by Ian Fletcher
Our smartest competitors, meanwhile, use every trick in the book to keep their citizens from going into debt. It is no accident that 500 million Chinese have cell phones, but only one million have credit cards.164
Perverse time discount has implications far beyond free trade and raises doubts about many other areas of economic policy over the last 30 years. For example, financial systems have been deregulated in many nations, especially the U.S. and UK, on the assumption that this is “efficient.” Efficient it may be, within a narrow definition of efficiency, but what if this just enables people to sink into debt more efficiently? Efficiency at the wrong things can be counterproductive. It is likely that many of the quaint old restraints on finance that have been deregulated away since about 1980 served, in theoretically unrigorous ways, to restrain the self-destructive potentials of perverse efficiency.
Perverse time discount can potentially ruin absolutely anything in the economy, given that every bad thing looks good at first (or else nobody would do it). For example, companies with short time horizons won’t invest for the long term. So they will be poorly equipped to handle technological innovation, which requires costly investments that only pay off years later. (We tend to think of innovation as being about quickness and rapid response to change, but it is also about delayed financial gratification.) So this seemingly abstract problem helps explain some very concrete facts, like America’s inexorably slipping lead in high technology.
Does all this mean that America must zero out its trade deficit as soon as possible? Unfortunately, the above analysis should make clear that the deficit is a chronic problem, not an acute one. It exerts a steady drag on our economic well-being, undermines our future, and we would be better off without it. But every Chicken Little who has screamed that the sky was about to fall has been embarrassed. (This has led a cynical public to conclude that no problem exists, which also is wrong.) And although failure to fix the deficit inexorably increases the ultimate risk of a financial debacle, there is no clear point predictable in advance when this will happen. We do not know exactly how much of our debt, or how many of our assets, foreign investors are prepared to hold. (They may not know either.) We only know that the one reliable way to avoid crossing that invisible line is to stop running deficits and adding to the total every year. And in the meantime, the deficit inexorably depletes our future.
THE SAVINGS-GLUT EXCUSE
Based on the above realities, in which America consumes too much and saves too little, it is sometimes claimed that our trade deficit is really a savings problem in disguise. Sometimes it is admitted that America saves too little; sometimes it is claimed that the real problem is a savings glut abroad, mainly in East Asia. Either way, this implies that trade policy is irrelevant (and futile to try to change), as only changes in savings rates can alter anything. For example, the China Business Forum, an American group, claimed in a 2006 report, “The China Effect,” that:
The United States as a whole wants to borrow at a time when the rest of the world...wants to save. The result is a current account deficit in the United Sates with all countries, including China.165
This analysis is dubious on its face, as it implies that whether American cars and computers are junk or works of genius has no impact on our trade balance. Neither, apparently, does it matter whether foreign nations erect barriers against our exports. Nevertheless, it is stubbornly asserted in some very high places, largely because it excuses inaction.
But this analysis depends upon misunderstanding the arithmetic relationship between trade deficits and savings rates as a causal relationship. In national income accounting, our savings are simply the excess of our production over our consumption—because if we don’t consume what we produce, saving it is the only other thing we can do with it. (If we export it, we’ll get something of equivalent value in return, which we must then also consume or save, so exporting doesn’t change this equation.) And a trade deficit is simply the opposite, as if we wish to consume more than we produce, there are only two ways to get the goods: either import them, or draw down supplies saved up in the past. As a result, trade deficits do not “cause” a low savings rate or vice-versa; they are simply the same numbers showing up on the other side of the ledger. (The decision to eat one’s cake does not cause the decision not to save one’s cake; it is that decision.) So neither our trade deficit nor our savings rate is intrinsically a lever that moves the other—or a valid excuse for the other.
Sometimes, it is even argued that foreign borrowing is good for the U.S., on the grounds that it enables us to have lower interest rates and more investment than we would otherwise have. But this argument is a baseline trick. It is indeed true that if we take our low savings rate as a given, and ask whether we would be better off with foreign-financed investment or no investment at all, then foreign-financed investment is better. But our savings rate isn’t a given, it’s a choice, which means that the real choice is between foreign- and domestically-financed investment. Once one frames the problem this way, domestically-financed investment is obviously better because then Americans, rather than foreigners, will own the investments and receive the returns they generate.
A related false analysis holds that our trade deficit is due to our trading partners’ failure to run sufficiently expansive monetary policies. (This basically means their central banks haven’t been printing money as fast as the Fed.) Some American officials have even verged on suggesting this is a form of unfair trade.166 Now it is indeed true that our major trading partners have not been expanding their money supplies as fast as we have. But as we have been doing so largely in order to blow up asset bubbles in order to have more assets to sell abroad to keep financing our deficit, it is not a policy sane rivals would imitate. We can hardly ask the diligents of the world to join us in a race of competitive decadence. (If they did, the result would almost certainly just be global inflation anyway.)
