welcome and keynote address2 welcome and keynote address rajeev dhawan wears a dual hat as associate...

WELCOME AND KEYNOTE ADDRESS2

Rajeev Dhawan wears adual hat as associateprofessor of managerialsciences and as directorof the EconomicForecasting Center at theRobinson College ofBusiness at Georgia StateUniversity in Atlanta,Georgia. As director ofone of the country’spremiere forecastingcenters, Dr. Dhawandevelops forecasts for theUS, Southeast regional,and local metro Atlantaeconomies. Ranked oneof the “most accurate”forecasters in the nationby Bank One EconomicOutlook Center atArizona State, Dr.Dhawan is known for hisability to articulatecomplex economic issuesin terms that areextremely relevant to thebusiness community.

Dr. Rajeev Dhawan,Director of theEconomic ForecastingCenter, RobinsonCollege of Business,Georgia State University

Stephen J. ZoukisAFIRE Chairman and Partner, JAMESTOWN

Welcome to the 17th Annual AFIREMembership Meeting. In particular, we

welcome our new members and guests. Sinceour last conference, 23 new members havejoined, bringing our total to 177, our highestever, hence the big attendance.

As you know, the theme of this year’sconference is This Is Not Your Father’s RealEstate Business, a phrase we borrowed fromthe now-defunct Oldsmobile car company. Wecould as well have used a line from the greatBob Dylan (who is on PBS tonight): AndSomething Is Happening Here But You Don’tKnow What It Is, Do You Mr. Jones? We hopewe’re going to help provide some insight.

I think we all agree that we find ourselves insomewhat unfamiliar circumstances right now,and while we might all generally agree on whatthe facts are, the significance of the situation isthe subject of a lot of debate. Our presentationsare intended to help sort this out by addressingnew types of deals people are doing, new placesthey are doing them, and new players enteringthe real estate market. Tomorrow morning, Mr.Bill Sanders will take a stab at putting this in abig-picture perspective for us.

I’d like to thank the top-notch AFIRE staff,who make my job with AFIRE a piece of cake.Those of you who may one day have theprivilege of serving in this position shouldn’tfear it, because Jim and Lexie and Soo reallytake care of everything. They make thechairman’s position a very easy job to handle.

I would also like to thank the sponsors ofthis program. We made the decision someyears ago to rely on sponsorships to cover alarge part of the cost of conferences such asthis, and we have been at it long enough thatsome are stepping up for the second or eventhe third time. So special thanks for this

conference’s sponsors: GMAC, ING, AEW andits European counterpart IXIS AEW, Macquarie,Madison Marquette, and UBS.

With all of that said, I would like tointroduce our first speaker, a fellow good oldboy from the South. Dr. Rajeev Dhawan is thedirector of economic forecasting at GeorgiaState University. (That’s the university inGeorgia that doesn’t have a football team, atleast yet.) He develops United States, regionaland metro area economic forecasts which arepublished and presented to business leadersand the media quarterly. Dr. Dhawan has beenranked as one of the most accurate economicforecasters by Arizona State University’sEconomic Outlook Center and he was recentlyawarded a major forecasting prize that hasn’tyet been announced, so I can’t tell you whom itis from. He is also an associate professor ofmanagerial sciences at Georgia State.Previously, he held the position of director ofeconomic forecasting at UCLA’s businessschool.

Dr. Dhawan was educated in India and inCalifornia where he received his Ph.D. fromUCLA. He combines the ability to write for anacademic audience, particularly on the subjectof business cycles, and to speak clearly tobusiness audiences. He will not leave you inany doubt about his opinions. Please welcomeDr. Rajeev Dhawan. [applause]

Dr. Rajeev DhawanDirector of the Economic Forecasting Center,Robinson College of Business, Georgia StateUniversity

I’ve been thinking about changing theadvertised title of this session from As theWorld Turns to As Katrina and Rita Do Damageto Us.

In that vein, or maybe just to give you anidea about how cheap I am, I have a little

Welcome and Keynote Address

AFIRE 2005 ANNUAL MEMBERSHIP MEETING DIGEST 3

story. My girlfriend demanded that I take her tosome place expensive…so I took her to the gasstation. That is what Rita and Katrina havedone to gas prices. I used to live in LA and hadalready seen gas at $2.50. I thought I couldlive with it. But just to shock myself, I filled upthree weeks ago at $3.79 a gallon. At thatmoment I figured out how I could get 20percent more efficiency. Having to pay theprice spurred the insight, so everybody has aprice limit somewhere. The specific limitdepends upon the person, but the point is, asprices go up we will conserve on energy. Theissue is what damage it does to the economy.

So is Katrina, on its own, going to derail theUS or the global economies? The answer is no.It is going to cause a temporary problem. (I’llshow you a bit later how I came to thatdecision.) The effect is basically only a one- totwo-quarter hit to the gross domestic product(GDP). The mechanism is through the oil prices,followed by natural gas heating prices.

