The US Recession – A Silver Lining?

Introduction

I have considerable respect for John Mauldin and Kenneth Rogoff. But when they go back 100+ years or six centuries, respectively, in search of useful economic precedents to help understand problems today, I draw the line. I am sorry; the world is so different now…. So in this article, I only go back 60 years to gain a better understanding of the reasons for the slow US recovery. 

Looking Back: The US in the Global Economy

At the end of WWII, the US economy was the only major country “left standing”. US leaders were so concerned about the Soviet Union that they launched the Marshall Plan to rebuild economies of Europe and Japan. Maybe we did it too well[1]. Over the last 30 years, the US has lost market share to countries with lower labor costs. First, it was Japan; more recently, China and many other countries in Asia and Latin America.

The effect of this growing competition has been a downward pressure on US wages. Since 1974, the average real weekly wage of US production workers has fallen 12%. Despite cheaper US labor, US manufacturing employment has fallen by 39% since 1973.

Other adjustments have occurred. For example, as Americans increased their purchases of cheaper foreign products, the US trade balance has gone from surpluses in the 1960s/early ‘70s to huge deficits in the 21st century. The current account deficit exceeds $400 billion and is approximately 35% of the total of all countries running current account surpluses. The dollar has also weakened. In 1970, a dollar would get you 358 Japanese Yen and 4.373 Swiss Francs. Today, it will get you 85 Yen and about 1 Swiss Franc.

How can such international imbalances exist with a strong dollar, little inflation, and low interest rates in the US? The answer is foreign purchases of U.S. dollar denominated assets, and more specifically, US equities and debt. Table 1 provides data on foreign holdings of US Treasuries for recent years.

Table 1. – Foreign Holdings of US Treasuries (in bil. US$)

Country 2000 2005 2006 2007 2008 Jun-10
China 60 310 397 581 727 843
Japan 318 670 623 478 626 804
Total 1,015 2,034 2,103 2,353 3,077 4,009

Source: US Treasury

China and Japan have purchased US securities to keep the dollar strong so as to give their exporters a competitive edge. The US has countered by establishing an import quota on Chinese clothing. Measured by the clothing imports blocked, the quota is the largest trade barrier in the world. The US also continues to jawbone the Chinese to let their currency gain value against the dollar.

It is notable that China and Japan have continued to purchase Treasuries since 2008. But with the US government deficit of $1.4 trillion in 2009, and projected deficits of $1.3 trillion in 2010 and $980 billion in 2011, it is unlikely that China and Japan can afford to buy significant portions of this debt. Why? Because together, China and Japan’s international reserves are about $3 trillion, and of that amount, they already hold $1.6 trillion of Treasuries.

The Silver Lining – An Accelerated Reduction in US Labor Costs

This article is supposed to be about a silver lining. That is coming. First, a summary of what has just been said:

  • For the last 30 years, the US has not been competitive in world markets, primarily because of high labor costs;
  • There have been adjustments – US wages in real terms have fallen and the dollar has weakened;
  • China and Japan have slowed this competitive adjustment by purchasing US dollar denominated securities.

Consider now the Recession effects. Remember that only Europe, Japan, and the US are still in recession. The rest of the world is back to rapid growth.

Recessions tend to accelerate processes already in motion. One such process are lower wages to make the US products more competitive globally. And the recovery is lagging in part because people are reluctant to buy in on this process by taking lower paying jobs. It will take time.

Here is how the Recession helps reduce US labor costs:

  • The 10% unemployment rate puts downward pressure on wages;
  • Companies are finding they can get by with fewer workers and will not rehire all they let go; this puts further pressure on wages;
  • The GM and Chrysler bankruptcies allowed them to break their costly union contracts, thereby lowering their labor costs;
  • Massive US government deficits to stem the recession should weaken the US dollar, thereby making US workers more competitive;
  • The unwillingness and perhaps inability of China and Japan to buy up a significant portion of US deficits going forward should result in a further dollar weakening.

A weaker dollar has numerous attractions: goods produced in the US become more competitive globally, the debt burden in real terms falls, and foreign companies invest more heavily in the US. Foreign direct investment (FDI) in the US in 2007 was $233 billion, more than any other country. FDI generates jobs, good for the US. And companies like to produce in the US: few electricity blackouts and a trustworthy legal system. German, Japanese, and Korean auto companies all have non-unionized factories in the US. These and companies in other industries will expand production in the US as their currencies gain value relative to the dollar.

