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Unsustainable Boom Saving the Dollar and the Economy

July 5, 2005

Everyone except perhaps some Democrat politicians were relieved when they saw how mild the 2001 recession ended up to be-in fact it might not even technically count as a recession, since we did not get two consecutive quarters of falling real GDP.

The Media did however, try desperately to point out how lousy the labor market had been since then and that the succeeding expansion has been a lot slower than the official numbers would indicate. Still, given the bursting of the great stock market bubble as well as 9/11, the 2001 - 2002 recession was indeed surprisingly mild even if the official numbers may have underestimated its severity. Compared to Japan in the 1990s and even more so to America in the 1930s or in 1973-74 , 1987 and 1990-92 It seems that we have absorbed the bursting of a stock market bubble exceedingly well. Or have we simply postponed the inevitable?

There are some very bright spots in the American economy.
The Corporate Sector

#1 Corporations are looking much stronger than they looked in the late 1990s. For one thing, after-tax corporate profits are at record high levels. #2 Corporate financial savings are back to near record highs. #3 Corporate debt while still at historically high levels at 65% of GDP, the debt burden has fallen since its 2001 peak and is actually no higher than it was at the last cyclical peak in 1990. All in all, the corporate sector looks pretty healthy, similar to way it looked just before the peak in 1929.

With the cost of money being so low, reflecting low interest rate and high stock market valuations, business investment will most likely continue to rise. However, new investment is likely to be limited by the exceedingly low level of capacity utilization.

The government sector, on the other hand, is a completely different story. Its financial balance sheet is now at its worst levels in history. If we include state and local governments, total government deficits are at roughly 6% of GDP. When it comes to trade, the current account deficit increased, during a supposedly recessionary period, from 4.4% of GDP in 2000 to 5.7% by the second quarter of this year, with a projected deficit of well mover 6% by year end.

The private sector

Typically the private sector has a large financial surplus during recessions and roughly balanced savings during booms. This time around the private sector has weaker financial savings than its ever had. What is truly worrisome is the complete disappearance of household savings all together. Meanwhile the government which is borrowing at all time record high amounts from abroad is masking their real overspending. In time there will have to be real spending cuts to curb the massive budget deficits. But the sector that poses the biggest threat to the economy is the household sector which is spending and borrowing at an unsustainable level. The household savings rate, which in the early 1980s ( the last time we had a surplus in our balance of trade) was more than 10% of disposable income, is now at a record low 1.3%. At the same time, household debt has risen steadily, from roughly 65% of total assets in the early 1980s to 80% in the early 1990s to 95% in 2000 to 114% in the second quarter of 2004. More importantly, mortgage debt relative to disposable income has gone from just over 40% in 1980 to 85% today. Record low savings and record high debt levels means that there is a substantial risk of a spending downturn. Alan Greenspan tries to downplay the risk of a collapse in the household sector by pointing out that household assets are also at historically high levels. While the rise in asset values until 2000 was mostly a result of stock prices, in recent years the stock market bubble has been replaced by what may be a new housing price bubble. There are, however, several problems with Greenspan's view. First of all, in most cases it is a different group of households that have huge assets than those that have high indebtedness. So for many households, leverage is very high indeed, despite the seemingly reasonable debt to asset ratios.

Second, given the fact that leverage is at record high levels which in conjunction with nonexistent savings, households are much more vulnerable to a drop in asset prices than ever before. Therefore there is the risk that asset values will decline, even as debt levels keep rising. Particularly worrisome is the high leverage in the housing market. With household real estate asset values rising from the (135% to 150%) range of disposable income, that it used to fluctuate within before 2000, to a record 184% of disposable income. means that the housing debt to income ratio has more than doubled from slightly above 40% in the early 1990s to 85% today. If housing prices were to fall back to their historical mean, at slightly above 140% of disposable income, that requires a decline in house prices of only 20%. One fourth of all home owners would then have their home equity wiped out completely and in many cases would be forced into bankruptcy. Since this has been a credit driven price boom there is no evidence that the relative housing price increases really reflect an increase in the subjective value of housing for the general population. History tells us that there is a stronger likelihood of a price correction, back to the mean, than has existed for decades. With a savings rate near zero and a quarter of home owners leveraged to an extent that would wipe out their entire equity, any financial crisis would be deeper than the one associated with the bursting of the 2000 stock market bubble. However, unlike after the stock market bubble, this time the Federal Reserve has very little room to reduce interest rates as interest rates are already negative in real terms and historically low in nominal terms. The Federal government also has very little room for any further fiscal stimulus because of its historically super high budget deficits. Nor is any help likely to come from abroad. To be sure, a falling dollar, which for the moment has stopped falling, may help export industries and domestic companies which compete with imports, but that will weaken the Asian and European economies making strong U.S. export growth unlikely despite any weaker dollar.

