Running Money, page 24
Still, the paradox lingers (appropriate salivating Pavlovian response). A thousand of our dollars flow out of the U.S. while only $350 flow back in, multiplied 50 million times for each PC and laptop sold in the U.S. Traditional economic theory suggests the dollar should fall in value until trade balances. But as Deep Throat once said and Mr. Zed paraphrased, “Follow the money.” Where is it? Where’d it go?
Well, the $650 difference has gotta go somewhere. It is assumed that it all sits in a central bank in Japan or Korea and is loaned out to local businessmen. Of course, that’s their problem. In the past, they rarely found a business or a building that they didn’t want to fund. It is almost as if their banks’ only function was to create nonperforming loans.
Fortunately, capital sloshes around the globe to seek its highest return. Over time, capital looks at the $300 in margin versus $50, and the decision is not a difficult one. Those same dollars that we ship out to pay for our laptops and DVD players and Mercedes S-class eventually come back home, into the U.S., where they are welcomed with open arms. It’s not because we somehow insist on those dollars back or beg for those dollars back; they naturally return.
Most of those returning dollars buy U.S. Treasuries, which are backed by the tax payments from the high wages that high-margin businesses pay to programmers and engineers versus low-paid factory workers. So far, so good. Foreigners own something like 45% of all Treasuries, some as reserves for their central banks in lieu of gold.
Some of those dollars, which are more risk tolerant, buy corporate debt. But the real smart dollars are invested in the high-margin businesses directly. Those dollars can and do buy Intel stock or Microsoft stock. Directly and indirectly, those dollars invest in a high-margin economy.
In fact, when they don’t, and invest at home, they almost always screw up. Not just the bank loan problems of Japan, but witness the Korean mess in 1998, which helped provide an introduction for me to Ssangyong.
The biggest problem with our trade deficits is that too many of our dollars get sold and converted into local currencies, like yen or baht or renminbi, creating overheated economies and overinvestment in the same old low-margin manufacturing companies.
They’ll figure it out. In the old days of the gold standard, countries were supposed to ship gold out to cover trade deficits. But everybody cheated, and as economists called it, sanitized their gold by printing more local currencies.
As far as I can tell, U.S. dollars are the new gold.
The old industrial model says trade deficits lead to a lower dollar. But that makes those imported cars and laptops and textiles and everything else from overseas more expensive and therefore less competitive. What good is that? Oh yeah, to save those NUMMI jobs. Yuck.
The message is real simple: Don’t convert our dollars into your currency, that’s what drives the dollar down. Instead, you should be intervening in the foreign markets and buying dollars, buying Treasuries, buying our stocks, if for no other reason than that is where the return is. Plus, it keeps your currency lower and your goods more competitive.
Sanitize or dry your eyes.
The Japanese finally figured this out in 2003 and are on the road to an economic recovery. George Soros and packs of New York hedgies may even figure this out someday.
In other words, we send them dollars to pay for all that great consumer stuff, you know, those nice 50-inch TVs and Toyotas and all, but they need to, in one form or another, send back all those dollars! And the sooner they do, the better off they will be!
Still, there is another paradox (drool). With those currency flows, foreigners will eventually own the entire U.S., or hold us hostage by threatening not to loan us anymore, i.e., not send our dollars back.
But the stock market is not 1:1—it is not a zero sum game. So those deaf, dumb and blind economists can’t find the capital flows. One million dollars invested in a stock can make the stock go up by $10 million or even $100 million in value on a slow afternoon.
Money flowing from overseas back into the U.S. stock market may not even cause a loss of ownership. Foreigners may always own 13% of U.S. stocks, as they do now, because they are not the only ones investing. U.S. investors are investing their excess income in the stock market. Stock options distribute equity to new workers. I assume that someone will wake up to this model and make Social Security an equity program as well. I’m supposed to be unemotional about this (I run a hedge fund, remember), but no one I know thinks they will ever see a penny from Social Security.
The paradox is resolved by putting the egg before the cart, er, chicken, where it belongs. We are not a bunch of gluttonous consumers who are mortgaging away our future by overindulging and running huge deficits in foreign goods. Instead, the U.S. turns out high-margin intellectual property that the rest of the world uses to build finished products for the American market and for their own market. The trade surpluses that foreign countries run are their way of paying the U.S. for this stuff. We may run trade deficits, but we have more margin than they do. (So there.)
In fact, we are running a surplus. Hmmm, let’s say we are running a margin surplus. As Jon Lovitz would say, “Yeah, a margin surplus, that’s the ticket.”
The U.S. has high margins not because we are exploiting the poor and downtrodden. Our stuff serves some useful purpose that the market sets a high value on—sorting tickets, moving messages, making cheap phone calls, shrinking tumors, lowering cholesterol or making us laugh at the movies.
The excess dollars that flow out of the U.S. create jobs around the world. In fact, they probably are creating a middle class in countries that never had a middle class before. Making stuff for us is a great way to end poverty in China and a few dozen African countries. But those outward-bound dollars that confuse everyone as deficits are in reality capital that gets reinvested back into the U.S. stock market. The virtuous circle is that this lowers the cost of capital for these same high-margin companies. Five hundred million dollars in trade deficits might actually create several trillion dollars in stock market wealth. So what’s wrong with trade deficits again?
