Smoot-Hawley Lives

John Mauldin | Thoughts from the Frontline
March 10, 2006

This week we look into my worry closet and ponder whether the Dubai port debacle is a one-off thing or does it signal a rise in protectionism. The recent polls suggest I will upset about 90% of you, but I look at the deal from the very negative economic impact it could have on this country. We then briefly look at the potential for more Fed rate increases and at a disturbing Federal Reserve Bank report on US wealth.

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Smoot-Hawley Lives

Long-time readers know that I do not think the world is going to devolve into a soft depression because of the imbalances in our trade deficit and our large and growing debt. Those will have to be dealt with, of course, but I think it will happen in the normal context of the business cycle. A recession here, a falling dollar there, and slower than trend average US growth over the next 5 years or so and we get to where the re-set button has been hit. It will not be fun, but it will not be the end of the world. It is what I call the Muddle Through Economy. I am actually quite optimistic about the investment opportunities once we get through that period, with the usual caveats and asterisks.

But I have maintained for many years that the one thing that could change my basic optimism is a new wave of protectionism. Senator Smoot and Representative Hawley infamously sponsored a bill in 1930 that raised tariffs on a variety of products in order to "protect" American jobs. Of course, the rest of the world retaliated and soon we went from a recession into a global Depression. Unemployment soared and all those jobs we "saved" went away.

Recessions are part of the business cycle. The Fed cannot stop one, try though it might, nor can Congress write legislation outlawing recessions. And in the main, and with a few exceptions, they have not on balance been all that bad. One can make the argument that they are needed to correct imbalances and "irrational exuberances" here and there. Typically, unemployment rises a few percent but comes back in a few years, the stock market falls but comes back and profits fall but go on to make new highs after the "reset" button is hit.

I am not trying to be cavalier. If it is your job or investment or profits that get hit, it can mean some very long and sleepless nights. Been there. Done that. But for the vast majority of US citizens, the last recession had little effect. Unemployment never rose above 7%, and corporate profits came back quite strong. The next recession may be worse, but it will end soon enough. That is the way of the business cycle.

But while recessions are part and parcel of the economic cycle, it takes a government to really mess things up and create a Depression. Show me a depression (not a shorter term recession!) in a free society that was not the result of government incompetence or some form of direct government involvement. You can't. Usually they are the result of multiple and coordinated government groups all working together to make things better and having the opposite effect.

Yes, I suppose you could say that Smoot and Hawley were just responding to the zeitgeist of the times, that the voters were demanding their jobs be protected, so that the American people got what they deserved, but Congress and the Fed aided and abetted. President Hoover should have used a veto. For that alone, he deserved to be defeated two years later.

This week, an updated version of Smoot and Hawley's Congress put together a veto proof gaggle to stop the United Arab Emirates from buying a British port management company that ran six of our nation's ports. Security was the ostensible reason, but anyone who did their homework knows that national security on any level was never at risk. This congressional tantrum bothers me on several levels.

Our ports are run by a number of companies that are not US based companies. Five ports have Danish firms running them, for instance. Two are run by the Chinese. Basically these companies move freight. Pick it up here and put it there. They have nothing to do with port security. Port security is the province of US Customs and the Coast Guard. And they hire American union workers.

The U.A.E may be the largest non-US port service for the US Navy in the world, based in Dubai. They are a solid ally and a voice of moderation and stability in an area of the world where such is needed.

There is a process where foreign investments in the US that have security implications are brought before the Committee on Foreign Investment in the US or CFIUS. This governmental inter-agency group looks at the investments and if one of them sees a red flag, they run it further up the command chain. This was an investment that was thoroughly investigated and caused no concern and it was approved. And then some politicians saw an opportunity for political gain.

Now, someone in the administration at the middle levels should have seen the political implications of this deal. Sadly, the Bush administration does not do a good job of explaining their policies. This should have privately been run up to Congress and vetted there before the approval went through. So, a lot of the blame should be laid onto the Administration for having a "tin ear."

