Does Size Matter ???

March 28, 2005

This time-honored question has historically been debated within the province of gender battle. Banter between the sexes has countered machismo, never to set the record straight on true satisfaction and lasting harmony among partners. Nowadays, size is debated frequently in financial circles on critical matters between trade partners, wholly and hopelessly dependent upon each other for supply and sustenance. The stability of the world economy hangs in the balance. Monetary foundations on which it stands are awkwardly balanced. International trade partners are increasingly at odds. Of course size matters. Try to tow a full-sized boat behind your compact car. Try to write a $100 thousand check to yourself on a company account. Try to deliver an 18-lb baby without a caesarian section. Try to take your two favorite 300-lb friends on a rowboat ride at the Boston Common pond. Try as a government official to put your entire sasquatch-like size 14 foot into your mouth. Even ships at sea have bilge pumps for accumulated water in the various compartments. These have limits though.

Recent friction has shown itself between the USA and South Korea on credit support. And Japan also. Ongoing friction is upcoming between the USA and China, or at least until the cows come home. The marriage of the Great Asset Economy & New Macro Economy has put great strain on all foundations, exposing numerous dynamics and their alarming magnitudes. A review can easily shake any doubter's notions that continued balance is anywhere remotely possible. The sword is a principal weapon to enforce balance. The symbol of the impartial mete of justice is borrowed here. Our economic policy makers are blind. Their counsel is incompetent, especially in applying micro-economic principles to bankrupt a macro economy. Our military might is being used to coerce a tenuous and completely unsustainable balance. The same forces used to keep shipping lanes open are used to threaten nations to provide credit supply, akin to a credit shark. A loan shark charges 10% per week in interest. US Treasurys offer a paltry 4.5% with an aircraft carrier off the port window.

TRADE GAP

The trade gap between the United States and the world has gone well into the red zone, where lights flash. When you live in a sea of red ink, a flashing red light is hardly visible. The US Economy has a new baseline of monthly gaps over $50 billion. The trade gaps from Oct2004 through Jan2005 have averaged a steady $57.3 billion gap. One can make the case for an annual imbalance in the $650B to $700B neighborhood. With the rise in energy prices in February, seen in an oil peak at $57 per barrel, my forecast is for a shocking gap over $60 billion which will put to quick rest the USDollar rally. The "USA Inc" stock is the USDollar, and its fundamentals scream from the hilltops "BANKRUPTCY !!!"

Our total of goods & services, what makes the GDP aggregate, is in the $11,000 billion level. Thus current account deficit gap hovers at the 6.0% mark, when 5% has for years triggered the dreaded alarm. Typically a nation will suffer at least a 25% further currency deprecation decline when that trigger is pulled. The USA balance sheet is actually worsening even as the supposed economic recovery takes root, an utter absurdity which makes lies of the recovery claim. Argentina imploded in 2001 in grand style when it racked up over 3% of GDP in combined external debts. The USDollar has come down 15% to 18% since 2001 versus the Asians, the original location of the bulk exports, yet the trade gap worsens. The USDollar has come down over 40% versus the EU currency, yet the trade gap worsens with them also. A sane observer must wonder about tipping points, as we plumb the depths and search for an elusive anchor. The US-style recovery requires worsening fundamentals, which curiously do not arouse any suspicion on Wall Street outside of Roach, Hormats, and Rubin. The chorus of co-opted collusion among economists sings over their voices.

This begs the question whether size matters. It certainly does. To deny this fact is to deny natural forces of financial physics, where momentum, gravity, and stress forces certainly apply. Our internal US structure has changed radically since the 1960 decade, when manufacturing was the cornerstone. It is now missing, replaced by debt. Authorities call that progress. It is more accurately de-evolution and movement toward untenable stress. Financial tectonic plates are under strain, only to force earthquakes just as they do within the earth. If not an earthquake, then a tsunami (great wave) will cause the damage from massive capital flight. A US$-based crisis is within view. The fact that a recognizable crisis has not occurred is not an indication that we are protected from its occurrence. More to the point, it indicates one must be directly on the horizon, begging. Any friction might disturb the balance, and the spark of friction is everwhere you look, provided your eyes are open at all. Two little items are worthy of mention from recent trade gap reports. The US Economy is now several months along in deficits for advanced technology, remarkably. We just registered our first of several surprising deficits in agricultural products, an $81 million gap. The last two pillars, tech and farms, are now running negative.

