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WARREN BUFFET IS BEARISH on the United States, and he’s bullish on Europe. For the first time in his life, starting in 2002, Mr. Buffett entered the foreign exchange markets and shorted the dollar. This rare macro-economic bet was based on a belief that U.S. consumers and the U.S. government were spending beyond their means, and that the trade deficit was a sign of economic weakness.
While his short position was profitable in 2004, he has lost more than half a billion dollars so far in 2005. Some Wall Street sources suggest that his breakeven exchange rate is $1.22/euro, so with the euro trading near $1.21 in mid-June, his short position was seriously in the red.
Buffett’s anti-American investment sentiment has cost Berkshire Hathaway shareholders dearly. During the 12 months ending in mid-June, his stock price was down roughly 7 percent, while the S&P 500 was up 5 percent. The stock market voted “non” on this Berkshire investment strategy, just like the French and Dutch voted against the European constitution.
And, of course, these two developments are inextricably linked. The French voted against the constitution because they are afraid it will force them to give up their 35-hour workweek and generous social welfare system. This system forces French taxpayers to support an unemployed contingent that has reached 10 percent of the labor force.
It’s hard to figure out why Warren Buffett is so down on the U.S. economy and so enthusiastic about Europe’s. But gloom and doom forecasts about the U.S. economy are a dime-a-dozen these days. It’s as if we rolled back the clock 20 years and it’s the early 1980s all over again.
Then, it was President Reagan’s tough stance against Communism, large budget deficits, growing trade deficits, Germany, and Japan that were bothering so many pundits. Today, it is President Bush’s tough stance against terrorism, trade and budget deficits, China, and India that stir fear in the hearts of the doomsters.
The gloom and doom of the early 1980s proved to be nonsense, just as the current pessimism will prove wrong as well. Corporate profits have climbed to an all-time record high, the U.S. stock market is more undervalued than it has ever been, and the unemployment rate has fallen back to 5.1 percent.
Despite all this good news, pessimists took refuge in the belief that U.S. consumers were spending beyond their means. The data supported this view. Personal consumption in the U.S. climbed 6.3 percent during the year ending in March, while wages and salaries only climbed 5.7 percent. This divergence was enough to test even the most bullish forecaster.
BUT SOMETHING INTERESTING happened in May. The Bureau of Labor Statistics revised income statistics over the past year. New data show that wages and salaries actually climbed 7.5 percent, not 5.7 percent. This is a massive revision. It changes the entire picture. With the flick of a statistician’s pen, a big part of the doom-and-gloom story evaporated. Incomes have grown faster than spending, not the other way around.
These revisions have become commonplace as the U.S. economy becomes more difficult to measure. The government’s statistical machinery was designed in an industrial era of large enterprises, time clocks, and paternalistic corporations. Today’s economy has more small companies and self-employed entrepreneurs. Decentralization makes it harder to gather accurate measurements.
As a result, it is not for months (and sometimes years) after the fact that full information is available. In order to accurately gauge incomes, the statisticians in Washington must wait for data from the state unemployment insurance systems. New small business start-ups eventually show up on state records even if they are missed by federal statistics. And when they are finally counted, the revisions are usually positive.
The upwardly revised income statistics solve another riddle. Individual income tax revenues have grown much faster than incomes. Through May 2005 total tax revenue rose 14 percent from the same time period in 2004. Because people do not pay taxes on incomes they do not earn, the surge in tax revenues suggests that the underlying U.S. economy is much stronger than the pessimists believe.
This cannot be said for “Old Europe.” Average GDP growth has been less than half that of the U.S., while unemployment is almost double. As a percentage of GDP, budget deficits in Old Europe are larger than those in the U.S. It is these countries, not the U.S., that are profligate with spending and stingy with investment. Old Europe is slowly decaying as global competition undermines the ability of insular social welfare states to maintain the status quo.
New Europe, especially the former Soviet bloc and Ireland, are fierce competitors, willing to embrace the entrepreneurial spirit of capitalism. It is the French who want to cling to the centralized social welfare system rather than adopt the more uncertain, but certainly more successful, decentralized free-market system.
This is not what many had hoped. Conventional wisdom argued that a single European currency would force countries to move toward lower tax rates and freer capital markets. Now, some are suggesting that the failure of the constitutional votes will lead to a collapse of the euro system, and with it the pressures on the whining socialists in Europe to reform. I am not willing to go so far. Eventually, even Old Europe will be forced to change, but it won’t happen fast. I suspect the euro will survive and that New Europe will continue to lead the way.
ALL OF THIS BEGS A QUESTION: Why was the dollar so weak in the early 2000s? Because the U.S. economy was weak, or somehow unstable? Or was it that consumers and government were spending beyond their means? None of the above is the answer.
The U.S. dollar was weak as a result of an excessively accommodative monetary policy. The Fed cut the federal funds rate eleven times in 2001 and pushed it down to 1 percent by 2003. And despite a series of rate hikes, the federal funds rate has been below inflation for over two years — the longest period since the mid-1970s.
In order to hold interest rates below inflation, the Fed has forced liquidity into the economy to such an extent that it caused a drop in the value of the dollar. As in any other market, supply and demand are the dominant forces affecting the value of the dollar. The Fed has supplied more dollars than the world demanded, and the dollar dropped.
Now that the Fed is boosting interest rates, monetary policy is slowly moving back toward neutral. As this occurs the dollar will strengthen. A strong U.S. economy will help this adjustment process as well.
Being short, the dollar in this environment is not a great investment strategy. Warren Buffett should just say “non.” The French already have.
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