And the great thing about foreigners owning U.S. Treasuries is that I don’t have to. Why earn only 3% or 6% or wherever they head to, when I can make 20% or 40% or a factor of 10 over 5 years investing in high-margin companies?
One more paradox. Economists love to focus on things like capacity utilization and output gap. The closer we are to full utilization, the more likely stock-market-killing inflation kicks in. Again, this is industrial thinking. In an intellectual property economy, there are few limits. Another copy of Windows costs almost nothing. Another Viagra pill has almost zero marginal cost. Another Lord of the Rings DVD costs 50 cents. This is why companies love to sell their IP overseas; it is an untapped market.
Inflation happens when you run out of supply of lumber or ethylene or oil. IP comes from a bottomless well. You only run out of usefulness. There is an infinite supply of DOS operating systems too, but no one wants them.
There is also an infinite supply of intellectual property for those that don’t want to pay—call it HIP, hot intellectual property. More of a “We think, they steal…no sweat.”
It’s a problem with no good solution. Pirates used to rule the high seas, pillaging early industrial trade until the British and American navies put a stop to it and new laws were put in place (and a few pirates walked the gangplank). I watched C-Cube make a fortune enabling video CD players that took advantage of pirated movies in China. And our fund did well with Elantec, which sold a $2 diode driver that was suddenly in huge demand after Napster turned moms and pops and kiddies into music pirates. You’ve got to invest around the problem, before and if property protection laws are ever fixed. Again, it’s one of those unemotional things. I have a feeling once this margin surplus concept is understood and how important intellectual property is to American wealth, a few modern pirates will walk the virtual gangplank, and investing in intellectual property will be much more straightforward.
The more I think about it, the more I like this margin surplus thing. And now, all I have to do is get in the way of a couple of interesting and probably ever-changing companies with pieces of high-margin intellectual property and I will have discovered the fountain of wealth. Why didn’t I figure this out years ago?
J-Curve
“You’re wrong, really wrong,” he told me. Ouch. That stings.
“But my point is that we are in a different world. All the existing rules are built around an industrial economy, and we are now in an intellectual property economy,” I replied.
“Oh, so, you are trying to pitch me the ‘it’s different this time’ nonsense?”
“No, it’s not different this time. It’s one of those ‘I see, said the blind man, as he picked up an ax and saw.’”
“Huh?”
“You see, the dollar is the new gold, and we export IP and import finished goods, and the difference ends up in our stock market and—”
“You are forgetting the J-curve.”
“The what?”
“Oh, you rookies always forget the important stuff. The J-curve just snapped you in the ass.”
I received an invitation via e-mail to attend the Annual Monterey Conference on the future of the euro. Alan Greenspan was scheduled to speak. So were the heads of the IMF, World Bank and the central bank of most European countries. I’d never been to the Monterey conference on currencies, so I thought it might be a great place to test my theory out on those that did attend the conference. Plus Monterey is only 45 minutes from my home. I could drive there, blast the group with my knowledge and then scram for home, hit and run economics.
So I sent an e-mail to Jim D. with a proposal for a talk at the Monterey Conference, titled “The Margin Surplus: Why It’s Imperative to Drive a Beemer, Tote a Toshiba Laptop and Watch a Big-Ass Sony TV.” That ought to shake ’em up.
The premise was real simple, my rudely named “we think, they sweat.” We export intellectual property from high-margin companies and on and on. The conclusion was simple—the dollar probably needs to go up, not down, to close the trade deficit, exactly the opposite of what economists think.
“First of all, it’s the Monetary Conference, not the Monterey Conference. It’s in Washington, D.C.,” Jim D. said.
“Oh, momentary dyslexia, sorry.”
“And you really need to read up on the J-curve.”
“And you on the scale,” I threw back at him.
“Huh?” he said. “Look, I generally agree with most of your points. However, you need to be careful with your point that the only way to lower trade deficits is to have the dollar go up.”
“But it works,” I insisted.
“Only for a little. The so-called J-curve accounts for the fact that the initial effect of an appreciation of the dollar is to decrease the trade deficit—because at the higher exchange rate, the value of sales to foreigners increases relative to the value of our imports.”
“Sure, because…”
“But over time, because our goods are more expensive, foreign demand for U.S. goods will fall and the deficit will increase.”
“That’s the industrial model.”
“That’s how trade works and has for hundreds of years. The mirror image of all this, of course, will be a capital account surplus. Meaning foreigners have to invest in the U.S. in order to balance our trade deficits.”
“But it’s the other way around,” I said. “We run a capital account surplus, not because we run trade deficits, but so we can run deficits.”
“I guess you’re just focusing on IP and the fact that there’s no good substitute for Wintel.”
“That’s it. There is no substitute. Same for drugs and Hollywood movies. In fact, we run deficits, on paper anyway, because we undervalue our intellectual property.”
