The Europeans

Among the obscure financial reports that have more pages than readers is one from the Bank for International Settlements. The staff economists had toted up the figures and found a massive black hole in the universe of money movements. In order for one country to run a current account deficit some other country must run a surplus. Money flows between nations is a zero sum business. By definition, what goes into one set of national accounts has to come out of another.

It is impossible for the entire Earth to run a current account deficit, just as it is impossible for everyone to have above-average income or uncommonly smart children. And yet, there it is, according to James Grant, a negative $213 billion worldwide net current account deficit, as if the money had been wired to Mars. We draw no particular conclusion or inference from this bizarre figure, nor do we take any offense. The missing billions are probably in a desk drawer in the accounting department of the BIS for all we know. Besides, $213 billion does not seem like a lot of money to lose in a $31 trillion world economy.

More interesting in the BIS report were the relative figures - the amounts of money changing hands from one nation to the other owned from one nation to the next. For there, the numbers are bigger...and likewise preceded by minus signs. In 1997, the U.S. ran a current account deficit of $140 billion. That is the difference in the goods and services sold by Americans to the rest of the world and those sold to them. By 2002, the deficit had risen to $435 billion.

Both sides took it as a fair trade. Americans got automobiles, champagne and geegaws. Foreigners got dollars. But as Americans bought more and sold less, the rest of the world accumulated dollars. By the end of 2001, foreigners had $9 trillion in U.S. dollar assets, reports Dr. Kurt Richebacher.

Pity the poor Europeans, says Richebacher. As much as Americans might have admired their New Economy of the late '90s...the Europeans admired it even more. Now they are the major holders of dollar-based assets outside of America...and are stuck with them.

The Frenchman cannot sell dollars to Americans - for what would Americans exchange for them; all they have is more dollars! All the foreigners can do is trade their greenbacks amongst themselves, like used polyester cargo pants...and hope they don't go out of fashion.

But who knows? The Frankfurter banker...the baker in Milan...or the fund manager in Amsterdam might begin to favor corduroy...or maybe tweed. Why he might do so is the subject of the rest of today's letter.

"The single worst threat not only to the U.S. economy and its financial markets but also to the world economy, implying to foreign investors huge currency losses on top of their huge houses in stocks and bad loans," writes Richebacher, is a "looming dollar disaster."

"When the dollar's plunge develops in earnest," he predicts, "it will...be brutal for the U.S. financial markets, which have become hostage to massive foreign capital inflows."

Foreign-owned assets in the U.S. rose by $895 billion in 2001 after increasing by more than $1 trillion in the year before. Much of this money went into stocks, providing "the single strongest support for America's stock market during these critical years..."

The poor Europeans were clueless.

"No European would ever dream of taking equity out of his home," says Richebacher. "And Europeans don't have credit cards either...they just have debit cards."

Nor could the eurolander imagine what would happen to him next. His Nasdaq stocks lost 70% of their value. His S&P stocks fell by 40%. Even his Dow stocks dropped 30% of their value. And on top of that, the dollar fell off by another 15%.

He thought he had placed his money in the strongest, most flexible, and most dynamic economy on the globe. (The poor frog's own economy seemed as stiff as a dead republican. It was so rigid, regulated and soooo '80s...as G.W.B. reminded the English, he didn't even have words in his language to describe the entrepreneurial, laissez-faire economy of America in the '90s).

And then he discovered that the U.S. companies he bought had cooked their books and went bankrupt...and that the U.S. federal budget surpluses that were supposed to be "as far as the eye can see" disappeared overnight...and that G.W.B. had gone a little mad in his War Against Terror...that the suburbs were a wasteland...the food was inedible...the average American was too fat and too much in debt...

...and heck, he didn't look good in cargo pants anyway!

And so, he begins to feel like "un pigeon" - a French fool, a Danish dupe, a Czech chump, or a Polish patsy.

What will he do now?

Not only does he finance the Americans' current account deficit - running at about $1.5 billion per day - he also bankrolls Americans' investments abroad. Europeans are not the only ones who may want to flee dollar assets. But with no current account surplus, Dr. Richebacher explains, Americans can only diversify into foreign holdings by importing capital from foreigners. Unless the BIS really has discovered a black hole in the system of international capital flows, the foreigner must be willing to accept dollars for whatever he is selling.

"These U.S. foreign investments amounted to $439.6 billion in 2001, after $581 billion in 2000," Richebacher elaborates. "There results a need for capital inflows into the U.S. between $900-$1,000 billion per year just to keep the dollar stable and the U.S. financial system afloat.

"Our nightmare is that continuous bad news about the U.S. economy and an associated continuous fall of the dollar will sooner or later induce a significant part of foreign investors and lenders to pull out of the dollar."

Here in Paris, we Americans sleep soundly - even at our desks. But all around us, heaving, tossing and turning...Europeans must fear for their money. Will they switch from polyester to tweed...if only to sleep more soundly? We think so.