. Not only would that be incredibly destabilizing to the global economy, but it also would be effectively impossible. The dollar has been the reserve currency for decades and there are just too darn many of them out there to be converted into something else. Bankers in Beijing, Hong Kong and Dubai are stuck with the rotting stacks of greenbacks.

So the outcome is inevitable. As the financial crisis in the U.S. persists, the combination of decreasing asset prices and a weakening dollar will make the U.S. cheaper and cheaper to foreign investors. Irresistibly cheap. The U.S. is, after all, still a highly desirable place to own property, companies and securities. Foreign investors will see the crisis as a golden opportunity to buy prime pieces of Americana at bargain-basement prices. So all those dollars in banks around the world will flood back into the U.S. to buy stocks, bonds and property. Debt-burdened Americans, desperate for fresh cash, will be only too happy to sell — or be forced to sell. The U.S. will become one giant garage sale, where the buyers are Japanese banks, Chinese state-run investment funds and oil-rich Arab sheikdoms.

Of course, we've heard all of this before. For the past two decades, pundits have warned of the dangers of the trade deficit, while the U.S. has powered on. The big difference these days is that far more countries are awash in dollars today than there were in the 1980s. Even back then, if you remember, Japan recycled its surplus into U.S. assets when the dollar weakened in the late 1980s.

The upside to greater foreign investment in the U.S. will be the strengthening of the dollar and the resurrection of stock and property prices. The downside is that the foreign business community – especially in Asia – will own larger swaths of the U.S. economy. And it is these foreign buyers who will benefit from the increases in the value of assets and the dollar. In fact, such a shopping spree has already begun. Look at the list of investors that recapitalized Citigroup in recent months – investment funds of the Singapore, Kuwait and Abu Dhabi governments. In fact, Asian investors bought a net $50 billion of U.S. stocks and bonds in January alone, up nearly 30% from December. "The U.S. is getting pretty cheap," says Charles Change, managing director of boutique investment banking firm Accolade in Seoul. "You always want to buy low and sell high."

There is, simply put, no way out of this situation for America. If you don't believe me, perhaps you'll believe Warren Buffett. The Sage of Omaha predicted this very scenario in 2003 in an article in Fortune. He tells the story of two fictional islands, Thriftville and Squanderville. In Squanderville, the residents live beyond their means by importing from Thriftville in return for IOUs. Eventually, Thriftville converts this debt into Squanderville assets until Thriftville owns all of Squanderville. America, Buffett warned, was facing the same fate. "Our trade deficit has greatly worsened, to the point that our country's 'net worth,' so to speak, is now being transferred abroad at an alarming rate," Buffett wrote.

http://www.time.com/time/magazine/article/0,9171,1725094,00.html?xid=rss-topstories