Greenspan Has a Faulty View of the Landing

Warren Buffett envisions a rougher ride for the economy that makes more sense.
By Jim Jubak ,

The Oracle vs. the Chairman. In terms of heavyweight bouts, they don't get much bigger than this. These two champions of capitalism are duking it out over the future of the U.S. economy.

Warren Buffett, the Oracle of Omaha and the CEO of

Berkshire Hathaway

(BRK.A) - Get Report

, charges that the U.S. is headed for a massive dollar crisis caused by a trade deficit running at better than $600 billion annually.

Bam!

Federal Reserve

Chairman Alan Greenspan counters that the economy is headed for a soft landing, and the debt owed to foreign investors and savers is no big deal.

Smack!

One of these guys is wrong. Before telling you which one I'm putting my money on, let me put the two head-to-head so you can make your own call.

First, the Numbers

Nobody has a better command of the data on the current state of the economy than Greenspan. And the picture he paints isn't pretty. The national personal savings rate has plunged to an average of 1% in 2004, shockingly below the 7% average for the last three decades.

Indeed, we've been running up debt like there's no tomorrow. The unified federal budget (which is the budget that includes the current Social Security surpluses) is running a deficit equal to about 3.5% of gross domestic product. That deficit is only going to climb as outlays for Social Security, Medicare and Medicaid, now 8% of gross domestic product, climb to somewhere near 13% by 2030 as the baby boom generation ages and retires.

Meanwhile, the U.S. current account deficit, a measure of how much more we buy from foreigners than we sell to them, has climbed to 6% of gross domestic product. According to the Fed's economists, you have to go back to the 19th century to find larger current account deficits as a percentage of the size of a country's economy. All of this debt has been funded by an increase in the value of homes (and the size of home mortgages) on the domestic side, and the willingness of foreigners to hold IOUs denominated in U.S. dollars, such as U.S. Treasury bills and notes.

Buffett's approach is light on data, but the data he does cite agree with the details of Greenspan's picture. Last year, we purchased $618 billion more in goods and services from the rest of the world than we sold. To pay for this current consumption, we're selling off our accumulated national wealth to the rest of the world at a rate of $1.8 billion a day. "Consequently, other countries and their citizens now own a net of about $3 trillion of the U.S.," Buffett wrote to his shareholders recently. Our overseas borrowing to fund the current account deficit is equivalent, he notes, to a family that sells off "part of its farm every day in order to finance its overconsumption."

Same Data, Different Conclusions

What's so striking is that from this remarkably similar picture of the current situation, Greenspan and Buffett reach almost diametrically opposed conclusions.

To Greenspan, it's no biggie. Even though we're running that huge trade deficit, the dollar's real exchange value, despite its recent decline, remains above its 1995 low, he told the Council on Foreign Relations. Interest rates on Treasury notes maturing 10 years in the future remain very low, despite the size of the federal deficit and the huge retirement obligations we're putting on the books. And there's no evidence that households are facing "inordinate financial pressures as a consequence of record-high levels of household debt relative to income."

The U.S., Greenspan notes, almost with surprise, "appears to have been pressing a number of historic limits in recent years without experiencing the types of financial disruption that almost surely would have arisen in decades past."

Buffett, on the other hand, believes that we're headed for real trouble. "A country that is now aspiring to an 'Ownership Society' will not find happiness in -- and I'll use hyperbole for emphasis -- a 'Sharecropper's Society.' But that's precisely where our trade policies, supported by Republicans and Democrats alike, are taking us."

Buffett Sees Dire Consequences

Buffett isn't forecasting economic collapse, because he believes that foreigners will continue to lend to us. Foreign investors, he wrote in his letter to shareholders, "may view us as spending junkies, but they know we are rich junkies, as well."

But the consequences are still dire, Buffett believes. If current trends continue, a decade from now, just at the time when we'll need every dollar to pay for the retirement benefits of baby boomers, the U.S. will be sending 3% of its current annual output to the rest of the world as interest on the debt run up by its past consumption.

That royalty would run forever unless we export more and consume less. And given the way global trade policies work, Buffett concludes, massively expanding U.S. exports isn't likely. Hence, paying off this royalty would require a huge decline in U.S. consumption, Buffett says, with all sorts of nasty consequences for the global economy and the lives of U.S. workers and retirees. Don't pay it off and the already-projected squeeze on such frills as health care and education spending just gets worse.

