EssaysVolume6
Issues in International Trade and Payments
Richard A. Stanford
Furman University
Greenville, SC 29613
Copyright 2024 by Richard A. Stanford
stored, or transmitted by any means without written permission
of the author except for brief excerpts used in critical analyses
and reviews. Unauthorized reproduction of any part of this work
is illegal and is punishable under the copyright laws of the
United States of America.
CONTENTS
NOTE: You may click on the symbol <> at the end of any section to return to the CONTENTS.
1. Comparative Advantage
2. National Identity
3. Government and Comparative Advantage
4. The Autarkic Argument for Protection
5. Dumping and Subsidies
6. Import Taxes and Resource Reallocation
7. The Border Adjustment Tax Proposal
8. Offshoring Motor Vehicle Production to Mexico
9. Globalization and Migration
10. Manufacturing and Free Trade
11. Industrial Policy and Comparative Advantage
12. Import-Substitution Redux
13. The Nafta Conundrum
14. Exchange Rates and Macroeconomic Stability
15. Exchange Rate Insulation of a Domestic Economy
16. The Value of the Dollar
17. Foreign Held Debt
18. Sovereign Debt in the Eurozone and the Future of the Euro
19. Why Payments Imbalances Persist in the Eurozone
20. Parity of the Dollar and the Euro
21. Deficits
22. "Things" in the Balance of Payments
23. Goods and Services in the Balance of Payments
24. Automatic Adjustment and Trade Deficits
25. Playing With Trade Balance Data
26. Can Current Account Deficits be Sustained Indefinitely?
27. How the Capital Account Might "Drive" the Current Account
28. Alleviating the Trade Deficit
29. Savings and Trade Deficits
30. Widening the Trade Gap
31. The Trade Deficit Upside
32. Trade and Presidential Politics
33. Saber Rattling over Trade
34. Why Workers Reject Free Trade
35. Languages and Currencies
36. Currency Regimes
37. Rethinking Industrial Policy
38. A Global Depression?
39. Leveling the Playing Field
40. Manufacturing Empoyment and Tariffs
41. Trade Balance Fallacies
42. Chaos, Uncertainty, and Risk
43. The Mystery of the Saving Surplus Gap
44. A Final Word
<Blog Post Essays> <This Computer Essays>
Economists subscribe to the so-called principle of comparative advantage to explain regional specialization in the production of goods and services. According to this principle, people in each region of the world should specialize in producing those goods and services that can be produced most efficiently in their region compared to other regions. "Most efficiently" means at least opportunity cost (in terms of other goods and services foregone) compared to the other regions. Since the production of goods becomes geographically specialized, people in different regions must trade their specialties for the specialties of people in other regions.
Generalization in consumption is enabled everywhere through trade even though there is regional specialization in production. It can be shown with theoretical exercises as well as empirical information that those who specialize their production according to the principle of comparative advantage and trade with one another enjoy higher welfare than they would under conditions of autarky.
It is sometimes suggested that there are regions of the world that are essentially devoid of productive advantages, whereas other regions seem to possess all of the advantages (veritable "Gardens of Eden"). We can resolve this issue by further refining the definition of comparative advantage. A region's absolute advantages include all of those things that it can produce at lower opportunity costs than can be achieved in other regions. A region's absolute disadvantage is anything that can be produced elsewhere at lower costs in terms of other goods and services which must be foregone.
It may well be that opportunity costs of most things are lower in one region relative to all others, but this does not mean that the region should generalize in production. Its comparative advantages lie in those things for which it has greatest absolute advantage(s), while the comparative advantages of other regions lie in the things for which they have least absolute disadvantages. They should still specialize in production, but the one in its greatest absolute advantage and all the rest in their least absolute disadvantages. It follows logically from this refinement of the comparative advantage principle that it is not possible for a region to have no comparative advantage(s). Furthermore, it can be shown that all of the regions of the world, the sparsely-endowed as well as the abundantly endowed, will enjoy higher welfare with specialization according to the principle of comparative advantage and trade with one another unencumbered by politically imposed constraints.
Modern elaborations of the theory of comparative advantage recognize at least five bases for regional comparative advantages: resource endowments, cultural preferences, known technologies, scale economies, and company-specific knowledge. The first three are endogenous to locale; the last two technically are independent of geography, but may become location specific at the discretion of production decision makers.
The world is composed of many regions, some of which are similar to others in respect to resource endowments, preferences, or technologies, and different from the other regions in various respects. The basis for comparative advantage of each may lie in one of these areas or a combination of them. Empirical evidence suggests that a larger volume of the world's trade is conducted among regions that are similar in income levels and preferences, than among regions that are widely divergent in any of these areas.
