Feature Stories | May 16 2006
By Greg Peel
GaveKal Research is an independent economic research house and consultancy created in 1999 in the US by Charles Gave and partners. GaveKal has a reputation for "original thinking". The following feature series is drawn from a GaveKal publication of 2005 entitled: Our Brave New World. This is Part IV.
Two facets of the US economy have been very much under the microscope of late. Recent years have seen a boom in housing prices and an unprecedented blow-out in the current account deficit. The bears would tell you both are a recipe for disaster as far as sustained US economic growth is concerned.
Australia has seen a similar transformation. Not only have Australian house prices surged but the deficit has also began to worry many observers. But while Australia has experienced a quietening of the housing market, it has not been devastating, and despite a growing deficit the Australian economy rolls relentlessly forward.
The bears have begun to either temper, or question their views. Why have there been no disasters to date? The US housing market may have eased, but it hasn’t collapsed, and the US economy continues to be strong in the face of record after record in the current account deficit. The answer is that the bears’ predictions are based on an economic world that has now passed. The platform company model has heralded a new paradigm.
Australia’s housing price surge actually led that of the US, and it’s a bit unusual that Australia should lead the US in anything much. One possible explanation is that because of the Sydney Olympics in 2000, the rest of the world found out just how great a place Australia is and hence foreign interest sparked a scramble for real estate.
There might well be truth in this, but the reality is that housing prices rose because interest rates fell, inflation was low, and disposable incomes increased. Throw all this together and it makes sense that the average Joe would aspire to own a better house, and had the wherewithal to pay for it. Result: real estate surge.
As discussed in Part III, the platform company model has led to a fall in volatility of corporate profits and worker incomes in "Western" countries. This has allowed both companies and individuals to feel far more secure about the future. In the meantime, the Chinese story has led to downward pressure on the real prices of many goods, and the platform company model has ensured that while margins have fallen in the emerging world, margins have increased in the Western world. That is why Westerners have more disposable income, and why they’ve had no qualms in spending it.
The surge in real estate pricing has not, thus, been a bubble at all, but a secular price adjustment under the new paradigm. That is why we’ve have seen the heat come off the market from the last great burst, but have only experienced a benign southward drift of prices to a new, higher average.
And have houses really become overpriced at all? Prices should realistically reflect the price of a mortgage, as that’s the way average Joe will finance his purchase. Leave the super-rich out of the equation for a moment (and besides, Sydney waterfront prices have hardly faltered). The best measure of mortgage prices in the US is the thirty-year mortgage zero coupon bond.
US figures suggest that the housing prices and the price of the bond have risen in close correlation for the last fifteen years. This means prices have only adjusted dollar-for-dollar with the decline in long term interest rates. Not a bubble at all.
Okay, so housing prices can be explained. But surely a massive US current account deficit (which reflects the amount of money borrowed by US corporations and individuals to finance ongoing consumption) is a dangerous beast?
To address this, let’s go back to the Dell computer of Part I. The flat screen, built in Taiwan, costs (all figures are in USD) $300. The Taiwanese manufacturer’s margin is $30. The mechanical part and the box it sits in are made in China and cost $100, with a margin of $5. The Intel chip, designed in the US but made in Taiwan, costs $70 with the margin split $35 to Intel and $5 to Taiwan. The Microsoft software costs $200 with a margin of $180. Dell takes a sales margin of $30 when it sells the completed PC.
If you crunch the numbers from an accounting perspective, US companies pick up a total margin of $35 + $180 + $30 = $245. Foreign companies earn $30 + $5 + $5 = $40. On the sale of the computer, the US is $205 ahead.
An economist, on the other hand, would look at it a different way. Leaving out the Microsoft software and the Dell mark-up, the PC sold in the US equates to a $470 import. Nothing is exported, thus the trade deficit is $470.
Between them Dell, Intel and Microsoft make a profit of $245 which adds to the US GDP. The economy thus suffers a net "loss" of $470 – $245 = $225.
The economist sees this result as unsustainable. The US moves further into debt and the risk is the US dollar will collapse if foreigners decide to stop selling into the US. But if the exporters to the US are making an average margin of 1%, and US exporters make an average of 20%, which economy would you prefer to own?
As far as economists are concerned, a country’s imports and exports need to balance over time otherwise debt continues to build until the whole system collapses. But trade balances are calculated on the value of sales, not on the sales margin.
Mature economies, those who have moved to a platform company model, enjoy stable incomes for workers who thus feel no need to save. Companies have a positive cash flow with high returns so they don’t need to retain large amounts of precautionary capital. Emerging market economies suffer unstable incomes for workers who must save to avoid a crisis. Companies work with negative cash flows and low returns and need to retain capital to avoid going bust.
Where do those savings go?
Into an investment that provides security of return – that’s where. So emerging market savings are fed back into mature market assets and the circle becomes complete. Hence the US has become part of what is called a "global trade imbalance". But what has really happened is that goods have been exchanged for assets.
In 1991, foreigners owned 11% of the stock market. In 2005, with a burgeoning current account deficit, the figure was 17% – a 50% increase. That goes some way to explaining why the US stock market has quadrupled over that time. Prices are made at the margin. And at the end of the day everyone is richer – the US consumer, US companies, Chinese companies and Chinese workers.
There can be no reason to worry as long as the US has assets to sell.
The US trade deficit does not exist because China has a comparative advantage in being able to save instead of borrow. It exists because under the platform company model the US can outsource its production to wherever it can get the best price. The deficit is offset by a colossal increase in earnings, and foreign investors also gain a benefit from that increase.
Economists will suggest if you have the advantage, this should manifest itself as a trade surplus. But the new reality is that the advantage has manifested itself as a higher standard of living. From 2000 to 2005, US profits have increased by US$500 billion, and the US current account deficit has increased by US$250 billion. If you apply a 20x multiplier to the value of US assets, this suggests the deficit could blow out to US$10,000 billion before there is a problem. In 2005 it was US$1,200 billion.
As long as corporate profits rise more than the deficit deteriorates, the imbalance is viable. It does not seem from these numbers that "unsustainable" is a word that can be applied yet.
The US has been balancing its current account deficit not with its GDP, but with the value of its assets, which foreigners are happy to buy as they provide security and healthy returns. Even buying a house in Miami represents value to a foreigner who is not used to a relatively stable and safe society. The deficit should not be measured as a proportion of GDP, but as a proportion of the value of US assets.
Coming up in Part V: how can this system continue to grow?
The ideas and examples put forward in this series are the work of Gave, Kaletsky & Gave: Our Brave New World, self-published, 2005. The writer has added observations as well.