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425 Davis Street

Evanston, Il. 60201

January 21, 2018

Dear

The U.S. stock market has been like an amusement park roller coaster for the last thirty five years, its gyrations are summarized Figure 1. The changes in cross border investment inflows to the United States have driven the price of U.S. stocks and the price of the U.S. dollar. Your assignment is to provide an estimate of the missing value in the bottom row in column (6). Column (1) identifies the quarterly dates for the expansive phase of the U.S. capital account surplus during each decade. The capital account surplus declines in its contractive phase; the dates for each contractive phase can be inferred from the end of the expansive phase of one cycle and the beginning of the expansive phase of the next cycle. The month when the price of the U.S. dollar peaked at the end of each expansive phase is shown in column (2). The month when the Wilshire 5000 index of U.S. stock prices peaked is noted in column (3). The percentage increase in stock prices during each expansive phase is shown in column (4). The annualized percentage increase of stock prices is shown in column (5). The percentage decline in stock prices in the contractive phase is shown in column (6). The decline in U.S. GDP in the recession at the end of each contractive phase is noted in column (8).

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FIGURE 1

FEATURES OF FOUR DOLLAR U.S. CYCLES

(1) (2) (3) (4) (5) (6) (7)

DATES $PEAK W5PEK %IN AN%IN %DE GDP

1980s 3/82-3/86 2/85 8/87 295 23.7 20 -2.7

1990s 1/91-3/00 1/02 3/00 433 15.3 46 -1.2

2000s 4/01-3/06 11/05 10/07 101 14.7 53 -5.1

2010s 2/09-1/16 12/16 12/17 272* 16.0 ???

*December 2017 value

The fourth U.S. dollar cycle is still underway--the data of the transition from the expansive phase to the contractive phase may recently have passed, or may be in the is in the future. The percentage increase in U.S. stock prices will be larger than xx percent, calculated to the end of 2017, because prices have increased by five percent in the first three weeks of 2018. And the percentage decrease is still unknown.

The length of the expansive phase of each cycle is significantly longer than the contraction phase, and the annualized percentage declines in the contractive phases are significantly larger than the annualized percentage increases in the expansive phases.

The surges in stock prices in each decade have been domestic adjustments to the increase in cross border investment inflows; when these inflows slow significantly, stock prices decline. The declines in the first and second cycles were followed by modest recessions, a massive recession followed the decline at the end of the third cycle.

The 1980s surge in stock prices was followed by a decline of 30 percent, the 1990s increase by a fall of 40 percent; prices plunged 50 percent beginning in 2007. If there is a ten percentage point increase in

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each successive decline, then the next decline would be sixty percent. But it would be a mistake to jump to that conclusion. Projecting the decline in 2018 or 2019 is getting ahead of the story. The main story centers on the explanation for the pattern.

The next section of this letter reviews the prospects for U.S economic growth and global growth in 2018. Then some of the unsustainable imbalances—the large trade surpluses of Singapore and Germany, the U.S. fiscal deficit, and property prices in China--are listed. An explanation for the boom and bust cycle that is associated with the variability in cross border investment inflows is then provided.

THE GLOBAL ECONOMIC BOOM

The U.S. economy is performing on nine cylinders, there is more than full employment (although many of the xxx million working part-time would like to work full time) and the participation rate is still below its peak. There is a massive number of "help wanted" signs. Wal Mart is raising its minimum hourly wage by $2, and providing bonuses of up to $1000. Chrysler Fiat will pay a $2,000 bonus to 60,000 workers. Apple has indicated it will spend $35 billion more on U.S. investment projects. Still auto sales will decline in 2018 and consumer optimism has declined for three months.

Germany has had positive growth for the last fifteen years. Economic growth in Europe is accelerating more rapidly than in the United States.

Chinese economic accomplishments remain impressive, including the stability in its growth rate around seven percent despite the variability in some of the inputs to growth. (Several of the provinces have now admitted that they have greatly exaggerated their growth rates to meet their targets.) China's industrial sector is shrinking, steel production capacity has been significantly reduced -which implies the

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growth in the service sector must be ten or twelve percent if the national rate is seven percent

THE CATALOG OF NON-SUSTAINABLE IMBALANCES

The projections for a global boom in 2018 implicitly assume that the various non-sustainable imbalances —international payments imbalances, fiscal imbalances, mis-alignment of the prices of securities and real estate relative to their incomes--will be sustained for the next year or more. Each of these imbalances reflects that the borrowers have been able to grow their indebtedness.

