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Article from Outside the Box by John Mauldin

an article By Louis Gave

“Talking about the Russian Revolution, Lenin once said that there are decades when nothing happens and there are weeks when decades happen.” The last quarter of 2001 looks in retrospect like one of those exciting periods: three events occurred which set in motion the main economic trends of the ensuing decade. Successful investors latched on to at least one of these trends. The problem is, all three trends are now over. The investment strategies that worked over the past decade will not continue to work in the next. What comes next?

The three big events of 2001 were:

• The terrorist attacks of 9/11. This unleashed a decade of bi-partisan “guns and butter”policies in the US and produced a structurally weaker dollar.

• China joined the WTO in December 2001. China’s full entry into the global trading system signaled a re-organization of global production lines and China’s emergence as a major exporter. Export earnings were recycled into the mother of all investment booms, which drove a surge in commodity demand and a wider boom in emerging markets.

• The introduction of euro banknotes. The introduction of the common currency unleashed a decade of excess consumption in southern Europe, financed unwittingly by northern Europe through large bank and insurance purchases of government debt.

But today, all three trends have stalled—and this perhaps accounts for the discomfort and uncertainty we find in most meetings with clients. Indeed:

• US guns and butter spending is over. For the first time since 1970, real growth in US government spending is in negative territory:

• Chinese capital spending is slowing. China still needs to invest a lot more, but future growth rates will be in the single digits.

• Excess consumption in southern Europe is done. Money is clearly flowing out to seek refuge in northern Europe.

Thus, like British guns in Singapore, investors whose portfolios still reflect the above three trends are facing the wrong way. Instead of lamenting over the past, investors should be coming to grips with the trends of the future: the internationalization of the RMB, the rise of cheaper and more flexible automation, and dramatically cheaper energy in the US.

1- The internationalization of the RMB

China is now the centre of a growing percentage of both Asian, and emerging market trade (a decade ago China accounted for 2% of Brazil’s exports; today it is 18% and rising). As a result, China is increasingly asking its EM trade partners why their mutual trade should be settled in US dollars? After all, by trading in dollars, China and its EM trade partners are making themselves dependent on the willingness/ability of Western banks to finance their trade. And the realization has set in that this menage à trois does not make much sense. Indeed, for China, the fact that Western banks are not reliable partners was the major lesson of 2008 and again of 2011.

As a result, China is now turning to countries like Korea, Brazil, South Africa and others and saying: Let’s move more of our trade into RMB from dollars” to which the typical answer is increasingly Why not? This would diversify my earnings and make our business less reliant on Western banks. But if we are going to trade in RMB, we will need to keep some of our reserves in RMB. And for that to happen, you need to give us RMB assets that we can buy”. Hence the creation of the offshore RMB bond market in Hong Kong, a development which may go down as the most important financial event of 2011.

Of course, for China to even marginally dent the dollar’s predominance as a trading currency, the RMB will have to be seen as a credible currency—or at least as more credible than the alternatives. And here, the timing may be opportune for, today, outshining the euro, dollar, pound or even yen is increasingly a matter of being the tallest dwarf.

Still, China’s attempt to internationalize the RMB also means that Beijing cannot embark on fiscal and monetary stimulus at the first sign of a slowdown in the Chinese economy. Instead, the PBoC and Politburo have to be seen as keeping their nerve in the face of slowing Chinese growth. In short, for the RMB to internationalize successfully, the PBoC has to be seen as being more like the Bundesbank than like the Fed.

Following this Buba comparison, China has a genuine opportunity to establish the RMB as the dominant trade currency for its region, just as the deutsche mark did in the 1970s and 1980s. But interestingly, China seems to consider that its “region” is not just limited to Asia (where China now accounts for most of the marginal increase in growth—see chart) but encompasses the wider emerging markets. How else can we explain China’s new enthusiasm in granting PBoC swap lines to the likes of the Brazilian, Argentine, Turkish and Belorussian central banks?

