Capital Surplus

Capital Surplus: Cerebral Striptease
(Edited) by Eric J. Fry
The Rude Awakening
Wall Street, New York
Thursday, December 29, 2005

Eric Fry presents the beginning of a debate among, among others, Chris Mayer, Dan Denning, and Justice Litle on, among other things, the US trade deficit and the Capital Surplus.

-------------------------

-------------------------

Eric Fry, reporting from America's financial nerve
center...

Sorry ladies, there will be no "Boys of the Rude Awakening"
calendar this year. But honestly, with the exception of
Aussie surfer, Joel Bowman, the boys' minds are much
prettier than their bodies...(and Joel has a beautiful
mind!)

Instead, we bring you an extended email debate among the
Boys of the Rude Awakening...just to expose a small slice
of their sexy minds.

For more than three weeks, Chris Mayer (editor of Capital &
Crisis), Justice Litle (editor of Outstanding Investments),
Dan Denning (editor of Strategic Investments), Byron King
(contributing editor of Whiskey and Gunpowder), William
Bonner (editor of the Daily Reckoning) and Addison Wiggin
(co-editor of the Daily Reckoning) have been debating the
gravity and the implications of America's titanic current
account deficit.

Based on the latest data, the U.S. current account deficit
is running close to $800 billion per year, or more than 7%
of GDP. Those are very big numbers.

Traditional macro-economic thought considered massive
current account deficits to be undesirable, if not
catastrophic. But the "new think," advanced by folks like
Charles and Louis-Vincent Gave in their book, "Our Brave
New World," asserts that current account deficits – even
great, big American-style deficits – reflect economic
vitality. In other words, they are a good thing.

"The current account," the thoroughly modern authors
assert, "in countries with well developed financial markets
(US, UK, HK etc.) should always be in deficit, and
massively so."

Continuing this line of thought, Prof. Thorsten Polleit
writes, "Under the prevailing flexible exchange rate
regime, the US trade deficit should not be viewed as a
worrisome economic 'imbalance' that will inevitably have to
be corrected. So far, the US trade deficit seems to be a
reflection of the US economy's strength vis-à-vis its
trading partners. And it might well be that the US trade
deficit will continue to widen in the coming years - which
would be the case if the United States' trading partners
prove to be unsuccessful in making their economies more
conducive to investment and growth compared with the status
quo.

"So the essential issue about the future of the US trade
deficit is whether and how the current relative growth
performance constellation in the world trading system will
be changing in the coming years. As long as the United
States keeps its preference for a free market regime, it
might well retain, or even increase, its competitive
advantage in allocating scare resources more efficiently
than currency areas where relatively wide-spread government
interventions have become a characteristic of societal
organization. In today's world of flexible exchange rates,
the United States' competitive edge is reflected by a
capital surplus, i.e., a trade deficit." (Please find the
rest of Prof. Polleit's article here:
www.mises.org/story/1955).

Um...okay.

Notwithstanding their clever arguments, Messrs. Paillet,
Gave and Gave failed to persuade your New York editor that
large current account deficits have become desirable
national attributes. But the trio did succeed in inspiring
an impassioned debate among the Boys of the Rude Awakening.

So without further ado, let the cerebral strip-tease
begin....

--- Advertisement ---

Tune into the 11 Hottest predictions of 2006, right here.

Imagine the money you could have made had you known the
trends of 2005 at the beginning of the year.

Listen in on the biggest financial minds discussing the
greatest trends for the year ahead.

This time-sensitive information is available only until
Jan. 2nd, 2006, when it will be withdrawn from the web.

Click here to learn more.

http://www.agora-inc.com/reports/400SPRED/E400FC33

-------------------------

Cerebral Striptease
Edited by Eric J. Fry

"Hey gang," Chris Mayer wrote on December 5th, "What do you
guys think of these 'new era' rationalizations of the U.S.
trade deficit? I am intrigued by the arguments advanced by
GaveKal (Charles and Louis-Vincent Gave), but not entirely
persuaded by them."

Justice Litle, editor of Outstanding Investments, replied
almost immediately:

"I like the Gavekal analogy of the US as a giant hedge fund
-- i.e. we take in the world's capital, leverage it up
through use of debt, and take a management profit based on
our skilled allocation efforts.

"A good hedge fund manager will always have a 'current
account deficit' in the sense that he will always be
working with a 'capital surplus' of investor funds.  If a
hedge fund manager starts with $10 million of his own
money, then takes in $90 million of investors' money into a
fund with $100MM, he has a 'capital surplus' of $90MM and a
'current account deficit' of the same amount. The same can
be argued for the US when it takes in foreign investor
capital -- we are allocating it, like the hedge fund
manager, and taking a management cut. This works well as
long as we are making a profit on our investments.