Bi-Partisan Idiocy

The next thing we know, talk radio is going over the edge, calls into Republican congressmen are running 9-1 against the deal in an election year that looks tough for them to begin with, Democratic Congressmen see a chance to appear concerned about national security and really tweak the President and before you know it, there is a move to stop the deal.

There is a reason for the CFIUS process. It works and it keeps politics more or less out of business deals. But now, Congress has learned it can basically look at any deal and say it is against the national interest for some foreign company to buy a US company. And every tin pot congressman who wants to posture in front of a camera and who has a company in his district that becomes a target will now want to get involved. Companies that lose a bidding war or that have an axe to grind will complain to Congress. "I don't want that foreign company competing on my turf and taking US jobs from my employees!" Shades of Smoot-Hawley!

We have spend decades persuading nations around the world to open up their countries to investment. And they have. We have over $10 trillion invested outside of the US, which made American firms $500 billion last year, a little under 5% of our GDP! That is about $1,600 for every man, woman and child in the US. (WSJ) That money gets paid out as dividends, gets invested in our economy and goes to pay our workers.

Last year, foreigners increased their investments in the US by $1.4 trillion, in a wide variety of investments. Without those dollars, the US dollar would have collapsed, interest rates would be through the roof and we would be facing (or in!) a REAL recession, not the garden variety ones we have had since 1990.

"A study by the Organization for International Investments finds that about 5.3 million Americans are directly employed by foreign owned firms with wages averaging $63,000, or about 50% more than the average US wage. Foreigners are not buying up America's wealth; they are investing in ways that add to it." (WSJ)

That means that about 8% of American workers are employed by foreign owned companies. You can bet they are happy they have the higher paying jobs. If not, they would simply leave. But the line for those high paying jobs is long.

But now, there are those in Congress who would like to stop that wealth and job creating foreign investment.

"In recent weeks Members of Congress have suggested that the foreign-ownership ban should apply to roads, telecommunications, airlines, broadcasting, shipping, technology firms, water facilities, buildings, real estate and even US Treasury securities." (The Wall Street Journal editorial, March 10, 2006)

How does this sound to those nations that we are trying to get to open up to US investments? Why should they cooperate id we re not going to practice what we preach, when it is in our clear interest to do so?

If this was just the U.A.E. deal, I could rest easier. But last year it was the dust-up over China buying a mid-size US oil company that had relatively little US production. We have Senators Charles (Smoot) Schumer and Lindsey (Hawley) Graham cooperating in a bit of bi-partisan idiocy to try and put a 27% tariff on Chinese goods.

And let's be blunt. To suggest such a thing demonstrates either astounding economic ignorance or simple political pandering of the worst kind. Probably both. Do we really want to raise the price of everything from China by 27%? On items that we no longer make here? Do we want to risk the start another trade war? Or have the Chinese stop buying US Treasuries? Can you say recession, boys and girls?

The Rise of Economic Nationalism

But it is not just the US where economic nationalism is on the rise. Good friend and uber-pessimist Bill Bonner writes yesterday:

"The votes are in...the House Appropriations Committee voted 62-2 to bar Dubai Ports World, a United Arab Emirates backed company, from holding contracts at U.S. ports.

" 'This is a national security issue,' said Rep. Jerry Lewis, the chairman of the House panel, adding that the legislation would, 'keep American ports in American hands.'

"Well, as patriotic as that sounds, the London-based Peninsular & Oriental Navigation Company previously owned the five U.S. ports in question. Last we checked, London was in Great Britain, not America. And what about the other foreign-operated shipping terminals in the United States? China already runs a terminal at the Port of Los Angeles and Singapore runs terminals in Oakland...are we going to shut those down?

"Another major detail the House seems to have conveniently overlooked - the UAE are our allies. U.S. Navy ships call at the port of Dubai, and the U.S. Air Force uses UAE airfields to launch missions into Iraq and Afghanistan. In addition, the UAE donated $100 million to Katrina relief - more than four times any other countries contribution combined.

" 'The lopsided House committee vote shows that the bull market in economic nationalism rolls on,' says Capital and Crisis' Chris Mayer.

