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The Dollar's Doomsday Cycle

A weakening dollar could erode foreigners' appetite to fund the yawning current account deficit.


debate on the budget deficit and household debt will likely go on as long as a

Celine Dion song, even optimists find little silver lining in the nation's current account deficit. This broadest measure of U.S. transactions with other nations increased to $503.4 billion in 2002 from $393.4 billion in 2001, according to the Bureau of Economic Analysis.

Some observers believe our reliance on foreigners to fund the current account deficit could ultimately trigger a simultaneous downward spiral of the dollar, Treasuries and U.S. equities.


Bill Fleckenstein neatly summed up this view in a column Tuesday, fitting on a day in which the dollar failed to sustain early gains, despite the stronger-than-expected consumer confidence data.

Full Circle, Downward Spiral (Postponed)

Such negativity brings us (not surprisingly) back to Morgan Stanley chief economist Stephen Roach. The recent increase in private-sector savings does not represent a new trend, Roach lamented, but stems from a "transfer of savings" from the government to the private sector via President Bush's first tax cut.

While some believe that's wholly desirable, Roach observed the nation's net savings rate -- aggregate of public, private and household savings -- hit a record low 1.3% of GDP in the second half of 2002. That's down from an average 4.8% of GDP in the 1990s and 7.6% from 1960 to 1999.

"America's plunging national savings rate is now plumbing new depths," he wrote. "And the risk is it is about to go even lower."

The economist further observed that because America lacks "domestically generated saving

s," it is increasingly reliant on foreigners to fund economic growth.

On an annualized basis, the current account deficit was $548 billion in the fourth quarter, or a record 5.2% of GDP, up from the previous record of 4.5% in late 2000 and vs. 3.4% in 1987, "the last time America was faced with a serious international financing problem," Roach observed, tacitly alluding to the 1987 market crash.

At some point, Roach and others warn, foreigners are going to balk at funding our current account deficit, currently requiring about $1.5 billion of international inflows daily, especially given the paltry yields offered by Treasuries. Many believe the current account deficit, along with the rising budget deficit (a.k.a. the "twin deficits") explain why the U.S. Dollar Index is down about 18% since early 2002.

A weakening dollar prompting foreigners to repatriate assets, leading to a downward cycle of more dollar weakness and more outflows by overseas investors is the doomsday scenario hardcore bears have been warning about for some time. Historically, "whenever a developed economy reached a current account deficit over 5%

of GDP, that country's currency collapsed and the economy fell into crisis," concedes the otherwise upbeat John Dessauer, editor of

Investor's World

, (although he foresees an "orderly decline" in the greenback vs. a crash).

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"At some point it will all come home to roost," agreed Michelle Girard, Treasury market strategist at Prudential Securities. However, she believes a mass exodus by foreign investors was more of a concern 18 months ago when the U.S. economy was clearly slowing. "That's probably not an immediate threat" today, the Treasury strategist said, noting there weren't significant outflows in the past few years despite the Sept. 11 terrorist attacks, recession and rising anti-American sentiment prior to the war vs. Iraq. Furthermore, there's a lack of competition for global assets from Japan and Europe.

Indeed, the BEA reported foreign-owned assets in the U.S. increased by $630.4 billion in 2002, while net foreign purchases of U.S. Treasuries totaled $53.2 billion, reversing net sales of $7.7 billion in 2001. Excluding Treasuries, foreigners purchased $284.6 billion of U.S. securities in 2002, although that was down from $407.7 billion the prior year.

Similarly, the dollar's weakness, rising federal deficits ("as far as the eye can see") and accompanying increased supply of Treasuries has not resulted in a material rise in market rates. Auctions of two-year notes have risen to $27 billion per month from $10 billion per month two years ago, Girard observed, yet yields on the two-year have fallen to 1.61% from 4.27% in the same period.

"The increase in demand for Treasuries has remained so strong such that additional supply has been easily absorbed," Girard said, although that could change in a hurry if inflation expectations rise, compelling the


to tighten. (


Mike Norman took a less upbeat view of the relationship between rising deficits and Treasury yields.)

At this juncture, America's public and private debt burdens and associated problems appear to be one of those things that "don't matter until they matter."

Optimists from President Bush on down are betting the economy will recover before that time arrives.

Good Debt vs. Bad Debt, Continued

Monday's column looked at the ongoing argument over the significance of the nation's corporate and public debt. It generated considerable response, some of it good fodder for the debate, so it bears repeating here.

In late 2002, total U.S. debt (all sectors) relative to GDP was at levels last seen in 1933, "in the depths of the Great Depression and just before one of the greatest reflations in U.S. history," according to a report from Barry Bannister, a managing director at Legg Mason Wood Walker. "In the current era, we see a mandate to stimulate the economy and service debt. When the rate of notional economic growth is insufficient to service legacy debt, our view is that the appropriate policy response is over-stimulation, similar to the 1960s and 1970s."

Based on expected inflationary monetary and fiscal policies in the coming years, Legg Mason forecast the PPI Commodities Index will outpace the annual average return of the

S&P 500

by 6.9% to 1.8% from 2002 to 2015. (The commodities index rose about 11% in 2002 while the S&P 500 fell about 23%, so commodities have a head start on Legg Mason's rather bearish long-term forecast.)

A more bullish view comes from Dessauer, who observed that while the household debt burden is about the same today as in 1985 -- at about 14% of disposable income -- the cost of that debt is down considerably, as interest rates have fallen dramatically. Also, mortgage debt (a.k.a. "good debt") is now 23% of total household debt while high-cost credit card debt (a.k.a. "bad debt") has fallen to 25.8% of total household debt from 48.4% in 1995, Dessauer wrote.

The newsletter writer further observed the national statistics on America's savings rate don't include "alternative forms of savings," such as stocks, bonds, 401(k) retirement plans, real estate and other hard assets.