PAUL KRUGMAN AND DAVID BROOKS GET IT WRONG

The pundits lost the plot when attempting to figure out how the U.S. and its trading partners will extricate themselves from their present economic and financial quagmire. Recent N.Y. Times Op-Ed pieces by David Brooks (“The Great Unwinding,” June 12, 9009 http://www.nytimes.com/2009/06/12/opinion/12brooks.html) and Paul Krugman (“China’s Dollar Trap,” April 2, 2009 http://www.nytimes.com/2009/04/03/opinion/03krugman.html) reveal dangerous blind spots in otherwise perceptive commentary.

Brooks, for example, writes of the need for over-extended American consumers to tighten their belts, save, and pay down debt (another form of savings); and for the American economy to “transition from an economy based on consumption and imports to an economy with a greater balance of business investment and production."

Krugman, on the other hand, approaches the issue from China’s point of view, and concludes that “China now owns so many dollars that it can't sell them off without driving the dollar down and triggering the very capital loss its leaders fear.” -- a teaser so succinct it sparkles. About the Chairman of China’s central bank, Krugman adds: “Mr. Zhou’s speech [proposing a super-currency to replace the dollar] was actually an admission of weakness. In effect, he was saying that China had driven itself into a dollar trap, and that it can neither get itself out nor change the policies that put it in that trap in the first place.”

At first glance, Brooks’ and Krugman’s observations seem to make sense, reflecting today’s conventional wisdom: Americans do need to tighten their belts and pay down debt and the American economy must transition into an “investment economy.” China will drive down the dollar if it sells dollars and invests the proceeds in some other currency. However, both columnists miss the central dynamic needed to restore economic vitality and financial stability to the U.S. and global economies. Failure to understand this mechanism can cause both policymakers and investors to commit serious mistakes. I’ll explain.

Brooks writes: "The American economy will have to transition from an economy based on consumption and imports to an economy with a greater balance of business investment and production." And then goes to say that "finding a political strategy to accomplish this" is difficult, if not impossible.

However, he’s missing a critical point. Where's the demand going to come from to fuel U.S. business investment and production?

First: transitioning to an "investment economy" requires a source of strong demand for what business produces. There are only 5 possible such sources: households, government, business, inventory accumulation and net exports. As Brooks properly points out, the U.S. consumer, laden with too much debt and needing to save, will not be a source of demand growth any time soon. Any policies calculated to revive the economy by propping up credit-fueled consumer spending or investment in housing will fail, simply by compounding the core problem of too much debt. (Tax-cutting Republicans take note.) Presently, the government is attempting to fill in the demand void left by households. However, government can't continue doing so indefinitely by taking on ever-more debt, or it will become insolvent or, if it prints its way out of debt, will produce runaway inflation. Nowhere is there much appetite for increasing taxes. Business can't be the source of its own demand without an ultimate purchaser of its product. That would be like business pulling itself up by its bootstraps. Additions to inventory are temporary and variable, not long-term sources of demand growth. That leaves U.S. exports as the sole remaining possible source of demand to fuel the transition Brooks envisions. Yet nowhere in his piece does he mention exports -- that’s because international trade is in the dumps presently, and, therefore, appears to be an unlikely source of vitality. However, as we all know, economic conditions, including international trade, move in cycles. Expect change, not constancy.

It was the surfeit of U.S. imports and recycling of the resulting surplus dollars into the U.S. economy by our trading partners that got us into this mess. Reversing the process -- deleveraging through exports -- is the most promising way out. Think of walking into a minefield – the surest way out of danger is to retrace your steps.

Brook’s key sentence should have read: The American economy will have to transition from an economy based on consumption and imports to an economy based on exports and the accompanying build-up in investment and production. There’s the symmetry his original sentence lacks!

And here’s the kicker: an export-driven transition to an investment economy requires no political will at all! The market mechanism will do the work, just as it did for the Asians following the "Asian 'Flu" in '97-'98 (although Asian governments did give the market a helping hand by continuing to undervalue their currencies so as to enjoy ongoing price advantages in international markets.)

Market forces will force capital outflows from the U.S. for three compelling reasons: 1) Asians are worried about their oversupply of shaky dollar-denominated loans, as indicated by Chairman Zhou’s comments. So too are oil-exporting nations. 2) Faced with sagging export sectors serving over-extended, cautious U.S. consumers, Asians need to fill the void by repatriating dollars to underwrite stimulus for their domestic economies. China and Japan have both announced plans for massive domestic stimulus, funding for which must inevitably come from their international currency reserves. Such flight from the dollar will drive down its value relative to creditor currencies, as Krugman suggests. 3) As the value of the dollar sags, there will be a rush for the exits by a significant contingent of panicked international investors, eager to forestall further erosion in the relative value of their remaining U.S.-based capital.

