Mean Markets and Lizard Brains Read online

  When the man with the golden brain’s wife dies, he spares no expense on the funeral. On his way home from the cemetery, he stops to buy a pair of blue satin boots. The store clerk hears a scream and rushes to find the man clutching the boots in one hand, while the other hand is covered with blood and contains gold scrapings at the ends of the nails. His golden birthright was gone; his entire brain sold off bit by bit over the years.

  In a far less dramatic manner, but to a far greater degree, over the last several decades the United States has spent its golden treasure. Figure 6.2 depicts how the United States has changed from an international creditor to a debtor. The figures are calculated by adding up all the U.S. investments abroad and then subtracting foreign investments in the United States.

  FIGURE 6.2 The United States Is the Biggest Debtor in the World

  Source: U.S. Commerce Department

  In the early 1980s, and throughout most of its history, the United States was a creditor. The value of U.S. investments abroad exceeded the value of foreigners’ investments in the United States. The positive figure in 1982 of $328 billion represented accumulated U.S. savings.

  When a country runs a current account deficit, it is borrowing. In the case of the United States, it began borrowing from a position of strength. The early years of borrowing just reduced the savings that had built up over decades. In the late 1990s and beyond, the growth in accumulated debt became extreme. The U.S. debt to the world at the end of 2004 stood at $3.5 trillion.

  As with the current account deficit, the debt that the United States owes to the world is the largest amount in history. As with other figures, there are nuances where the figures are adjusted for the size of the economy and the current value of the assets (the data in Figure 6.2 use the historical cost of the investment, not the current market value). When these nuances are taken into account, the trend is identical. The United States has had a dramatic change from global creditor (and saver) to debtor (and consumer).

  Loan Sharks and Latin American Defaults

  The accumulated U.S. debt to the rest of the world stands at $3.5 trillion. While this is a lot of money to you and me, the real puzzle is why such a small amount of debt is any trouble at all. After all, $3.5 trillion is only about three months’ worth of U.S. economic output.

  Compared to how much individuals frequently borrow, the U.S. international debt seems small. For example, my brother in-law Henry racked up about $150,000 in debts during graduate school. At the time, the loans represented many years of income. However, his education allowed him to become a physician so the borrowing was justified. When people borrow for houses, we borrow many years’ worth of income.

  Therefore, the puzzle is why such a puny amount as $3.5 trillion is considered a problem for the United States. The answer, as my Harvard Business School colleague Professor George Baker points out, is that the amount of credit available is a function both of the income of the borrower as well as the ability of the creditor to force repayment.

  “Charlie, the bedbug took my thumb,” says Paulie (played by Julia Roberts’s brother Eric) in The Pope of Greenwich Village. The “bedbug” is the local Mafioso chief and by a series of poorly executed steps, Paulie owes more than he can pay. The bedbug actually goes easy on Paulie because of family connections. Nevertheless, debts that aren’t repaid in this world invite severe punishments.

  Why would anyone borrow money from a loan shark? As one might expect, people who borrow from loan sharks usually have no alternative. Some desperate circumstance leads them to need money, and with all other doors shut, the loan shark fills the void. The puzzle then is not why people borrow from loan sharks, but why loan sharks are willing to loan money when all others aren’t.

  The ability of the bedbug to take Paulie’s thumb explains why loan sharks will loan money to people who cannot borrow from anyone else. Because loan sharks are willing to collect in extreme ways, most people try really, really hard to repay them.

  The financial situation of the borrower as well as the tools available to collect debts are the keys to understanding credit limits. With this perspective, it is easy to see why the biggest loans in most people’s lives are associated with their houses. Banks lend a lot of money, relative to salary, for housing because it is relatively easy for banks to get their money back by repossessing the property. When creditors cannot take thumbs or houses to ensure repayment, they are not willing to lend very much.

  International lenders always have to consider the possibility of default. In December 2001, Argentina defaulted on its loans and stopped repaying agencies such as the International Monetary Fund. At the time, Argentina owed more than $100 billion. Could Argentina repay these debts? Absolutely—they represented about one year’s worth of production.10 So just as a homeowner can pay down a similarly sized debt over the years, Argentina could have repaid the money it owes.

  But countries will default on loans when it is in their interest to stop making payments, not when debts become too large. Argentina’s President Néstor Kirchner said that he would rather bear the consequences of default rather than cut spending; he stated that repayment would be “paying with the sweat and toil of the people.”11

  John Maynard Keynes said, “If you owe your bank a hundred pounds, you have a problem. But if you owe your bank a million pounds, it has.” The United States owes the world $3.5 trillion and Keynes suggests that this is a bigger problem for the creditors than for the United States.

  Because the creditors appreciate their trouble, they are reluctant to loan even more. This is one reason why the U.S. debt is problematic even though it is a relatively small sum for such a large economy. A second reason is that no bank or country has the ability to come to the United States and force repayment, so lending money to the United States relies upon its good graces for repayment. By this second measure alone, the United States is the worst sort of borrower. No one can force the United States to repay debts.