In the last couple of days, the question hasbeen whether Rita, on its own, is going to derailthe economy. As it turns out, Rita did not hithead-on as it might have. So far, the report isthat refining capacity may be down for a littlebit, but nothing seems to be damaged. Butremember, when Katrina happened the firstimpression was that we had dodged the bullet.Only later did the news come that the leveeswere broken and the water was coming in.

So with Rita still blowing, we don’t fully knowthe extent of the damage, especially to therefineries. If damage there is extensive, thenbetween Katrina and Rita, about 50 percent ofthe US gasoline production could be affected.

So are Rita and Katrina together going tomake for the perfect storm? Still the answer isno. Given the information so far, it’s not goingto cause any problem. So if you are waiting fora recession to change your business, it’s not

going to happen. Insurance companies, forexample, can’t assume they’ll see a higher 10-year bond rate resulting from thehurricanes, not that easily.

Let me show you the outline of how Icalculate the impact and you can make yourown calculations. Factor number one is refinerydamage. Figure out how much has beendamaged, how much is back online, and whattime it will take.

The next thing is consumer confidence,which shouldn’t be a big factor, butpsychologically these events have an impact.The University of Michigan’s preliminaryreading of consumer sentiment dropped like arock last month (August), and tomorrow theConference Board’s number will come out.

In my calculation, I have these thingshappening in September–October and thenslowly starting to recover by January, as NewOrleans starts to get rebuilt (if it’s going to berebuilt, which is another issue). Here inWashington, it seems so far that the president

Dr. Dhawan addresses the general session.


will spend every dime he’s got to rebuild and todefend his name. At this point, the political willis to spend the money, no matter what, to getthe city back on-line. Of course, that will haveits own consequences.

One small fact not played up in the mediauntil recently is that about 10 percent of thenatural gas capacity is off-line and won’t comeback for another three to six months. Refineriesmay be back in service by the end of this monthor early next, but not the natural gas. This will ofcourse cause a shock with the bills in Decemberand later. It’s definitely coming; the issue is howthey slip it in. What kind of a price increase theywill be able to do is going to be an issue.

The next factor is monetary policy. TheFederal Reserve (Fed) will keep on with its“measured coast.” It will keep raising rates,which I think will go up to 4.5 percent by thetime Greenspan leaves office in January. TheFed is not going to stop, and may even have todo a stronger hike in the end just to shock thesystem, because housing construction is gettingout of control. Two million housing starts is justway too strong. I will have some opinions aboutthat later on.

The 10-year bond rate remains a little bitlow. I am going to examine in detail today how,in this booming economy where the Fed hasbeen raising rates for the last year or more, the10-year bond rate has actually come down.Why has that happened? Who is responsiblefor it? And what is going to keep it going thatway for a while? It has given a big break tohomeowners and to things like your cap ratecalculations.

The first factor I mentioned was the impactof the hurricanes on gas prices. In mycalculations, I have put in a spike in gasolineprices, the average rising from $3.00 to $3.25,and then quickly coming down. I was preparingthis forecast three days ago, before Rita camein, although the media was after me to talkabout the impact of Rita. It’s a bit like askingme to do a post mortem on a body where the

murder has not even been committed — theevent hadn’t even happened.

I want to show on this graph (Graph 1) howthe oil prices go through the system, and why itshould or shouldn’t make an impact. The graybars show, from the GDP income accounts,what we spend on gasoline. The US economy isabout $12 trillion. Two years ago about $140billion went to gasoline. That figure is now at$270–$280 billion, an increase of roughly $130billion. So we have not driven less. We areaddicted to driving the cars, so it seems we’regoing to drive.

But where are we going to get this extramoney? For some of us here it may not be a bigincrease, but where will average folk, making$50,000–$60,000 a year, get that money? Thenational income accounts show us spending byvery detailed categories. I looked at spendingon food, clothing and shoes and it seems thatpeople took the money out of a category calleddiscretionary income spending. It also seems tocome from spending on recreation; for a typicalguy that means it’s coming out of his beer andpoker money, which causes a lot of grief. Hecan’t go back to the wife looking for extramoney for the gas habit, so he has to take itout of the beer and poker money. Although thereal impact is not that much, psychologicallyit’s nasty, and that shows up in consumerconfidence, which often leads to a slowdown inspending three to six months later. If arrested,this won’t be a problem.

The outright tax cuts in the Bush years havehelped us out, particularly in contrast to the1970s. The oil price shock in the ‘70s occurredat a time when people were facing increasingtaxes caused by “bracket creep.” (Taxpayerskept moving up in the tax brackets withoutactual tax rate hikes.) But now, the Bush taxcuts have absorbed the energy price shocksand helped us along. Additionally, many peoplehave refinanced numerous times in the last twoyears, blunting the cash-flow issues presentedby the hikes in gas prices.


Returning to the impact of the hurricanes,consider the typical pattern. When a localeconomy is doing well before a hurricane hits,which typically happens in August andSeptember, income in the local area usuallytakes a big plunge in the third quarter. Then, asthe rebuilding begins, it comes back like arocket. So the farther you fall, the faster youcome out.