The Mystery of Record Low Interest rates

One mystery surrounding the current situation is the near record low level of interest rates given the huge budget deficit, record low household savings, a housing bubble and an investment recovery, one would expect high interest rates. Are the low interest rates due to low inflation? Not hardly, while inflation is far below the levels of the 1970s they are well above 3%. Are they this low because of massive money supply increases that have pushed real interest rates below their natural level? No, the money supply is increasing at a far slower rate than it has been over the last ten years. The only logical reason seems to be the massive purchases of U.S. government bonds by Hedge Funds (For was is known as the carry trade) and Asian central banks, particularly the Bank of China and the Bank of Japan, in their effort to maintain their exchange rates and keep interest rates low. During the first half of this year foreign central banks bought more than $200 billion of U.S. assets, $180 billion of which was U.S. government bonds. This means that foreign central banks financed more than 60% of the U.S. current account deficit and nearly the entire increase in government debt. The reasons why they are doing this is because they want to avoid a sharp increase in the value of their currencies. But this is in itself an unsustainable situation. Their increasing purchases of U.S. treasuries make them increasingly vulnerable to heavy losses if the dollar falls and interest rates were to rise, as the ever increasing U.S. current account deficit forces them to purchase ever increasing amounts of treasury Securities. . The longer this unsustainable process is allowed to continue the heavier the losses will eventually be.

Conventional Wisdom states that only if Asian countries accept a sharp appreciation of their currencies and the U.S. adopts much tighter monetary and fiscal policies can the situation be prevented from getting worse. But that would most probably precipitate a world wide recession and its my opinion NO politicians in either Asia or the United States would be willing to face up to that.

The conclusion is that Alan Greenspan and George W. Bush did not prevent the stock market bubble of the late 1990s from turning into a crisis. They have only postponed it. IS THERE ANY WAY OUT OF THIS DILEMMA?


It may be hard to believe but there is a one in a million chance that we can work our way out of our dilemma and avoid a Depression. That one chance is If BUSH can get his whole agenda passed in one neat and complete package. (Highly Unlikely) A complete package ideal is the only way to accomplish all its goals, without nickel and dimeing each proposal so that none of them ever achieve their stated objectives. Even if they were all able to be passed separately, which I doubt, It would still be necessary to examine them all together, since the Problems, Objectives and the Solutions are all intertwined.

In order achieve the prerequisites of 1) Increases in the National Savings rate 2) Reducing Government Budget Deficits 3) Trade Deficit reduction 3) Resolve the eminent bankruptcy of Medicare/Medicaid, Social security reform and last but of utmost importance 4) Tort reform.

1) First and foremost, the US National Savings rate must be dramatically increased, if we are ever to reduce our trade deficit, (Without starting a Trade War) reduce our reliance on foreign central banks to buy our bonds, stabilize the dollar and maintain low interest rates. The best way to accomplish this is by first instituting a 20% Consumption tax as part of completely revamping (replacing) the federal income tax. This would, for the first time in our Nations history, eliminate the penalization of savers. In order to get bi-partisan support we could also institute a Flat 10% tax on all incomes over $250,000 and an additional 10% Tax on all income over $1,000,000. This should immediately raise the savings rate between 6% - 8% immediately reducing pressure to raise interest rates, while at the same time, reducing our insatiable demand for imports by at least 6%. As an aside all foreign companies would now be contributing to our total tax revenue and would be on the same footing as our domestic companies. As part of this package we would have to institute a negative income tax to all people with valid S/S numbers of $12,000 per adult 21 and over and $6,000 for each child. (this would be in lieu of all other forms of welfare )