The ratios of the current account surpluses to GDPs of Germany, the Netherlands, Denmark, Switzerland, and Sweden are exceptionally high relative to their rates of GDP growth and the rate of growth of global GDP--which means that eventually these countries would own all securities in the world. The same ratios for Singapore, Taiwan, Thailand, and to a lesser extent South Korea are even higher. These countries have high savings rates and are extending credit to other countries.

The mirror of these surpluses is that the United States, Canada, Britain, and the other English speaking countries--as well as Egypt and Turkey and a few other countries-- have current account deficits that are three to four percent of their GDPs. (The sum of the combined current account surpluses seems larger than the combined current account deficits--but that's another letter.) The U.S. current account deficit of $452 billion is a bit smaller than the combined surpluses of Germany ($279) and Japan ($199). China has a surplus of $122 billion or $138 billion including Hong Kong. Britain's external indebtedness is four percent of its GDP, about the same as the increase in its nominal GDP.

Bond prices are too high relative to the growth rates in the United States, Britain, Germany, and Japan compared with the long run relationships between prices and growth rates. House prices in China

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and Hong Kong are extraordinarily high relative to household incomes; the property prices are remindful of those in Japan in the late 1980s . Property prices in China morphed from measuring the cost of housing services to a store of value that increased because it had been increasing. There are several tens of millions of unoccupied apartments in China, at one stage there were ten or twelve ghost cities developed by the provincial governments. At one stage, the home purchases were financed almost exclusively with cash--although much of the cash was borrowed from family members. More recently purchases were financed with bank loans. The task for the authorities is to secure a significant increase in occupancy rate without a inducing a decline in prices. House prices in Vancouver and Toronto have become exceptionally high because of the purchasers from China.

The U.S. fiscal deficit is 3.5 percent of U.S. GDP. Perhaps there will be a surge in GDP that will validate the view of the supply-siders. The more likely case is that the ratio of the fiscal deficit to GDP will increase to 5.00 percent as a result of the reduction in tax rates in the most recent legislation. The ratio of government indebtedness in the hands of the public might increase slightly as long as nominal GDP increases by five percent a year.

CREDIT FLOWS AND BANKING CYCLES

More than sixty countries have had banking crisis since the early 1980s. Many have occurred in one of four waves—the first was in 1982 and involved Mexico, Brazil, Argentina, and ten other developing countries. The second in the early 1990s tripped Japan and two of the Nordic countries, Finland and Sweden. The Asian Financial Crisis that began in July 1997 initially caught Thailand, Indonesia, the Philippines, and Malaysia and then impacted South Korea. The fourth wave was in 2007/8, and involved the United States, Britain, Spain, Ireland and Iceland.

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Each of these waves was preceded by a surge in cross border investment inflows and in the domestic supply of credit. The external indebtedness of Mexico and the other developing countries increased by twenty percent a year in the 1970s for nearly ten years. There was an extraordinary growth in the supply of credit in Japan in the second half of the 1980s as the surge in the American demand for Japanese stocks led to a sharp decline in its capital account deficit. Thailand the other now-emerging market countries experienced rapid growth of domestic credit in the late 1980s and the first half of the 1990s in part as a result of the sharp increase in their external indebtedness. The United States, Britain, and other countries experienced a rapid increase in the growth of credit after 2002 as a result of the surge in the international reserve assets. The U.S. supply of credit has increased sharply since 2010 as a result of the increase in the investor demand for U.S. securities.

Each of the banking crises since the early 1980s has resulted from a slowdown in the growth of credit, often prompted by move toward a more contractive monetary policy--a "correction" of a non-sustainable imbalance. The borrowers had become dependent on the inflow of credit and could not readily adjust to the decline in supply. The 1982 developing country banking crisis followed the dramatic change in Federal Reserve policy in late 1979, which led to a global recession and a sharp decline in commodity prices. The financial implosion in Japan in the early 1990s followed an increase in the discount rate of the Bank of Japan in December 1989 and window guidance from the Governor of the central bank that the banks should limit the increases in the growth of their supply of credit. The Asian Financial crisis began when international banks became much more skeptical of the credit worthiness of the Thai banks. The global crisis of 2007/8 began when investor demand for U.S. dollar securities slackened; the U.S. capital account surplus had peaked in the third quarter of 2006.

