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By rclosch
January 20, 2004

Posts selected for this feature rarely stand alone. They are usually a part of an ongoing thread, and are out of context when presented here. The material should be read in that light. How are these posts selected? Click here to find out and nominate a post yourself!

There is something about the writing process that focuses the thinking, if you want to understand something, try explaining it to someone else. Composing a post about a company that I am interested in whether it is Berkshire or some other company helps me to understand the subject better than just reading 10K's and annual reports. Writing makes you focus on the things you think are important about the company.

A good message board, such as this one, adds a lot to the process in the form of instant feed back. Even though I do not like criticism any more than the next person, I find the best thing about posting, other than the writing process itself is that you find out right away what the weak points of your argument are. There is always someone around to point these out to you.

Some of the material I posted earlier on the trade deficit appeared to conflict with the article that Buffett wrote for Fortune magazine. One of the Posters (jm2421) on the Yahoo BRK board suggested that he was not sure that I completely understood the point Buffett was trying to make.

Well, I thought about that for a while, and decided that this was dead on. In fact it was because I did not exactly get the point of Buffett's piece that I decided I needed to understand the subject better, and that the best way to do this was to post about it.

Anyway I posted a couple of long comments on the subject, and am not sure that I am any smarter that I was when this whole process started but at least now I have convictions, and some of those views are quite a bit different than they used to be. What have I learned about the trade deficit in the last few months? (Really the question should be what do I think I have learned about the trade deficit?)

1. First of all I have arrived at the conclusion that 98% of the noise about the subject is politics. Now when I hear some one talk about the "twin deficits" or about "American profligacy", I look to see where the author is coming from, and it is mostly either some politician trying to get elected to something; or some businessman or labor leader whose ox has been gored by foreign competition, and is looking to the government to bail his ass out.

2. If someone bases his argument on the premise that the Trade Deficit is a fixed obligation that we will have to pay back someday, that person is pushing a political agenda. If this Imbalance is a problem, then if and when the problem is solved it will be solved by the currency market. This not to say that the solution when it comes will be painless, but it is my opinion that any tinkering by Politicians will prolong the problem and make any eventual solution more painful

3. There is no question that the dollar was, and probably still is, overvalued, but the reason for this has nothing to do with American consumers desire to own an infinite number of flat panel TV screens. The dollar is over valued NOT because of our desire to buy, but by the rest of the world's desire to sell to us. '

4. The Trade deficit exists because of the power of the American consumer, and while it is likely that currency markets will remain volatile, or perhaps get violently more so in the near term, the underlying factors that are the cause of this overvaluation of the Dollar are not likely to change in our lifetime.


What do I have to support these conclusions? Well for one thing, the market for US Treasury securities. Last week there were two big auctions of treasury securities. The demand at the auctions was so strong that Interest rates were down about 250 basis points in the next two trading sessions. So who is buying all this paper and why? The rumor is that 40% to 50% Bonds where purchased by the Bank of Japan. So why does the Japanese Central Bank need all this low yield American bonds?

Japan has been going through a twelve-year economic contraction and has recently experienced the beginnings of a recovery. The American economy is getting stronger and we are starting to buy a lot of stuff from Japan. US Dollars are flowing into Japan and as the dollars flow in, a lot of them end up in Japan's Central bank, the BOJ. The BOJ can sell those dollars or the can hold them, the problem is, if the bank dumps their dollars, it drives the price of the dollar down relative to Yen. The last thing that Japan needs, right now, is a weak dollar. A weak dollar makes Japanese goods more expensive for the American Consumer. With the American Economy the only large economy showing much life right now, if the American's stop buying, the Japanese economy goes back in the toilet and the existing Japanese politicians will be looking for a new line of work.

But it is not just the Japanese, In the last three months of 2003, Foreign Central Bank Holdings of U.S. government Securities grew by 37.4%. Yesterday the Russian Central Bank announced that it was buying dollars. The dollar has declined by 12% in the last year relative to the Rubble and Vladimir Putin thinks it important that Americans should not have to face a cost increase for their Stolichnaya Vodka. (Thanks Vlad.)

The U. S has a trade deficit because the Dollar has been overvalued for a long time. It has been over valued because Foreign Central Banks like it that way. When they get dollars to the extent that they can, they hold on to them. The foreign Central Banks Like it that way because the local politicians want it that way. Everyone wants to sell to the American Market. If you have a product and you aspire to world class status for that product you have you have to be able to sell successfully in our market place in order get the economies of scale that you need to compete in the international market place.

Assuming that some or all of this is true, what does it mean, and what are the consequences? Well I would not expect that the long-term trend will change much. People are still going want to sell their products to us. In the long run the dollar is likely to remain overvalued because the rest of the world would prefer that it did... Are we likely to see an American foreign trade surplus in our lifetime? I doubt it.

However, the short term may be a lot more interesting. The imbalances have become so glaring that it has attracted a lot of currency speculators and the speculators are can swamp the foreign Central Banks. History tells us that once the speculators start to smell blood, central banks usually get crushed.

The market is basically just doing its job, and trying re-adjust for the trade imbalance. Unfortunately markets can get a little messy sometimes, particularly when working on imbalances that have been around a long time, and where Politicians try to mess with things.

As for the American Economy, I personally will stay away from large financial institutions like J.P Morgan Chase, BOA, or Citibank because of the off chance that currency traders might set off a small nuclear accident in the derivatives market, but I was going to stay away from those stocks anyway.

If you are planning to buy a house or refinance a mortgage this year you might want to write a thank you note to the Bank of Japan, because their massive purchases of treasuries is doing a great job of holding interest rates down in this country. This however is a temporary reprieve. Sooner or later Inflation will return and interest rate will go up.


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