2) As part of the same package, we must also fix the Social security problem in such a manner so that its solution is intertwined with the rest of the program. We can do that by first including a gradual increase in the retirement age to 70 ( as life expectancies continue to expand), in conjunction with an in Increase Social security payment of 2% or $1000( which would be a forced savings). But unlike the last FICA tax increase, this time the 2% would go to buy a special 8% zero coupon US savings bond that would go directly into the hands of each individual, that cannot be touched for any reason until retirement. Anyone 35 years old or younger, would forfeit any and all future claims to social security. The 2% paid by people older than 35 would receive the same 8% savings bond and would go to supplant future S/S increases while they are all still guaranteed NO decreases in their benefits. In 40-50 years as the baby boomers die out, the government would be by then almost completely out of the social security business. Of equal or even greater importance, poverty in the USA would be well on its way to being eliminated, once you realize that $1,000 per year, invested at 8% compounded for 50 years grows to approximately $1/2 million and that money would be owned by the individual, not the state and thus be available to be passed on to their heirs. Please Note: Unlike passed FICA Tax increases, that really only served as a hidden income tax, which was then quickly spent by the Government. The whole 2% is a forced savings that belongs 100% to the individual and can never be touched by the government. This 2% forced savings would also increase the countries saving rate and reduce the trade deficit by about $126Billion. That would also serve to relieve any pressure to raise interest rates. Remember this 2% is NOT a tax, it would be sold as a savings plan with the money never leaving the possession of the individual but would never the less be part of the over plan of saving the Dollar and the economy. (If Bush's complete package is passed, since the savings to corporations, arising from a COMPLETE Tort reform package as well as the extensive savings from a reformed Health Insurance program, would amount to between 12 - 20%, They could then easily afford to pick up the 2% for S/S as well as the 2% for Medicare/Medicaid or Better yet match the 2% up to maximum $1,000, This would assure that every young person retires as a millionaire)

3) Health care reform. As part of the overall package to save our economy there would also be an increase of 2% or $1,000 for Medicare/Medicaid. Which like the S/S 2% would go into a personal Medical Savings Accounts, in conjunction with a reformed medical insurance plan. This Plan would revolve around a life time 100% catastrophic coverage, with a $5000/yr deduction which would be available to all citizens and taxpayers, with valid Social security Numbers. Additional coverage could be obtained in a competitive environment through Pvt. Insurance Companies; The 2% increase would like the Social security increase, NOT be considered as a TAX since the individual would be keeping all this money from day one. Any monies not spent on health care would be allowed to accumulate in the same 8% zero coupon Bonds and go towards future health care needs or their estate. It too would be a saving plan with the Government unable to touch that money. In this way the 20 million 18 to 34 year olds, that are now part of the 43 million uninsured but that choose not to buy insurance, even though it is available to them at a very low cost, would become part of the total medical insurance pool reducing the Pool's over all risks and costs. This too would also be done as part of the complete package, It too. like the Social Security 2% would also work towards reducing the trade deficit. In this case as with S/S it to could be easily be paid for or added to by the corporations

4) Complete Tort reform must be part of the package. It alone would reduce the cost of doing business and especially health care costs, by between 10 to 20%. This would automatically make all Domestic companies ultra competitive in the new world economy. The elimination of ridiculous law suits, would also allow our public sectors, especially schools to be improved without one cent of additional money.


Once the entire package was passed, our National Savings Rate would immediately increase from its present 1.3% to an absolute minimum of 13% (and increase from 1 to 9% from revamped income tax, 2% from Social Security and 2% from Medicare care). Companies would achieve a minimum cost savings of 10%, making American companies that much more competitive. The economy would boom Tax revenue would increase and we could easily grow our way out of the governments budget deficits. The increase in our savings rate in conjunction with the corporations cost savings would immediately begin to shrink our trade deficits, as well as reduce our reliance on foreign central banks. Interest rates would stay lower than they would otherwise have to be and the economy would be able to increase its growth rate to its full potential. Everyone would now have a minimum of basic health insurance. And in less than 50 years the government would be almost completely out of the social Security and health insurance business. We would we well on our way to eliminating poverty in our country, not through government programs but through Capitalism, the only known way of increasing wealth.

All of the above is just the bare bones outline of the idea and must of course be fleshed out but it's the best I could do without doing extensive research and writing a book. The Devil is in the details. Every objection can be easily overcome, especially if you don't try to mix in specific situations, which should more reasonably handled as a welfare program. What are the chances of all this happening? No more than one in a million but at least there is a chance


Aubie Baltin CFA, CTA, CFP, PhD.
Palm Beach Gardens, FL
[email protected]


5 July 2005

According to the Talmud you should keep one-third of your assets each in land, business interests, and gold.
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