  While the United States looks like a bad debtor for these two reasons, it has another feature that makes it a low risk for default. When it gobbles down the world’s oil, cars, and other products, the United States issues IOUs denominated in U.S. dollars. Now, guess who controls the ability to create as many U.S. dollars as are needed to ensure repayment? The answer is the United States. Because the United States can create an infinite supply of dollars, it is impossible for it to default.

  Many other countries, including Argentina, promise to repay in a currency they don’t control (usually U.S. dollars). When Argentina needs to come up with U.S. dollars to repay a loan, Argentina has to trade something valuable in order to get those dollars. In contrast, the United States has the ability to make U.S. dollars for nothing (both by actually printing banknotes and by electronic entries in the Federal Reserve system).

  In some respects, therefore, the United States is the best possible debtor. No lender need fear a default. U.S. creditors can be absolutely certain to get back every penny of the $3.5 trillion in loans. Because dollars can be created by the United States at no cost, the same would be true if the U.S. debt totaled $35 trillion or $350 trillion. So we still haven’t figured out why anyone would be worried about the United States’ debt to the world.

  In an early scene in Waterworld, Kevin Costner enters a community in search of trade. Costner offers to sell some dirt, a precious resource to a floating world that needs to grow plants. In return for his dirt, Costner is offered money and after some haggling, a deal is reached. When he goes to buy something with his money, however, Costner is angered to find that the amount that he has just earned is too little to buy anything useful.

  Hey, I’ll give you 16 quadtrillion “credits” for your car. Is that a good price? Obviously, it depends on what real goods you can buy with a credit. Costner’s behavior makes no sense. Haggling over price makes sense only if the money has known value. Similarly, the people who have lent the United States money do not need to fear default. They will get whatever amount of dollar
s they are owed.

  The real value of those dollars, however, is very much in doubt. As we discussed regarding inflation, the U.S. Federal Reserve determines the value of the U.S. dollar. The larger the total debt, the more incentive there is for the Federal Reserve to create money to erase those debts. Even though $3.5 trillion is a small debt for the United States, creditors have reason to fear getting repaid the full value of their debts.

  Where Do We Stand in the Cycle of Irrationality?

  What is fair value for the U.S. dollar? In the long run, countries can be neither borrowers nor lenders. Because the United States has accumulated a massive debt that will be repaid, the United States will need to run many years of current account surpluses. This change from current account deficit to surplus will be accompanied by a fall in the value of the dollar. Let’s look at some major currencies in detail. Figure 6.3 shows that the dollar has already lost a lot of value against the euro.

  FIGURE 6.3 The Dollar Has Lost One-Third of Its Value against the Euro

  Source: Federal Reserve

  The dollar looks to have hit an overvalued high in late 2000 and 2001. The dollar rose in value almost every day for years, and the airwaves were filled with negative comments on the euro. On October 17, 2000, Tony Norfield, currency analyst with ABN Amro, said, “It is simply ridiculous for people to keep suggesting the euro is fundamentally undervalued. It isn’t.” At the same time, Jane Foley of Barclays Capital went on record with: “It is still the case that Europe needs to implement structural reforms more quickly. Until that happens and productivity improves, investors will still want to be in dollars.”12

  As is so often the case in mean markets, you’ll note from Figure 6.3 that these experts were exactly wrong. In contrast with Mr. Norfield’s opinion, the euro was fundamentally undervalued, and even though Europe hasn’t implemented structural reforms, Ms. Foley was wrong in predicting that investors would still want to be in dollars.

  Obviously, the dollar was overvalued against the euro in 2000. Since then, the dollar has lost one-third of its value in euros. Is that enough? If markets were rational, we might expect the decline to end when the price of products in the United States equaled those in the euro area. The Economist magazine, for example, calculates the average cost of a Big Mac hamburger in the United States to be $2.90, and the cost in the euro area to be $3.28.13

  Since everyone prefers to buy Big Macs for $2.90 instead of $3.28, the theory of purchasing power parity (PPP) suggests that prices in different countries are pushed closer together. In the case of Big Macs, the dollar would have to rise in value against the euro to equalize the two prices. Thus, this burger application of PPP is saying that the dollar has fallen enough against the euro. If the Big Mac prices were indicative of all prices, particularly of goods that are actively traded, then the dollar does not need to decline any more.

  So the dollar might be close to fair value against the euro (there are, of course, far more comprehensive analyses of PPP beyond Big Macs). What other currencies are particularly relevant to reducing the U.S. current account deficit? Figure 6.4 shows that the dollar has lost about one-quarter of its value against a basket of major currencies.