Certain qualifications to the comparative advantage principle should be acknowledged. One is that comparative advantages, whether attributable to resource endowments, preferences, or technologies, are not "struck in stone," i.e., they are changeable. Circumstances of resource depletion can terminate a former comparative advantage based on the richness of a resource endowment. The discovery of a new deposit or pool of a natural resource can confer a comparative advantage. Population growth or immigration may confer a comparative advantage in producing labor intensive goods where one formerly did not exist. By the same token, emigration may result in depletion of a former comparative advantage based on labor abundance. Natural disasters such as a volcanic eruption, a hurricane, or a freeze that destroys a crop stock may bring to an end some historic comparative advantage. Changing preferences away from "old" goods and toward newly developed ones may shift comparative advantage from regions specializing in the "old" and toward regions specializing in the "new."
One of the most significant forms of comparative advantage comes about through technological advances that develop new items or new processes that economize on scarce resources. Another significant phenomenon which may change comparative advantage is capital investment. Regions that formerly were capital scarce may become capital abundant, as for example the newly industrialized countries ("NICs") of South Asia. The reason that these two forms of comparative advantage transition are significant to managerial decision making is that they are implemented at the discretion of managers of firms. It is by mounting an effort at research and development (R&D) or by capital investment that managerial decision makers may seize entrepreneurial opportunities and deliberately change the competitiveness of their firms and the comparative advantages of their regions.
The emergence of the nation state over the past four centuries has enabled two additional factors that provide for regional differentiation: nationalism and the operations of government.
National identity leads to nationalism, a sort of emotional cement that binds together people of the same cultural background. They may share a common history and heritage; they may be more-or-less homogeneous with respect to race and ethnicity; typically they subscribe to the same religion or various sects or denominations of a common religion; the vast majority of them speak the same language; and, most importantly, they share a common vision about what it means to be a citizen of the nation. The term is often used to describe a "nation of people" or simply "a people" in the biblical sense (the "Children of Israel" in the Bible are an example of a nation in this sense). The emotional cement of nationalism may reveal itself in the form of patriotism, i.e., love of homeland, its cultural and political heritage, its flag.
Other terms such as provincialism or regionalism may attain almost the same sense of nationalism, but with respect to the attitudes of people in more restricted geographic locales. Belgians typically are much more nationalistic with respect to being Flemish or Walonian than they are about being Belgian. It is more important to some in the United States to be Texans or Southerners than it is to be American. The European Union is attempting to establish a sort of super-national regionalism so that citizens of the member states will begin to feel a sense of European nationalism that eventually may displace nation-state nationalism. Although there is no good term to describe it, a similar emotional cement often exists among the students and alumni of an American state university, especially when in athletic competition with a rival state university.
Nation states are political entities defined by boundaries encompassing areas that may coincide closely with that populated by a "nation of people" in the biblical sense. Sometimes a nation state encompasses two or more nations of peoples. American Indian tribes have often been referred to as "nations;" there were many nationalities in the former Soviet Union; modern India encompasses numerous tribal peoples. In the early 1990s, the various nationalities contained by both the Soviet Union and Yugoslavia began to pull apart.
Occasionally political boundaries separating nation states divide peoples of the same nationality. The post-war political division of Europe left the German people separated by "walls" as well as borders. In South Asia, the Bengali tribal people are split by the India-Bangla Desh border. The Pakistan-Afghanistan border divides the Baluchi people, while the Pakistan-India border separates Punjabi tribal people. Separatist movements in these and other areas may have as their goal the reunification of peoples of the same nationality that have been separated by political boundaries.
Nation states also may not coincide with economic regions that are characterized by the possession of natural resources. Both the United States of America and the Russian Republic include numerous uniquely definable economic regions. Sometimes national boundaries split a common resource endowment region. Europeans have often redrawn national boundaries across the rich coal and iron deposits of the Alsace-Lorraine region.
The essential characteristic of the nation state is its possession and exercise of national sovereignty by the government of the nation state. "National sovereignty" means that the government of the state has the authority and the power to do anything it wishes with respect to the peoples and resources contained within its political boundaries. This power includes the ability to determine the form of economic organization of the economy of the state (until recently, the government of the former U.S.S.R. mandated socialism), and to impose protectionist measures with respect to the industries within the economy (the government of the U.S.A. has a long history of protectionism). It includes the right to insist upon the use of a national currency within the realm and to exclude the of currencies preferred by others. Sometimes this authority and power leads to human rights abuses to which people and authorities in other nation states raise objections. Such exercise of discretion by the state is constrained only by the tolerance of its citizens and by attitudes and military prowess of other nation states.