In the case of hurricane Hugo, incomedropped off 19 percent in one quarter, androse 40 percent the next quarter (Graph 2,page 6). It looks like the impact of thehurricane on the local economy lasted onequarter at the most. In the employment data,you can’t even find an impact.

The destruction of a house is not counted asa negative in the GDP, because it affects the

capital stock. But when you build it again, itgenerates income and gets counted in thenational income records. So whichever way wecount it, it is a one-quarter hit. This storm isgoing to affect two to three quarters becauseof the impact on consumer confidence.

I had just released a forecast on August 24and all of a sudden I had to create a new one.In the revision, I put in about a 10 percent dropin consumer confidence in the coming months.Thereafter, you see recovery as the rebuildingbegins. There is a very minor drop inautomobile sales — minor because we keep onbuying the cars. (And why wouldn’t we? If GM,Ford and Chrysler are basically giving you thegas guzzler and offering the $5,000 that paysfor your gas for the next four years, whywouldn’t you take it? So people are doing that.


Graph 1


It’s a big game, of course, taking the moneyout of the shareholders’ pocket and giving it tothe people, but it’s not going to stop.)

Inflation will peak up, which it has alreadybegun to do this quarter, but it is a temporaryblip. The Fed will counter it and it will comeback to normal. The 10-year bond rate willactually dip a little bit lower than the level Imentioned before. But the biggest impact is onthe housing stocks, because availability ofsupplies will not be easy. They say lumber,cement and other materials are in shortsupply, which is going to hold back a little biton building.

In the long run, there is no net loss. Whatyou lose over here in the GDP growth you makeup later. The biggest impact is in the fourthquarter, where I see a drop of almost 1 percent

in the GDP growth rate. But if you average itout over the four quarters, the drop is only 0.2percent. So we can say with a straight face it’snot a big impact, but a very big quarterlyimpact for one quarter (Graph 3). So that’s theeffect of these hurricanes.

Looking at “how the sausage is made,”virtually all of the impact is coming from highergasoline prices cutting into discretionaryspending and from the drop in housing starts.Without the drop in housing starts, theeconomy wouldn’t be affected nearly as much.

What else is going on in the economy? Theoverall economy is fine, though we do havesome problems. One of the problems peoplereally care about is the trade deficit. To thinkabout the trade deficit, I go home to India andI go up to the Himalayas to watch the

Graph 2


snowcaps. In this setting, the first thought Icome to is about the oil prices. I am thinkingabout why oil is so high and whether we canblame China for it. (In the newspapers, it isalways China and India.) In my thoughtprocess, I am trying to differentiate: is it reallyChina and India, or is it China or India, orChina with India?

Considering oil production and consumptionfour years ago and now (i.e., considering thenet change in supply), it turns out there are twobig contenders putting the pressure on the oilmarket. One is the US and one is China. Indiadidn’t put much pressure on the market; itschanges in production and consumption werealmost balanced.

The oil market is not like the stock market,where you pick up the phone, call the brokerand take the oil. It’s about relationships,

contracts, politics and geography. Chinadoesn’t buy any oil from Russia; it comes fromthe Middle East. The US can buy oil from theMiddle East and other places, but Russian oiltypically goes to Europe. Pipelines, boats andinfrastructure components like that play a part.So even if you want oil from Russia, you maynot have a relationship. The guy over there inthe Kremlin may not know who you are, inwhich case he’s not going to write the contractfor you.

Taking into account those realities, you findthat it was Russia that had the net supply toshare, not OPEC. Typically OPEC has been ableto produce more supply than it needs. So nowwhen you have the battle between the two guyslooking for the last barrel of oil, the currentprice, the market price, goes up. When themarket price goes up, the trader on the futures


Graph 3


desk, knowing that his counterparts were alltrained in MBA classes, jacks up the prices onthe futures and speculation begins.

At that point, Goldman Sachs feels thepinch, and reasons that in the stock market,managing money for a 3, 5 or 7 percent returnis not going to make its high-net-worthindividuals happy. So Goldman decides to getonto the bandwagon, into oil trading. All of asudden you have the speculators, hedge funds,Goldman Sachs and everyone coming in and itbuilds up momentum. It’s like bidding on ahouse in Los Altos. There are 17 buyers andone house, so it goes on. It becomes a bubblewhich is going to correct itself.

But in between you are going to think aboutone thing. You may want to ask Colin Powelltoday this question. Who in the future will have

the excess oil? The answer is Africa — that’s thenew frontier. So now you can understand whyBush and the British Prime Minister andeverybody stood shoulder to shoulder and saidwe are going to do something for Africa. It’sabout oil.

