by Ian Fletcher
America’s accumulated financial obligations to foreigners mean that an increasing percentage of our future output will go to their consumption, not our own. This applies to both the public and private sectors: as of 2009, 5.5 percent of the federal budget goes to interest on debt,129 and about half the federal debt is foreign-owned.130 In 2006, for the first time since we paid off our own 19th-century debts to Europe due to British borrowing here to pay for WWI, America paid more in interest to foreigners than it received from them.131 Luckily for us, the average interest rate on what we own abroad (largely high-yielding corporate assets) exceeds the average interest rate on what foreigners own here (largely low-yielding government bonds), so we crossed this line long after becoming a net debtor.132
But we can’t keep borrowing forever. Both the private sector and the government are threatened by the surging interest rates that would result from our international credit drying up. This surge could easily knock America back into recession.133 And tens of millions of ordinary families are so indebted that they could be pushed into bankruptcy by a sustained rise in the interest rates on their credit cards and other floating-rate debt.134
Because wage increases have been barely outpacing inflation for 35 years,135 consumer spending has only kept pace thanks to the ability of consumers to tap into the equity of their homes at low interest rates. Without this, the spending surge of recent years—consumer spending has gone from 63 percent of the economy in 1980 to 70 percent in 2008—would have been unsustainable.136 Americans have, in effect, papered over their economic difficulties in recent decades by massive borrowing from abroad. Because this borrowing helped enable the deficit, and because the deficit itself has been responsible for a large part of our economic difficulties, we have been caught in a slow-motion self-reinforcing doom loop.
THE SELL-OFF OF AMERICA
America’s global overdraft is not only financed by debt, of course. It is also financed by selling off existing assets. This tends to make the news only when foreigners buy some huge thing people have actually heard of, as when Japanese investors bought Rockefeller Center in 1989 or a firm controlled by the United Arab Emirates tried to buy six of our major seaports in 2006 (and withdrew upon national-security scrutiny), but it is quietly going on all the time. Sometimes the purchasers are private entities abroad, but they are sometimes actual foreign governments, by way of so-called sovereign wealth funds.
By definition, accumulated trade surpluses can only be invested abroad. Asian sovereign funds investing such monies are expected to have $12.2 trillion by 2013, with the funds of petroleum exporting nations reaching a similar level.137 Tiny Singapore has $330 billion.138 Little Norway, flush with North Sea oil wealth, has $380 billion.139 Kuwait has $200 billion140 and Abu Dhabi $875 billion.141 South Korea, Brunei, Malaysia, Taiwan, and Chile also have such funds.142 Even Canada has a huge state pension fund—which denies that it is technically a sovereign fund or would ever politicize its investment decisions, but is still a huge block of capital under foreign government control.143
These funds are getting more sophisticated all the time and have the ambition to become even more so. This is why China’s State Investment Fund recently bought a 10 percent stake in the elite New York investment firm The Blackstone Group, which specializes in taking large private stakes in corporations and other sophisticated investment strategies. China’s government not only wishes to manage its American investments more profitably, but in the long run probably also wishes to learn from this firm the fine art of corporate takeovers and other more active investing strategies.
As a result of this massive shift in wealth, the world’s center of financial power is moving away from the Western nations that have held it for centuries. The Central Bank of China (Taiwan), the Bank of Japan, and the Abu Dhabi Investment Authority (ADIA) have, in fact, been bailing out the crippled powerhouses of Wall Street.144 The ADIA invested $7.5 billion in Citigroup’s rebuilding of its balance sheet;145 all told, Citigroup received $17.4 billion in sovereign money.146 The sovereign wealth funds of Kuwait and South Korea helped bail out Merrill Lynch.147 In all, from March 2007 to June 2008, Asian sovereign wealth funds contributed $36 billion to the recapitalization of Western financial institutions, with oil-based funds kicking in another $23 billion.148 Without this money, Wall Street’s bailout demands upon American taxpayers might well have been too much to stomach.
This all raises profound issues of economic security, especially as some of these governments are not reliably friendly to the U.S., especially in the long run. Unfortunately, America’s mechanisms to prevent problems in this area, principally the interagency Committee on Foreign Investment in the United States (CFIUS), deliberately limit themselves to conventional national security concerns and ignore economic security. CFIUS rarely blocks transactions. Of the 404 foreign investments evaluated in the most recent reporting period (2006-2008), not one was actually blocked, although a number were withdrawn in response to scrutiny.149 An attempt was made in 2007 to expand CFIUS’s brief to include economic security, but it failed. In the words of deputy U.S. Trade Representative John Veroneau:
Doing so would have unhinged CFIUS from its core function of assessing national security and would have left a wide and ambiguous definition of what constitutes ‘economic security’…Blocking an inward investment is an extraordinarily serious exercise of governmental power and should be done in only the rarest circumstances, namely when national security interests require it.150
So the U.S. government, like the Soviet Politburo, remains stuck in a narrowly military definition of national security. It has no institution explicitly dedicated to protecting America’s economic security, and is uncertain how even to define the concept. (We can perhaps best define it on a straight analogy to conventional military security: it is the ability to prevent foreign nations from doing us harm by economic means.)