" 'Not only in the United States, but abroad as well. We have the French government trying to block an Italian bid for Suez. We have the Spanish government trying to block a German bid for Endesa. We have the Polish government trying to quash an Italian takeover of a German bank because it involves Polish subsidiaries...

" 'This is starting to sound like a joke. But it's real and a new global depression hangs in the balance. The more governments push, the closer we get to the edge of a very mean cliff...'"

If there are national security concerns about a foreign investor, I am all for blocking a deal. But short of that, when you get a government meddling in the free market, the real loser will be the investors and workers in that country. There is a reason that much of the rest of the developed world grows at a much slower pace than the US. But it seems Congress is going to try and fix that. If some members had their way, we could really slow things down!

The need for politicians to show their constituents they are "concerned" is very large. So now that politicians have seen that foreign investing is a "hot button," my first concern is that Congress for purely political reasons will try to put their nose into every deal involving foreign investment, slowing the wheels of commerce. The foreign company has no votes in the district, but a call to protect American jobs or companies sounds all too reasonable to the average voter who has no more understanding than the average congressman about how the world economy actually works - about how foreign investment is critical to our economic well-being. That will drive down bids for US property of all sorts, as what foreign entity will want to put itself through that emotional wringer, not to mention the extra cost?

Secondly, I am concerned about the lesson we are sending to trading partners around the world. It is ok for Americans to invest in your countries and sell your products we make here, but you cannot do the same? These things get emotional all too quickly, witness the short fuse on the U.A.E port deal.

The Bush administration needs to become much better at making the case for free trade. Where is free trade Bill Clinton when you need him? Oh, he was literally advising the U.A.E. (who pay him hundreds of thousands for speeches) on how to deal with the port issue while his wife was calling for the deal to be stopped. Memo to Bill: call home every now and then and coordinate policy with the next Clinton about to run for President. And maybe tell her why free trade is a positive for the country. She has a better than running shot at being president, so that is important.

And finally, I am very concerned about the message this sends to the Islamic world. This note from George Friedman of Stratfor came in about 6 pm tonight while I was writing, which briefly and eloquently analyzes the problem.(Stratfor is my main source for international political analysis. www.stratfor.com.)

"The United Arab Emirates (UAE) state-owned firm Dubai Ports World (DPW) reacted to opposition from the U.S. Congress by announcing March 9 it would transfer control of six U.S. ports to a U.S-based entity. The next day, U.S. President George W. Bush said he was concerned about regional fallout from the way in which DPW was forced to back down. Bush said the deal's failure could send a broader message to U.S. allies in the world, particularly in the Middle East, and added that to win the 'war on terror' Washington must strengthen its ties with moderate Arab countries in the Middle East.

"Bush is right about the repercussions this development could have on U.S. interests at a time when Washington is trying to prosecute its war against jihadism and when relations between the West and the Islamic world continue to deteriorate. Though governments in the Persian Gulf region and beyond -- including the UAE -- will remain U.S. allies, the port deal's death will enhance anti-U.S. and anti-Western sentiments among the people. Radical and militant Islamists can manipulate those sentiments, raising the probability of violence in countries prosperous and stable enough to have resisted radical Islamist and jihadist impulses thus far.

"It should be noted that the UAE is among the few places in the Middle East that comes close to resembling a Western country. It is one of the few countries in the region that might qualify as a U.S. ally on a standard other than energy and security.

"Radical Islamist activists and jihadist operators, in an effort to gain a foothold in such countries, will try to take advantage of the situation by arguing that no amount of wealth or cooperation will make them respected in the eyes of the United States or the West. These Islamists likely will convince many that moderation and alignment with the West has not paid off because the West will always look down on Arabs and Muslims. They will also try to promote the view that in the end, the West will always view Arabs and Muslims -- whether radical or moderate -- as the proverbial 'other.'