FEDERAL BUDGET DEFICIT

The topics of the federal budget deficit as it relates to welfare programs, taxation, aid to states, bloated burokracies, Social Security, Medicare/caid are thorny. Let's not touch taxes and burokracies here. One must consider the cold consequence of cost impact from current commitments as well as ongoing future obligations. One must factor in changing demographics. For instance, the prescription drug portion of the Medicare program is potentially much more devastating than the Social Security payment obligation. So the SS debate might be a diversion. Given our aging population, and obesity health problems, taxpayers (read: Asian credit suppliers) will be thrust to pay a growing bill. From wider prescription drug coverage in Medicare, we might see an added $500 billion over the next three years in the USGovt budget deficit. Debate swirls over privatizing Social Security. Put aside the games played to pander to Wall Street, whose agents salivate like dogs over the staggering stream of money likely to be invested in financial securities (stocks or bonds). Put aside the conniving deception to abandon defined benefit (fixed SS income) in favor or defined contribution (fixed amounts withheld) in a backstab maneuver. The end result is that if privatization passes through Congress, the budget deficit will be revealed for what it is, between $600 billion and $700 billion. The SSTrustFund confiscation would be discontinued. Wall Street might love the capital flow, but Asia will not like the added funding requirements.

In the late 1990 decade, opponents to the current Administration argued that the budget was balanced. No, it was not. Only after improper confiscation of Social Security Trust Fund money was it brought into balance, and not even then. Bear in mind that neither SS nor Medicare "taxes" are tax-deductible for income tax purposes. In other words, payroll deductions are more akin to extortion costs. While medicine is replete with Medicare fraud and huge preventive procedures, doctors face rising malpractice insurance premiums. The health industry is in disarray.

Privatization of Social Security carries with it enormous risk from a perception standpoint. Foreigners already fund 45% of Treasury debt issuance. If SS income sources are no longer pilfered from 30-somethings and 40-somethings, then the spotlight will be cast squarely on the "ACTUAL BUDGET DEFICIT" which has steadily been almost $200 billion greater than reported. Worse still is that military and homeland security budgets add to federal budget deficits, but they do so off the official balance sheet. Somehow that makes them less worrisome, or less visible, or less constant from year to year. Few seem aware, but military budgets are actually higher from mercenary costs, in order to avoid a military draft. That is another story altogether for another day. Our intrepid press might be ordered not to report details. One bright light has been a 10% rise in payroll income taxes withheld in the last 3 or 4 months. Perhaps jobs are actually being created, or maybe it is just quarterly tax payments from hedge fund profits. So instead of a bad $700 billion deficit, we might see a deficit closer to a gentler $600 billion.

This begs the question whether size matters. It certainly does. To deny this fact is to deny natural forces of financial physics. My personal view expects foreigners to balk, to withdraw, to pull back from financing $170 billion more of the federal budget deficit after SS raid discontinuation. They are showing strained reluctance in the last few months. Asia invests less in USTBonds than a year ago. The Caribbean (home of one hundred and eighty-six million hedge funds and shady investment banks) invests more, or are they conduits for USGovt hidden bond support? The Fed covers the bills with more printed money in its monetization scheme. When foreigners generally refuse to cover added deficits, our interest rates will rise from sheer supply to the imbalanced balance. If the Fed continues to cover up the black hole with printed money, our costs will rise instead from weaker US$ exchange rates. We import everything under the sun. This dilemma leads to a "Sophie's Choice" of whether to allow bonds to be damaged (higher interest rates, housing decline), or whether to allow the USDollar to be damaged (higher costs, more profit & saving squeeze). The effects are different from each. My view is that the banking sector is tied too closely to the US Treasury bond system. Bonds will be supported, monetized, and subsidized even as the economy is made to suffer for higher material, supply, food, and energy costs systemically.

CONSUMER DEBT

At $2850 billion, the consumer debt operates as a ball & chain tied to household ankles across the nation. The trend of the last few years, from year 2000 to the present, has been for falling interest rates to permit and even encourage a greater borrowing binge. Economic growth is built upon debt as its foundation, without a peep of objection from Wall Street. Our economists do not categorize this or that as a good or bad expense. They only account for the totals in a inept exercise repeated each month. The consumption of "things" within the US Economy is actually nearing 80% of all transactions, that is right, almost 80% of our GDP !!!Competent tally and analysis would dictate some measure of judgment as to whether we spend on things which support job hiring through the healthy construction of a system, as opposed to that which frivolously wastes through needless, extravagant, or indulgent erosion of the system. Household credit card debt averages roughly $8000 per home in the USA. Massive curve balls await our spenders and brain trust alike. If less debt is taken on by households and government bodies, then the US Economy might be put in danger. Already, evidence mounts that credit card debt and home equity credit has turned flat in growth.

This begs the question whether size matters. It certainly does. To deny this fact is to deny natural forces of financial physics. The ball & chain drag heavier with each passing month and year. We talked in 2001 and 2002 of inflating debts away in utter nonsense. The reality is that debts are exploding before our eyes, and new methods of acquiring a debt burden are being invented within our financial engineering factories. If interest rates do not rise from here, then insufficient income will render future purchases more difficult from basic suffocation. If rates do rise from here, then borrowing costs will exacerbate the debt burden. The battleground to offer clues is the shopping malls and big box retail centers.

