Wednesday, October 31, 2007

Money, Oil, and China

Once upon a time, the dollar was as good as gold at a fixed price per ounce at the U.S. Treasury. One dollar bills were payable in silver on demand at the U.S. Treasury. Those days are long gone. Now the dollar bill is a piece of green paper that is legal tender for all debts, public and private, in the United States. That it can be used to pay taxes gives it intrinsic value. But its real value depends on its purchasing power, what it can buy. Its exchange value depends on what people holding other currencies will pay to buy dollars. Many factors determine the exchange rate of the dollar, but one thing is clear: The dollar has been falling for reasons posted on this blog, in particular the large annual current account deficit ($800 billion), the federal budget deficit, and other factors.

Most critics point to the large trade gap with China as the bugbear of the weak dollar. The problem with this focus is that it diverts us from the real culprit of oil imports. It does so because it is easier to beat up on China than on countries in the volatile Middle East, Africa, and Latin America on whom we depend for oil. Without their oil, the price would rise to astronomical proportions, from $95 a barrel to perhaps several times that. We cannot afford to offend the oil producers, even if they are the source of anti-Americanism, anti-Semitism, and Islamic extremism. Oil producing states, which import goods and services from Europe and other countries with strong currencies, seek higher prices to compensate for the weaker dollar. The dollar is now at its weakest point in eleven years.

The challenge is to reduce our heavy dependence on imported oil. Many projects and plans are underway, but these are years away from any significant reduction in our consumption of imported oil. Worse, the trends are for oil demand to increase and prices to move higher. India’s energy demand is projected to triple in 20 years. As an increasing number of Indians enter the middle class, demand for cars will rise markedly. In China, auto sales are up 25 percent over last year, and are on track to surpass annual U.S. auto sales sometime in the next decade. Add in Vietnam, Indonesia, Thailand, and other fast-growing economies, and oil demand will continue to rise. Production will not keep pace given the stagnation in output in many of the world’s largest producers. Oil-exporting countries need hundreds of billions of dollars to maintain, renovate, and add new production facilities.

Easy Money

Instead, the markets are focused on the cost of money. Cheap money created the sub-prime loan crisis and concerns over the quality of credit. Many market participants want still cheaper money to prevent further losses and an economic slowdown. Exporters have become major beneficiaries of a weaker dollar as their foreign earnings translate into more dollars. But a weakening currency typically gives rise to inflation and economic stagnation, the condition known as stagflation that marked the U.S. economy in the late 1970s and early 1980s. Perhaps most money managers are too young to remember those difficult times.

Friday, October 26, 2007

U.S. Relations with the Muslim World

This is really a tough problem, and one which occupies the foreign policy establishment and defense department. U.S. foreign policy is often governed by mirror imaging, which amounts to Americans believing that foreigners see us from the same vantage as we see them. This is a huge problem in understanding the attitudes and actions of Islamic states. U.S. policy makers largely deal with Arabs and other Muslims in the world of Western educated elites, suits and ties, good manners, and excellent English, leaving Westerners with the impression that they are just like us. But in the Muslim Middle East, Muslims dress in flowing robes, adhere to Islamic doctrine and practices, and often loath the West for its sexual decadence. Our so-called strategic ally, Saudi Arabia, has underwritten the construction of mosques around the world and fostered an extremist, anti-Western rendition of Islam in Wahabiism. Muslim uprisings have infected Paris, London, Amsterdam, and Brussels. Our supposed ally in the war against terror, Saudi Arabia, does not permit Christians or Jews to openly practice their religion in its territory. Indeed, it is a crime to bring a Western bible into Saudi Arabia. The U.S. and Western Europe, dependent on the production of Saudi oil to keep the high price of oil from going even higher, make no attempt to secure reciprocity of religious freedom for Western residents in Saudi Arabia and other countries in the Middle East.

There is no meaningful separation of church and state in Islamic countries (save Turkey). This puts Western countries in an asymetric relationship with Islamic countries. Islam is tolerated and accepted in the West, while Christianity and Judaism are rejected in the Islamic world.

Hand-in-hand with the rise of Islam is the decline of mainline Christianity in the U.S. Here are some figures on the Catholic Church. Between 1965 and 2007, the number of diocesan and religious priests fell from 5,632 to 41,440. More alarming is the more than fifty percent fall in priestly ordinations, from 994 to 456. Graduate-level seminarians declined from 8,325 to 3,274, religious brothers from 12,271 to 5,015, religious sisters from 179,954 to 63,699, while the number of parishes without a priest increased from 549 to 3,238. Apart from Spanish-speaking parishioners, church attendance is way down.