China’s attempt to move more of its trade into RMB is interesting given the current shifts in China’s trade. Indeed, although the US and Europe are still China’s largest single trade partners, most of the growth in trade in recent years has occurred with emerging markets. And China’s trade with emerging markets is increasingly not in cheap consumer goods (toys, underwear, socks or shoes) but rather in capital goods (earth- moving equipment, telecom switches, road construction services, etc; see China Bulldozes a New Export Market). In short, yesterday China’s trade mostly took place with developed markets, was comprised of low-valued-added goods, and was priced in dollars. Tomorrow, China’s trade will be oriented towards emerging markets, focused on higher value-added goods, and priced in RMB.

This would mark a profound change from China’s old development model: keeping its currency undervalued, inviting foreign factories to relocate to the mainland, transforming 10-20mn farmers into factory workers each year, and triggering massive labor productivity gains—gains which the government captures through financial repression and redeploys into large-scale infrastructure projects. But China’s change in development model may be less a matter of choice than of necessity.

2– Virtue from necessity: the rise of robotics

The first harsh reality confronting China is that the country is now the world’s single largest exporter. Combine that impressive status with the reality that the world is unlikely to grow at much more than 3% to 4% over the coming years and it becomes obvious that the past two decades’ 30% average annual growth in exports just cannot be repeated.

Beyond the limits to export growth, the other challenge to China’s business model is the second step, namely the transforming of farmers into factory workers. Not that China is set to run out of farmers (see The Countdown for China’s Farmers). But the coming years may prove more challenging for unskilled workers as robotics and automation continue to gather pace. Over the coming decade, cheap labor may not be the comparative advantage it was in the previous decade, simply because the cost of automation is now falling fast (see The Robots Are Coming).

Of course, factory and process automation is hardly a new concept. What is new is the dramatic recent shift from fixed automation to flexible automation.For decades we have had machines that could perform simple repetitive tasks; now we have machines that can be reprogrammed easily to perform a wide range of more complicated functions. With improved software and hardware, robots can do more, in more industries; and the purpose of automation has shifted from improving crude productivity (making more of the same things at lower cost) to more sophisticated targets like adaptability across product cycles, and improved quality and consistency.

One consequence of cheaper and more flexible automation is that some manufacturing that fled the developed world for cheap-labor destinations like China may return to the US, Japan and Europe, as firms decide that the benefits of low-cost labor no longer outweigh the advantage of better logistics and proximity to customers. Even if this does not occur, factories in places like China may become ever more automated (e.g.: electronics assembler Foxconn, Apple’s main supplier and one of the world’s biggest employers with some 1mn workers, has started to talk about building factories manned with robots). This then raises the question of what China’s hordes of manufacturing workers will do should Chinese factories automate and/or re-localize to the developed world. One obvious conclusion is that China’s leaders will thus have to deal with slowing growth through further deregulation, rather than stimulus and currency manipulation. The remedies of 2008 (large fiscal and monetary stimulus) will not work again.

This dilemma implies that the robotics trend dovetails with the RMB internationalization trend. To understand just why, it is important to recognize one aspect of policymaking which makes China unique: the country’s leaders wake up every morning pondering how to return China to being the world’s number one economy and a geopolitical superpower in its own right (few other world leaders harbor such thoughts). And ever since Deng Xiaoping, the answer to that question has typically been to sacrifice some element of control over the economy in exchange for faster growth.

Today, China faces the imperative of making just such a trade-off between control and growth: the old model of cheap labor and vast capital spending is near exhaustion, so the only way to sustain growth is to go for more efficiency, especially through financial sector reform. For China’s leaders, reform will be painful but the cost of missing out on the global power that comes with further growth would be even more painful. Hence we are convinced Beijing will eventually bite the financial reform bullet, and RMB internationalization is the leading edge of that reform. In that light, the creation of the RMB offshore bond market is an event of much greater significance than is currently acknowledged by the general consensus.

3– Cheap US energy

Along with the possibility of manufacturing returning to the developed world from China and other low labor-cost countries, another key trend of the coming decade should be the gradual achievement of energy independence by the US. Given the discoveries of the past few years in the exploitation of shale gas and oil, and assuming the existence of political will to invest in reshaping US energy infrastructure, such a development is now within reach.