MANUFACTURING SECTOR

The size of our manufacturing sector has been the subject of constant debate, ever since it disappeared. Certainly, we make some computer networking equipment, some satellite telecom equipment, some construction equipment, some aircraft, some environmental equipment, some machine tools, some furniture, some clothing, some household products, some cans. They add up, but not enough to matter. The primary items within our once vaunted (and now gutted) manufacturing sector consist of four industries which do little to aid in growth or even growth potential, and do less to remedy the trade gap.

  1. The automobile industry is in grand retreat as Japanese carmakers gain ground. Ford Motor market share declines each and every year. General Motors makes 27% of its income from China, according to their latest quarterly report. With the United Auto Workers negotiating plant closures (instead of worker salaries) and retiree health benefits (instead of worker conditions), signs are clear that the car industry will not help to close the trade gap. Not only have we shut down at home and erected plants overseas, but foreign-made car components are on the rise inside domestic cars, and newly built foreign-owned car plants are coming online with cars & trucks rolling off the production line. The trade gap will likely worsen from a car sector retreat. Look for steel frames to be shipped to Detroit from China within two years!!!
  2. Electrical utility generation (yes, it is classified as "mfg") does expand incrementally each year, but we do not export electricity. In fact, we import it from Quebec hydropower centers in the NorthEast. The fuel bill for the utility industry is growing at an alarming rate, mostly from foreign supply. Look for northern border states to attempt to import electricity from Canada in future years, not export it.
  3. Gasoline refineries (yes, it is classified as "mfg") are in shortage. We clamor for more refineries to produce wanted gasoline, but block at every path construction of new refineries on environmental grounds. Not in my back yard is so often heard that its acronym of NIMBY is now understood. The $100 million new refinery cost is also somewhat prohibitive. Energy companies neither want to absorb the high cost, nor to suffer the lost pricing power afterwards. Offshore refinery locations are sure to expand, sure to lead to greater import, not export, in future years.
  4. Lastly, drug products (yes, it is classified as "mfg") have become the latest industry to be protected, as in protectionism in the trade war sense. The USGovt has valliantly put up trade barriers against importation of drugs from Canada, but such attempts are futile, bound to fail in time. The USA has the highest priced drugs products in the world.

Our economists chirp and moan that the lower US$ exchange rates will stimulate exports. They have risen, but imports make 3 steps backward for every 2 steps forward made by exports. Since Jan2002, imports have grown by 47.2% versus export growth of 28.5% remarkably. For those who prefer to make empty claims that the recent trend has improved, check the data. Since June 2004, imports have grown by 7.1% versus an export rise by 8.6%. However, imports have grown over those seven months by $10.5 billion, versus export growth of only $8.0 billion. My desk received a nasty email in January on this issue. Too bad the person who wrote it was incorrect and forgot to check the data over the past two years.

This begs the question whether size matters. It certainly does. To deny this fact is to deny natural forces of financial physics. Legitimate income through making things cannot for long hide the paper shell game of wealth production through asset inflation. We have sadly morphed into a dangerous Asset Economy, as Stephen Roach has called it. Our wealth generation has been blessed as legitimate by the chief wizard of our inflation machinery, Fed Chairman Alan Greenspan. He can ordain it as legitimate, but that does not make it so, nor does the blessing make it immune to reversals in asset values. A decline in housing and bonds will have a rather severe impact on our economic fortunes.

SAVINGS RATE

The catastrophic savings rate reverses the question as to whether small size matters. The wizards at the USGovt ministries have adroitly managed to make it seem like we save something at all. They report miniscule savings of 0.2% in recent months, even as pundits minimize the need for domestic contributions to supply investment capital. So we import that capital. If not for the deceptive practice of counting self-paid rent (like $800 billion per year) and self-paid checking account services (like $300 billion annually), we would report significant negative savings. Such an honest practice would be a reflection of reality. Savings are not a small percentage of income, but rather are actually about minus $400 billion annually after one pushes off the ledger several fraudulent adjustments.

The USA imports the majority of world savings, so we can waste it on newer cars (and gas-hog SUV's), bigger houses, the latest in home electronics, tax cuts, foreign wars, and greater commitment on drug bills for an aging population. If the world feels coerced to provide us credit, and life is good, then why save at all? If vendors sell on zero percent finance terms, then why not purchase? If my homestead is rising in value, then why save? Instead, why not borrow more against it and enjoy the wondrous fleeting fruit from this great land? This begs the question whether size matters. It certainly does. To deny this fact is to deny natural forces of financial physics. One cannot take a neighbor's lawn mower, hedge clippers, porch lounge chair, savings account, and college fund, even exploit the cheap labor from its children, without impact in resentment, anger, and eventual retaliation. The form of retaliation is unclear. The inevitability of that retaliation is absolutely certain in my eyes.