Another dubious theory holds that America’s deficit is nothing to be ashamed of because it is due to the failure of foreign nations to grow their economies as fast as ours. Thus George W. Bush’s Treasury Secretary, Henry Paulson, Jr., said in 2007 that:
We run a trade deficit because our vibrant and growing economy creates a strong demand for imports, including imports of manufacturing inputs and capital goods as well as consumer goods—while our major trading partners do not have the same growth and/or have economies with relatively low levels of consumption.167
This analysis appeals to American pride because it carries the implication that we are merely victims of our own success and that our trade deficit is caused by the failure of foreign nations to be as vibrant as we are. It implies that somebody else ought to get his house in order. Unfortunately, it is obviously false that our deficit is caused by slow growth abroad when some of our worst deficits are with fast-growing nations such as China. As for “relatively low levels of consumption” abroad causing our deficits, this is true enough, but it also implies that balancing our trade will remain impossible as long as we have major trading partners with low consumption levels, as we indeed do.
ARE FIXED EXCHANGE RATES THE SOLUTION?
The foregoing analysis gives a big clue as to why the 1945-1971 Bretton Woods system of fixed exchange rates worked so well, despite being a centrally planned system flouting the basic principle that prices (for currency, in its case) can only be efficiently set by a free market. This system generated trade deficits that were tiny by present standards, and the world economy grew faster while it was in operation, with less inequality between and within nations, than ever before or since.168
The key virtue of Bretton Woods, as we can now see, is that while floating exchange rates may be efficient, they are efficient at the wrong thing. They are driven by the total demand for a currency, that is, demand to buy not only a nation’s exports but also its debt and assets. As a result, demand for a nation’s currency is determined not only by its export prowess, but also by its willingness to sell off assets and
assume debt. But this entails treating unsustainable demand (for assets and debt) the same as sustainable demand (for exports). So floating exchange rates will not necessarily find the level optimal for that part of the economy devoted to present production. But this is the only part of the economy that actually creates wealth, as opposed to shifting it forwards and backwards in time. It is no accident that we live in an age when the financial tail often seems to be wagging the dog of the real economy! (From 1945 to 1985, the financial sector never made more than 16 percent of U.S. corporate profits, but since then, its share has steadily climbed, peaking at 41 percent in 2005.)169
Floating exchange rates famously give an economy flexibility. But this flexibility includes the ability to do the wrong things. (Nobody wants to drive over a “flexible” bridge.) Under a Bretton Woods-type system, bad economic policies that affect trade quickly run aground and produce balance-of-payments crises. Britain, for example, had such crises repeatedly during its long pre-Thatcher economic slide, in 1947, 1949, 1951, 1955, 1957, 1964, 1965, 1966, and 1967.170 These crises force corrective action on the trade front long before serious damage in the form of debt accumulation and asset sales can be done. But with floating exchange rates and correspondingly free capital flows, pressure is postponed by the cushioning effect of asset sales and debt accumulation, allowing bad policy to go on much longer. So a nation can, in effect, sell the family silver and mortgage the house to pay the gas bill, rather than be forced to ask why it is using too much gas.
Formerly, this was all well understood. As John Maynard Keynes, one of the architects of Bretton Woods, explained it, the economies of the world:
Need a system possessed of an internal stabilizing mechanism, by which pressure is exercised on any country whose balance of payments with the rest of the world is departing from equilibrium in either direction, so as to prevent movements which must create for its neighbors an equal but opposite want of balance.171
The architects of Bretton Woods, traumatized by the economic chaos of the 1930s and worried about the Soviet threat, wanted a system that avoided outright socialist central planning but would still prevent financial crises. They understood that eliminating such crises entirely was utopian, so they settled for the next best thing: to keep crises small. Keynes himself actually wanted something even more radical: a system of fixed exchange rates mediated by an international reserve currency called the “bancor” and managed by an institution called the Clearing Union. The IMF is a vestige of this idea, but the world got the dollar as its reserve currency instead.
Unfortunately, the dollar, like all national currencies, is a sovereign political artifact, exposed to all the problems of American politics. The Bretton Woods system eventually broke down when Lyndon Johnson inflated the dollar to pay for the Great Society and the Vietnam War at the same time without raising taxes.172 Initially, this “exported inflation,” in the words of France’s annoyed president Charles De Gaulle, as other currencies were dragged along with the dollar by their fixed parities. It eventually collapsed the system entirely as nations tried to swap their shriveling dollars for gold, by which the dollar was backed and of which we had a finite supply. The whole system ended in 1971, when President Nixon was more or less forced to abandon it.173 Exchange rates have floated ever since.