The analysis of nationalism would be much simpler if every nation state were associated exclusively with a certain nation of people. But this is not the case. Whether we are speaking of the nation state or a particular nation of people who share a common heritage, the principal implication of nationalism is that there are significant differences among populations that yield important consequences for trade and the location of economic activity. These differences may spring from natural phenomena such as heritage, customs, language, etc., or they may be artificially imposed by the behavior of the governments of the nation states.
Even if political relationships are not involved, differences of national heritages and languages lead to suspicions about the customs and intentions of "foreigners," and in extreme cases to xenophobia, i.e., fear and hatred of foreigners. An extreme economic consequence of xenophobia is the attempt to achieve autarky. The important point is that nationalism, whether emanating from cultural differences or state sovereignty, tends to diminish the potential for gains from interregional and international specialization and trade. In the extreme, nationalism can completely eliminate such potential gains if sovereign national governments pursue strategies of extreme political isolation and economic autarky.
Because of nationalism, it is necessary to recognize that, irrespective of resource endowments and technology differences, comparative advantage may be based upon preferences that differ by regions which are defined by national boundaries as well as by cultural heritage. It is also necessary to note that natural comparative advantages may be enhanced or neutralized by the discretionary actions of government officials.
How do market mechanisms pertain to the principle of comparative advantage? Regions don't seek and identify comparative advantages, individuals and business enterprises do. Business decision makers, seeking profitable investment opportunities, attempt to "outfox" rivals by discovering competitive advantages (new demands for goods and services) of their own and other regions, and then to exploit market opportunities to supply goods and services both locally and abroad. Regional comparative advantages can develop only when microeconomic business decision makers "see" potential competitive advantages. The process of discovering and exploiting markets is central to comparative advantage specialization.
If government officials do not become involved, the private-sector pursuit of competitive advantages can be counted on to achieve comparative advantage specialization that provides goods and services at least opportunity costs (what must be given up) to all parties through interregional trade. The by-products of specialization and trade are welfare increases of the trading regions.*
But the provincial interests of government officials in international commerce necessitate qualifications to the comparative advantage principle. The government may attempt to protect an old domestic industry in order to preserve a comparative advantage that is fleeing to foreign regions. The government may attempt to neutralize another region's comparative advantage, or it may take "compensatory" action to offset some policy being implemented by the government of another region. In any of these cases of protection, the effect will be to diminish any potential for gain by comparative advantage specialization.
Governments sometimes attempt to contravene the comparative advantages of their regions by creating artificial advantages for their domestic producers or neutralizing the comparative advantages of their trading partners. They do this by implementing protectionist measures that offset the comparative advantages of their trading partners. Protectionism becomes manifest in the enactment of tariffs on imports, subsidies for domestic producers, and so-called "non-tariff barriers" (NTBs, e.g., quotas on imports, health and safety restrictions on imports, import packaging and labeling requirements, discriminatory performance standards for imports, etc.) that are intended to curb imports or raise their delivered prices. Protectionist policies may expand or preserve employment and enterprise opportunities for the region's own workers and businesses, but they diminish freedom of enterprise and employment opportunities within the trading partners, and they almost certainly diminish the welfare of the region's consumers. Labor unions are almost universally in favor of "leveling the playing field" (i.e., neutralizing the foreigners' comparative advantages) by implementing protectionist policies.
Government may attempt to neutralize another region's comparative advantage by imposing an import tariff that is intended to eliminate a foreign cost advantage. The government may impose an import quota as a means of limiting the damage resulting from importation of an item that can be produced at lower cost elsewhere. Or the government may take "compensatory" action in any of these areas to offset some policy being implemented by the government of another region. In any of these cases of protection, the effect will be to diminish any potential for gain by comparative advantage specialization.
Governments occasionally attempt to contravene natural or acquired comparative advantages for non-economic reasons. The most obvious such reason is the perception of national security. This reason may become critical during a period of hostilities as has been witnessed in early 2022 during the Russian invasion of Ukraine. The United States and European Union members have imposed sanctions and suspended the import of items for which Russia has comparative advantages, e.g., natural gas, oil, and various minerals. Such interruptions of international trade inevitably diminish the benefits of specialization and slow economic growth.
Protectionist policies implemented by the government of a country also limit the consumer sovereignty of its own people by narrowing their range of consumer choice (including making religious and charitable contributions), but at the same time they increase the range of consumer choice for people of its trading partners. When a government implements protectionist policies, it risks eliciting rising protectionist pressures in its trading partners. Rising protectionism is dangerous because it tends to induce reciprocal protectionist responses by trading partners. The US Smoot-Hawley Tariff Act of 1930 did just this, and it spawned global protectionism that aggravated the Great Depression.