There’s one reason why Condoleezza Ricevisited Sudan — one simple reason. Sudaneseproduction of oil was zero four years ago. Nowthey are producing half a million barrels perday and it’s going to go up. Angola is comingup. South Africa is coming up. These peoples’own consumption is not going to rise thatmuch, but the production has already risen.That is where the new frontier is and it’s wherethe new battlefields will be. China and Russiadon’t have a pipeline, so China can’t go toRussia. China will be in the market too. This is

Graph 4


going to be the reason for high oil prices,because oil without contracts or previouscommitments is very limited right now.

The other thing going on right now inWashington is spending with both hands. Thegovernment is spending a billion dollars perday right now. How can you do that?! That kindof pattern brings up worries about the 10-yearbond rate. Isn’t the spending going to causeinflation? Won’t it cause interest rates to go up,especially on the 10-year bond?

When you go to an economics class they willtell you what causes the 10-year or the long-end bond to go up. Typically the factors areinflationary expectations, what the FederalReserve is trying to do, and the liquidity/safetypremium. These would come up in a financeclass. And the last but not least, according tome, is the trade deficit. I’ll show you thestatistical indicators later, but let me veryquickly build up the argument as to why thetrade deficit affects the 10-year bond rate.

My thesis is that high trade deficits keep theUS long-term bond rates low. It’s the reverse ofwhat they are going to teach you in classes. It’sbeen happening a lot more since the mid-1990sand it really intensified after September 11.

First, you heard about global savings gluts,meaning that there’s too much money floatingaround in comparison to investmentopportunities. It turns out economic theory saysthat money should flow from the high-net-worth, big developed countries to thedeveloping countries where there are frontiersfor higher returns. But the reverse has beenhappening since 1996. Until then, the industrialcountries were net loaners of funds and thedeveloping countries were net borrowers(Graph 4).

Now, it’s the reverse. Industrial countries,led by the US, have the highest foreignborrowing, and the developing countries havebeen loaning out money. In the last 10 to 12years, the United Kingdom (UK), which hadgreat growth, ran a trade deficit, whereas

Germany ran a trade surplus. When you run atrade surplus, by definition you are going toinvest that money voluntarily abroad. But ifyou run a trade deficit foreigners have loanedyou the money. It’s a voluntary thing, no gunto the head.

The flip side of a trade deficit is capitalinflows. All of you in the business of investingwill make portfolio choices and so do thesecountries. They also have to decide whatportfolio to invest in.

What do the foreigners buy over here? Graph5, page 10, shows the net foreign purchases ofUS financial instruments from foreign sources.The line showing T-bonds represents the netbuying of Treasury bills, the 10-year bonds. Itshows that they were in big demand until 1997or so, when the stock market took off in the USand people ran over to stocks. When the stockmarket ride was over in about 2001, they wentback into Treasury bonds.

Since then the level of foreign activity haschanged from net sales of $100 billion, topurchases of $400 billion, a flip of $500billion. Of course, if you buy more bonds, theirprice goes up and interest rates come down.That’s what’s been going on. But the issue iswho is buying.

I have shown that when the foreigners haveto invest the money in the US because we arerunning a trade deficit, they have four choices:agency, corporate bonds, stocks and Treasurybonds and they seem to be picking up Treasurybonds. Why? According to Bill Gross at PIMCO,who manages about $200 billion of bonds, theFed controls short-term rates while intermediateand long-term rates “are determined byinstitutions, individuals and foreign centralbanks such as China’s, which have beenmassive buyers of Treasuries.” So let’s look atwhether his hypothesis is right.

Here is the shocker. Looking at the trade inand holdings of US Treasuries by foreigncentral banks (Graph 6, page 11), we see thatin one year the Japanese bought $350 billion



worth of Treasury bonds. But if our trade deficitwith Japan only goes up by $10 billion, theyneed only buy $10 billion more to fund thedeficit. So why are they spending $350 billion?That is one issue. And why is the UK, whichdoesn’t run much of a trade deficit with us,buying $120 billion worth of Treasury bonds?The net change in that deficit is only $2 billion.Why did they buy 60 times that amount ofTreasury bonds?

Well, it seems they want to keep their currencyvalues low. And if you want to keep your currencylow, you need to buy the 10-year bond. The AsianCentral Banks do that because of growth in netexports, and so do the UK and Germany.

Only South Korea decided not to buy so much— the South Koreans are not too happy with theUS policy on North Korea. They don’t think they

are getting the attention, so they keep makingnoises about diversification. When they do that,the bond market jumps for a day but then itcomes back to reality. Imagine you are a centralbank in Asia. You have just gone through acurrency crisis six years ago. By definition youcannot suffer capital losses, so you are not goingto keep your money in corporate bonds orstocks; you are going to keep it in the risklessasset: the 10-year bond of the US Treasury. Youcan buy Euro bonds, too, but it’s not clear thatthey are really liquid. In the case of a currencyrun, could they be used to stop it? The answer isno, the Euro does not develop as a credible,liquid, alternative riskless asset.

In the last four years, we in the USconsumed a lot and we financed it by printingthe 10-year bond, which the foreigners snapped

Graph 5


up. That’s why the interest rates never went up.But we were lucky that what they were buyingis what we were printing. The issue is whetherthis can go on forever.