These large natural gas discoveries have two potential global impacts. First, the combination of low-cost automation and low-cost energy could encourage manufacturers to locate their plants not in countries with the lowest labor cost, but in those with the lowest energy cost. For example, on a recent visit to Germany we kept hearing how chemical plants would have a tough time competing with American plants if the price of US natural gas stayed below US$2.50. In fact, with Germany having decided to pull away from nuclear and bet its future on high-cost wind power, energy- intensive industries in the country could be in for a challenging decade.

Second, the return to manufacturing and energy independence should lead to sustained improvement in the US trade deficit. Energy imports account for around half of the US trade deficit (while the other half is broadly manufactured goods from China). Today the US, through its trade deficit, sends roughly US$500bn worth of cash to the rest of the world every year. This money helps grease the wheels of global trade since more than two-thirds of global trade is still denominated in dollars. But what will happen if, in the next ten years, the US stops exporting dollars, thanks to its new strengths in manufacturing and cheap energy? In such a scenario, the dollars would run scarce.

In fact, this may already be happening. This would explain why the growth of central bank reserves held at the Fed for foreign central banks has been in negative territory for the past year—and why, over the past two quarters, the Fed has been exceptionally generous in granting swap lines to foreign central banks (notably the ECB).

This does not make for a stable situation. And given that the RMB is unlikely to replace the dollar as the principal global trading currency for many years to come (see History Lessons and the Offshore RMB), the likely combination of expanding global trade and a shrinking US trade deficit should mean that either the dollar will have to rise, or US assets will outperform non-US assets to the point where valuation differnces make it attractive for US investors to deploy dollars abroad (since US consumers won’t).

4– Conclusion

Obviously, we do not claim to have identified all the big trends of the coming decade. The next several years will doubtless deliver many more important changes and investment opportunities (monetization of Japan’s debt and a collapse in the yen? Demographic challenges in numerous countries? Reform and modernization in the Islamic world? Political upheaval and regime change in Iran? Water shortages in China, India and other Asian countries? Possible energy independence for India through thorium-based nuclear energy plants?). But we are nonetheless confident on these main points:

• The three key macro trends of the past decade have come to a screeching halt. This explains why financial markets seem to lack conviction and direction.

• The internationalization of the RMB and the birth of the RMB bond market is likely to be one of the most important developments of the decade. The closest analogy is the creation of the junk bond market by Michael Milken in the 1980s. Interestingly, just as in the early 1980s, few people are taking the time to work through the ramifications of this momentous event. Understanding this new market will prove essential to understanding the world of tomorrow.

• The likely evolution of the US from record high twin deficits to much smaller budget and trade deficits should help push the dollar higher over the coming years. And this in turn will have broad ramifications for a number of asset prices.”

Contact john at: JohnMauldin@2000wave.com.

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By John Mauldin

John Mauldin, Best-Selling author and recognized financial expert, is also editor of the free Thoughts From the Frontline that goes to over 1 million readers each week. For more information on John or his FREE weekly economic letter go to: http://www.frontlinethoughts.com/learnmore

I admit that of late my writings have had a rather dark tone. There are certainly a number of severe long-term problems that we must deal with, and they’re going to serve up a lot of economic pain. But the Thanksgiving weekend with the kids has me in a reflective mood, and one that has only served to underscore my long-term optimism. This week we look at why 2007 will not be the good old days we will yearn for in 20 years, after we briefly visit Dubai and the latest unemployment numbers.

Subprime Dubai

While we in the US spent our Thursday eating turkey and watching football, the rest of the world’s markets went into a downward spiral as Dubai announced it wanted its lenders to give the country a six-month moratorium on some $80-90 billion in debt. This has the potential to be the largest sovereign debt default since Argentina. Somehow this was a shocking development. (How can too much debt and real estate be a problem?) And by markets I mean gold, commodities, oil, stocks, and risk assets everywhere. They all went down. Today the US markets experienced their own sell-off, though not as deeply as the rest of the world.

As I wrote last Friday, the world is now negatively correlated with the dollar, and as money went into the dollar and US treasuries, everything else went down. Vietnam devalues, Greece is looking increasingly risky, Russia wants to devalue some more, the world is still deleveraging, etc. Is this another repeat of 1998, when Russia and the Asian debt crisis tanked the markets?