"But -- and it's a very big but -- this argument relies on
the notion that the money is being invested wisely for
future returns. It goes back to the fact that there is good
debt and bad debt. If you or I borrow a large sum of money
and invest that sum of money productively, we will see a
return on investment above and beyond our borrowing costs -
- a profitable result. Alternatively, if we borrow a sum of
money and spend it frivolously, we will not see a long term
return above carrying costs -- an unprofitable result.

Capital Surplus: Verify, Verify, Verify

"Those who advise us not to worry about the trade deficit
imply that the money we borrow is being put to good use.
But that is an assumption that has to be verified!  Maybe
we are borrowing from the world in order to create the next
generation of Microsofts and Intels.  But it might be true
we are just spending the dough on Winnebagos and beer. 

"Also concerning the capital surplus, there is a difference
between inflows of FDI (foreign direct investment) and
inflows going into Treasuries... If the current account
deficit is offset by foreign investor stock market
purchases, that's one thing. If it is offset by central
bank Treasury bond purchases, that is wholly another.  The
end number looks the same, but they are two different
animals.

"When we send a trillion bucks to the Middle East to buy
oil, they can swap out that trillion for investable US
assets (US real estate, Exxon stock etc) or they can swap
it out for US debt (treasury bonds, mortgage swaps etc). 
In both cases the 'capital surplus' argument can be made... 
but if the Middle East is buying debt instead of assets,
that is a distinctly inferior situation. When global
investors put their money in US debt, they are not
investing it so much as 'parking' it. 

"That's why a big buildup of foreign debt holdings is a bit
like the sword of Damocles. If interest rate differentials
shift enough, or superior investment opportunities pop up
elsewhere in the world, foreign investors' desire to hold
large chunks of US debt may suddenly disappear. It's not
the same as having shareholders enthused about your long-
term prospects.

"If the US were showing signs of allocating capital
efficiently -- a healthy stock market, strong FDI flows,
intelligent immigration policies spurring innovation etc --
then a massive trade deficit wouldn't be a big deal. We
would simply be the good hedge fund manager, allocating the
world's capital efficiently for a high-quality return. 

"But when much of the world's capital is being parked in US
Treasuries rather than wealth-building entities, and when
we are spending like mad at home on flat-screen TVs and I-
pods, and US stocks have dangerous valuations and
entitlement programs are looming large, it is hard to be
sanguine about the deficit. In this case, the capital
account surplus looks more like a bulge of borrowed money,
parked in Treasuries that could be quickly 'unparked' at
any given time. 

"And this is really what the globalization argument comes
down to. Those who say 'don't worry' are implicitly saying
America will continue to be innovative enough to get a
superior rate of return on its long-term investments...
that our status as top-notch allocators is a given. But is
it? A competitive edge cannot be assumed permanent. No
hedge fund manager gets a free pass; the manager must
continue to make the grade in terms of his allocation
decisions. And lately, America's allocation decisions have
been alarmingly bad. Not predicting that we'll definitely
lose our edge, but we certainly haven't done the greatest
job of enhancing or preserving it."

Capital Surplus: Efficient Allocation

Then Dan Denning entered the fray:

"Good point by Justice. Just how efficiently have we really
been allocating this so-called capital surplus? Not very,
at least if the equity markets are any judge. What assets
have we created with this huge bounty of capital...assets
that create a new stream of income and employment in the
economy? What, in other words, is our return on this
capital?

"It's really almost laughable the lengths some people are
going to make what to me seems a completely absurd
argument: we can sustain and grow an economy of 300 million
people chiefly by adding value to the world's economy as
great allocators of capital.
 
"'Give us your tired, huddled masses of savings, yearning
to earn a high yield,' we tell the world. Yet our
businesses sit on huge cash surpluses, with nothing to
invest in apparently. Not new capacity. Not new employment.
Not research and development. How is business sitting on a
huge pile of cash like that an efficient allocation of
capital? I suppose it's better to sit on it that lose it,
and efficient in that sense, but still...
 
"Even the metaphor that America has become a giant hedge
fund gives the game away...this amounts to the
financialization of economy. Which is another way of saying
we haven't generated a genuine capital surplus...we've
generated a huge sum of excess and enormously unproductive
liquidity which, more than anything, is a MIS-allocation of
capital.
 
"This isn't a new-era model for adding value in a post-
industrial world. It's a lame-brained way to apologize for
an enormously destructive monetary policy and the inane
idea that an entire country can get rich simply by having
better ideas--without making or trading anything.
 
"I'm not saying that some industries or companies can make
a living on value-added intellectual innovation. But an
entire economy? Please....
 
"The only real innovation we need in America is one in our
economic thinking: that saving and investing and producing
are preferable, and yes, I'll say it, morally better for us
than spending and consuming. No amount of clever phrasing
about a new era can change that. This is just the lame-
brained new era thinking revisited and dressed in fancier
clothes, designed to look more respectable and be more
intellectually baffling, and thus harder to disagree with.
 
