Some simple thoughts on international trade

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.

The Distorted Nature of Global Trade Imbalances

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.

Unnecesary Blunders in the GFC- Revising the Role of Government

The collapse of Lehman Bros. on September, 15, 2008 precipitated a global collapse in confidence among creditors and depositors alike; but whilst the heavily indebted economies of Europe and the United States were structurally unsound (with production geared against export-led growth), extreme economic slowdown was not a necessary condition for the subsequent structural adjustment. The behaviour of the US treasury during the crisis epitomized the ineffectual and indecisive policymaking deemed largely responsible for the exacerbated nature of an otherwise mild cyclical downturn.

It is now common knowledge that nearly all developed economies had become highly indebted before the winding up of Bear Stearns in March 2008. One commonly overlooked aspect however, was that this debt was largely illusory, and was a result of complex financial swaps and hedges that expanded credit, leverage, and the broader money supply. Much of the debt counted in the US economy was a result of inter-bank lending, where banks created complex chains of borrowing. For example, J.P Morgan would lend $1 to a hedge fund, which lends $1 to an investment bank, which lends $1 to a broker, which lends $1 to a mortgage bank, which lends $1 to the homeowner. The total financial leverage therefore becomes $5, but the actual indebtedness of the household (real economy) is only $1. The virtue with this structure, known as Fractional Reserve Banking, is that as long as all the links are safely capitalised and secure, debt can be quickly deleveraged without serious repercussions on the non-financial economy. The longer the chains are however, the more pronounced the effects are if one link breaks. In the US, the chains were extremely long (in some cases chains reached leverage ratios of 30:1) and the situation quickly became an untenable deleveraging nightmare.

This is exactly what happened with the bankruptcy of Lehman Bros, and the US treasury’s decision to not guarantee creditors and lenders. The chain was allowed to break, and otherwise modest losses in the financial sector matured into system-wide threats to the world financial system. But why were the banks so poorly capitalised in the first place? Was it because they expected government aid in conditions of system wide failure? Or was there some other fault line in the system? Many commentators do indeed simplistically blame “crony capitalist” relationships between congress, the Federal Reserve, and Wall Street; where an implicit promise from congress to socialise losses if they are systemic encourages the mass accumulation of tail-risk (financial jargon for risks that are rare, but catastrophic, and systemic if realised). But a more technical approach towards the problem of poorly capitalised institutions points the finger towards accounting standards stipulating transparency.

The new accounting standards (Known as “Mark to Market” accounting standards) took discretionary power away from regulators and banking officials, and handed it over to the forces of the market. Institutions were required to report their solvency as a function of the market value of their assets. During a boom period, with rapidly rising asset values, these institutions witnessed enormous profits and were able to reward large bonuses to their employers and run down their capital reserves. But when values began to fall, losses built up, and to maintain “official” solvency they were required to liquidate their assets en masse with virtually non-existent capital reserves and anxious depositors. This drove down the value of their previously profitable assets, and a positive feedback loop spiralling downwards compounded the problems yet again, and financial balance sheets did not recover until the suspension of the new accounting standards in March 15, 2009.

The relevance for both of these points is that financial sector losses were compounded by the government’s reluctance to intervene in Wall Street, and instead rely upon the efficiency of the market to allocate resources. The Federal Reserve was even forced to increase interest rates early 2008 during the deleveraging process, and winding up of Bear Stearns due to an unsubstantiated attack on commodity prices (and specifically oil) leading to an increase in cost-pushed inflation. With the monetarist paradigm stressing inflation control over demand-management the Federal Reserve hiked up interest rates, despite the contraction in the money supply as a result of deleveraging. The effects were again ruinous, as the money supply contracted rapidly as a result of monetary policy plus the necessary structural adjustment. If the treasury had instead intervened in commodity speculation directly, and regulated oil hoarding in the typical post-war Keynesian approach, the money supply could have expanded and supplementarily supported the deleveraging process, which would otherwise have been deflationary.