To get an answer, let’s look at some facts about Dubai. It is one of the Arab Emirates; but unlike its neighbor Abu Dhabi, oil is only about 6% of the economy. While the foundations of the country were built with oil, the country has diversified into finance, real estate, tourism, trading, and manufacturing. It is a small country, with a little under 1.5 million residents, but with less than 20% being natural citizens – the rest are expatriates.

The gross domestic product is around US $50 billion.
(Note: http://www.ameinfo.com/67802.html and then converting the currency. I found the numbers on various websites and services strangely at wide discrepancies. This seems close to a median number. I think the discrepancy is mostly people confusing the GDP for the United Arab Emirates as a whole, which includes Abu Dhabi, rather than just Dubai.)

Dubai has become a byword for thinking large. The world’s tallest building, underwater hotels, the largest manmade islands (plural), indoor snow skiing in the desert… For links to more information try this from Wikipedia: “The large-scale real estate development projects have led to the construction of some of the tallest skyscrapers and largest projects in the world, such as the Emirates Towers, the Burj Dubai, the Palm Islands and the world’s second tallest, and most expensive hotel, the Burj Al Arab.” The list goes on and on.

UBS suggests that the $80-90 billion in debt may not include rather large off- balance-sheet debt (where have we seen that one?). So, a country with a GDP of $50 billion borrows $100 billion. They build massive projects, which are now among the most expensive real estate in the world. The latest manmade island plans for one million people to buy property there. Seriously. Talk about Field of Dreams.

Then came the credit crunch. Property values dropped by as much as 50%. Sales, say the developers in understatements, have slowed. Seems there was a lot of debt used to speculate on real estate, not to mention buying Barney’s, Las Vegas casinos, banks, etc. And while US banks have little exposure, it seems England has about 50% or so of the debt, with the rest of Europe having the lion’s share of the remainder. Admittedly, the estimates seem to confuse the debt of Dubai with that of Abu Dhabi, so it is hard to know a reliable number, other than that European banks are the most exposed.

Now, here’s the deal. Abu Dhabi has the world’s largest sovereign wealth fund, at over $650 billion. Dubai has a “mere” $15 billion. If they cared to, Abu Dhabi could write a small check and make all the problems disappear. It just seems that they are not ready to do that, at least not yet. Abu Dhabi already got the world’s tallest building on past debt problems.

Construction and real estate were as much as 25% of the economy. Let’s see. Large leverage with maybe $5 billion in interest in a $50 billion economy that is 25% construction? A construction and real estate-driven economy. A real estate bubble. Sound like California, Florida, Spain? How can this be a surprise, except that everyone expected big brother Abu Dhabi to pick up the check?

While Abu Dhabi did advance $5 billion earlier, Dubai is not letting that money out of the country. There are projects to be finished, you understand. From where I sit, this is just rather hard-headed negotiations, a restructuring of who owns what and who will get what assets. It will all settle out. Given the massive losses that world banks have already taken, this is rather small potatoes.

So why the reaction by the markets? Because I think many participants know that the potential for there to be a serious correction is quite real. When anything as relatively small as Dubai spooks the market, it should serve as a warning sign. The world has priced in 5% GDP growth for the US and much of the developed world in the equity and commodity markets. Either we have to get that or the markets are going to have to come back to the reality of what I think is going to be a much lower growth figure.

But in any event, one of the lessons to be learned is that investors should pay attention to where the leverage is. Unsustainable debt trends end in tears. They always do. Spain, Greece, Italy, the UK, and Japan will all have to face major restructuring in the next decade due to leverage. And we in the US will also find that we cannot grow debt at our current levels. Will we pare our debt willingly or be forced to by the market? Either way, it will make for a less than optimal economy over the coming years. Muddle Through, indeed.

 

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John Mauldin is the President of Millennium Wave Advisors, LLC (MWA), which is an investment advisory firm registered with multiple states. To contact directly, please find him at: JohnMauldin@InvestorsInsight.com

To read the full article and view all charts, please go here.

