What's Going On

Some ideas about the economy and markets. I have been thinking about the macro trends in the economy and have wondered how we can maintain these trends:

The US government spends more money than it raises each year.

As a nation we import more than we export each year.

As a nation we consume more than we produce each year.

As a nation individual house-holders spend more than they make.

Some individuals borrow more than they can repay.

So he have a huge and growing national debt. Living it up ..

The concern of foreclosures is leading to a tightening of credit and leading financial losses for the financial services companies and a slowdown in home-building.

And, lastly, a huge and growing deficit in the balance of payments. Let's start there.

The trade imbalance means that China ends up with lots of US dollars that they do not spend on US goods and services. What happens to the money? It goes into savings and investment accounts denominated not in Chinese Yuan but in US dollars. So the money has to be invested in either US dollar financial assets, e.g. stocks or bonds, or the Chinese investor can exchange the US dollar for some other currency. Since China has so many USD they primarily invest in US Treasury bonds, e.g. they are buying the bonds the US government has to issue each year since the US government spends more than it collects in taxes, fees, etc. So China is lending the US government money to finance the war in Iraq, tax cuts for the wealthy, and bridges to nowhere.

When the Fed reduces interest rates, short term T-Bills will pay less in interest and and inflation may grow. If we get inflation the value of long term bonds will decrease. Both of these make buying USD financial assets less attractive. So holders of USD trade them for more "stable" currencies such as the Euro, British pound, etc and then buy financial assets dominated in these currencies.

For this currency trading, if someone is selling Euro for USD they will play less for the USD as the number of sellers increases. This is just basic supply and demand combined with the financial risk of owning USD. So what happens, the USD gets cheaper in relationship to other currencies, the price of imported goods and services increases. The price of oil may exceed $100 a barrel before I finish writing this.

So what does this all mean?

The bond market is worried about inflation.

The stock market is jittery.

Stuff, especially imported stuff will cost more. Since we import oil this means the cost of energy will go up so the cost of US produced goods will also increase. In a word, inflation will increase and eventually interest rates will go up.

We will have to buy less stuff. This means a "reduction in the standard of living". I put that in quotes because it does not mean a reduction in the quality of life for most of us. It just means less stuff.

This could be a good thing. We spend less on imported stuff and maybe more on local goods and services. We use less energy. We create less waste. We buy only what we can afford because of the increase in the cost of borrowing. Maybe we save a little money from time to time. We visit the Blue Ridge or Rocky Mtns instead of the Apennines. Maybe we ask Dad for some money.

Maybe the Chinese economy slows down and they slow down a little in the pollution of the planet. Maybe the US government balances the budget.

In the meantime if you are an investor, invest in stocks not bonds especially not bonds in USD. Invest in natural resources as a hedge against the USD continuing to getting weaker.

Lastly and most importantly, Don't Panic.

It's just stuff and mostly harmless.