CURRENT ACCOUNT DEFICIT

The USA imports $1.8 billion per day to finance the current account deficit, last registered in 4Q2004 at $187.9 billion. The full year hemorrhage was $665.9 billion for 2004. The amount is rising over time, as our foreign dependence increases. The C/A deficit combines the trade gap, in an offset by foreign purchases of our financial securities (stocks, bonds, mortgages) and physical assets (property, commercial buildings, industrial plants). The C/A is a "bottom line" report card on all the above nasty notoriously negatives above. Our inflation engineers must not relax. They must continue to inflate our financial assets if foreigners are to continue their investment in our asset base.

Net investment income is dropping, an entirely new development. This is defined as US investment income in foreign assets minus the income in US assets owned by foreigners. The net is going down. In 4Q2004, net investment income dropped from $17.6 billion to $6.7 billion, a whopping 62% decline in a single quarter. This net figure is a component to the US balance of payments current account which measures income from trade, worker remittances, investment income, and other items. The new trend is ominous for the USDollar, which in the last couple weeks enjoys a respite from assault. The buck is bouncing from a favorable interest rate differential relative to Europe. Combine that with a growing energy bill for Japan, and a lower trade surplus for the island nation powerhouse. Japan's surplus is down 60% in the last twelve months. The movement to send mfg functions offshore to China might be having a negative impact on Japanese trade.

This begs the question whether size matters. It certainly does. To deny this fact is to deny natural forces of financial physics. The strain imposed on our trade partners has never been so immense. It does have limits. Resentment leads to harmful reaction when provoked. As a nation, the USA specializes in provocation, whether in heavy handed trade sanctions, in coerced central bank interventions, in induced monetary ease which disguises competitive currency wars, in international banking dictums (such as the IMF) which cripple foreign economies, and in blaming others for our internal problems. More importantly, we provoke from our size and errors in consequential impact. We are the largest economy and cast a large shadow. If we inflate money, then we implicitly force a currency competition which is destructive. If we restrict money, then we inhibit other regions which rely on our open markets, only to heap restrictions indirectly on them. If we wage war, then we heighten tensions, interfere with commerce, and render more difficult the supply of materials for constructive purposes.

YES, SIZE MATTERS

Yes, size matters, as the next couple years will clearly show. In the battle of the bedroom, too big can be a problem. There are physical limits in docking and maneuvering procedures. Bigger is not always better, and can be a problem. Moreover, small can be nice and should be quite satisfying. The same goes for economic and financial problems. The size of their unaddressed rebalance projects is in direct proportion to the magnitude and damage from the crises they lead to. Our economy will be subject to the same physics forces that a coiled spring must face. Our economy will be subject to the same physics forces that a large electrical potential difference creates. Our economy will be subject to the same physics forces that tidal waves and tsunamis deliver after shocks to earth's surface plates. Even the earth is "flexible," which Greenspan might not argue with. Great stress is building and must be relieved. Furthermore, political accidents are likely, leading to trade war. The financial world obeys the laws of physics also. We are in for a rocky ride for a long time. We have interfered with the free market for so long that we invite an earthquake, and pound our chests in pride that no revenge from Economic Mother Nature has occurred. Not yet. The duration of the rocky ride will be for as long as we block the correction, then add 3 to 5 years.

 

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Jim Willie CB is a statistical analyst in marketing research and retail forecasting. He holds a PhD in Statistics. His career has stretched over 23 years. He aspires to thrive in the financial editor world, unencumbered by the limitations of economic credentials. Visit his free website to find articles from topflight authors at www.GoldenJackass.com.

Jim Willie

Jim Willie

Jim Willie CB, also known as the “Golden Jackass”, is an insightful and forward-thinking writer and analyst of today's events, the economy and markets. In 2004 he launched the popular website http://www.goldenjackass.com that offers his articles of original “out of the box” thinking as well as content from top analysts and authors. He also has a popular and affordable subscription-based newsletter service, The Hat Trick Letter, which you can learn more about here.  

Jim Willie Background

Jim Willie has experience in three fields of statistical practice during 23 industry years after earning a Statistics PhD at Carnegie Mellon University. The career began at Digital Equipment Corp in Metro Boston, where two positions involved quality control procedures used worldwide and marketing research for the computer industry. An engineering spec was authored, and my group worked through a transition with UNIX. The next post was at Staples HQ in Metro Boston, where work focused on forecasting and sales analysis for their retail business amidst tremendous growth.

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