A Tale of Two Depressions
By Barry Eichengreen and Kevin O’Rourke

This week’s Outside the box looks at some very interesting research done by two economic historians, Barry Eichengreen of the University of California at Berkeley and Kevin O’Rourke of Trinity College, Dublin They give us comparisons between the Great Depression and today’s downturn. They continue to update their data from time to time, the link to their work is at http://www.voxeu.org/index.php?q=node/3421. I have not previously heard of www.voxeu.org, but it is a collection of the work of well regarded international economists that seems quite interesting for those who enjoy readings in the dismal science.

This week’s OTB will print long, but it is primarily charts. Please note that I have re-arranged some of the new charts to cut down on space because of some duplications. Word count is not all that much and it reads well. I will be referring to their work in future letters as well. Have a great week! John Mauldin, Editor

A Tale of Two Depressions

New findings:

  • World industrial production continues to track closely the 1930s fall, with no clear signs of ‘green shoots’.
  • World stock markets have rebounded a bit since March, and world trade has stabilized, but these are still following paths far below the ones they followed in the Great Depression.
  • There are new charts for individual nations’ industrial output. The big-4 EU nations divide north-south; today’s German and British industrial output are closely tracking their rate of fall in the 1930s, while Italy and France are doing much worse.
  • The North Americans (US & Canada) continue to see their industrial output fall approximately in line with what happened in the 1929 crisis, with no clear signs of a turn around.
  • Japan’s industrial output in February was 25 percentage points lower than at the equivalent stage in the Great Depression. There was however a sharp rebound in March.

The parallels between the Great Depression of the 1930s and our current Great Recession have been widely remarked upon. Paul Krugman <http://krugman.blogs.nytimes.com/2009/03/20/the-great-recession-versus-the-great-depression/>  has compared the fall in US industrial production from its mid-1929 and late-2007 peaks, showing that it has been milder this time. On this basis he refers to the current situation, with characteristic black humour, as only “half a Great Depression.” The “Four Bad Bears <http://dshort.com/charts/bears/four-bears-large.gif> ” graph comparing the Dow in 1929-30 and S&P 500 in 2008-9 has similarly had wide circulation (Short 2009). It shows the US stock market since late 2007 falling just about as fast as in 1929-30.

Comparing the Great Depression to now for the world, not just the US

This and most other commentary contrasting the two episodes compares America then and now. This, however, is a misleading picture. The Great Depression was a global phenomenon. Even if it originated, in some sense, in the US, it was transmitted internationally by trade flows, capital flows and commodity prices. That said, different countries were affected differently. The US is not representative of their experiences.

Our Great Recession is every bit as global, earlier hopes for decoupling in Asia and Europe notwithstanding. Increasingly there is awareness that events have taken an even uglier turn outside the US, with even larger falls in manufacturing production, exports and equity prices. In fact, when we look globally, as in Figure 1, the decline in industrial production in the last nine months has been at least as severe as in the nine months following the 1929 peak. (All graphs in this column track behaviour after the peaks in world industrial production, which occurred in June 1929 and April 2008.) Here, then, is a first illustration of how the global picture provides a very different and, indeed, more disturbing perspective than the US case considered by Krugman, which as noted earlier shows a smaller decline in manufacturing production now than then.

World Industrial Output, Now vs Then (updated)

Similarly, while the fall in US stock market has tracked 1929, global stock markets are falling even faster now than in the Great Depression (Figure 2). Again this is contrary to the impression left by those who, basing their comparison on the US market alone, suggest that the current crash is no more serious than that of 1929-30.Updated Figure 2. World Stock Markets, Now vs Then (updated). Another area where we are “surpassing” our forbearers is in destroying trade. World trade is falling much faster now than in 1929-30 (Figure 3). This is highly alarming given the prominence attached in the historical literature to trade destruction as a factor compounding the Great Depression. The Volume of World Trade, Now vs Then (updated)
Sources: League of Nations Monthly Bulletin of Statistics, http://www.cpb.nl/eng/research/sector2/data/trademonitor.html <http://www.cpb.nl/eng/research/sector2/data/trademonitor.htmltarget=>

It’s a Depression alright
To sum up, globally we are tracking or doing even worse than the Great Depression, whether the metric is industrial production, exports or equity valuations. Focusing on the US causes one to minimise this alarming fact. The “Great Recession” label may turn out to be too optimistic. This is a Depression-sized event. That said, we are only one year into the current crisis, whereas after 1929 the world economy continued to shrink for three successive years. What matters now is that policy makers arrest the decline. We therefore turn to the policy response.

