1.

U.S. ECONOMY TO BE IMPACTED BY ENERGY PRICE SHOCKWAVE
By Charles Mackay

Wall Street Examiner
July 6, 2005

http://wallstreetexaminer.com/?itemid=1159

The efforts of the U.S. consumer to outrun the approaching energy shockwave will soon falter.

As the third quarter starts, the U.S. economy is about to be hit harder by the impact of the energy price shockwave. Like a financial sonic boom, the price shockwave will shake the financial markets -- possibly in unexpected ways. Since the start of 2004, stepped up borrowing by the U.S. consumer has kept the economy one step ahead of the negative effects of rising energy prices (see "The Oil Paradox: How the Current Account Deficit has Buffered the Economy from the Energy Price Shockwave") [#2 below]. But now, for example, as the price of retail diesel climbs 35 to 40% year-over-year, there is a growing recognition of a permanent change in the cost structure of energy. This will sink into the reality of business and consumer investment and spending plans.

Why would the economy now falter when it has outrun the price shockwave for six quarters? Initial economic reports for June are positive. The U.S. consumer was still mainly coping with higher energy costs by increased buying on credit and refinancing home mortgages -- even while interest rates were climbing. Also, savings were being reduced, which kept the inflation adjusted money supply on a downtrend most of the time since January. Consumer credit is being indirectly supplied by foreigners through the current account deficit. (The current account deficit is mostly the trade deficit plus net interest/dividend payments on international investments and debt between the U.S. and the rest of the world). The U.S. current account deficit accelerated to nearly an $800 billion per year annual rate in the first quarter. The use of credit was necessary to maintain spending, as real disposable personal income per person has concurrently followed real money supply lower since January.

With the latest burst of credit-backed spending, the U.S. economy is approaching real limits of just how much it can borrow domestically and internationally. Therefore, further increases in the price of the energy may not be papered over by more credit, and personal spending on goods and services other than for energy must decline. This change in spending will directly and quickly impact the U.S. economy.

What are these credit limits? The U.S. is close to reaching the absolute limit of total world savings available each year. This limit may be around $1 trillion and the U.S. current account deficit at mid-year is probably about an $850 billion annual rate. Yet there are also other countries increasing their current account deficits, too, for the same reasons as the U.S., competing for the remainder of that savings pool. Despite the recent strength of the U.S. dollar, we now may be very close to the maximum practical limit which the U.S. current account deficit can reach.

Domestic credit limitations are harder to gauge. Accumulated household debt is 56% higher in the first quarter 2005 than five years earlier and required debt repayments are mounting fast. Still, spending has remained strong, even while the personal savings rate falls to near zero. It may be best just to keep in mind that the easy availability of credit within the U.S. is dependent on the massive current account deficit inflows, financed at a low interest rate.

The energy price shockwave, hitting the U.S. economy at the same time credit may become less available to consumers, will be an unsettling combination. This will likely result in a significant slowdown in economic growth, and quite possibly a recession.

2.

THE OIL PARADOX: HOW THE CURRENT ACCOUNT DEFICIT HAS BUFFERED THE ECONOMY FROM THE ENERGY PRICE SHOCKWAVE
By Charles Mackay

Wall Street Examiner
June 20, 2005

http://wallstreetexaminer.com/?itemid=1101

Can the U.S. economy really stand up to the energy price shockwave? It can while the current account deficit escalates at a rate of $200 billion or more per year.

The question of the day on Wall Street is -- When will rapidly rising energy prices diminish economic growth -- or even worse -- cause a recession? A first glance, it appears to be another 'conundrum' for Wall Street analysts to ponder. However, a closer look at the dynamics of the current account deficit since the latest ongoing round of energy price increases started, provides the answer to this riddle.

The U.S. current account deficit started expanding at an accelerated pace in early 2004, just as substantial energy price increases hit. The current account deficit, which is generally defined at the amount of money needed to finance the trade deficit plus net interest/dividend payments on international investments and debt, was running at a little over a $500 billion annualized rate in the fourth quarter of 2003. In the latest figures released by the U.S. Bureau of Economic Analysis, the CA deficit for the first quarter of 2005 was $195 billion, or about a $780 billion annual rate. In other words, in just five quarters the CA expanded almost $280 billion -- or more than 50%!

Actual costs of energy imports in 2005 are increasing at about a $60 to $100 billion annual rate compared to year earlier periods, with significant fluctuations in import costs month to month. However, per the Energy Information Agency, imports account for a little more than half of petroleum and related products used in the U.S. So the total increased energy costs to the economy are increasing roughly about twice as fast -- or $200 billion per year.

Coincidently, over the last five quarters, the current account deficit has also increased at about the same $200 billion rate. The accelerating trade gap that underlies the increasing current account gap is the primary reason that the U.S. economy has been able to maintain its steady growth and shrug off higher energy prices. In the past few years, foreigners (mostly foreign central banks (FCBs)) have been willing to finance the expansion of the trade deficit -- mostly to peg or stabilize their respective currencies against the U.S. dollar.

Do the financing needs of U.S. consumers drive the trade deficit higher? Possibly so. The U.S. savings rate dropped to near zero in April and May, and no improvement should be expected when June's rate is reported. If domestic savings aren't available to U.S. consumers as energy-inflation depresses their disposable income, foreigners have been so far more than willing to make up the difference.

The downside of this current account-financed debt boom is, however, that the entire amount of the current account represents a growing liability of the U.S. This is a bill that must eventually be repaid with interest -- or alternatively repudiated through dollar inflation.

So far U.S. consumers have voluntarily taken on additional debt, mostly increased mortgage debt, while foreigners have been willing to provide it -- even if that meant some FCBs ended up accumulating hundreds of billions of U.S. dollars. But what will happen if energy prices do not level off or decline -- but go higher? As the current account deficit moves past the $800 billion mark towards possibly a $1 trillion annualized rate, it will be increasingly difficult to finance the current account without ever-higher interest rates. That is because the total current account deficit is now quickly approaching a theoretical limit of free total world savings -- which may be around $1 trillion per year. As the remaining pool of available savings becomes smaller, it will be harder and harder to get those savers to finance the current account deficit.

Will be the U.S. be able to garner ever greater savings from the world? The rest of the world is also being hit by the energy shock wave too, and may have less savings to go around. Whether foreigners want to invest more in the U.S. or not, those foreigners may someday soon find they have reached their respective limits of just how many U.S. dollars they can buy.

When that day comes, the illusion that rising energy costs can be shrugged off will quickly disappear.