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The U.S. economy has been jerked around by the variability of the cross border investment inflows. In 1980 the United States was the world’s largest creditor country, by 1990 it had become the world’s largest debtor; its international indebtedness has increased in every subsequent year. The surge in investor demand for U.S. dollar securities in the 1980s led to a sharp increase in the price of the U.S. dollar, a dramatic increase in the U.S. trade deficit, and the "hollowing out" of the industrial economy.

There was a lot of chatter in the in the 2016 presidential campaign about job losses because trade agreements had led to a large U.S. trade deficit. Employment in U.S. manufacturing has declined from 19 million in 1980 to 11 million; my back-of-the envelope estimate is that two to three million jobs were lost because of United States had an $800 billion trade deficit rather than a zero trade balance.

The view in most foreign capitals is that the United States has become an increasingly large U.S international debtor because Americans save too little and spend too much. That view was captured in a rhetorical question from the 1990s, “What would happen if the U.S Government had a large fiscal deficit and the Bank of Japan did not buy U.S. Treasury IOUs?" More recently, the Peoples Bank of China has replaced the Bank of Japan in the question.

If the Bank of Japan stopped buying U.S. securities, the price of the U.S. dollar would decline and the price of the yen would increase, the United States would have a smaller trade deficit and Japan would have a smaller trade surplus. U.S. GDP would increase as the U.S. trade deficit fell; the U.S. fiscal deficit would be smaller because tax revenues would be higher and government payments to the unemployed and the marginally employed would shrink. The decline in the U.S. trade deficit might lead to a one-for-one decline in the U.S. fiscal deficit because the initial increase in spending on domestic goods.

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There is agreement that when a country's currency is floating, it will have a trade deficit if its savings are less than its investment and government fiscal deficit. The view in virtually every foreign capital is that Americans save too little and spend too much. The competing view is that the large current account surpluses of the Germans and the Dutch and the Singaporeans and the Thais and the South Koreans and the Chinese reflects that they spend too little and that their excess saving has led to their extraordinarily large current account surpluses. If Americans saved too little, then the U.S. demand for foreign saving would have "crowded out" some foreign borrowers because Americans would pay a higher price for credit than some foreign borrowers. If instead foreigners save too much, then their demand for U.S. securities "crowds into" into the United States and displaces American savers because it induces higher levels of consumption. In the latter case, the current account surpluses of many foreign countries are larger than they prefer, but each is reluctant to adopt the policies that would lead to a smaller surplus. In September I was at a meeting in Washington that was focused on the source of large trade imbalances and offered to buy lunch for anyone who could name a country that had accepted a lower level of domestic investment because some of its savings were used to buy U.S. securities. No one accepted the offer.

The United States has become the world’s largest debtor because of the surge in the foreign demand for U.S. dollar securities. Very few Americans have borrowed in a foreign currency to finance U.S. spending. (The U.S. Treasury sold "Roosa bonds" in the 1960s and "Carter bonds" in the 1970s; these bonds were denominated in a foreign currency.)The cumulative U.S. trade deficit since 1980 is $14,000 billion. Sovereign wealth funds--think Norway, United Arab Emirates, Saudi Arabia, Chile--have acquired $8,000 billion of U.S. securities and assets since 1980. Foreign central banks have acquired $5,000 billion of U.S. securities, including more than $3,000 billion by China. The

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likelihood that China and Japan acquired U.S. securities to make it easier for Americans to finance investment or consumption is trivially low.

The cyclical variations around the trend increase in the foreign demand for U.S. securities have been large. The U.S. capital account surplus—think cross border investment inflows to the United States--increased in the 1980s and each subsequent decade. The United States could experience an increase in its capital account surplus only if there was a counterpart increase in the U.S. current account deficit. The primary factor that contributed to the increase in the U.S. current account deficit was the increase in the price of U.S. securities noted in Figure 1 and the secondary one was the increase in the price of the U.S. dollar. The price of U.S. securities had to increase by enough to ensure that the U.S. spending on imports expanded as rapidly as U.S. exports of securities.