The War in Iraq

Just when the U.S. military is reporting progress on many fronts, new crises in Iraq seem to emerge. U.S. military forces have empowered the Kurds in the north, which has emboldened the PKK, the Kurdish rebel group seeking greater autonomy for Kurds in Turkey, in killing Turkish soldiers. Turks regard PKK rebels as terrorists, and have tired of these attacks. The Turkish parliament has authorized massive military measures to halt these attacks. Tens of thousands of Turkish troops have moved to the Turkey-Iraq border and some are carrying out military operations on Iraqi soil.

The Turkish government demands that the Iraqi government and the U.S. take whatever measures are necessary to put down the rebels. This amounts to the threat of another front in Iraq. It might be recalled that the invasion plan for Iraq included moving a large number of U.S. troops from Turkey, a plan that was thrown off track when the Turkish government refused its permission.

Democracy in Pakistan?

In late October, Pakistan was riven with maneuvers among rival political groups in Pakistan, including supporters of Benazir Bhutto, President Pervez Mushariff, and radical Muslims. The U.S. government has weighed in with its support for democratic elections. Evidently no one in power can recall what happened when Hamas won the election in Gaza, when the Muslim Brotherhood picked up seats in Egypt, and Hezbollah became a major player in Lebanese politics. The U.S. government should be careful what it wishes for given a stock of several hundred nuclear bombs in Pakistan that could fall into the hands of anti-Western forces.

Getting Serious with Iran

The U.S. government announced new financial sanctions against several factions inside Iran and has been trying to mobilize leading foreign governments to support strong efforts to dissuade Iran from realizing its nuclear ambitions. President Bush has warned about a possible World War III if diplomacy does not succeed, and Vice-President Cheney has said that Iran must not be permitted to get the bomb, period. General David Petraeus has charged Iran with supplying sophisticated weapons to Iraqi militias and insurgents. The Israeli attack on a Syrian nuclear reactor site indicates the seriousness with which the Israelis regard the development of nuclear weapons by Iran. Let’s hope for diplomatic success, but prepare for a nuclear-armed Iran.

Thursday, October 18, 2007

The Staggering Dollar

The U.S. dollar hit an all-time low against the euro on October 18, 2007. The secretary of the treasury, Henry Paulson, repeated the mantra of all treasury secretaries that the U.S. supports a strong dollar policy. In contrast, Harvard professors Martin Feldstein and Kenneth Rogoff, in chorus with the International Monetary Fund, assert that the dollar has more to fall, perhaps another 20-30 percent, in order to reduce the U.S. trade deficit with the rest of the world.

In September, foreign investors were net sellers (sales minus purchases) of U.S. securities, resulting in the biggest monthly outflow since 1990. This suggests that support for the dollar is continuing to wane. Numerous reasons have been cited for the falling dollar, among them the large $800 billion annual current account deficit, the rising price of oil (surpassing $89 a barrel on October 18, 2007), the ongoing (seemingly endless) cost of U.S. military operations in Iraq, the fear of an expanded conflict in Iraq due to a possible Turkish military incursion to suppress Kurdish rebels, a slowing U.S. economy, and others. At some point, further increases in the price of oil will take a real bite out of the U.S. economy, with adverse effects on the dollar, growth, and inflation.

The G-7 (the seven leading industrial democracies) meet Friday, October 19, 2007. Topics on the agenda include the rising euro (the flip side of the falling dollar), financial turmoil stemming from the sub-prime mortgage mess, and the growing investments of sovereign wealth funds (government controlled pots of money) in private companies, which implies a partial nationalization of assets by those countries, in marked contrast with private investment. The harsh truth is that there is little the leaders of the G-7 countries can do to alter these trends, until and unless the U.S. substantially reduces its dependence on, or weans itself off, foreign sources of energy.

China is Changing Everything

Business cycles come and go. What has changed in world affairs is the rise of China, the beginnings of high growth in India, economic recovery in Russia, and the transformation of former centrally-planned economies around the world into rapidly-growing market economies. China by itself is responsible for a disproportionate increase in the global demand for energy, copper, iron ore, and other natural resources. Annual economic growth of 11 percent in China means that output doubles in 6.5 years and quadruples in 13 years. U.S. growth of 2-3 percent means that it takes between 24-36 years to double output and 48-72 years to quadruple it. Higher growth in China, India, Vietnam, and other countries implies that demand for commodities will remain strong and that prices are likely to continue to rise.

