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Integrity
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The size of the trade deficit has caused a great deal of angst among economists, who view it as a bill that will be presented for payment some day. Essentially, this debt is the result of our sending dollars abroad as payment for imported goods, mostly consumer related products. It is the amount America spends on foreign products in excess of what foreigners purchase from us. These excess dollars ultimately wind up in foreign central banks and are invested in U.S. Treasury obligations. The anxiety is caused by fears that the foreign governments will decide to sell the treasuries, flooding the market with unwanted treasury securities, and causing a sharp rise in interest rates. Under the worst scenario, the international value of the dollar would decline steeply, and inflation would break out with a roar from its long hibernation. The growing size of the trade deficit is the cause of the increasing anxiety. It has been running about $41 billion a month, and setting new records regularly. The total amount of dollars held by foreign central banks is estimated at $2 trillion dollars, equal to about 33% of our Gross Domestic Product. Japan and China, at $545 billion and $145 billion, respectively, hold the lion’s share of the debt. While the sheer size of the deficit is stunning, it is not the ticking time bomb some observers speculate on. We believe it is a concern at the margin only, and is neither an imminent nor realistic threat at this time. There are financial and demographic reasons for this opinion. Foreign central banks have little incentive to convert dollars into some other currencies. Outside the United States the debt markets are severely limited in size. For example, the Euro bond market, the largest debt market after the U.S., is barely one third the size of our treasury market. All the world debt markets combined cannot provide the liquidity required to substitute for the U.S. Treasury market. Furthermore the period of maximum potential threat from the trade deficit is past, when our capital spending and information technology markets collapsed. Both are now enjoying a strong recovery, and U.S. exports are growing again. Demographically, the United States population is older and wealthier than foreign, especially Asian, counterparts. Moreover, our culture differs dramatically. In other countries, grandparents, parents and children often live in the same household, requiring one purchase for household items, such as appliances. In our country the opposite is true. Young people are more likely to leave the nest and establish their own independent households. This results in more purchases of appliances and other items than in a single household environment. The fact that most consumer items are manufactured abroad indicates that this source of foreign imports will not change. Despite concerns about the size of the trade imbalance, consumers benefit from access to foreign goods. The more serious shadow over our economic landscape is the growing federal government deficit. Spending discipline has collapsed since the refusal of Congress to renew the automatic spending caps, which expired in 2002. Since then, government spending has grown at 7% per year. At the same time, government revenue has declined sharply due to the impact of the tax cuts. The result is a rapid deterioration of the government’s finances. The deficit for fiscal 2003, which ended September 30, was $374 billion compared with a little less than $200 billion in 2002. It is projected to rise to $455 billion this year, or about 4.2% of Gross Domestic Product. Excluding the Social Security Trust Fund, which will begin to decline when baby boomers retire en masse, this year’s deficit is estimated to be $617 billion, or 5.7% of Gross Domestic Product. If left unchanged, recent enactments and proposals such as Homeland Security, Medicare Bill and the Energy Bill, will accelerate the rate of government spending. Without remedial action or restraint, the deficit will continue to rise, eventually threatening the excellent progress in the recovery. There are times when deficits are preferable, even desirable, as a short-term policy tool. Deficits allow the government to finance vital national priorities, or to stimulate a sluggish economy. Last year was such a period, when our economy was struggling to rise from a serious recession at the same time the threat of terrorism was holding our national psyche hostage to indecision and fear. The large tax cuts enacted then gave a significant lift to virtually every sector and income level. Combined with an early end to the Iraq war, at least officially, confidence and optimism have returned, capital spending has resumed, consumer spending has remained strong, and our growth prospects have brightened considerably. A continuation of very large deficits can shorten the life cycle of this balanced economic advance. Over time, government borrowing competes with business and consumer borrowing and can drive up interest rates, depress private sector savings, crimp investment, and stunt growth. Perhaps most serious, given the demonstrable inability of the Congress to discipline itself, the federal deficit spending machine can assume a life of its own, putting off solutions to future generations of workers. Experience proves that one should not extrapolate trends and current difficulties into intractable and unmanageable problems. For example, deficits ballooned during the 1980’s without disastrous consequences to our economy. Nevertheless the current trend in deficit government spending is worrisome, and calls for a more disciplined approach to funding national priorities are valid. Faced with elections in 2004, it is unrealistic to expect restraint this year. We expect that upcoming years will see significantly greater emphasis on spending discipline. In the meantime, current trends point to a healthy economic growth path throughout a large part of the world this year. Investment Policy Committee Alfred A. Lagan, CFA, Chairman February 26, 2004 The opinions expressed herein are those of Congress Asset Management and are subject to change without notice. 2 Seaport Lane Boston, MA 02210 www.congressasset.com
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