Policy responses: Then and now
Figure 4 shows a GDP-weighted average of central bank discount rates for 7 countries. As can be seen, in both crises there was a lag of five or six months before discount rates responded to the passing of the peak, although in the present crisis rates have been cut more rapidly and from a lower level. There is more at work here than simply the difference between George Harrison and Ben Bernanke. The central bank response has differed globally. Source: Bernanke and Mihov (2000); Bank of England, ECB, Bank of Japan, St. Louis Fed, National Bank of Poland, Sveriges Riksbank. Figure 5 shows money supply for a GDP-weighted average of 19 countries accounting for more than half of world GDP in 2004. Clearly, monetary expansion was more rapid in the run-up to the 2008 crisis than during 1925-29, which is a reminder that the stage-setting events were not the same in the two cases. Moreover, the global money supply continued to grow rapidly in 2008, unlike in 1929 when it levelled off and then underwent a catastrophic decline.Figure 5. Money Supplies, 19 Countries, Now vs Then Source: Bordo et al. (2001), IMF International Financial Statistics, OECD Monthly Economic Indicators. Figure 6 is the analogous picture for fiscal policy, in this case for 24 countries. The interwar measure is the fiscal surplus as a percentage of GDP. The current data include the IMF’s World Economic Outlook Update forecasts for 2009 and 2010. As can be seen, fiscal deficits expanded after 1929 but only modestly. Clearly, willingness to run deficits today is considerably greater.

Government Budget Surpluses, Now vs Then
Source: Bordo et al. (2001), IMF World Economic Outlook, January 2009.[They added some country data in their revision that I put here, hence the two figure 5’s, but they are labeled as such on the website and I did not change their labellling – JFM]New Figure 5. Industrial output, four big Europeans, then and now New Figure 6. Industrial output, four Non-Europeans, then and now. The facts for Chile, Belgium, Czechoslovakia, Poland and Sweden are displayed below; New Figure 7: Industrial output, four small Europeans, then and now.

Conclusion
To summarise: the world is currently undergoing an economic shock every bit as big as the Great Depression shock of 1929-30. Looking just at the US leads one to overlook how alarming the current situation is even in comparison with 1929-30. The good news, of course, is that the policy response is very different. The question now is whether that policy response will work. For the answer, stay tuned for our next column.

John F. Mauldin
johnmauldin@investorsinsight.com

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Here is an analysis by John Mauldin at InvestorInsight. It was originally published as a special series at Stratfor.

John Mauldin is president of Millennium Wave Advisors, LLC, a registered investment advisor. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions. Opinions expressed in these reports may change without prior notice. John Mauldin and/or the staff at Millennium Wave Advisors, LLC may or may not have investments in any funds cited above. Mauldin can be reached at 800-829-7273.

This information is not to be construed as an offer to sell or the solicitation of an offer to buy any securities.

“Dear Friends: One of the first things you learn about analyzing a company is how to dissect a balance sheet. What assets and liabilities can be deployed by a company to create equity over time? I’ve enclosed a fascinating variant on this process. Take a look at how STRATFOR has analyzed the “geographic balance sheets” of the US, Russia, China, and Europe to understand why different countries’ economies have suffered to varying degrees from the current economic crisis.

As investors, it’s precisely this type of outside-the-box thinking that can provide us profitable opportunities, and it’s precisely this type of outside-the-box thinking that makes STRATFOR such an important part of my investment decision making. The key to investment profits is thinking differently and thinking earlier than the next guy. STRATFOR’s work exemplifies both these traits.

I’ve arranged for a special deal on a STRATFOR Membership for my readers, which you can click here to take advantage of.  Many of you are invested in alternative strategies, but I want to make sure that you also employ alternative thinking strategies. So take a look at these different “country balance sheets” as you formulate your plans.
Your Mapping It Out Analyst, John Mauldin

The Geography of Recession

The global recession is the biggest development in the global system in the year to date. In the United States, it has become almost dogma that the recession is the worst since the Great Depression. But this is only one of a wealth of misperceptions about whom the downturn is hurting most, and why.As one can see in the chart, the U.S. recession at this point is only the worst since 1982, not the 1930s, and it pales in comparison to what is occurring in the rest of the world.

