on July 20, 2003
Summary and rating comment:
This book economics theory is flawed. It assumes that foreign central banks hang on to 100% of the accumulated U.S. current account deficits. Instead, the U.S. current account deficit gets reinvested in U.S. assets. He explains that overseas banking crisis since 1977 were triggered by large U.S. current account deficits. But, these deficits got materially large only after 1998. The author maintains that U.S. households and businesses have deteriorating balance sheets. Meanwhile, a review of Fed data shows the opposite. Flawed economic assumptions go on and on within this book.
The author states that the foreign banking crisis in the eighties and nineties were caused by the U.S. running large current account deficits. These U.S. deficits caused a built up in dollar currency reserves of the exporting countries central banks. These excess reserves caused lending booms, and asset valuation booms. These ultimately lead to banking crisis due to borrowers defaulting on their loans which financed overvalued collateral.
His explanation of foreign banking crisis ignores the basic international accounting equality that current account deficits equal net foreign investments flowing back into the U.S. He states that foreign central banks reserves increased by the same amount as the U.S. current account deficits. They did not, as U.S. current account deficits get reinvested in U.S. assets by the foreign exporting countries. Thus, foreign central banks do not hold on to their countries current account surpluses.
Additionally, the author mentions 24 countries which suffered banking crisis between 1977 and 1997 all due to the infamous U.S. current account deficits. But, the U.S. current account deficits never exceeded $150 billion until 1998. This deficit level is peanuts within a global trading system measured in $trillions. Thus, the U.S. current account deficit can't possibly explain foreign banking crisis going back to 1977.
Many of the countries he mentioned that experienced banking crisis in the nineties (Indonesia, Korea, Malaysia, Philippines, Thailand) were actually running large current account deficits themselves. Thus, current account surpluses were not a factor in their respective banking crisis.
The author also states that the current account deficit caused an asset inflation boom in the U.S. particularly in stocks and real estate.
Here, the author runs into a contradiction that he chooses to ignore. How can the same U.S. current account deficits cause an asset inflation in both the exporting countries and the U.S. (importer). As mentioned, they certainly are not responsible for the asset inflation within the exporting countries. They could have caused asset inflation in the U.S. since these current account deficits have gotten reinvested as direct foreign investments in the U.S. But, the U.S. incurred a stock market boom from 1995 to 1999 when the current account deficit was not that high. And, it suffered a bear market since early 2000, when the current account deficit got significantly larger. These outcomes are the opposite of what the author theory suggests.
The author also mentions highly inflated real estate prices. Meanwhile, U.S. commercial real estate valuation have been lackluster for the past decade. Residential real estate is really a local market that varies greatly from one county to another. At all times the U.S. will have residential markets that appear overvalued and others who appear cheap (nothing to do with current account deficits here).
The author makes a popular case that the U.S. current account deficit level is not sustainable, because the U.S. can't borrow that much. Well, is that really the case? We are really talking of prepaid self financing here. If China experiences a $100 billion current account surplus with the U.S., we actually pay the Chinese that money upfront. They don't have to raise a dime themselves to reinvest this $100 billion back into the U.S. These foreign direct investments are broadly diversified between bonds, stocks, and direct investments. If we look at the U.S. net foreign investment position divided by the U.S. net worth (assets minus liabilities of individuals, businesses, and government), this ratio is only 6.3%. Several countries have foreign investment position ratio 50% or greater than the U.S. Australia has a ratio equal to 14%, Canada is 10%. I developed a model showing that the U.S. could sustain its level of current account deficit level for another 20 years to reach the same net foreign investment position as Australia today. And, Australia is no basket case. It's economy is doing a lot better than Europe and Japan. So, the U.S. current account deficit appears sustainable for at least a couple of decades.
The author maintains that the U.S. consumers and businesses are already dangerously over leveraged, and thus, he expects rising defaults. However, actual Fed data contradicts him. Household balance sheets remain strong. At 2002 yearend, household debt represented only 24% of household equity. Meanwhile, businesses have steadily improved their balance sheet over the past two decades, as their respective Debt/Equity ratio declined from 150% in 1980 to 82% in 2002. The author supports his theory with media headlines on corporate failures (Enron, WorldCom). But, these are isolated attention grabbing incident. Looking at the balance sheet of the whole economy, as we did, you get a different picture. Unfortunately, dull good news never sells.
The author's theory that the U.S. current account deficit is the cause for the World's deflation is ludicrous. The cause is China's exporting boom Worldwide. Also, China is buying dollars to keep the Chinese Yuan artificially low relative to the dollar and maintain its export surplus with the U.S. Thus, deflation is a Chinese phenomenon associated with its being the lowest cost producer and its manipulating the value of its currency.