Yet even despite the difficulties imposed on the deleveraging process by accounting madness and artificially high interest rates, the non-financial economy was acting with typical flexibility moving employment away from the bloated domestic-demand sectors towards exporting sectors throughout the credit crunch. The trade deficit from 2006-2009 almost halved for example, whilst the current account deficit narrowed from $974 billion in 2006 to a mere $189 billion in 2009. This path had already begun before the collapse of Lehman- and the excessive output gaps experienced alongside stagnant growth could have been avoided if the US Treasury was more willing to consider its full role in the management of economic affairs.

This argument leads on to the topic of financial life-support by government which I will analyse in another piece, citing the Third World mass defaults on debt from 1982-1989, the Swedish crisis of 1992 and Japan’s lost decade.

Outline of Australian economic trends

*The following outline of Australia’s economic trends is an addition to Systemdestroyer’s analysis of Australian economic performance. Hopefully the data/analysis provided will be useful to readers*

Systemdestroyer’s article can be found here-

Australia’s annually adjusted growth in Gross Domestic product (GDP) since 1990 has been relatively stable. Despite negative growth in 1991, the economy has been growing steadily reaching a climax of 5% in 1999. This robust growth expedited by the Freemarketeer reforms implemented by the Hawke-Keating government has been accompanied by rising income inequalities however.

The value of the gini coeficient (a common measurement of income inequality) has risen from 0.28 in 1990 to 0.33 as of 2013. Many Keynesian and progressive economists have blamed Free market ideology for such income differentials, but the general consensus is that the rise is a natural result of globalisation, which introduces more Labour market competition and labour replacing capital, undermining the wealth share of the lower classes.

Services and commodities have accounted for an increasingly large share of GDP and employment in the domestic economy since the sweeping economic rationalist reforms of the Hawke-Keating era eliminated the protection previously given to manufacturing. Although the initial devaluation of the Australian dollar following its float in 1983 initially helped exporting manufacturing sectors grow more quickly than their tertiary industry counterparts, their market share has fallen at an accelerating rate, reflecting more efficient use of organisational capital relative to wages in Asia (specifically China), and an appreciated currency. The effect on GDP of the declining manufacturing sector however has been minimal, since Asia’s shift towards manufacturing has precipitated an increase in Australian commodity exports, where there is a strong comparative advantage. As a result, the shift away from manufacturing represents a major structural adjustment in Australia’s economy in favour of sectors where our comparative advantage in human capital and natural resources is more apparent. This structural adjustment has become one of the factors contributing to Australia’s stable growth rates despite fluctuating global trade conditions.

Australia’s current account deficit since these structural reforms has been in a healthy condition. After the credit dry up of 2007, and subsequent bust after 15, September 2008 with the collapse of Lehman bros, Australia fared well relative to other OECD countries, with the lowest public debt rates and sturdy economic growth despite a single quarter of contraction in 2009. The maintenance of employment and healthy terms of trade is largely attributed to the ascent of bilateral and multilateral trade agreements alongside the reforms mentioned with the Asia-Pacific region which has experienced sturdy growth using the export subsidy growth strategy, and through protectionism, shifted production away from commodities and low-demand-elasticity industries towards manufacturing. Trade with China for example has grown from $113 million dollars in 1973 to over $85 billion dollars in 2009 (despite sluggish growth conditions), reflecting an enormous increase in trade with the region facilitated by trade agreements and structural reform. This represents an ongoing long-term geopolitical-economic shift towards the region, and away from debt laden developed markets.

An interesting anomaly in Australian economic trends is a reversal of the prediction of Wagner’s law. This economic law states that government spending as a percentage of GDP is inclined to rise as a result of increasingly dangerous technological monopoly, and public demands. Following the ascent of Milton Friedman’s monetarism and Reaganist ideology, both the Liberal and Labor parties have extensively privatised existing public enterprises such as QANTAS and TELSTRA, and any R & D investment is usually open to usage by private enterprise (as seen by the implementation of the National Broadband Network). This privatisation under third-way ideology has consequently led to a lot less government regulation of sectors deemed important, and competition has flourished under the laissez-faire growth model. Cuts in subsidisation have also strengthened the government’s revenue base despite remnants of protectionist subsidisation aimed at low skill manufacturing under pressure from an appreciated currency.