Let’s look at the makeup of the trade deficit:in which commodities, and where, do we run asurplus? It’s a bit of an eye opener. One thing isvery clear. Oil and vehicles — cars and the stuffneeded to run the cars — are causing half thetrade deficit. The commodities in which we dorun some kind of a surplus are airplanes,chemicals, soybeans, corn, wheat and cotton.These last are agricultural commodities, whichsurprised me. When I was learning myeconomics, developing countries, not developedones, ran surpluses in commodities. And thatgave me the idea as to what’s going to solve itin the future.

This imbalance cannot go on forever. In realestate you always think about a seven- to 10-year horizon. Well now just go a little bit longerand consider 15 or 20 years out. Are we goingto give up our cars and oil with a straight face?No. But if the gas price stays high, we mayeconomize. So we can cut down the gas bill alittle bit. That still leaves the cars, which I’llcome to. It’s not going to be that easy to solve.

On the other hand, if China keeps onproducing all the stuff for WalMart, it’s notgoing to have enough people left over to workthe agriculture, so it’s going to need food. Andwho’s got the food now? We do! You maywonder about somewhere like Brazil, everybodyknows Brazil can produce all the grain it wants.But there is one problem. Brazil has nohighways, no boats, nothing to move the grain


Graph 6


out of there. These things would take another20 years to build and they don’t have themoney anyway. We already have the Midwest,the granaries, the boats. New Orleans will comeback and we can send it out. So in 10 or 15years, we will be earning the surplus from here.

Until then, the issue of the cars is left. Tradedata show that the US runs the largest deficitin car consumption (we buy more cars than weproduce — in 2004 by a margin of 3.5 millionvehicles) and Japan and Germany run thelargest surpluses (3.8 and nearly 2 millionvehicles, respectively). It is a case of bilateralmonopoly. We consume the cars and theyproduce them for us. So if we cut ourconsumption, where are they going to sell thatsupply? Think about it.

I recently ordered a BMW and nine monthslater when it was delivered the price wascheaper and the Euro had gone up by 20percent. The car was produced in Germany,delivered over here, so I thought it was theforeign worker who had lost out in the process.But later I was joking with the mayor ofDüsseldorf, who was visiting Atlanta, tellinghim his countrymen were paying for my car,cutting into the workers’ money to pay for me.But he told me I was mistaken. “We alreadyfired all the workers. It’s automated.” Whenyou push it, they’re going to do that.

What’s the next step? When the Japanesewere forced to voluntarily restrain exports after1984, they saw that they were taking on thehassle of currency and political risks. So in the1990s, they came over to the US, to the South.That’s what’s going to happen. In response tothe deficit in cars, they’re going to startbringing the plants over here. We will againbecome a manufacturing site and that’s goingto solve it.

One day while I was musing about thisconcept, my assistant director, who reads thenewspaper too, said, “What about China? Whycan’t China absorb all the cars?” But Chinadoesn’t have the purchasing power. It doesn’t

grow that much. Two months later she cameback showing me that Chinese car sales were upby 50 percent. Without telling her what theproblem with the data is, I said, “look, it’s up by50 percent in one year. This has to keep on goingfor five more years before they would be able toabsorb those 5 million cars. The NASDAQ hasonly once gone up by 66 percent. We would belooking for such gains five times in a row,” I toldher. And three months later the report came in —Chinese sales were down 40 percent.

So there is no option. Why are these peoplebuilding those cars to sell over here? They aregoing to bring the plants over here down theroad.

Meanwhile, we are going to have our ownproblem with GM, which right now seems to bein business just to service the pension plans ofthe workers. I have been working on this issuefor the last ten years with a professor friend ofmine. We have compared Japanese and UScompanies’ productivity and it’s pretty clearwhich way the arrows go. Starting in 1968,productivity levels were similar. Over the last30 years one company, Toyota, has moved upto the frontier, out-performing everybody else.The laggards are led by GM.

So what’s the issue and what is the solution?There are some steps the laggards could take.First they could follow the Japanese just-in-timepractices, increase volume at the plants, stepseconomists would describe as standard stuff.Second, they could negotiate with the unions.That’s obvious. Third would be to bring backsome creative designing to appeal to customers.

But the ultimate step I suggest is, instead ofgiving the top management stock options, givethem the company’s 30-year bonds. That tiestheir reward to long-term results. If they screwup right now in hiring practices and otherareas, 30 years down the road they won’t gettheir pensions. Make the incentive profile 30years. Part of the problem is that the typicalCEO of a big company serves only about twoand a half years. They’re likely to be fired by


the board, get their severance and go homeand retire. Why would they want to make anydecisions with implications 15 years down theroad? They have no incentive; they only live forthe short term. So we need to change thatstructure. Instead of compensating themthrough stock options, compensate themthrough bonds. By tying the CEO’scompensation to the company bond, if he hiressomebody and they mess up later on, they’llpay the price.