  FIGURE 6.4 The Dollar Has Lost One-Quarter of Its Value against Major Currencies

  Source: Federal Reserve

  The Japanese and Chinese economies are so large that their currencies deserve special attention. The Chinese currency is fixed to the U.S. dollar by Chinese government mandate. China runs a significant current account surplus. There is speculation (both whispered and in the futures’ prices) the dollar will eventually weaken against the Chinese currency (known as yuan, it is officially called renminbi or RMB).

  The large current account surplus of China suggests that the dollar will fall in comparison to the yuan. What about the Japanese yen? In 1980, I saw a talk by Douglas Fraser, then president of United Auto Workers. Fraser said that the reason Japanese cars sold well in the United States was that the dollar was too strong against the yen. At the time, you could buy more than 250 yen for one U.S. dollar. If only the dollar would weaken to about 200 yen, Mr. Fraser suggested, American-made cars would be a better value than those made in Japan.

  The U.S. dollar soon weakened to far beyond Mr. Fraser’s target and currently fetches about 110 yen. In spite of this weakening of the dollar, Japanese cars and other products remain so cheap that Japan runs a large current account surplus with the United States. Thus, the expectation is that the U.S. dollar will continue to weaken against the yen.

  Furthermore, both the Japanese and Chinese currencies are kept at artificially low levels by their governments. Because such government interventions always fail in the long run, these currencies are likely to rise to their correct levels over time. The Bank of England attempted to keep the British pound at artificial levels in 1992. Speculator George Soros earned a reported $1.1 billion by betting that the Bank of England could not maintain artificial levels—he was right. So the dollar is likely to fall against the Japanese yen and the Chinese yuan.

  Putting these facts together, I conclude that the decline in the dollar that began in 2001 is not over.

  The U.S. current account deficit remains near its historical high. Furthermore, sentiment toward the dollar is not negative enough for a market bottom. Recall that at market extremes, our lizard brains tend to be exactly out of sync. Even if rational financial calculations suggest that the dollar’s decline is over against some important currencies, mean markets don’t stop at fair value. Just as the dollar became wildly overvalued before it stopped rising, the science of irrationality suggests that it will have to become undervalued (and scorned by experts) before its decline can end.

  How to Invest in a World with Fluctuating Exchange Rates

  Cartoon characters have neat tricks that help them avoid disaster. When one of our heroes is trapped in a falling house, the solution is simple. Just as the house is about to crash into the ground, Bugs, Daffy, the Road Runner, and others simply step out of the house. They walk away from the wreck with nary a scratch.

  While we cannot exit falling houses without injury, we can leave behind declining currencies. For the last few years, my wife and I have owned a good-sized position in bonds issued by the German Central Bank. The bonds pay low interest rates of no more than 4.5% annually. In spite of the low interest rates, we have been earning more than 10% a year on our German bonds.

  The payoff from owning euro bonds is the interest rate plus the change in the currency. For example, we bought some of these German bonds in 2001. At the time each U.S. dollar bought 1.1 euros. For each $1,000 that we invested we received more than 1,100 euros’ worth of bonds. When those bonds matured a year later, the 1,100 euros had grown to 1,133 euros (3% interest rate). Furthermore, the dollar had declined in value so the dollar value was almost $1,150. So in one year these euro bonds earned 3% interest plus more than 10% in currency change for a 15% return.

  To avoid being hurt by a falling U.S. currency, the goal is to escape the falling house. The protection is to own investments in nondollar currencies. A simple and effective solution is to buy non-U.S. stocks and non-U.S. bonds.

  There are two subtleties to this guidance. First, a company’s exposure to the dollar is not determined by the location of its corporate headquarters. For example, Toyota may have more exposure to the U.S. dollar than does Microsoft. Toyota sells a lot of cars in the United States, and Microsoft sells lots of software outside the United States. So the definition of a non-U.S. stock depends on the location of sales.

  Second, a declining dollar puts pressure on foreign companies. For example, the weakening dollar has made German goods less attractive and consequently fewer German workers have jobs. Remember that the U.S. current account shrinks when Americans stop buying Italian handbags and German cars. That means the companies who make Italian handbags and German cars need fewer workers. The savvy investor has to escape the effects of the falling dollar both within the United States and in
other countries.

  How much should be invested in nondollar assets? My advice for the average investor is 15% of net worth. To minimize risk of currency fluctuations, I suggest that people align their investments with their buying behavior. For example, the average American spends about 15% of her or his income on foreign goods. Thus, a completely reasonable and low-risk strategy suggests that 15% of an investor’s net worth be invested in nondollar assets. Those who want to speculate with me on a further dollar decline, and those with a taste for foreign goods, could allocate even more to foreign investments.

  Update since the First Edition

  The U.S. dollar has declined broadly and persistently since the publication of the first edition (Figure 6.5). The euro has almost doubled from 82 cents in 2000 to over $1.50. Try to name a currency that has not strengthened, and your search will underscore the breadth of the dollar’s decline. Furthermore, while the decline against paper currencies has been broad and deep, the decline against commodities, including gold, oil, soybeans, and wheat, has been far greater.