(Figures for China have not been included, in part because of the unreliability of Chinese statistics, but also because the country’s financial system is so radically different from the rest of the world as to make such comparisons misleading. For more, click here.)

But didn’t the recession begin in the United States? That it did, but the American system is far more stable, durable and flexible than most of the other global economies, in large part thanks to the country’s geography. To understand how place shapes economics, we need to take a giant step back from the gloom and doom of the current moment and examine the long-term picture of why different regions follow different economic paths.

The United States and the Free Market

The most important aspect of the United States is not simply its sheer size, but the size of its usable land. Russia and China may both be similar-sized in absolute terms, but the vast majority of Russian and Chinese land is useless for agriculture, habitation or development. In contrast, courtesy of the Midwest, the United States boasts the world’s largest contiguous mass of arable land — and that mass does not include the hardly inconsequential chunks of usable territory on both the West and East coasts. Second is the American maritime transport system. The Mississippi River, linked as it is to the Red, Missouri, Ohio and Tennessee rivers, comprises the largest interconnected network of navigable rivers in the world. In the San Francisco Bay, Chesapeake Bay and Long Island Sound/New York Bay, the United States has three of the world’s largest and best natural harbors. The series of barrier islands a few miles off the shores of Texas and the East Coast form a water-based highway — an Intercoastal Waterway — that shields American coastal shipping from all but the worst that the elements can throw at ships and ports.

The real beauty is that the two overlap with near perfect symmetry. The Intercoastal Waterway and most of the bays link up with agricultural regions and their own local river systems (such as the series of rivers that descend from the Appalachians to the East Coast), while the Greater Mississippi river network is the circulatory system of the Midwest. Even without the addition of canals, it is possible for ships to reach nearly any part of the Midwest from nearly any part of the Gulf or East coasts. The result is not just a massive ability to grow a massive amount of crops — and not just the ability to easily and cheaply move the crops to local, regional and global markets — but also the ability to use that same transport network for any other economic purpose without having to worry about food supplies.

The implications of such a confluence are deep and sustained. Where most countries need to scrape together capital to build roads and rail to establish the very foundation of an economy, transport capability, geography granted the United States a near-perfect system at no cost. That frees up U.S. capital for other pursuits and almost condemns the United States to be capital-rich. Any additional infrastructure the United States constructs is icing on the cake. (The cake itself is free — and, incidentally, the United States had so much free capital that it was able to go on to build one of the best road-and-rail networks anyway, resulting in even greater economic advantages over competitors.)

Third, geography has also ensured that the United States has very little local competition. To the north, Canada is both much colder and much more mountainous than the United States. Canada’s only navigable maritime network — the Great Lakes-St. Lawrence Seaway —is shared with the United States, and most of its usable land is hard by the American border. Often this makes it more economically advantageous for Canadian provinces to integrate with their neighbor to the south than with their co-nationals to the east and west.

Similarly, Mexico has only small chunks of land, separated by deserts and mountains, that are useful for much more than subsistence agriculture; most of Mexican territory is either too dry, too tropical or too mountainous. And Mexico completely lacks any meaningful river system for maritime transport. Add in a largely desert border, and Mexico as a country is not a meaningful threat to American security (which hardly means that there are not serious and ongoing concerns in the American-Mexican relationship).

With geography empowering the United States and hindering Canada and Mexico, the United States does not need to maintain a large standing military force to counter either. The Canadian border is almost completely unguarded, and the Mexican border is no more than a fence in most locations — a far cry from the sort of military standoffs that have marked more adversarial borders in human history. Not only are Canada and Mexico not major threats, but the U.S. transport network allows the United States the luxury of being able to quickly move a smaller force to deal with occasional problems rather than requiring it to station large static forces on its borders.Like the transport network, this also helps the U.S. focus its resources on other things.”

John F. Mauldin
johnmauldin@investorsinsight.com

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