Getting back to the 10-year bond rate andthe influence of the trade deficit, I offer theregression equation (Graph 7). My forecast isthat the 10-year bond rate won’t touch 5percent until the middle of next year. Inflation isnot going to be a problem, so the Fed will nothave to really step on the brakes.

I’ve only talked about the commodity side ofthe dollar so far, but what about the value ofthe dollar? Two things can happen. If you can’tsell them the other goods, you can sell themreal estate. In the national income accounts,real estate shows up as a statisticaldiscrepancy in the flow of funds — there’s nocategory for real estate. I have been talking toFederal Reserve Bank officials, trying to figureout how to track when somebody in Germanyinvests over here to buy a building, but there’sno tracking it. We just know the money camein. It goes into the pot.

To give you an example, our trade withVenezuela is barely $10 to $15 billion, $25billion at the most. But the statisticaldiscrepancy runs $50 billion. That means theyare spending more money over here than we


Graph 7


can even figure out from the national incomeaccounts. That money is going to Miami to buycondos and homes. The new buyers there areArgentineans and Venezuelans looking toescape chaos and turmoil in their countries.When the money leaves the country, it getsinvested in real estate.

Ultimately, the value of the dollar will fall ifyou keep on running this kind of deficit. We’llneed to sell them something, so there have evenbeen jokes that the world can come and get itsplastic surgery here, [laughter] we’ll sell services.

But there’s another issue. What creates jobs? Icame across a Dilbert series about outsourcing.(Only I can get away with this stuff about India!)Dilbert comes to the boss to report the“disturbing news” that the company outsourcedits service function to India a few years ago.

“So?” retorts the boss. “Apparently theysubcontracted the job to Mexico. Then Mexicosubcontracted to Vietnam who subcontracted tothe Philippines who subcontracted it to us. Whatgoes around comes around.” Happily now therevenue of the big companies is beginning togrow in the US, as is job growth, trends I expectto continue notwithstanding Katrina and Rita.Alan Greenspan faces the dilemma ofreconciling fundamental pressures such as thatjob growth, possible incipient inflation andproductivity. But the biggest challenge is thesuper-hot housing market.

Looking at the housing market, I have acrazy chart (Graph 8). It shows activity in themarkets with the fastest home price increases,and they are all in three states: Florida,California and Nevada. The top three markets

Graph 8


show 30 percent home price appreciation in ayear. That defies some logic, doesn’t it?

I can explain it in Las Vegas, since peoplewho can’t buy in California move there. Butwhat’s going on in California and Florida, twocoastal areas? Statistically I cannot prove thereis a bubble. But I’ve charted income growthand home prices since 1991 and characterizedthe activity into some zones (Graph 9). The redzone, in which annual home price appreciationhas been high (over 8 percent) and incomegrowth has been very low, includes the BayArea. In the safe zone, income growth has beenhigh (over 5 percent annually) and appreciationlow (under 7 percent). California is sitting onthe border of the red zone! Florida is not evenin the bad zone, but poor Minnesota is.[laughter] You think there is a bubble going onin Minnesota? [laughter]

What this shows is that if you try to go tostatistics to prove there is a bubble, youcannot. Statistically, bubbles are nothing butnon-fundamental solutions to a differentsituation. It’s like beauty. You can’t define it butwhen you see one, you know.

The public has used houses as a bank andtaken money out in the form of home equitycredit. But the productivity of this depends onthe use to which the money is put. If you takethe money out to pay down expensive debt, Ilike it. That’s the beginning of entrepreneurship.That’s how people build new businesses. I lovethat activity.

What about the consumption of durablegoods — a big- screen TV, for example -— is thatinvestment or consumption? Economists willclassify it as consumption, but I say it might beinvestment. When I watch the TV and I see those


Graph 9


nice movies, my mind feels light and I am moreproductive at my job the next day. I can justify it.[laughter] (My dad said I could justify anything.)

What about using the money to take avacation to Bahamas? I make the same point. IfI take a vacation, I feel refreshed, come backand work harder.

One thing I do not recommend you shoulddo, which you probably won’t like, is to take themoney out and send your kids to Ivy Leagueschools. Why? Has any kid ever paid back theirparents? [laughter] The homeowner is takingthe risk. The kid eventually earns a greatincome, hopefully, so the household as a wholebenefits, but the inter-household dispersion ofrisk is different. So save your money, send themto the state and local colleges. (Send them toGeorgia State. We give a good education.)

One thing everybody wants to talk aboutthese days is Social Security. Private accounts,is it going bankrupt, what’s going on? This is aproblem that is going to happen in 2042. Doyou care? Neither do I. Okay.

Health care is hitting us right now. If wekeep on growing and aging when there are notenough young people, then, as a proportion ofGDP, the 9 percent of your paycheck you aregiving for Medicare and Medicaid will go to 13under simple assumptions. If I blow theforecast a little bit, it goes to 21 percent; a littlebit more, it goes to 30 percent. Are you goingto pay one-third of your salary as taxes forMedicare and Medicaid? No.

