The United States seems to need a sinister, threatening menace around which to structure political debate. We have had the Cold War, the Energy Crisis (the "moral equivalent of war" in President Carter's words), the War on Drugs, and the War on Terrorism. Any day now, I expect to see "The War on the Deficit" gracing the front page of Time or Newsweek. Political interest groups use these themes to advocate policy measures that they would support even in the absence of the latest "War" and somehow justify their positions in terms of the latest menace. I remember my parents driving me to college (where my studies were partially financed by National Defense student loans) on roads that were part of the National Defense Highway System. It is not surprising that the Republicans are using the deficit to justify the abolition of programs that they would oppose in any fiscal climate nor is it surprising that the Democrats are using the deficit as to resuscitate their argument to raise taxes for anyone making more that $250,000.
While all this is going on, the United States is piling up another, much more important deficit. The trade deficit is measured and defined in a variety of ways but no matter how you look at it, the numbers are discouraging. Our merchandise trade deficit is in the $600-700 billion range and our current accounts deficit is a little shy of $500 billion. The merchandise deficit is about the size of the surpluses of the four largest trade surplus countries combined. We are not the only country in the world with a current account deficit, but ours is about six times larger than anyone else's and is roughly equivalent to the combined deficit of the other eight countries in the "top nine" of deficit champions combined!
To put it in perspective, the deficit is at least three percent of GDP and, by some measures, nearly five percent. If the deficit were eliminated due to either increased exports or import replacement by domestic production and if that production was roughly as labor intensive as the rest of the economy, an elimination of the trade deficit would reduce unemployment to the 4-6% range. The deficit has important implications for macroeconomic policy. To the extent that deficit spending and expansive monetary policy increase consumption, many of the jobs created by that increase in consumption are not in the United States.
I am going to disappoint those readers looking forward to a protectionist rant because I am a free trader and I also believe that the postwar trade system that the world adopted with aggressive American encouragement is immeasurably superior to the trade wars which characterized the world before 1945. But the United States must begin to utilize the tools available to it to create a level playing field for its industries. The Value Added Tax (VAT) could be an efficient source of revenue and would definitely help put domestic production on a better competitive basis. It would be imposed upon imports but would be rebated against exports. Today, a U.S. producer exporting to a VAT country has to pay corporate and other taxes in the United States and pay the VAT abroad. A producer in a VAT country is relieved of its VAT obligations when goods are exported to the U.S. and no VAT is imposed here. Another way to view it is that most of the rest of the world taxes consumption with the VAT while the United States taxes production with corporate and income taxes. It should be no surprise that the U.S. has become the "consumer of last resort" rather than the "arsenal of democracy."
An analysis of the numbers reveals that a large portion of the trade deficit is due to oil imports. While we always seem to be in the process of developing a "new" and "improved" version of our "energy policy," most of the attention is generally directed to the electricity sector where arguments about the comparative merits of coal, nuclear and renewable technologies proceed endlessly. Meanwhile, over the past 30 years, natural gas has replaced petroleum in the electrical sector making debates about these technologies essentially irrelevant to the immediate problem posed by our increasing dependence on the precarious supply of an expensive transportation fuel. We should be transitioning our vehicles from oil to natural gas (which cost roughly 1/4th the price of oil on a BTU equivalent basis) either through electric vehicles (plug in hybrid or pure electrical), CNG, or methanol.
From an investment point of view, if current trends continue, the only real mechanism for bringing trade into balance is provided by floating exchange rates. And, in the long run, it is the trade deficit, not the budget deficit, that will drive the dollar down (the Japanese are a great test case - they have been running huge budget deficits and huge trade surpluses for years and their currency consistently appreciates in value). A declining dollar makes U.S. produced goods less expensive in the rest of the world, encourages foreign tourists to visit the United States and encourages U.S. tourists to stay home. Unfortunately, a declining dollar has various other negative implications - to the degree that gasoline consumption is price inelastic, we may be setting ourselves up for a very nasty "energy shock" as a declining dollar leads to increases in the dollar denominated price of oil and, because consumption doesn't decline, the trade deficit actually deepens only to be resolved by a deep recession.
I am not a currency trader and it is possible that the current "buzz" about the weak dollar is overdone from a trading perspective. But, in the long run, I like stocks that will experience a tailwind from a declining dollar - two attractive positions are Philip Morris International (NYSE:PM) (almost all revenue from exports) and Yum! Brands (NYSE:YUM) (big existing and potentially increasing foreign revenue due to China's love affair with Kentucky Fried Chicken). This is another reason that large cap U.S. companies [Coca Cola (NYSE:KO), Proctor & Gamble (NYSE:PG), Intel (NASDAQ:INTC), Microsoft (NASDAQ:MSFT) and Apple (NASDAQ:AAPL)] should continue to generate good results in terms of dollar denominated earnings.
The transition from petroleum to natural gas in the transportation sector (either directly or through plug in vehicles) is becoming virtually inevitable and will receive an added tailwind from a declining dollar. It is very hard to pick the winning technology because an engineering and economic analysis is extraordinarily difficult given the constant evolution of technology and even if such analysis suggested a clearly optimal path, it is possible that it would not be pursued for political reasons. For example, we seem now to be as wedded to methanol as we are to the tax deductibility of mortgage interest. However, the upside for certain stocks like Methanex Corporation (NASDAQ:MEOH) (a strategic position in methanol) is becoming disproportionate to the downside risk. Natural gas producers like Chesapeake Energy (NYSE:CHK) will also be potential big winners in such a transition.