Thomas Schinkel and Associates

America: Export Nation?

How currency imbalances and the price of oil may transform Consumer-centric Economy into an Export-centric Nation

by

Thomas Schinkel

June 2008

The other day I was watching a news program on PBS where several oil industry experts in the oil industry were asked why the price of oil was so high. Very quickly they pointed to the two main culprits. One was the Federal Reserve which had made the fatally flawed decision to lower interest rates, starting in August of 2007. The other was that new wave of speculators, financial institutions that had entered into investing in oil futures but not knowing how to do it. In passing they noted that the dollar was low and that was causing problems for the oil markets too.

What did not get addressed is WHY the dollar was so low. In today’s business environment, anyone charged with figuring out the long term direction of their enterprise has these twin questions at the center of their concerns. And if you are thinking of selling your company, these issues are equally important, since they may dictate who your buyers will be and where they come from.

How important is it? Here are some examples. If the price of oil goes up to $160-$180 per barrel, chances are that:

• General Motors may not survive the ensuing twelve months. As of today’s date their stock price is where it was in 1954.
• Several of the major American airlines and a bunch of international ones will either be gone or merged into larger entities slashing their fleet, their debt, and their retirement obligations along the way. Airlines are preparing for a 10% drop in traffic worldwide.
• Shipping costs between China and the U.S., which have seen a dramatic increase already this year, will go up even further, easily doubling the cost of moving product between the two countries.
• Infrastructure repair costs (i.e. roads and bridges), tightly connected to the cost of petroleum, will rise exponentially, creating a further drain on national, state and local treasuries.
• A slew of familiar consumer brands will disappear from the retail scene.

A leading question in all of this, of course, is whether the high oil prices and a low dollar are structural and therefore lasting in nature, or just a temporary condition that may fade away with a few clever policy decisions that the Feds could implement with the stroke of a pen.

Here is how I discuss these twin questions with some of my clients for whom planning ahead is crucial for their survival and prosperity. Keep in mind that these twin questions are line items on top of a laundry list of issues and questions that ultimate drive the opportunities that may present themselves during the years ahead.

Take a look at the following exhibit, which provides a long-term historic view of some of the most fundamental trade imbalances in the American economy.

Prepared by Thomas Schinkel from publicly available data provided by the U.S. Department of Commerce

The yellow curve shows the decades-old trade imbalance between the U.S. and the rest of the world. In nominal terms it does not mean much whether you have a trade deficit of $100 billion of $500 billion. What matters is the size of the deficit in relation to the total economic output of the country. Therefore, the yellow curve shows the trade deficit relative to the U.S. Gross Domestic Product. For example, from 1989 to 1991, the trade imbalance between the U.S. and the rest of the world actually declined from 2% of GDP to 1% of GDP. Later during the 1990’s it went up again to approximately 4% of GDP. But throughout the next decade, it ballooned way out of control to 7% of GDP in 2006, more than tripling in the short time span of ten years. The two main drivers were energy imports (mostly petroleum products), and manufacturers accelerating their shift of manufacturing facilities from U.S. shores to the Far East, with China being the major beneficiary.

Indeed, in the short term, this shift to outsourcing has proven to be a quick and sure-fire way to drive down costs and in some cases, I am sure, improved margins. But throughout the last twenty years a small band of independent economists and analysts from time to time would point to the flaws in this seemingly virtuous cycle of cost control, connecting the dots to jobs, pensions, insurance policies, health care, education and other civic issues. Invariably these voices were moved to the side lines, with the deadpan statement that the American economy was different and that small deficits did not matter to such a large and vibrant economy.

The blue and magenta curves refract the U.S. Trade Deficit into two major components, magenta showing the Energy Deficit between the U.S. and the rest of the world and blue showing the U.S. Trade Imbalance with China. The Energy Deficit means the U.S. is importing so much more of its petroleum and natural gas needs than it exports, again not just nominally, but relative to the size of its economy.

The magenta curve shows that in 1991, the energy deficit was the single largest component of the U.S. trade deficit with the rest of the world. That year, it mushroomed to 60% of the total trade deficit. But throughout the 1990’s there was a sharp correction in this imbalance and by 1999 it stood at a mere 20% of the total trade deficit.

As an aside, this favorable turn of events with the reduced energy imbalance coincided with a government budget surplus during the same period and remarkable productivity improvements throughout society.

Future historians may give at least partial credit to Windows 95 and a host of other productivity enhancing software tools that were widely being embraced by society throughout that period and they may say that this confluence of factors had something to do with the overall perception of prosperity of the late 1990’s.

The blue curve shows that the imbalance in the trade relationships between the U.S.  and China just kept growing and growing, not just in nominal terms but relative to the size of the U.S. economy as well. Today, China makes up in excess of 30% of the total trade imbalance between the U.S. and the rest of the world. Ever since China’s acceptance into the World Trade Organization in 2001, this trade imbalance has widened, again, not just in absolute terms but relative to the size of the U.S. economy.

One of the consequences of this never ending and largely unmanaged saga of growing trade imbalances is that the Chinese and the Japanese governments, and a whole bunch of lesser governments for that matter, are ever more flush with dollars which they routinely re-invested in U.S. treasury bills, with the expectation of steady returns on their investments.

