On the campaign trail and now in the Oval Office, Trump has continually talked about trade. One of the first executive orders was a withdrawal from the Trans-Pacific Partnership, and one of his most influential means of getting the US rust belt to ‘vote red’ was by threats of tariffs on China and increased border taxes on Mexican imports.
Missing in this post-election landscape has been a nuanced discussion on trade policy. Instead of exploring the complexities of trade properly, policy wonks and establishment politicians blindly jump on the free trade bandwagon, whilst populists equally shout that ‘trade deficits are bad’. What is the middle ground between these two echo chambers, and were there potentially areas where Trump was right instead of wrong?
In general, arguments for free trade are supported by the principle of comparative advantage — the idea that some individuals or nations are relatively better at producing certain goods than others. This is a strong argument that can be found in any Microeconomics textbook. Moreover, the magnitudes of excess productivity involved in specialisation are often larger than our intuitions would imply. The world would genuinely be far worse off if China were to specialise in mineral exports and Australia in manufacturing. In this context, Trump’s protectionist rhetoric seems silly on a macro level, akin to the behaviour of a lobbyist institution that wants to protect its particular sector to the detriment of the rest of humanity.
Whilst free trade in goods and services is crucial to boosting people’s standards of living, free trade in financial capital can be even more important. My view on the subject is that it is usually capital flows that drive goods rather than the obverse, at least in the extreme cases. Unfortunately the capital flow aspects of trade policy are often ignored by pundits and establishment politicians to the detriment of policy outcomes. It is for that reason that I will focus in particular on the dynamics of capital flows in this article to expose some missing pieces of the trade puzzle.
In light of this it is important to recognise that one cannot have free trade in goods without free trade in capital. At the risk of oversimplification, basic arithmetic requires trade in goods to be matched by trade in capital — if $10 of goods are shipped from Europe to the US, then the US must ‘ship’ $10 (which is capital) to pay for those goods to Europe. Thus, when the Eurozone exports goods to the USA it in turn imports ownership of USD, and then must decide to do something with that USD. In the case that the Eurozone then spends the USD on US goods, the export is netted out and nothing happens. In the other case, where the Eurozone buys US financial securities and assets, the underlying structure of both economies will shift in a few ways which I will outline below.
(For intuition’s sake I will refer to the purchase of foreign assets as a ‘capital export’. In economics broadly capital exports can mean a few different things but here it is assumed to just mean the purchase of foreign financial securities.)
To see why capital flows can be what drives international economies instead of goods, consider the case of the post-war Atlantic world. At the end of WW2, the USA had huge stocks of physical and financial capital at its disposal with little marginal return to be had at home. Just across the Atlantic Ocean however was an entire continent that had been decimated by war and desperately needed investment. Europeans were educated and productive agents that had no capital stock to utilise. Under a free trading Atlantic partnership the production imbalance was solved almost instantly. Here the USA was allowed to flood Europe with finance and capital so that the Europeans could rebuild their economies in a mere decade with an investment surge. All the while Europeans could maintain high levels of consumption and continue investment in education under the proviso of continued American financial support. This created the bedrock of an Atlantic world which quickly resumed its position as the global economic centre.
There are many similar examples to this in economic history, but this one should illuminate why thinking about free capital flows is often more powerful than thinking about free flows of goods.
With all this in mind, it seems like capital exports and free trade form an amazing and dynamic duo. But there is more to the story.
In the last few decades, international trade has witnessed huge volumes of capital shift between countries in a way that is fundamentally not free. Superficially, goods have been traded in a free market, but capital flows have been distorted hugely by China and Northern Europe. The ways in which China and Germany have managed to distort global trade are not simple, but are nevertheless well understood by economists. In general the way in which these countries distort trade involves a cohort of policies which force up domestic savings rates. Some example policies are currency devaluation, interest rate repression, union busting, wage repression and industrial subsidies. All of these policies implicitly shift income from consumers to producers. That is, households to firms. I will henceforth call this system of policies “industrial policy”.
By forcing up savings rates, these economies are able to make investment cheaper at home, since income that is saved goes through the banking sector to become loans for investment. Moreover, by shifting incomes from households to firms economic growth can be accelerated and low unemployment maintained. This arrangement forms the foundation under which the Chinese political system operates. Chinese citizens implicitly accept less political freedom and income redistribution to firms in exchange for sky-high growth and low unemployment. In a world in which firms are desperate to invest and productive opportunities abound there isn’t a huge problem here. Indeed, I think this model is by far the best if one’s aims are to bring a country out of poverty and into middle-income status. Example countries that have used this model to great benefit are Japan, Taiwan, South Korea, Germany, Britain, Sweden, China and the USA when they underwent their growth miracles. (If there is demand I may go into greater depth on this model in another article).