So how do you solve this problem? Apolitician will recommend tax hikes and benefitreductions, as will an economist. For the otherrecommendation you must blame my mentor,who is a Texan. That solution is to ship theboomers to India. Outsource it! [laughter] Ofcourse, there are some problems involved.

The technical solution is to bring in hundredmillion immigrants. That means 10 million peryear. Right now legal immigration is less thanthree-quarters of a million a year, at which levelit’s causing social and political problems. Ten

million is impossible. Additionally, even if it waspossible politically and socially, there are notenough people in the world, not even in Mexico,India or China, to achieve it. So to solve thisproblem you have to think outside the box.

Some years ago, I heard my mentor talkingabout this problem. He noted that 90 percent oflifetime medical expenses happen in the last sixmonths of your life. If you could eliminate thelast six months, this would never be a problem.[laughter] But how do you do that? If I live to be85, I want to be going to work in the morning,doing my nice job, coming back home to lightup a Cuban cigar and have my nice scotch anddrop dead of a heart attack. Done. Gone.

Of course that’s too radical. But luckilyeconomists came along and distinguishedbetween medical advances that prolonged theproductive life span and those that prolongedthe actual life span. We’re already able toprolong the actual life span. What we need istechniques to prolong productivity. With that Iwill end, leaving time to take some questions.

QuestionThank you very much for that very delightful

presentation. You talked about some structuralimbalances in the US economy, taxes andSocial Security, but what about the budgetdeficits? What about the impact of spending bythe government? No doubt it’s about theaccounts directly behind the imbalance of theforeign accounts, but what about themechanisms in the budget deficit?

Dr. DhawanThe question is what about the current big

budget deficits, which will be exacerbated withKatrina.

As I said, the budget deficit turned out to benot a problem because we financed it byprinting the 10-year bond. We monetized it andthe foreigners were holding that bond. So wewere very lucky the last five years, given thatthe world economy needs a certain amount of


dollars, in the form of the 10-year bond, tomake it work, kind of like the grease. So as longas we keep the deficit around $300–$400billion at the most, not forever but for a fewyears only, you can pass on the extra bonds. Forthat reason, I am saying that for a year the 10-year bond will remain low. Ultimately, with allthis spending, it will catch up. There is a limit tohow much the foreigners can absorb. But aslong as a substantial part of Asia and quite afew other countries want to have an export-ledgrowth at any cost, and as long as they havethe US as the ultimate consumer, this game cango on for another four or five years easily. Theissue would be that it can’t go on for 20 years.

Follow-up Question…Which makes the US economy fairly

sensitive to the savings rates in those countriessupplying the capital, doesn’t it? Because iftheir economic growth and their tendency toconsume turn around…

Dr. DhawanIt makes it a little more risky, but I point to

one thing. You hear a lot about the risk of theJapanese and Chinese deciding to dump theTreasuries. But what would they buy instead?That’s the answer. I would love to holdAustralian bonds in my portfolio, they are rocksolid, and they pay well. But I think one bank inPittsburgh can buy up the entire supply. Theissue is the amount of liquidity. The only marketthat is liquid is the 10-year bond. Financeprofessors talk about markets, but they forgetone thing. In a stock market, there is onemarket-clearing mechanism, one central tradermatching the buyers and the sellers. It’s calledthe market maker. And it typically works forevery stock — when you place an order yourbroker goes to the market maker and theliquidity allows you to get it done.

But a bond market is totally fractious. Thereis no central clearing place. All you see on theBloomberg terminal is what trade happened

and at what price, and that is only 40 percentof the market. It’s like trading in islands. I havea relationship with you. You are in JP Morgan. Iam a hedge fund with 10-year bonds I want tosell. I have been dealing with you, so I come toyou. You give me almost 99 cents to the dollar.

When the LTCM collapsed it was because,when they were making money, they werelording it over all these Wall Street guys andticked them off. When the day came for theircollateral to be liquefied, the Wall Street guysweren’t too happy with them and offered 80cents to the dollar for the bonds they wereholding. When they balked at that, the WallStreet guys got even tougher and paid only 60

cents to the dollar. Unlike in a stock marketwhere there is a central market clearingmechanism, in bonds it’s nebulous. There is nomarket clearing.

So as long as that is the case, what’s going tohappen? Suppose 10 years down the road I seethe Japanese selling Treasuries and taking themoney back to their country because theeconomic prospects have suddenly changed. Youknow what you are going to do? You’re going tofollow the same trail and go where the bestreturn is. At that point, you may suffer capital


Mark Preston, Grosvenor; Mark Baillie, Macquarie Real Estate, Inc.; Gen. Colin Powell; and Steve Zoukis, JAMESTOWN, at lunch.


losses by selling the 10-year bond, planning tomake it up on the investments from Japan.

In the end, it’s all a question of economicopportunities. Why does the European moneyflow over here for real estate? Because thereturns at home don’t look too good. The 4.5percent return over here on the 10-year bondlooks great compared to the 3.2 for theGerman one. It’s a case of what kind of risk youwant to take, where the returns are and howthe money goes.