Greenspan: The Landing Is Soft

Don't worry, Greenspan says. We're headed for a soft landing. Foreigners will continue to send us their savings without demanding a huge increase in U.S. interest rates. Market forces -- a fall in the price of the dollar and a consequent rise in U.S. exports and a drop in imports -- will gradually defuse the potential bomb represented by the huge increase in the U.S. trade deficit.

What's his logic?

Because the federal budget deficit, the run-up in consumer debt, projections of huge future retirement liabilities and the buildup in the trade deficit haven't resulted in the expected crisis to date -- and, in fact, haven't even produced the big projected hike in U.S. interest rates or a crash in the dollar -- something must be different this time. "Has something fundamental happened to the U.S. economy that enables us to disregard all the time-test criteria for assessing when economic imbalances become worrisome?" Greenspan asks.

Answering his own question, it's the increasing globalization of capital markets that has made all the difference. What Greenspan calls the "home bias" that kept investors' money in their national financial markets has eased so that investors seeking higher returns or diversification have sent more of their savings overseas. And the U.S. has been the prime beneficiary of that trend. (As you'd expect from Greenspan, he has data to support his belief in a decline in home bias: One measure of the propensity to invest at home for the developed countries representing four-fifths of world GDP has declined to 0.8 in 2003 from 0.97 in 1990.)

The Problems With Greenspan's Theories

I have two problems with Greenspan's formulation. First, as Greenspan admits, a change in home bias doesn't solve the U.S. current account deficit; it just delays the reckoning. But because economists don't really know -- and can't reliably project -- the lag between trade deficits and deficit corrections, we don't really have any idea whether we are currently just in the lag period for a business-as-usual correction of the trade deficit, or whether we've entered some unspecified lag period created by Greenspan's increasingly global financial markets.

It's an interesting theory. But as a guide to investing strategies, it leaves me completely without a road map or time line.

Second, we've been down this "it's different this time" path with the Fed chairman before. Sometime after his more famous remarks about the irrational exuberance of the stock market, Greenspan became an apologist for higher valuations by citing the extraordinary productivity gains in the U.S. economy in the late 1990s. Historical measures of danger weren't valid for the then-current situation because the U.S. economy was growing so much faster than it had in other periods. Frankly, having bought into the first "it's different this time" argument to my pain and chagrin, I'm reluctant to buy into this new version.

The rate of capital-markets globalization remains vague. And while we know there must be some point at which foreigners will stop putting money into U.S. dollar-denominated investments, home bias or no, we have no idea when that might occur.

I've also paid attention to Greenspan's recent characterization of the problems of using productivity growth as a guide to policy. If you change "productivity" to "financial globalization," they're a warning to anyone who wants to use the newest version of "it's different this time" financial globalization to guide policy in the current global economy. "Productivity is notoriously difficult to predict. ... We have scant ability to infer the pace at which such (productivity) gains will pay out and, therefore, their implications for the growth of productivity over the longer run."

A bet that globalization of the financial markets will give the capital markets time to engineer a soft landing is a bet on faith in the powers of omniscience of the Fed. That may be good enough for Congress, these days, but it doesn't hold much appeal to me.

My money is on Buffett. He's not asking me to believe it will be different this time. Again. And he has actually put $21.4 billion of his company's money in foreign exchange contracts that will pay off only if the dollar declines.

Changes to Jubak's Picks

Sell The St. Joe Co.

I think it's time to take some profits in

St. Joe

(JOE) - Get Report

. For Jubak's Picks, which operates on a sell-none-or-sell-all basis, it means selling this entire position. The stock has had a huge run-up and has looked weak recently on fears that long interest rates will finally start to kick up. Under those circumstances, I think investors would be wise to trim positions. In my case, this means selling it all. I have a 117% gain since I added the shares to Jubak's Picks on Oct. 3, 2003. (Full disclosure: I will sell my shares of St. Joe on March 18.)

Sell Penn Virginia.

I think we're near a short-term top in energy prices -- much of the recent move in the price of the commodity seems linked to unusually cold/snowy weather in the East -- so I'm going to take my profits in

Penn Virginia

(PVA)

here. The shares are near the top of their recent price channel and are ahead of themselves in the short term. The sale also frees up some cash for a buy if the current overall stock market weakness continues through the end of the month, as I expect. I have a 14% gain on these shares since I added them to Jubak's Picks on Dec. 14, 2004. (Full disclosure: I will sell my shares of Penn Virginia March 18.)

At the time of publication, Jim Jubak owned or controlled shares in the following equities mentioned in this column: Berkshire Hathaway B, Penn Virginia and The St. Joe Company. He does not own short positions in any stock mentioned in this column. Email Jubak at

jjmail@microsoft.com.

Loading ...