For example, consider the following table for a Japanese auto company. Assume that at 100 yen to the dollar, yen production costs in the US and Japan are the same. But with a rate of only 50 yen to the dollar, it is much cheaper to produce in the US.

¥ Costs at  ¥100/$ ¥ Costs at ¥50/$
US Japan US Japan
1000 1000 500 1000

Who is hurt by a weakening dollar? Those holding dollar-denominated assets. And as I have been suggesting for more than a year, get out of dollars: you should be holding as few dollar-denominated assets as possible.

Will the Silver Lining Be Enough?

A weaker dollar will improve the competitive position of the US, but will it be enough to put the US on a sound economic footing? I wonder. Further problems to be considered include: a poor education system and apparently unmotivated students; energy dependence; health/obesity; and Washington corruption as reflected in health, finance, and military legislation.

1. Ineffective Lower Education and Unmotivated Students

The OECD tests reading, science and mathematics in more than 50 countries. The US does not participate in the readings tests, but the results of the science and math tests are given in Table 2.

Table 2. – OECD Science and Math Test Results, 2006

Science Math
Country Rank Score Rank Score
Finland 1 563 1 548
Hong Kong-China 2 542 2 547
Canada 3 534 6 527
Taiwan 4 532 No Score
Japan 6 531 9 523
New Zealand 7 530 10 522
Australia 8 527 12 520
Netherlands 9 525 4 531
South Korea 11 522 3 547
Germany 13 516 17 504
United Kingdom 14 515 21 495
Czech Republic 15 513 14 510
Switzerland 16 512 5 530
Austria 18 511 16 505
Belgium 19 510 11 520
Ireland 20 508 19 501
Hungary 21 504 24 491
Sweden 22 503 18 502
Poland 23 498 22 495
Denmark 24 496 13 513
France 25 495 20 496
Iceland 27 491 15 506
Latvia 28 490 27 486
United States 29 489 30 474

Source: OECD Programme for International Student Assessment (PISA )

The US scored significantly below the OECD average in both Math and Science. Note the emergence of Asian countries in test score performance. Keep in mind that only 70% of US high school students graduate. Not good. Bad system? Unmotivated students? Probably some of both.

2. Energy Dependence

As I wrote in an earlier piece:

Unlike Japan and China, the US was richly endowed with energy resources. It is even today the third leading producer of energy from oil, the second leading producer of energy from coal, the second leading producer of energy from natural gas, and by far the largest producer of nuclear energy (http://www.bepress.com/ngs/vol2/iss1/art5/). But because of its voracious energy consumption, it must supplement its own production of energy with imports. It imports 21% of all oil traded internationally. Unlike the European countries and Japan who have imposed heavy taxes on motor vehicle fuels, US government policy has been to keep the gas price as low as possible. This has resulted in the US consuming almost four times as much as much oil per capita as the other OECD countries.

3. Health/Obesity

Obesity has become a global epidemic.  The UN reports there are now more obese people in the world than hungry people. But obesity in the US leads all developed countries (30% of all Americans are obese), and childhood incidence suggests it will get worse. Obesity contributes to most medical problems, and it will remain a spur to growing US health costs.

4. Washington Corruption

Open Secrets reports that the health industry spent $545 million lobbying in Washington in 2009. And they got what they wanted: a bill that makes them all health stakeholders happy except for their clients. Open Secrets reports that the Finance industry spent $467 million lobbying in 2009, and they got what they wanted: a bill that allows banks to continue trading. And trading cauysed them to effectively collapse in 2008.

5. The US Military

The US military is also well-connected in DC. In addition to spending over $150 billion in the two lasts years in Afghanistan and Iraq, it has more than 700 bases worldwide. According to Chalmers Johnson, those bases employed 196,975 uniformed personnel as well as an equal number of dependents and Defense Department civilian officials. The bases employed an additional 81,425 locally hired foreigners. And then there are the military contractors such as Halliburton. They are also well-connected. And they want to keep their lucrative overseas contracts going.

Conclusions

The recession and resulting US budget deficits should weaken the dollar and make the US more competitive on world markets. That is good. But the US has other problems….


[1] Under the Marshall Plan, US allies got blank checks while WWII enemies (Germany, Italy, and Japan) could only use funds to rebuild their economies. In retrospect, the restriction probably should have been applied to all countries.

The content above was saved on the old Morss Global Finance website, just in case anyone was looking for it (with the help of archive.org):
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