Consider the U.S. dollar cycle in the 1980s; the move to a more contractive monetary policy in October 1979 led to a surge in investor demand for U.S. dollar securities once investors became convinced that the inflation rate would decline, U.S. bond prices increased sharply and U.S. stock prices increased three fold. The price of the U.S. dollar peaked in July 1985, the investment inflows peaked in the third quarter of 1986. The subsequent decline in these investment inflows meant that the U.S. current account deficit also fell because consumption spending slowed.

There was a massive increase in investment inflows to the United States from 2002 to the third quarter of 2006; the investment inflows to a some other countries--Britain, Spain, Iceland, Ireland, and Greece surged. One primary source of these inflows was the surge in China's trade surplus, which led to the rapid growth of international reserve assets; the international reserve assets of the oil exporting countries also increased sharply.

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THE 2017 DECLINE IN THE PRICE OF THE U.S. DOLLAR

The decline in U.S. stock prices that began in the early Spring of 2000 followed an increase in interest rates that began in March and the withdrawal of $500 billion of liquidity that had been distributed to facilitate any adjustments following the Y2K concerns. The decline in U.S. stock prices that began in 2007 followed the decline in the U.S. capital account surplus that began in the fourth quarter of 2006.

The cover story on The Economist of December 3, 2016 shows George Washington's face on Hulk Hogan's body, the title of the story is "The Mighty Dollar". The price of the U.S. dollar had generally increased since the 2007/8 crisis, U.S. interest rates while low, were still higher than those in other countries. The price of the U.S. dollar has declined by more than ten percent since the beginning of 2017. The U.S. trade deficit may have peaked in November 2017. The inference from the decline in the price of the U.S. dollar and perhaps a smaller U.S. trade deficit is that investor demand for U.S. securities has been declining.

The apparent paradox is that the price of the U.S. dollar has been declining, even as interest rates on U.S. dollar securities have been increasing. The real or inflation adjusted interest rate on the ten year U.S. Treasury bond is 0.70 percent while it normally might be 2.50 percent to 3.00 percent at this stage of the cycle. The Fed has increased its discount rate three times in 2017, and has indicated that it will increase this rate three times in 2018. The increase in spending that will follow the 2017 tax changes will lead to higher interest rates. The Federal Reserve is reversing its Quantitative easing policy, the private sector will end up owning many more U,S. securities. The tax cuts will lead to an increase in the supply of securities.

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The prospect is that the decline in the demand for U.S. dollar securities will lead to a decline in U.S. stock prices, much as 1986 and 1987, or as in 2000, or as in 2006/7.

How far will stock prices decline? The inference from the three previous dollar cycles is forty to fifty percent.

CONCLUSION

The United States evolved from the world's largest creditor country in 1980 to the world's largest debtor because saving in its trading partners became larger than their domestic investments; these countries concluded that it was preferable to develop current account surpluses to absorb the imbalance between their saving and investment rather than adopt measures to reduce the imbalance. None of the countries with a large current account surplus appears ready to claim that part of its surplus has developed to accommodate the shortfall of U.S. saving relative to U.S. investment and the U.S. fiscal deficit. Perhaps two to three million of the decline in U.S. manufacturing jobs since 1980 can be attributed to the $800 billion increase in the U.S. trade deficit. There have been four surges in U.S. stock prices since the early 1980s; each was associated with a sharp increase in cross border investment inflows to the United States. The shortest of this episodes lasted four years, the longest more than ten years. Three of the four episodes involved a significant increase in the price of the U.S. dollar, the nominal price of the U.S. dollar did not increase in the 2000s even though the ratio of the U.S. capital account surplus to U.S. GDP increased sharply. China experienced a surge in its exports, and the real price of the U.S. dollar increased. The United States could experience an increase in its capital account surplus only if there was a counterpart increase in its current account deficit, which was a response to the surge in the price of U.S. securities induced by the expansion of the cross border investment inflows. The primary factor that explains the cyclical

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increase in U.S. current account deficit is the increase in the prices of U.S. stocks (and the increase in the price of U.S. real estate in the first decade of the 21st century). When the U.S. capital account surplus fell the price of U.S. stocks and the price of the U.S. dollar tended to decline. The price of U.S. stocks has increased nearly fourfold since the 2009 as the U.S. capital account surplus has increased; as this surplus declines, the price of U.S. stocks is likely to fall.

Apologies for the length of this letter. Please forward your comments and questions