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Monday December 18, 2006 - 16:36:16 GMT
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Does the Current Account Matter?

Key News

• The U.S. current-account deficit widened to a record $225.6 billion last quarter. (Bloomberg)
• Stock market listings have hit a record $227bn (£116bn) worldwide this year, with London reinforcing its position as a global investment hub. (BBC)
• Key Reports for Tuesday 19 Dec (WSJ):
7:45a.m. ICSC Store Sales Index. For Dec 16 Wk. Previous: +1.0%.
8:30a.m. Nov Producer Price Index. Previous: -1.6%.
8:30a.m. Nov Producer Price Index, Ex-Food & Energy. Previous: +0.6%.
8:30a.m. Nov Housing Starts. Previous: -14.6%.
8:55a.m. Redbook Retail Sales Index. For Dec 16 Wk. Previous: -1.7%,
5:00p.m. ABC/Wash Post Consumer Conf. Previous: +1.


"Construction is an extreme case in point, largely because it takes several months to build a house. Although employment in the building industry has fallen by over 20,000 in each of the past two months, the drops are modest compared with the collapse in construction spending. The fall in permits issued for new houses suggests there may be many more job losses ahead. Economists at Goldman Sachs expect housing-related employment to fall by 1.5m-2m in the next couple of years. Unless employment growth in the rest of the economy speeds up and absorbs some of the surplus, the overall jobless rate will soon rise, perhaps rather further than the central bankers would like.”

The Economist

FX Trading – Does the Current Account Matter?

Another blowout current account deficit was reported by the US today. And the dollar is drifting higher on the news. Depending on one’s perspective, the current account may imply many different things.

Here are two competing camps that battle on the issue current account deficits:

1) Structural decline crowd: To the long-term structural decline crowd, the seemingly ever-widening US current account signals that the US has lost control of its international fiscal position because of over-consumption, under-saving, and under-producing of “real goods” and capital. In effect, because of this lack of discipline, the US has handed control of its future to others, as it has become completely dependent on the flow of capital from other nations to fund growth—which represents primarily consumption. The US has eaten much of its seed-corn. At some point, the US will have to rebuild its seed-stock if it wants to remain an economic power—that will be a painful long-term process—if it can be done.

2) It’s no problem crowd: The fact that US is running large current account deficits is a reflection of a vibrant economy that increasingly demands goods—lower priced goods more efficiently produced overseas—Ricardo rules!: In economics, the theory of comparative advantage, sometimes known as "Ricardo's Law", explains why it can be beneficial for two parties, countries, regions, individuals and so on, to trade, even though one of them may be able to produce every item more cheaply than the other. What matters is not the absolute cost of production, but rather the ratio between how easily the two countries can produce different goods (from Wikipedia).

In short, specialize in what you do best, and let others do the same. The US is best at services—value added services such as research and development, entertainment, financial services, innovation, and entrepreneurship across the broad spectrum of knowledge-based industries. It is why capital flows briskly into the US, to gain access to this vibrant and creative economy and services much more stable for economic growth than manufacturing or agriculture. The current account deficit calculation is a reflection of old school thinking i.e. mercantilism. It doesn’t properly account for the value services create.

There are likely many kernels of truth floating about in both camps. It is well beyond the scope of Currency Currents, and frankly our depth of economic theory, to build a strong theoretical rationale to support one of these views at the exclusion of the other. They created the Journal of Economics for stuff like that…LOL

We’d have to say, that most of the material foisted into the public square falls squarely into camp #1—structural decline crowd. The argument seems easier to make, as doom and gloom sells faster than optimism in the financial world, it seems.

So, in a minor bit of balancing, on the occasion of yet another blowout current account, below is a camp #2 view from Hoisington Investment Management’s third quarter economic review [our emphasis] for your review:

“…the trade deficit and its associated internal capital flows have allowed foreigners to amass a total of $13.6 trillion in claims on U.S. assets. From the U.S. position, this could be seen as $13.6 trillion in debt or, conversely, from the foreigner's perspective they hold $13.6 trillion of U.S. assets. This could be of great concern since it does represent 106% of one year's total U.S. economic growth. However, this statistic ignores the important fact that U.S. investors hold $11 .1 trillion in foreign assets. In other words, the world is in debt to us by $.1 trillion. Of significance, the difference is $2.5 trillion, only 20% of one year's income or GDP for the United States. This ratio is about the same as the average homeowner pays for housing expenses, or about 20% of income. Two Nobel Laureates, Milton Friedman and Edward Prescott, shed significant light on this complex problem. They maintain that any impact on the dollar comes from the difference in what is earned on the $.1 trillion that we own versus what foreigners earn on their $13.6 trillion. In Chart 4 we derived the yield on those various assets. As evident in the graph, historically U.S. investors have achieved a higher yield than their foreign counterparts. And, this differential is much more closely correlated with movements in the dollar (Chart 5).


Source: Hoisington

“The great bulk of U.S. asset holdings are in the form of direct investments in plant equipment and companies. On these assets we enjoy a higher income and a gain from the rise of their value. The rest of the world, however, invests heavily in U.S. securities that provide lower yields and less potential for capital appreciation. The most recent statistics (Table 1) reveal that, of the $13.6 trillion, the rest of the world held $6.4 trillion in long term securities, with $.1 trillion in equities and $4.2 trillion in debt. As the table indicates, the debt instruments are highly concentrated in the short end of the market. With the recent rise in the Fed funds rate, yields on short dated instruments have risen, and therefore essentially evened the yield differential in this calendar year. As short term U.S. rates fall away, the spread will move back in favor of U.S. asset holders. Therefore, concerns regarding the dollar and its impact on U.S. interest rates are fundamentally unfounded if they are based on the trade deficit or massive foreign holdings of U.S. assets (chart 5).”


Source: Hoisington

Jack Crooks


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