From the May 2006 issue of Wealth Manager Web • Subscribe!

Weighing It Up

The open economy in the United States has fostered rampant consumerism. We just love to shop. The trouble is, we save very little as a nation compared to the rest of the world. In fact, the current gap between disposable personal income and personal consumption expenditures reflects the lowest annual savings rate since the Great Depression.

But every cloud has a silver lining, right? Think of it this way: Our willingness to spend has driven economic growth that far exceeds our trading partners in Europe and Japan.

As savvy consumers, we have an insatiable demand for foreign-made goods, mainly because they are inexpensive. Currency manipulation--most notably by China, Hong Kong and Japan--is one reason they are so cheap. Another reason is that many U.S. companies outsource the manufacture and assembly of their goods to foreign countries with cheap labor costs, and ultimately these goods are imported back into the United States.

The trade balance is the difference between the amount that we spend as a country and the amount that we earn from our production. And right now, we're not looking so hot. The U.S. trade deficit hit another record in January, rising 5.3 percent to $68.5 billion. The deficit for all of 2005 was $723.6 billion, and economists predict 2006 could be even worse.

The consequences of the trade deficit are fundamentally changing the shape of the U.S. economy. On the positive side of the equation, the trade deficit has kept a lid on inflation--not to mention that the large variety of goods we have to choose from contributes to our high standard of living.

On the negative side, we have to finance the deficit out of our national savings, which happens to be negative. As Bernard Baumohl, executive director of The Economic Outlook Group, points out, "The Americans don't save, and the government doesn't save. The only sector of the economy that saves right now is the corporate sector, but it's not enough."

That means the U.S. government has to borrow money from abroad. In fact, it is borrowing to the tune of about $1.5 million a minute. The requirement is so huge that the Senate recently moved to increase the debt ceiling to nearly $9 trillion, preventing a default on U.S. Treasury notes.

The flip side is that foreigners now have much more control and influence over the U.S. financial markets because they own so many corporate bonds and treasuries. And foreign investment is not limited to U.S. securities. Part of the debate over Dubai Ports World's attempted acquisition of some American port facilities actually had to do with the trade deficit. As foreign companies acquire more dollars, they want to buy more physical assets in the United States.

Given our current situation, our macro-economy is doing well. "It is not the case that this deficit means that somehow or other we have fewer people working," says Alan Deardorff, an economics professor at University of Michigan. "The fact is we're pretty fully employed."

So far, foreign investors perceive that dollar-denominated bonds issued by the U.S. government are a safe place to put their money, and that we will continue to service our debt. But the United States has become so dependent on foreign investment that many economists fear what will happen if investors pull the plug. At some point those foreign investors may look at their portfolio, determine they are too exposed to dollar financial assets and ultimately start to diversify. In the past, weaker countries have plunged into financial crisis when investors lost confidence and fled.

"That's not happening at this moment, but it certainly is something that we need to contemplate seriously," says Baumohl. "I think it could happen--if not in the next two or three months, this year if not later."

Economists agree that we must reduce our trade deficit. The question is how to do it.

One strategy is to induce a recession in the United States, which will slow the economy and reduce our demand for imports. But that move could also slow the rest of the world's economies.

Some members of Congress advocate raising tariffs, especially against China. Trade barriers would most certainly land us in a suit with the World Trade Organization and to some extent deprive us of inexpensive foreign-made goods, but will have little or no impact on the trade deficit.

Perhaps a more practical approach is to convince foreign leaders to make structural changes in their economies to enable faster growth which, in turn, will boost demand for U.S. goods. But Americans also have to be willing to save more and spend less.

And even that strategy is not a slam/dunk. The U.S. government ran a surplus in the late 1990s, but our trade deficit continued to grow. As Deardorff says, "Government getting its act together may help a little bit, but it didn't solve the problem before."

Sherree DeCovny is the author of several books and reports on financial services

and technology. Her work has appeared in leading journals in the US and the UK.

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