Drawing from the theories of Ludwig von Mises and Friedrich August Hayek, from the Austrian school of Economics, many market economists have viewed the US and Spanish trade deficits as healthy reflections of the comparative advantages enjoyed by different economies.
A deeper look at the economic structures of surplus and deficit trading countries alike however highlights how external imbalances are often a reflection of internal imbalances and/or distortions. Policy makers therefore should not overlook trade imbalances and assume that they are reflections of optimum market performance and global comparative advantages.
The ECB famously noted in 2004 that “A widening of the household sector deficit was a pattern not seen in earlier episodes of current account deficit widening”. The implication here was that the rising deficit on the current accounts of periphery Euro zone countries and the US was accompanied directly by foreign borrowings from the household sector to fund consumption rather than investment.
This should not however lead to the simplistic belief that American and Spanish households are directly responsible for their indebtedness, and should stop consuming to ease the imbalances. The true causes of excessive trade imbalances are more complicated, and much of the fault lies with the financially crippled and regulated surplus nations such as China and Germany.
With the ascent of globalisation and financial innovation it suddenly became much easier for nations such as the US, Spain and Greece to run persistent deficits with access to easy credit. The US was able more than ever to attract international credit flows due to its reputation as a secure investment market, coupled with a large financial sector able to create collateralised debt obligations (CDOs) which spread individually crippling risks across multiple investors.
Other nations such as Spain and Greece found easy access to credit streams from the European Central Bank, lending on distorted Value at Risk (VAR) calculations, which were supported by the easy transfer of savings across Euro Zone borders. With the artificial access to German savings, Spanish and periphery markets proved to be much more lucrative sources of consumption than their German counterparts.
This is largely due to the history of the German export-led development model. Under government direction of resources away from household consumption and towards export-oriented firms, domestic sources of consumption had historically been handicapped. This was due to distorted interest rates, high levels of government protection, and a crippled financial sector unable to adequately evaluate investment opportunities. The financial sector, unable to efficiently apportion savings towards local investment, instead relied upon established ‘crony’ relationships with exporting firms and government bureaucracies to allocate funding across the economy. The German economy grew at two speeds under this export-led growth strategy, with a super efficient manufacturing sector and an inefficient services sector unable to attract domestic demand.
With no attractive outlet for their savings appropriated by high-end exports, German households instead poured their savings into the Euro Zone’s financial sector- injecting billions of dollars into economies where domestic demand was healthier and more competitive. This influx of easy credit flows kept periphery interest rates low, and household consumption boomed in housing and similar activities that had experienced widespread deregulation. This was most famously seen in the Spanish President Aznar’s “Ley de Suelo” and similar reforms, which deregulated financial transactions and encouraged housing construction.
China’s domestic imbalances had a similar financial structure to that of Germany, but were also compounded by government industrial policy. With the Yuan undervalued by the Jintao administration, exports yielded higher returns relative to domestically geared production, and the structural trade surpluses similar to Germany were deliberately exacerbated by government policy.
As a result of this trade surplus the Jintao and Jinping administrations built up enormous reserves of US dollars. If these dollars were to be converted back to Yuan however, it would create a large demand influx for the Yuan, thereby revaluing the currency at its natural value. Instead, the Chinese government opted to return their foreign currency reserves (FCRs) back into the US economy- buying government bonds and providing the financial sector with high liquidity. With the competitive nature of American finance and household consumption, these funds again led to an influx of demand (and therefore supply) for housing projects and similar household investments and consumer items.
The obvious correlation between trade deficits and economic busts should provide enough empirical support to refute the notion that trade deficits are healthy reflections of global competition, but it isn’t. Market fundamentalism is intoxicatingly simple to cite, but the assumptions that underlie its arguments are baseless.
The build-up of household debt and consumption seen in domestically geared economies was not a healthy manifestation of global comparative advantages. Instead, it symbolised a sinister allocation of resources in surplus nations, which fuelled household debt accumulation in deficit nations.