"But I'll tell you what I really think it is, a huge con
job."

"I have to say, from my perspective of looking at hundreds
of individual companies, that I don't see any loss of
competitiveness. Many of the US companies I see have great
balance sheets, lots of cash, high profit margins and good
returns on equity.
 
"You can argue that the stock market is over-valued (I
think it is), but it's a different argument to say US
companies are poor asset allocators. I don't think that's
the case - again, as a broad generalization.
 
"They have lots of cash for good reasons - US profit
margins are as high as they have been in a decade. They
are, generally speaking, making lots of money.
 
"What to do with it? That was the topic of my last issue.
I'm betting we'll see a lot more 'corporate events' and
shareholder activism. We're already seeing battles pitched
for that pile of cash between activists and management.
We're seeing record high buybacks, lots of dividend
increases... even in my own (small) model portfolio, we've
had three separate companies announce special dividends.
I've had one buyout. The pressure is building.
 
"Some industries are losing competitiveness - automotive,
basic manufacturing, and such. But this has been going on
for a long time - and it's to be expected. The fact that
these businesses go out of business and lose jobs is ipso
facto evidence that the US market collectively is a fairly
good allocator of capital. Capital is not allowed to sit in
losing businesses for long."
 
To be continued....

[Joel's Note: What do we do with a recording of the hottest
investment trends coming in 2006? We post it on the web for
you to listen to, of course. Eric, Justice, Chris and a
host of our editors got together recently to discuss and
record their financial predictions for the new year. You
can access this 'webinar' by clicking below.

The 11 Hottest Investment Trends of 2006 – Right Here
http://www.agora-inc.com/reports/400SPRED/E400FC33

--- Advertisement ---

Profit in the coming year from the number one financial
letter of the last 5 years.

Outstanding Investments has recently been voted the top-
performing financial newsletter of the last five years by
the Hulbert Financial Digest.

But the news is not all cheery. The "Petrol Apocalypse" is
on its way...find out what all the fuss is about right
here.

The Coming "Petrocalypse"
http://www.isecureonline.com/Reports/OST/EOSTFC25/

-------------------------

[Joel's final utterance: Following Tuesday's essay on the
value of the debate, I got some wonderful emails from
readers, keen to enlighten their antipodean editor with a
vast array of informative websites. Thanks to all those who
wrote in. I have included below a few of the most popular
for you to read through at your leisure. Please note
though, these websites do not (necessarily) represent the
opinions of your Rude team...

Mike wrote in with these suggestions:

"http://www.accidentalconsultant.blogspot.com/

Strange guy...interesting views

http://www.lileks.com/

Lileks pounds out 5-8 newspaper columns a week - this
is what he knocks out in his spare time - most
publishers would pay a hansome penny to print this
stuff.

http://www.aldaily.com/

Regardless of political persuasion, views on science
or religion, Arts & Letters brings together some of
the best writing available on the Net today.

http://www.brusselsjournal.com/

The EU is a strange and mysterious animal to most
Americans. This blog demonstrates why - and why even
Europeans don't know what the hell is going on.

MT"

Some interesting reads in there. David had these to
contribute:

"Dear Joel, 
 
Here is my list of favorites. 
 
http://www.financialsense.com/
 
I am sure you know this one. 
 
http://www.bullandbearwise.com/
 
Another great site for quick information on financial
issues. 
 
http://www.oil.com/
 
So, so, but the main stream site for oil. Regards, David." 
 
If you have a favorite blog or website that you visit, you
can share them with me, your knowledge-seeking junior
editor, at aussiejoel@the-rude-awakening.com

Enjoy the rest of your day and be sure to stay tuned for
part II of the "Cerebral Striptease" debate tomorrow.

Cheers,

jOEL

And the Markets...

	Wednesday	Tuesday	This week	Year-to-Date
DOW	10,796	10,778	-87	0.1%
S&P	1,258	1,257	-10	3.8%
NASDAQ	2,229	2,227	-20	2.5%
10-year Treasury	4.37	4.34	-1.00	4.33
30-year Treasury	4.53	4.50	-2.00	4.48
Russell 2000	680	677	-6	4.4%
Gold	$516.60	$508.00	$13.81	18.1%
Silver	$8.91	$8.71	$0.34	30.8%
CRB	329.32	324.59	3.01	16.0%
WTI NYMEX CRUDE	$60.07	$57.86	$1.64	38.3%
Yen (YEN/USD)	JPY 117.93	JPY 117.42	-1.70	-15.0%
Dollar (USD/EUR)	$1.1831	$1.1834	43	12.7%
Dollar (USD/GBP)	$1.7166	$1.7280	182	10.5%