This new world differs from the twentieth century, in which China and other emerging economies were backwaters. The U.S. is so preoccupied with Iraq that it has little energy left to plan for the consequences of the new economic reality.

Chinese companies, both private and state-owned, have abundant cash to purchase overseas assets at an ever-accelerating rate. If they are blocked from doing so, this will not endear the Chinese government and people to the U.S. The official reserves of the People’s Bank of China (the central bank) have surpassed $1.4 trillion and continue to grow at a rapid rate. Should China decide to sell, or simply announce its plan to sell, a large portion of its portfolio of U.S. government securities, the dollar could fall even more rapidly.

The (Mis)Conduct of U.S. Foreign Policy

It is one thing to offer advice when asked. It is another to give unsolicited opinions, especially when it comes to telling other nations how they should change their policies to what we (the U.S.) wants because we say it is in the interest of other nations. Imagine how Americans feel when other nations tell us, without our asking, how we should behave because they know better what is in our interest.

President George H. Bush routinely advises Russia and China how to behave in their domestic and foreign affairs. He does so in a way that appears arrogant, out of place, and only strains relations with these countries. His welcome mat for the Dalai Lama, the spiritual leader of Tibet, at the White House and Congress during the weeklong meeting of the Chinese Communist Party held every five years amounts to poking a finger in the eye of the Chinese leadership. This action will be duly noted in China’s little black book of insults, to be dealt with at a later date. Instructing Russia’s president Vladimir Putin on how Russia should behave in its relations with Iran only strengthens Russia’s resolve to pursue an independent foreign policy.

The U.S. remains by far the strongest economic and military power in the world, but each year that edge slips a bit. China’s growing economy and Russia’s vast natural resources give these two potential adversaries of the U.S. more and more power and control in their relations with Asia and Europe respectively. The time when other countries will listen to unsolicited advice or implied threats from the U.S. may draw to a close sooner than U.S. leaders recognize. And the means of the U.S. to backup its advice or threats becomes less credible with each passing year.

Friday, October 12, 2007

Our Friends in Turkey

The Foreign Affairs Committee of the U.S. House of Representatives voted 27-21 on a resolution stating that Turkey’s former Ottoman Empire engaged in genocide in 1915, killing a million or more Armenians. The full House could take up the measure for consideration very soon.

Turkey’s response? It has recalled its ambassador to the United States "for consultations." If the resolution passes, Turkey could deny the U.S. the use of bases and other facilities to conduct operations in Iraq. It could invade the Kurdish region of Northern Iraq to halt what it regards as Kurdish rebel attacks on its troops and civilians, further complicating the task of U.S. forces in Iraq. The president and numerous high-ranking U.S. officials have pleaded with the House not to adopt the resolution.

It should be noted that Turkey is a Muslim state, although Turks are not [yet] subject to the same strict Islamic regulations found in Saudi Arabia and other Muslim countries. Still, if the U.S. must choose a course of pragmatism over principle on a relatively minor issue of setting the historical record straight, how can the U.S. government be expected to handle more serious threats emanating from the oil-producing Arab Muslim states, who, as in the past, could impose an oil embargo?

Our Friends in Qatar

The United States military has a major presence in Qatar. This benefits our operations in Iraq and Qatar benefits from our protection.

On October 9, 2007, Qatar’s energy minister said that the price of oil should be much higher than $80 a barrel, already a record high. He called for an increase to $100 a barrel to compensate for inflation since 1972. The U.S. currently imports over $400 billion a year in oil and petroleum products. A further $20 rise in the price of a barrel of oil would add another $80-100 billion to that. Is Qatar a helpful ally?

What is Qatar doing with its oil earnings? The ruling family recently announced an investment of $1.5 billion for a five-star hotel and other projects in Zimbabwe. Zimbabwe is one of the world’s greatest pariah states.
Too Clever by Half

For the past thirty-one years, I have been commuting from my home to my office on the campus of Stanford University. It must be noted that the undergraduate and graduate students at Stanford are among the smartest in the world, on par with Harvard, Yale, Princeton, Oxford, Cambridge, and the world’s other great universities.

Bicycles are an extremely inexpensive, popular, and convenient mode of transportation for those living on or near the campus. It is troubling to note that well over 90 percent of bicyclists do not wear helmets, use lights at night, or cease wearing headphones so they can hear the traffic around them. The Stanford Hospital treats about 200 patients every year due to bicycle accidents.