QuestionCould you comment on the likelihood of an

inverted yield curve? Since in the past we’veseen a fairly good connection betweensustained inverted yield curves and recession, ifthe yield curve were to invert what are the risksof a recession in the US?

Dr. DhawanI think you answered most of the question

yourself. Sustained inverted yield curve. A yieldcurve did invert a little bit a few years ago andthere was no recession. The issue is separatefrom the inversion of the yield curve; theabsolute level of the interest rate matters. The

best example is 1990. Iraq invaded Kuwait. Atthat time, the federal funds rate was 7.5percent, the 10-year bond was around 8.5percent. Then the fed funds rate went up,inverting the yield curve. At that level it doesn’tmatter whether it was inverted or not. At 7.5percent interest rate, with inflation only 2 or 3percent, that’s a very high real interest rate.

Right now, any inversion would behappening because of the trade deficit. I firmlybelieve when I build the models, that every timeyou grow the GDP, your imports have to growin proportion. When the imports grow, so doyour inventories and so does your consumption,so there’s always going to be some kind of adeficit. That’s why I put up that global savingschart. If you notice, Germany runs a tradesurplus. German growth in the last three yearscannot be said to be a great one. So I thinktrade deficits are good for growth, as long asthe foreigners are willing to hold your 10-yearbond. Any other country that tries to run thisone is going to get into trouble because theyare not the international reserve currency.

Also, as long as you have other assets tosell, real estate, parks, land, beachfront inCalifornia, you can sell those assets. As long asthere are Argentineans and Venezuelans in themarket, rich Iranians who want to buy inBeverly Hills, your assets have value, locationhas a value.

QuestionBack in the 1970s, you heard a lot about the

challenge of recycling petro dollars. Today Ihaven’t heard too much about that. I wonderedif you have looked at where the excess capitalfrom high oil prices is going.

Dr. DhawanThe trouble is the Treasury data for last year

didn’t show much because things are onlyhappening in the last nine months. Only whenthe data come out in another six to eightmonths will we know how they recycled it.

Capitol Steps imitate Bill and Hillary Clinton.


But one thing does show. Middle Eastern oilis priced in dollars and commodity trading is indollars. But only 10 percent of Middle Eastimports are from the US. Sixty percent are fromEurope. The recent increase in oil prices, from$25 to $50, can be explained by a need formore dollars, because the Euro hadappreciated so much. They just raised the priceand the market took it. So if they are alsospending a lot of it in Europe, there’s not muchleft over to recycle.

QuestionYou mentioned that the deficit is not a

problem as long as investors are willing to holdthe 10-year Treasury. And you made the goodpoint about Australian bonds — there are notenough of them. Ten or 15 years from now,what would it take for the Chinese to have a10-year bond that the whole world wanted tohold and what would the world look like if theyhad one?

Dr. DhawanI think your question is very good, but you

have to tell me. They are still playing with apegged currency, almost a basket of goods.They don’t have a currency peopleautomatically want to trade in. First you haveto have a currency investors will willingly holdand a central bank with a reputation as aninflation fighter. There are a lot of ifs there. Thebest thing China did was to peg its currency tothe dollar in the early 1990s. If you don’t havea central bank with a reputation, buysomebody else’s reputation. The moment youpeg the currency, however, you have to acceptthat your inflation rate is going to become thatof the country to which you’ve pegged. That’swhy you could see the Chinese and US inflationrates converging.

Their biggest mistake was to give in to thepolitical demand from here to take away thatcoupling. Having implemented the couplingbecause they didn’t have the reputation, why

give it up without having an independentcentral bank, with the government still runninga commodity economy and without knowingwhat’s going on? Technically, they have onlyupped the currency by 2 percent, but if theyallow it to float by 0.3 percent every day,technically in a year it will appreciate by 20 to30 percent. At that point, it will become aproblem for them because Malaysia and otherplaces are also selling goods over here, andChina needs the break. But WalMart is notgoing to give them the break. China will haveto eat the cost to supply the same goods toWalMart if the currency appreciates that much.

It’s another case of a big buyer and a bigsupplier, a bilateral monopoly. The solution isindeterminate; it all depends upon bargainingpower, but who has the guns? So I don’t seeChina becoming a force in that sense. I’drather put a little bit more money towardsEurope if they can get their act together.

I say that because Europe has a problem: 11 independent elections, 11 independent fiscalpolicies and one monetary policy. They aretrying to balance 11 equations with only onefree variable. You need 11 free variables. In theUS we have a union. None of the states areallowed to run a deficit technically on paper,but they run it somehow. But still they cannotprint their own money. There’s one nationalelection, one national fiscal policy and onenational monetary policy. There exists asolution. I see that as a problem for Europe. Forthe Euro to become an international reservecurrency, the EU will have to show that thesecountries can somehow manage that equation.So far, in the verifying of those constitutionaltreaties, it didn’t work out. ◆


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