WHEN THE WELL RUNS DRY
America’s massive asset sell-off must come to a halt when we run out of assets to sell. More precisely, it must end when our remaining assets promise foreign investors less return on their money than they can get elsewhere. It may taper off gradually as our government’s credit rating and the attractiveness of our private assets gradually decline. Or it may grind to an abrupt halt in a financial panic due to a sudden collapse of confidence in the U.S. economy. Or it may be choked off by a political decision on the part of major buyers. They are well aware of what is going on. As Zhou Jiangong, editor of the online publication Chinastakes.com, recently asked, “Why should China help the U.S. to issue debt without end in the belief that the national credit of the U.S. can expand without limit?”151
Short answer: because the U.S. is importing about eight percent of China’s GDP.152 China’s productive capacity is mismatched with its own consumer demand, so it cannot switch overnight to supplying domestic markets. Its own population is still far too poor to buy the fax machines and other goods its factories produce for export, so China risks mass unemployment—potentially 100 million people—if it ceases to run huge trade surpluses. This pretty much requires it to keep devouring American debt and assets in return. China is in a terrible bind, and one can speculate endlessly on what sort of endgame its rulers may have in mind. Their ideal move obviously would be to segue smoothly from foreign to domestic demand, and they are clearly trying to do so, but there does not appear to be enough time to make this switch before America’s capacity to absorb their trade surpluses is exhausted.153
In the developing world, which is not rich enough (does not have enough accumulated assets) to engage in massive asset sales, the upshot of the above problems is a bit different than for the U.S. Free trade, combined with corresponding free debt and asset flows, makes it easier for such countries to pile up huge debts. These are often worsened by the fact that these countries cannot borrow internationally in their own currency, so both their public and private sector borrowers end up owing money in a foreign currency whose local price soars when th
e exchange rate drops. (This is a big part of what went wrong in Thailand and nearby nations in the 1997 Asian Financial Crisis.)
Both the International Monetary Fund and the World Trade Organization actually understand all the above problems perfectly well, at least on paper. For example, Article XII of the General Agreement on Tariffs and Trade (annexed to the founding agreement of its World Trade Organization successor in 1994) explicitly permits nations to restrict the quantity or value of imports in order to avoid trade deficits.154 Similarly, the IMF’s frequent attempts to package free capital flows with free trade are a violation of Article VI of its own Articles of Agreement, which recognizes the right of nations to maintain capital controls (which limit foreign debt and asset sales).155 Neither of these wise concessions, products of a generation of policymakers more realistic about the pitfalls of free trade than those working today, are honored in practice anymore.
THE FREE MARKET WON’T SAVE US
Readers with a free-market bent may wonder how all the above unpleasant outcomes are possible in a capitalist economy. They may suspect that there is some free-market comeback which proves that the above problems are not really problems after all. After all, doesn’t the free market guarantee rational economic decisions? Isn’t that a basic axiom of capitalism?
Well, no. Not absolutely.
The root problem is simple: when free-market economics says free trade is best for our economy, it takes no position on whether this is best in the long or the short term. In fact, free-market economics takes no position on whether any policy it recommends is best in the long or the short term. It treats short- vs. long-term well-being as an arbitrary consumer-driven preference, like whether the economy should produce pork or beef. Some policies deliver the best short-term results, others the best long-term results, but it’s an arbitrary choice which we care about more. Free-market economics certainly does not say that we “ought” to prefer long-term well-being, and it has no invisible hand that will push our economy toward an optimal time horizon the way it will set optimal prices as those that match supply with demand.
The technical way of saying all this is that free-market economics “treats the time discount on consumption as an exogenous preference.” An exogenous preference is one brought to economic life from outside, like the fact that Frenchmen prefer wine and Germans prefer beer. Time discount on consumption is a reflection of the fact that economics doesn’t literally deal in time horizons. Time horizons are the idea that outcomes matter up to some point in the future (the “horizon”) and then don’t matter after that. Instead, economics deals in time discount, which is the idea that the further into the future an economic event is, the less it means today. This is the basis of interest rates, among other things: if you lend me money today and I promise to pay you back later, the longer you have to wait, the more interest you’ll demand in return. So “treating the time discount on consumption as exogenous” means that while economics can give us lots of advice about the most efficient way to produce whatever it is we want, it cannot tell us what we ought to want (or when we ought to want it!) in the first place.
There is no way to evade this problem with minor technical adjustments, as the entire logic of free market economics is explicitly set up this way, baked into its mathematical structures from the very lowest levels. As a result, we’re going to need to change that economics a bit to find a solution to our trade problems.