“But the J-curve never fails.”
“It works for commodities or textiles or anything where we have to balance labor costs. But for intellectual property, the J-curve is bogus. But when there is no substitute for Windows or for a Pentium or Viagra, when the dollar goes up, Japanese need to cough up more yen, the Chinese a few more yuan, and guys named Dieter a few more euros.”
“But we operate at the discretion of foreigners investing in the U.S.,” Jim D. insisted.
“No, it’s the opposite. They have no choice but to invest in the U.S. We’ve got the margin. We ship dollars to them to pay for the Beemers and DVD players. But since we have higher margins, smart capital, return-seeking capital, not only wants to but has to invest back in the U.S., chasing our margins. This gets balanced out by the dollar reaching such heights that we no longer run deficits, meaning the value of our IP going out equals the value of the goods coming back in.”
“And the J-curve?”
“It’s our margin surplus that makes this all work. Lose that, and the J-curve is back in effect, and we are all toast and back working in auto factories.”
“See you in Monterey?” Jim D. asked.
“I thought the conference is in D.C.?” I asked.
“It is. But not with you. Thanks.”
Why It’s Imperative to Drive a Beemer, Tote a Toshiba Laptop and Watch a Big-Ass Sony TV
Mr. Zed: My grand unifying theory of why the U.S. is still the best place to invest. Rejected in D.C., but here it is:
I just love American customs and tradition. My favorite? Well, years ago, I got stuck in Detroit Rock City, on the night before Halloween, so-called Devil’s Night. The Motor City was glowing. Quite literally. It turns out that Detroit’s quaint tradition revolves around arsonists who randomly select parked cars to burn. Well, not randomly, 99.9% of the time, it is a Toyota or a BMW or other foreign-made cars (any Yugos left?) that get torched. Xenophobia? Patriotism? Loud message to job-stealing foreigners? How about just amazingly backward? These industrial-age “hoodlums” ought to be lighting up a few Fords and GMC trucks if they want to create more local jobs.
You see, car manufacturing used to be a great business. In 1962, General Motors made just over half of all cars sold in the U.S. market and had profits of $1.5 billion, the equivalent of $9 billion today. Now they are struggling to sell one in four cars and work on wafer-thin margins. But if foreigners want to bend sheet metal and tighten bolts for less than $20 per hour and still make barely 1% of sales as profit, why should we stop them? Instead of providing capital to U.S. automakers, Wall Street, as it always does, focuses on businesses that make higher returns. It’s creating its own world order.
History does rhyme. In the 20th century, the resource-rich U.S. took over leadership of the industrial era. But now it is grappling with a painful transition to an economic system based on intellectual property rather than factories. We are all used to an industrial America, the Dow Jones Industrial Average and all that. But now all of those great traditions sparked by Watt and Wilkinson are coming to an end.
There is a classic Wall Street adage that says, “Money sloshes around the globe, seeking its highest return.” It’s been sloshing away from Detroit for decades. But where is it sloshing to? That’s where I want to be.
In the U.S. the Industrial Revolution is dead. Kiss it goodbye. Heating, stirring, mixing, stamping and bolting have all been played out. These are no longer things that make America great. Instead it’s, uh, thinking. I know what you’re thinking, “Why didn’t I think of that?” It’s what people who think they are smart call intellectual property. This IP is the Silicon Valley model.
But how did we get here? The biggest change since World War II is that design and manufacture are no longer linked. Computers and communications move designs around in nanoseconds, while industrial-era factories locate near cheap labor.
A computer on a chip, an operating system, a wireless packet switching network—these are all highly intelligent properties that come from mind instead of matter. But so is a Nike swoosh, an anti-intelligent Adam Sandler movie or Baywatch rerun, a pill to stop the runs from eating a Happy Meal, Vanilla Diet Coke and a venti double decaf blended caramel macchiato with a twist at Starbucks.
The 225-year-old Industrial Revolution never did burn out but merely faded away into a pit of profitlessness. On the flip side, intellectual property is highly profitable, which makes Wall Street squeal with delight. Money would flow uphill, if it had to, to fund these high-margin intellectual enterprises. Money sloshes to margin!
The stock market sorts all this stuff out. A stock is nothing more than the current value of a company’s future profits. Capital sloshing around, seeking its highest return, naturally funds highly profitable companies.
General Motors’ days were numbered when Wall Street figured out the company couldn’t dominate as they did back in 1962. GM should have been creating subsidiaries in Japan rather than trying to keep Japanese imports out of the U.S. Wall Street probably would have provided them all the capital they wanted.
As the Pink Panther Inspector Clouseau said when told, “That’s a priceless Steinway baby grand piano,” right after he had smashed it with a knight’s chalice stuck on his arm: “Nuut anymeure.”
Give GM expansion capital? Not anymore. Over time, stock markets are all-knowing and very persuasive. It’s the stock market that is leading the change to the intellectual property economy we are in today, by canceling the credit cards of companies that don’t fit the model. You have to squint to see it happening now, but it will be more and more obvious every day.