But the world in which firms are hungry to invest and financial opportunities are numerous does not describe the current global economy. It is my contention that this has not actually described international economics since at least 1990. The world today is one in which desire to save exceeds desire to invest, and thus countries that are growing quickly due to their manipulated policy environments do not suck up their own savings but rather push it out into the rest of the world. When a country ‘pushes savings’ abroad what they are doing is exporting at artificially high levels due to their industrial policies. The result is an accumulation of foreign currency which is then used to underwrite capital exports with the purchase of foreign securities.
We therefore need to rethink the impacts of policies that force up the savings rate for a context where the world seems over-inundated by financial capital. In particular let’s think over what happens when a country begins a capital export surge and accumulates foreign currency in 3 key scenarios.
For the first scenario, consider an importing country which is hungry for investment- for instance a country with large, productive firms that can’t get domestic finance. In this instance, the capital from the exporting countries will go to fund this arrangement. Both parties benefit and we have a situation akin to the post-war Atlantic.
In the second scenario let’s think about an importing country without too much need for investment but with flexible financial markets, and consumers that want more credit. In this instance, the households generally borrow the capital from the capital surge and therefore boost household consumption. What should be noted is that debt cannot rise indefinitely, so this scenario is thought to lead to financial pressures that induce the next scenario.
Finally, there is the case of an economy that lacks the willingness to boost investment but that also has households which are paying down debt rather than accumulating it. Normally, such economies would not import capital, as there is no demand and there is excess supply, but international industrial policy can give rise to capital imports in these economies.
Note that the second scenario in many ways describes the USA in the lead up to the GFC, whilst the third describes it post-GFC. It is a common thread among international economists that international trade policies were crucial factors influencing the GFC.
One example policy is the Chinese devaluation of the renminbi (RMB). Since the late 80s, the People’s Bank of China has managed to accumulate trillions of dollars in US reserves by printing and selling RMB and then buying dollars. By then using these dollars to buy treasury securities — essentially a long-term loan to the US government — it can force the Chinese economy to lend to the US economy. This then allows China to be more competitive against the US since the capital import must be matched by a goods import, where the US then covers the import gap with the finance provided by China’s purchase of treasuries.
In a context where US consumption and investment doesn’t rise but imports do rise there is only one way to weather this trade distortion: decreased consumption of US goods and decreased investment, which creates unemployment and slower growth.
It is in this environment of an artificially cheap euro and renminbi that the current global trading arrangement has been detrimental to southern Europe and the US, while being hugely profitable to Northern Europe and East Asia. Consequently, it is easy to see how Trump could actually solve the situation, and how protectionism could be the key to rebalancing the world economy. But Trump’s proposals seem to fundamentally miss the mark.
Take tariffs on China. This doesn’t really address the route of the problem since China is using capital to drive goods, so a tariff could have uncertain efficacy. Moreover this ‘solution’ it is also coming too late in the game. Since late 2014, China’s purchase of US dollar reserves has gone into reverse, with the head of its central bank expressing interest in avoiding another devaluation of the RMB. China is still manipulating trade to its advantage, but the moment to oppose them was back in 2008. Trump’s tariffs look much like beating a dog with a stick just as it starts to behave well.
Another issue involves Trump’s obsession with country-to-country trade dynamics, as opposed to global ones — a key case being the trade deficit against Mexico. Mexico runs a trade deficit with the rest of the globe, and only runs a surplus with the US due to supply-chain dynamics. If one were to take Mexico out of the global trade environment, the effect would likely be to increase the US trade deficit as exports to Mexico shift back to being purchased in the US. Looking at bilateral trade seems like an intuitive way to address trade distortion, but it almost always tells you nothing about the actual situation. Consider the case of Mexicans consuming lots of iPhones, but selling shoes. Most of the Mexican imports would show up through China, which in turn just gets the parts off of the US. Thus Mexican imports are hidden in the accounting. Indeed, according to the financial times about 40% of Mexico’s reported exports to the US are actually traced back to US manufacturers. When it comes to trade, the accounting clouds the economics.
Trump simply came too late to the party. Potentially, his policies would have worked in ’08, but now he is just likely to just increase global confusion more on the issue of trade. Likewise, Hillary Clinton and the establishment are equally to blame for not actually addressing the many capital market distortions that have devastated swathes of the US economy. In 2012, Hillary even went to China to reinforce the notion of safe US-bonds, thereby encouraging the Politburo to lobby the PBoC to buy more USD. It is this kind of dumb rhetoric from both sides that has left the West in shambles, with left and right wing populism on the rise as far as the eye can see.
One cannot help but be depressed by the lack of nuance in today’s economic discourse. This article should be seen as a call to arms for more Paul Keating-esque figures to reinvent politics in the West. Electorates have the capacity to be informed and nuanced, but politicians need to lead the charge.