Experts in many fields of health and behavior advise individuals to eat properly, get plenty of rest, exercise, avoid tobacco and too much alcohol, and so on. If brilliant students can’t be bothered to put on a helmet to prevent serious head and brain injuries, why do you suppose the average person would listen to experts in other fields?
Investment or Consumption? Consumption or Investment? What’s a Person to do?

The minutes of the September 2007 Federal Reserve Board Meeting indicated that fed governors were concerned that "if declines in house prices were to damp consumption, that would feed back on employment and income." They voted for a 50 basis-point interest rate cut to stem that prospect.

The U.S. suffers a savings/investment imbalance. We run an annual current account deficit in excess of $700 billion. This requires that the rest of the world lend us $2 billion a day to keep our international accounts in balance. Economists decry the lack of saving on the part of Americans. Although the gap can be filled by transfers of foreign savings, it puts the U.S. in a position of dependence on foreign capital, and also puts the dollar at further risk should foreigners decide to reduce their holdings of U.S. assets.

Whenever the economy looks weak or is threatened by a reduction in consumption, pressure is put on the fed to reduce interest rates lest the economy slow down. Yet almost every member of the fed and economics communities routinely assert the need for more domestic saving. It is obvious that the latter goal cannot be met if, as a first priority, consumption must be sustained. This amounts to an "iron law of consumption." Selling the family jewels, furniture, paintings, antiques, clothing, and ultimately the mansion to sustain consumption, however desirable in the short run, has very serious long-run consequences.

Kenneth Rogoff and Maurice Obstfeld, economics professors at Harvard and U.C. Berkeley respectively, believe that continued high current account deficits could lead to another 30 percent fall in the dollar against the euro and pound. That would take the euro up to $1.80 and the pound to $2.60. Imagine the bite that travelers will feel paying a thousand dollars a night for a premier hotel room and $80 for breakfast on their European vacations or business travel.

This prospect raises an important issue: Is globalization compatible with sovereignty? (More on this later.)

Tuesday, October 2, 2007

The Thin Edge of the Flat-Tax Wedge in Britain

Speaking at the Conservative party conference in Blackpool on October 2, 2007, George Osborne, the opposition "shadow" chancellor of the exchequer, proposed several changes in British taxation. To fund reductions in property tax, increase the exemption for inheritance taxes, increase tax breaks of married couples, and abolish the 1 percent stamp tax for first-time home buyers, he proposed a change in the treatment of non-domiciled British residents.

Britain has created a tax haven for so-called non-domiciled residents. These are wealthy individuals who keep their money offshore, live and/or work in London, and only pay local council property tax and tax on earnings received in Britain, but not on offshore earnings. Osborne proposes that non-domiciled residents choose between paying normal British tax on offshore investment income or, in lieu of that, pay a flat rate of £25,000 (a bit over $50,000). Osborne estimates that there about 150,000 non-domiciled business men and women living in the United Kingdom who are not registered to pay tax, and that his proposal would collected about $7 billion in additional revenue. He further believes that multi-millionaires will not change their residents over an annual tax of $50,000.

The proposed flat tax amounts to a poll tax on a class of foreign residents. Nonetheless, it would be assessed at a flat rate, rather than a progressive rate, regardless of the amount of offshore investment income.

Aesop’s Lost Fable

The price of oil is always on the minds of politicians, investors, and economists. Although the U.S. economy uses less oil per unit of economic output and consumers spend a smaller portion of their income at the gas pump than in 1980, further increases in oil prices may begin to stoke fears of inflation and the "R" word, recession.

If oil reaches $100 a barrel, alarm bells will grow louder. During the first oil crisis in the 1970s, petro-dollars were recycled into the U.S. economy. Many people will recall double-digit inflation during President Carter’s term and the subsequent savings and loan debacle in the early 1980s.

Low-cost Chinese manufactured goods, which were not available in the earlier oil crises, have helped to cushion the shock of higher oil prices. But a stronger yuan (the Chinese currency) and rising labor costs are gradually raising the cost of Chinese goods. In the era of globalization, analysts and investors believe that if Russia, Middle Eastern, and other oil-producing countries recycle their dollars in the United States, the economy may survive $100 a barrel oil without a significant downturn. As mentioned in previous postings, there is concern that continued accumulation of U.S. assets by potentially unfriendly oil-producing nations may pose a security risk.