THE ART OF EFFICIENT SELF-DESTRUCTION
How does all this apply to trade? Try this small thought experiment. Imagine two neighboring nations between whom trade is forbidden. Make one a “decadent” nation which prefers short-term consumption. Make the other a “diligent” nation which prefers the long-term variety. The difference between them, of course, is time discount on consumption. In economic equations, this is conventionally designated with the Greek letter rho (p). A higher value of p means one is more short-termist, because one discounts the future more aggressively. Think of p as impatience.
Now lift their protectionist barriers so the two nations can trade. And let them lend each other money and sell each other assets so they can run deficits and surpluses. Then see what happens. Standard mathematical models of trade, accepted even by free traders, can then be used to run out various scenarios of what happens next.156
One scenario in particular is very interesting. In this scenario, the decadent nation maximizes its short-term consumption by buying all the imports it can get. So it buys all it can afford with both its exports and by assuming debt and selling off assets.
In the short run, both nations are happy. The decadent nation is delighted to be able to consume more right now. And the diligent nation is delighted that its neighbor has expanded its range of investment opportunities, which will enable it better to accumulate wealth and consume more later.
In economic language, both nations have “maximized their utility,” the odd word economists use for happiness. So according to free-market economics, both are now better off. This outcome is also “efficient,” as free-market economics understands efficiency, and it agrees with the core libertarian intuition underlying that economics: more freedom makes people more able to better themselves.
So is free trade vindicated?
No, because then come the consequences. The increased well-being of both nations (as they define it, remember, decadently or diligently) depends on the ability of the decadent nation to borrow and sell assets. And it cannot do this forever.157 Eventually, when it exhausts its ability to sell assets and assume debt, it ends up poorer than it would have been if it had not had free trade with its neighbor. Because it depleted its assets and saddled itself with debt, it must now divert money from its own consumption to give to its trading partner.
This outcome should make clear the answer to the question that haunts all criticism of free trade:
How can reducing people’s freedom possibly make them better off?
The answer is:
When they would use short-term freedom to hurt themselves in the long term.
The citizens of the decadent nation would have been better off if restrictions on their ability to trade had prevented them from being quite so decadent. Trade restraints for them would be like restrictions on an heir’s squandering his inheritance. The citizens’ “inheritance” is the entire accumulated wealth of their country that can be sold off to pay for imports, plus its entire debt-servicing capacity upon which debt can be floated.
Mathematical modeling actually reveals that under these conditions, outright Las Vegas decadence is not necessary for there to be a problem. It reveals that under free trade between nations with merely different time discounts on consumption, the nation with the higher discount (more impatient) will tend to maximize present consumption by having past generations (who produced the assets that can be sold off) or future generations (who will service the debt) pay for present consumption.158 Various factors can interfere, but that’s the underlying dynamic.
The fact that two separate societies are involved is key. If the “decadents” in a society can borrow only from “diligents” in the same society, then every borrower creates a lender in the same society, keeping society as a whole in balance. So no amount of decadence (whatever other problems it may cause) can reduce that society’s total net worth or future consumption possibilities. But if members of a society can borrow from outside that society, then it can. Worse, things can spiral out of control, given the self-reinforcing way in which social and cultural validation of behavior creates more behavior, then more validation, and so on. So it matters whether people engage in economic relations with compatriots, with whom they share a social and cultural system, or with foreigners, with whom they share only arms-length economic relations. (As noted in Chapter One, nations are far from being economically irrelevant.)159
THE DANGERS OF PERVERSE EFFICIENCY
The profoundest fact here is actually that this entire mess is efficient, as free-market economics understand
s efficiency. This explains why free trade’s dangers in this regard have mostly been ignored by economists.160 Within the rigorously logical (albeit perverse) assumptions of mainstream economics, it is merely a mathematical curiosity that free trade can make a nation worse off by seducing it into decadent consumption. It wanted a short-term consumption binge; it got what it wanted; what’s not to like? The problem has been defined out of existence at the level of basic premises.
Once one realizes how treacherous efficiency can be, and how important preferences are, it becomes clear that economics needs to focus less on the former and more on the latter. One surprising result of all this is a renewed respect for traditional bourgeois culture, or at least that aspect of it which inculcated people to save and not consume. It seems those silly old Protestant misers had a point after all!161 (Given that they created modern capitalism, it is no surprise they were onto something.) Crudely put, they reinvested their money in industry, rather than spending it all on palaces as the aristocrats who came before them had done.
The signs of debt addiction in the U.S. economy are not hard to see. The thrift-oriented generation that remembered the Great Depression has mostly died off, and households have become accustomed to endless consumer credit. As the interest rate on consumer debt has exceeded income growth since 1982—the classic formula for a debt trap—consumers have only remained afloat by relying on serial asset bubbles, especially in housing, to prop up their net worth.162 The combined debt of America’s households and government is now 243 percent of GDP—more than our (understandably) high debt level at the end of borrowing to pay for WWII.163