A cheaper dollar will make U.S. exports more competitive, providing the previously mentioned stimulus for the export sector, and will discourage Americans from buying foreign goods. The resulting U.S. trade surpluses will be a principal source of funds to repay foreign debt. For the past decade, Asians and oil exporters have been exchanging hard goods and services for flimsy paper. Now it is time for the flow to reverse, with Americans redeeming that paper in exchange for hard goods and services. We need to borrow a page from Asia’s playbook.

Makes sense, doesn't it? When looking for a source of demand, you have to look to those who have money, and right now, Asians and oil exporters are the ones with spendable cash. It is logical, therefore, to look to them to be the new "engines of world economic growth," and not frightened, over-extended American consumers or self-levitating U.S. businesses.
A devalued dollar makes it all possible, once international investors disabuse themselves of the notion of the dollar as a safe haven, thereby propping up the dollar. Talk of downgrading the credit ratings of the U.K., Ireland and the U.S. due to gobs of debt they are taking on to fund their rescue plans is a significant step in that direction. The sheer volume of new dollars being “printed” recently by the Fed is another.

Second: by definition, the U.S.’s transition to an “investment economy” also requires capital. Where will capital come from if Asians and oil exporters are repatriating dollar reserves?

Which brings us to Mr. Krugman’s piece, restated: “China now owns so many dollars that it can't sell them off without driving the dollar down and triggering the very capital loss its leaders fear.” In effect, he was saying that China had driven itself into a dollar trap, and that it can neither get itself out nor change the policies that put it in that trap in the first place.

Krugman turns uncharacteristically myopic when connecting the dots, mistakenly assuming China’s only choice is between continuing to hold Treasurys or selling them to buy some other currency – presumably yuan (if it wants to repatriate the money for domestic consumption and investment), or yen, pounds or euros (if it wants to continue to warehouse reserves abroad).

Krugman completely misses the third option for China and other creditor nations: sell a major chunk of their present hundreds of billions in U.S. Treasurys and use the money to invest in the best companies in America. There’s your capital plus another major source of foreign-debt repayment – two birds with one stone.

Moreover, those Treasurys Krugman thinks China is trapped in can be sold without driving down the dollar further, by simply reinvesting the proceeds in bargain-priced U.S. stocks. Some trap.

I mean, why not? In addition to its short-term Treasurys, China and other creditor-nations have invested heavily in long-term U.S. Government bonds, which have appreciated handsomely in recent years as interest rates have fallen. So their bonds are high while stocks everywhere are selling for bargain-basement prices. It’s pretty much a no-brainer.

Corporate stocks and real estate, already cheap, are very likely to get cheaper if, as I suggest, there is a significant flight from the dollar, apparently now beginning, according to the Treasury's latest TIC reports. Failure to anticipate such an exodus poses grave danger for investors. That’s because flight from the dollar will push interest rates up (remember Mexico in '94, Asia in '97-'98), inhibiting domestic economic growth and driving down stock and real estate prices further.

However, danger to American investors is opportunity to foreigners: U.S. assets will be doubly cheap: low prices, low dollar -- an irresistible opportunity to invest in America's corporate crown jewels and move into some prime U.S. real estate. Moreover, what foreigners lose in the relative value of their dollar assets by repatriating dollars, they gain in the reduced cost of the U.S. assets they will be acquiring by converting their remaining dollar-denominated debt instruments to equity. In effect, capital-rich foreigners have the power to create U.S. asset bargains for themselves simply by withdrawing a portion of their capital from the U.S. while converting the remainder from debt to equity. The U.S. will learn a hard lesson in “The Golden Rule”: Those with the gold make the rules.

On the plus side for the U.S.: Foreign investment in U.S. assets will provide much-needed support for both the stock and real estate markets, helping the U.S. to emerge from recession. Any reluctance Americans might have to foreign ownership of prime U.S. assets is likely to be overcome by the prospect of a rebound in asset values induced by foreign “rescuers.”

All this is market-driven, requiring no political will other than for government to stay out of the markets' way -- i.e. don't follow Larry Kudlow's jingoistic call for "King Dollar," or resort to xenophobic prohibitions of foreign purchases of American stocks or real estate. Here’s where policymakers’ clear perception of the evolving global dynamic will make or break the recovery.

If they don't like the idea of a weaker dollar or foreign ownership of U.S. assets, consider this: the only remaining viable alternatives to U.S. exports and asset sales as the source of foreign debt repayment is default or resort to the printing presses.

A final thought for investors: It will take time for our creditor trading partners to shift from export-driven to domestically driven economies. Until they do, and U.S. exports begin to rebound, the foundation for sustained global and U.S. economic recoveries will not have been laid. Without such foundation, the outlook for the stock market is fraught with misperception and risk. The stock market can run on the heady fumes of hope for just so long until eventually reality bites.