"This propaganda will feed on existing frustrations and anger against the West because of the invasions of Afghanistan and Iraq, the Quran desecration scandal, the Abu Ghraib torture scandal and the recent controversy over cartoons of the Prophet Mohammed. Resentment against the West for being anti-Islam and having anti-Muslim prejudices runs deep and wide in the Muslim world, beyond the Islamist and jihadist spheres of influence. Even mainstream and secular Muslims will view the UAE port deal reversal as an example of an 'Islamophobic' attitude gaining ground in the United States and Europe.

"Most Muslims will not resort to violence, but the growing anger and frustration increases the potential recruiting pool for al Qaeda and other jihadist groups. Consequently, countries like the UAE, Kuwait and Qatar, where political stability and economic prosperity have kept radical ideologies from taking hold, could become insecure. Thanks to the law of unintended consequences, the port deal's failure will result in an increased security threat -- which was the raison d'etre for opposition to the deal."

My hope and actual belief is that this will simmer down. I remember the same talk in the 70's and 80's as the Japanese started buying so much of American real estate. Remember the outcry over Pebble Beach and the Rockefeller Center? Hopefully, this too shall pass.

But if things keep going on this trend, we will look back from the dark times and point to this deal and realize this is where the lights started to go out. Shame on us.

How Far Will the Fed Go?

New York Federal Reserve President Timothy F. Geithner hinted that the Fed may have to raise rates even more because of the growing economy. "To the extent that these forces act to put downward pressure on interest rates and upward pressure on [stock, real estate and other asset] prices, they would contribute to more expansionary financial conditions ... the Fed might have to act to offset these effects." (Washington Post)

He went on to say there are reasons for low level of long term interest rates such as foreign investors buying US government debt, slower growth in the rest of the world and low inflation. Thus, he seems to be saying that the flat yield curve is not sending a warning signal.

Geithner is a voting member and the vice-chairman of the Fed Open Market Committee. What he says matters. This sounds like a man who is not convinced that one or two more rate increases will be enough, or that an inverted curve will be a problem.

With the recent increase in longer term rates, I think this will give the Fed the feeling they have room to raise rates without significantly inverting the yield curve. I continue to point out that the historical propensity for the Fed is to raise rates too much. It takes about a year for rate increases to really have an effect.

The Wealth of the American Nation

Americans are clearly the richest people on earth. Or are they? With some $50 trillion in stocks, bonds and real estate, we are watching our net worth grow each year. Some argue that the low US saving rate is not a problem as real net worth is growing fairly rapidly.

But not for the average family. A survey by the Federal Reserve Board's Survey of Consumer Finances offers us the most detailed recent look at the balance sheet of U.S. households.

The median family has about $3,800 in the bank, do not have a retirement account, has a home worth $160,000 with a mortgage of $95,000. No mutual funds, stocks or bonds populate their investment portfolios. They make (jointly) $43,000 and struggle to pay off their $2,200 in credit card debt. That means 50% of Americans are in worse shape than the above. It is not a pretty picture.

As I noted last week, "...we find that 67% of the people aged 50-64 saved less than $10,000 last year. Over 40% saved less than $1,000!!!" No wonder that most people expect to work after age 65.

March Madness Comes Home

ORU did in fact win their conference tournament, so my daughter, the captain of the cheerleaders at ORU (he says proudly), will get to do her thing at least one NCAA tournament game. They will get to be the sacrifice for some #1 or #2 seed, but they did make it to the show. Dad hopes it will be at a city that is easy to get to. Both twins will be home next week for Spring break, although Amanda will have to go back early to go with the team to wherever they play. And Abigail is bringing that special guy to spend the week. (Sigh, they grow up so fast.)

It will be a busy week. Monday is oldest daughter Tiffani's birthday, and the clan will gather. Tuesday we will watch the Dallas Mavericks play Cleveland. Should be fun watching Dirk and LeBron go at it. Then hopefully ORU will play its game in Dallas and not Dayton, so I will not have to get on a plane.

This week has been quite busy. In addition to the usual work, I am really doing a lot of reading and research on the next book. It is quite a lot of fun, actually. The world is going to be an interesting place in 20 years, and trying to figure out how we get there is a real challenge.

Have a great week!

Your waiting for baseball season to start analyst,

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