All of these trends have been driven by the general economic and philosophical structure of the world since the 1970s. Such “Megatrends” (as referred to by the UK political commentator Anatole Kaletsky), have encompassed economic thinking and been practiced widely. Multilateral trade agreements, domestic and foreign structure, open market policies, and income equities have all been changed in the Australian economy since 1990 within the paradigm of the free market fundamentalists. Whether these changes will finish in flourishing growth and competition, or disaster is still to be seen.

Failure of the neoclassical synthesis-Long term unemployment

Despite enormously high deficits,  apocalyptic C.A.D levels and mountains public debt, western democracies by and large are still finding themselves in the midst of sluggish growth rates, high unemployment and record levels of income inequality. The U.S public debt levels have been steadily growing, with notable periods of exception, since the advent of fiat money allowed politicians to effectively spend indefinitely (or so they thought)­­ creating money out of thin air. With over 9 trillion dollars artificially circulating in the economy the problems still remain. How is it that even the most vigorous stimulus programs have failed to see noticeable gains in economic growth since the early 1970’s? Surely, with Keynesian logic, we should have seen exponential levels of growth accompanying the public debt. Instead we have seen incrementing deficits and lacklustre growth.

I do not claim to have all (or even any) answers to these problems. I am writing out of the desire to expand my thought and network with others who are passionate about these issues. I am hoping that by exploring these ideas online in a blogging format, I can start a dialogue and prematurely avoid the mistakes that come alongside solitary thinking, and if I get good responses, I will also translate the blogs into Spanish. (As was the motivation of John Maynard Keynes when he wrote ‘The General Theory of Employment, Interest and Money’). In my intended exploration of the failure of current employment theory, I am going to briefly go through the orthodox theories that have encapsulated economics over the past century, and analyse them one by one.

In classical economics, or supply side theory (according to Keynes), a recession cannot logically exist. The logic here is that basically in Say’s law, supply creates its own demand (Again, the definition has been changed, but this was Keynes’ interpretation). There is no such thing as diminishing returns, or levels of production efficiency, and an economy should constantly experience full employment levels (the only unemployment being voluntary and frictional). When demand falls, there will be excess supply, and so, prices as a result will fall until supply matches demand (In basic macroeconomics, lower prices increase demand for an individual item, this is one of the fundamental economic propositions). This can be applied to labour markets, so that when there is high unemployment (In Keynesian jargon- high factor cost competition), there is an excess supply of labour; therefore wages will fall, and businesses will be able to cut the wages of their employees, and lower the cost of their product assuming the industry isn’t monopolised. From here, production costs are lower, and demand is restored, so the employment should start to rise again straight away, and no recession should occur because prices and wages are flexible.

(Please note this is the cynical Keynesian version of the theory, if any Neoliberals out there could correct my interpretation of the classical theory, please do!!)

Keynes’ theory on the other hand, accepts many of these assumptions but refutes the idea that wages and prices are flexible. In Keynesian thought, wages and prices are “sticky” due to a host of external political factors, such as the influence of trade unions, wage agreements and reluctance of businesses to lower prices enormously and witness immediate losses. As a result, the only way for businesses to reach efficient levels of production to meet the decreased demand is to cut employment levels until the workers and businesses accept lower wages and prices respectively. Therefore the duration of a recession depends upon the flexibility of the system.