The results have not been happy. In essence, the present system gives nations enough rope to hang themselves with: it lets them get into worse trouble, and then has no choice but to be more intrusive in getting them out. This doesn’t produce greater economic stability (let alone more growth), but it does produce some handy opportunities for coercively imposing aggressively free-market economic policies on otherwise unwilling nations, especially in the Third World. Institutions such as the World Bank have opportunistically taken advantage of such crises to impose free market “reforms” they could not otherwise achieve.174 For example, according to Dani Rodrik, an economist at Harvard, “no significant cases of trade reform in a developing country in the 1980s took place outside the context of a serious economic crisis.”175 Translation: now that you’re broke, privatize all those state-owned assets and stop subsidizing food for the poor, or you don’t get your emergency loans.
So perhaps the greatest advantage of fixed exchange rates is that, of all the policies available to rebalance the world’s trade imbalances, they are actually among the least intrusive. Changing a society’s time discount on consumption is very hard to do: there is no lever directly attached to this variable, and most peacetime attempts to change it in the Western world have failed. Only the authoritarian technocrats of East Asia have pulled it off, by heavy-handed measures ranging from forced savings plans (Singapore) to tight limits on consumer credit (China) to zoning that makes it hard to build large houses (Japan).176 These are policies no Western electorate would tolerate and that most Third World governments simply don’t have the administrative competence to pull off.
A fixed exchange rate system, on the other hand, operates at the perimeter of an economy, leaving most of its internal mechanisms untouched. It violates few economic liberties. But even though it leaves flows of goods untouched, regulating the countervailing financial flows that must take place when goods are paid for imposes a balance just as effectively. If the pure free market won’t produce the best results on its own in trade and therefore must be regulated somewhere, it might as well be here. And if the market is so distorted by taxes and subsidies that these distortions need to be rectified for it to produce rational outcomes, this would be a good way to do it. Fixed exchange rates are a complex issue, but they ought at least to be on the table as part of a solution to the United States’ (and the world’s) trade problems.
Chapter 3
Trade Solutions That Won’t Work
Americans in recent decades have not, of course, been entirely unaware that they have a trade problem. This has drawn into public debate a long list of proposed solutions. Unfortunately, many will not work, some are based on analytical confusions, and a few are outright nonsense. If we are to understand the true scope of our problems and frame solutions that will work, these false hopes must be debunked forthwith.
For example, since the early 1990s it has been repeatedly suggested that the U.S. is on the verge of an export boom that will erase our trade deficit and produce a surge of high-paying jobs. (Bill Clinton was fond of this idea.)177 The possibility looks tantalizing when we observe that America’s exports have indeed been growing rapidly—just not as rapidly as our imports. (Between 1992 and 2008, our exports more than doubled, from $806 billion to $1,827 billion.)178 This seems to imply that we are not uncompetitive in world markets after all, and that if only our export growth would climb just a few points higher, the whole problem would go away.
Unfortunately, our deficit is now so large that our exports would have to outgrow our imports by two percent a year for over a decade just to eliminate the deficit—let alone run the surplus we need to start digging ourselves out from under our now-massive foreign liabilities.179 This doesn’t sound like much, but it is, in fact, a very strong export performance for a developed country, and unlikely in the present international economic environment, where every other nation is also trying to expand its exports. Much of our recent export growth has been hollow anyway, consisting largely in raw materials and intermediate goods destined to be manufactured into articles imported back into the U.S. For example, our gross (i.e., not net of imports) exports to Mexico have been booming, to feed the maquiladora plants of American companies along the border.180 But this is obviously a losing race, as the value of a product’s inputs can never exceed the value of a finished product sold at a profit.
Not only is America’s trade deficit the world’s largest, but our ratio between imports and exports (1.24 to 1 in 2009) is one of the world’s most unbalanced.181 Given that our imports are now 17 percent of GDP and our entire manufacturing sector only 11.5 percent,182 we could quite literally export our entire manufacturing output and still not balance
our trade. Import-driven deindustrialization has so badly warped the structure of our economy that we no longer have the productive capacity to balance our trade by exporting more goods, even if foreign nations wanted and allowed this (they don’t).183 So the solution will have to come from import contraction one way or another.
Exporting services won’t balance our trade either, as our surplus in services isn’t remotely big enough, compared to our deficit in goods (in 2009, $136 billion vs. $507 billion).184
Neither will agricultural exports balance our trade (a prima facie bizarre idea for a developed nation). Our 2009 surplus in agriculture was only $25 billion—about one fourteenth the size of our overall deficit. 2009 was also an exceptionally good year for agricultural exports; our average annual agricultural surplus from 2000 to 2008 was a mere $13 billion.185
PRODUCTIVITY GROWTH WON’T SAVE US
It is sometimes suggested that America merely needs to regain export competitiveness through productivity growth. Comforting statistics, showing our productivity still comfortably above the nations we compete with, are often paraded in support of this idea. Unfortunately, those figures on the productivity of Chinese, Mexican, and Indian workers concern average productivity in these nations. They do not concern productivity in their export industries, the only industries which compete with our own. These nations are held to low overall productivity by the fact that hundreds of millions of their workers are still peasant farmers. But American electronics workers compete with Chinese electronics workers, not Chinese peasants.