Against this backdrop of the growing trade imbalance between the U.S. and the rest of the world and its two main components, Energy and Trade with China, back to the question of why the price of oil is so high and the value of the dollar is so low. If, in August of 2007, the Federal Reserve Bank had chosen to raise the interest rate instead of lowering it, this might have bought some time for the value of the dollar, encouraging these foreign governments to hang on to their t-bills just a bit longer.

This in turn, indeed, might have had a slowing effect on the rising price of oil, which is traded in dollars. The folks overseas who own the oil and want to sell it to us argue simply that if the value of the dollar goes down their purchasing power goes down, and therefore they need to raise their price to make up the difference.

But the consequence of such a rising interest rate would have been an avalanche of real-estate induced bankruptcies throughout the country; far larger than what we have seen to date. In other words, with the trade deficit remaining out of control and with no policies that are credible in the eyes of the creditors to stem the tide, the Feds seem to be caught between a rock and a hard place.

The Pullitzer prize winning author and journalist with the New York Times, Tom Friedman, argues for trying to get a comprehensive fix on the structural imbalances in our trade relations with the rest of the world. More importantly, he argues, we need to get our energy deficit under control.

After all, you cannot have 1) a trade deficit, 2) an energy deficit, 3) a government budget deficit, 4) a wholesale shift of manufacturing jobs to destinations overseas AND a strong dollar, AND low prices for imported energy AND have this go on ad infinitum. Come to think of it, those are the ingredients, not of a virtuous upward cycle but for a negative, downward spiral. And that is what we seem to be in right now.

To break out of this spiral, Friedman argues for a Federal tax on all those conventional energy carriers that make us more dependent on foreign sources. First of, the tax would end up in the coffers of the U.S. treasury as opposed to that of other countries, many of which are hostile to our interests in the first pace. It would help stimulate the introduction and lasting integration of clean energy sources such as wind, solar, hydrogen and other sources. In other words, he argues, now that all else has failed, let’s try common sense and adjust our life styles and work styles to accommodate the reality of the situation we find ourselves in. After all, consider the following:

A prosperous nation like Denmark derives 19% of its energy requirements from .  wind.

• The population of Iceland many years ago made a conscious decision to wean themselves off of dependence on petroleum fuel by embracing hydrogen as their energy carrier for prosperity. They are well on their way.
• German companies dominate the world market for practically all aspects of solar energy generation. They accomplished this by introducing – years ago – a series of well coordinated policies aimed at stimulating and integrating technology breakthroughs combined with creative tax credits that touch the lives of everybody.
• Going against the grain of a thousand voices, the Honda Motor Company of Japan stuck with their guns, pouring millions of dollars into the development of a hydrogen fueled engine that they mounted on one of the world’s most balanced chassis, the Honda Accord. Baptized the FCX Clarity, they ended up with a brilliantly innovative product that five years from now, may be at center stage of what the world wants and needs. Going forward, it turns out, they are the leaders, once again showing the way.

Here at home, taking a first step at the state level, the Commonwealth of Massachusetts, in a first in the nation initiative, recently adopted a comprehensive Energy Law that remakes the electricity market, provides incentives for clean energy sources and introduces a new building code requiring new structures to consume as little energy as possible. At the Federal level, watch the government introduce policies that address the twin questions of our energy deficit and our overall trade deficit in a way that comes across as credible to our creditors.

When the crisis is over, many assumptions about the U.S. economy will have been turned on their ear. One of those assumptions is that seemingly all-important consumer spending without which little would be left of the U.S. Economy, or so the theory goes.

Overseas, watch the European Union’s monetary policies. They are focused on inflation and inclined to raise the interest rate in the Euro-zone, not lower it. This will only add to the strength of the EURO and further weaken the U.S. dollar.

None of this is very good news – at least not from the vantage point of the American middle class – but there is a silver lining in this gathering storm and that is that the opportunities for American manufacturers that have innovative and leading-edge, high quality products have a SPLENDID OPPORTUNITY to gain and regain world markets.

Indeed, my sense is that within a short period of THE NEXT FIVE YEARS we will be going through a metamorphosis from a “Consumer-centric Society” to an “Export-centric manufacturing nation”. Excuse me for the metaphor, but this after all, is the only way towards a new equilibrium in a world economy that has allowed major imbalances to accumulate as part of a set of policy assumptions that date back to the 1950’s and 1960’s and whose validity had evaporated a long time since.

In short, if your manufacturing facilities are still state-side, and you have been thinking of moving off-shore, hold off on the decision for just another bit. The iceberg may be tipping over and many strategic moves towards outsourcing may have to be reversed. Produce Local, sell Local. Keep distribution pipelines as short as you can to keep unpredictable energy costs out of the equation. Also: Work, Live and Play Local.

In the process, the entire country will be turned into a bargain hunter’s paradise for acquirers of all assets, fixed and variable, corporate and individual. If you are an overseas acquirer, now is a great time to start looking for business investment opportunities in this country. It will be “Globalization in Reverse”.

Tom Friedman’s metaphor that “The World is Hot, Flat and Crowded” is right on the mark. The time for quick fixes in our trade imbalances has long since past. Letting these imbalances fester for too long has created a witch’s brew of forces that may set us up for a perfect storm. The opportunities resulting from the crisis that this storm creates will be significant and those who seize the moment will be rewarded for decades to come. At least, that’s my take on it. Thank you and have a good day!

Tom Schinkel