This may all seem quite intuitive but the modern textbooks have acknowledged a problem, that the ‘neoclassical synthesis’ addresses. In demand-side economics, as opposed to supply-side, the problem is low aggregate demand and insufficient sales. The problem stems from the fact that the initial problem is low aggregate demand. If wages fall to increase supply, demand is not likely to increase, and may fall. How are lower wages across all sectors going lead to increased consumption?! The only compensating factor will be increased profits for the firm. Prices also work differently than is thought at first sight. Whilst lower prices lead to increased demand in individual sectors and firms, lower aggregate prices could react differently. There is no alternative for lower/higher consumption patterns when price changes are universal and so demand again will not be restored disproportionately. Where the neoclassical synthesis comes in is next, and it is a little hard to summarize but basically, the higher utility of the currency leads to smaller demand for cash in hand, since the same product can be purchased with less physical money. As a result there is less demand for currency and so the ‘price’ falls. The price of money is the interest rate. This encourages increased borrowing and investment, stimulating growth. Another accompanying factor is a psychological “wealth effect”. Whereby the relative return on assets becomes more valuable and so consumption temporarily increases because people feel they are wealthier, although this is offset by something else which I am about to raise, and has not been addressed by orthodox thinkers. With these theories considered, long term unemployment should not occur, even in highly debt ridden countries such as Japan. How then, have these countries managed to muck up their growth prospects so much?

Well, one of the most important effects of wage adjustment has simply been ignored by politicians internationally; and a number of economists (Both Peter Schiff monetarily and Paul Krugman fiscally) also fail to see these effects that destabilise the economic environment and lead to hampered long term growth. Indeed, it appears the only institutions that have embraced the theory wholeheartedly are the central banks of the world, especially the Federal Reserve. The ignored effects are the ones of deflation, or more accurately in the modern economic environment, disinflation (Lower than expected levels of inflation, not falling into deflation). With disinflation, people are earning less than they normally would, but their debts have remained constant. This leads to an opposite effect to that of a ‘wealth effect’; only the effects are permanent if the economy does not return to pre-recession levels of inflation, or reduce debt levels substantially. The borrowers will often reduce borrowing and spending as a result of disinflation making debts more burdensome, or close down their enterprises, whilst lenders may also be less inclined to loan funds due to the riskier return rates (The ‘too-big-to-fail’ policies will reduce this lending tendency, but cause even worse problems down the line which I will address in another blog article). This factor helps to explain in macroeconomic terms, why countries heavily involved in credit activities have had slowing recovery rates over the past 40 years, and why constrained aggregate demand seems so persistent in many areas of the Western world despite policies designed to remedy it. Employment rates if this theory is correct, will be largely dependent upon the credit composition of an economy.

Evidence can be seen in the lacklustre stimulus performance of Japan in the past 2 decades, despite all efforts to ramp up activity; and also in the sluggish recovery of the USA and Southern Europe right now. If these factors are taken into account, it appears the European fiscal policies are ahead of those in the USA, putting long-term growth ahead of short-term viability, but it is unfortunate that it requires the bust on sovereign debt to have been so severe before proper action to reduce the deficit is taken. Monetary-base expansion (As proposed in Japan by Paul Krugman) could be another way to reduce the burden of disinflation, and explains why the short-term inflationary policies of the Federal Reserve may actually be working in the medium-long term (SHOCK!), that is not to say we should advocate Central Banking monetary policy on the whole, but rather give Bernanke a little credit for understanding the effects of disinflation on a heavily indebted country. The mixture of fiscal austerity, with monetary expansion seems very unpopular and indeed counter intuitive, but if debt has a significant impact upon employment levels, as many well known economists believe, action must be taken in both monetary and fiscal policy to reduce it.

Sovereigns and international leaders alike need to completely reform their frame for economic policies and look even further into monetary economics (and all social science fields) if we want to see real and sustainable global development. The neoclassical synthesis has historically failed its adherents, and economists need to start looking at the economy as an aggregate again, and not focus solely on labour markets. Macroeconomics requires subtle analysis of the economy as a whole and her components, we have lost touch with it, and we need to find it again if we seriously expect and desire sustainable global development.