Government may attempt to protect an old domestic industry in order to preserve a comparative advantage that is fleeing to foreign regions. An example is the cotton textile industry as it moves from the South of the United States to East and South Asia. Such protection may take the forms of subsidies to the domestic industry or quotas or tariffs imposed on imported merchandise. Or the government may promote the development of what is believed to be a latent comparative advantage of the region by subsidizing a so-called "infant industry." A recent example of this may be the developing electronics industries in India and Singapore.
Foreign producers often are perceived to "dump" their products in domestic markets as a means of driving domestic producers from the market, thereby conferring monopoly power upon the foreign producers. Although lower prices of foreign products may reflect lower direct (variable) production costs, another rationale for such apparent dumping is that overhead costs typically have been fully allocated by the foreign producer to the output produced for its domestic market. In this case the price of output destined for foreign markets needs to cover only the direct (or variable) costs. Hence the price of the output produced for the foreign market (excluding any allowance for overhead costs) can be lower than the domestic price (including full allocation of overhead costs.
Technically, "dumping" means that a foreign producer is selling in a domestic market at a price below the foreign producer's full cost of production (including overhead cost allocation). However, it is virtually never possible for one who charges another with dumping to gain adequate information about the other's costs (direct or overhead) of production. For this reason, the "political" definition of dumping is sale by the foreign producer in the domestic market at a price below the domestic producer's full cost of production (including overhead cost allocation). Sometimes domestic producers claim that the foreign producer is dumping when the price is simply below domestic prices. This is a "political" definition because it usually serves as the basis for an appeal by domestic producers to their governments for protection from the foreign producers who are reputed to be engaged in dumping.
The problem with the political definition of dumping is that it really cannot be distinguished from the phenomenon of competitive pricing. For example, if another domestic producer were selling at a price below our own preferred price, or even at a price below our own per-unit cost of production including overhead cost allocation, we could hardly charge our domestic competitor with dumping. The most that we could do is complain about competitive pricing which may be predatory in nature. But if a foreign firm engages in exactly the same behavior, domestic producers are quick to charge dumping and appeal to their governments for relief.
Actions by governments are potential sources of threats as well as opportunities. If domestic producers can enlist the authority of government to protect them by imposing tariffs or quotas, this constitutes an opportunity for domestic producers to sustain or expand production and employment (in spite of a lack of comparative advantage), but it is a threat both to foreign exporters and to domestic importers. By the same token, actions by foreign governments to protect their industries will constitute threats to domestic firms that may have real competitive advantages. As already noted, protection also tends to distort the world-wide allocation of resources and diminish the potential for gains from trade.
Governmentally imposed quotas implemented by import or export licensing also constitute a source of threat for domestic firms. Import licensing is more commonly used as a means of protecting domestic producers, but governments of resource-rich regions (particularly petroleum exporting countries) may use export licensing as a means of capturing income from the foreign sale of the resource. The source of the threat is that uncertainty arises as to which firms can acquire licenses to import or export what quantities of goods. Production and shipping schedules may be significantly disrupted, and earnings from sales of imported materials or goods for export may be jeopardized.
During the second half of the twentieth century, governments in a number of countries (mostly Latin American and East Asian) pursued import-substitution industrialization (ISI) policies in efforts to contravene their natural comparative advantages or develop new or latent comparative advantages ("infant industries"). The usual vehicles of ISI policy implementation have been subsidies for domestic producers and tariffs on imported goods that would compete with domestically produced goods, with the intent of reserving the domestic market for exploitation by domestic companies.
ISI development policies have failed almost universally, not only because they contravened the comparative advantages possessed by those nations that implemented them, but also because they induced more imports of raw materials, machinery, and technology than the reduction of imports that were tariffed. While ISI policies have attempted artificially to broaden domestic entrepreneurial opportunities at the expense of foreign firms, they have also narrowed the range of consumer choice to higher-cost domestic goods. In most countries where ISI policies have been attempted and failed, they have been succeeded by export-oriented investment (EOI) policies that exploit the country's natural comparative advantages.
But there can be too much of any good thing. While EOI development strategies usually are congruent with the principle of comparative advantage, governments sometimes attempt to gain artificial advantages or increase their regions' natural comparative advantages by manipulating the exchange rates between their own currencies and those of their trading partners. By keeping their currency exchange rates artificially low, their exports appear to be cheap to foreign buyers, and foreign imports appear to be more expensive to domestic purchasers. This strategy increases exports and decreases imports, thereby producing trade surpluses (or diminishing trade deficits) that alleviate or avert domestic unemployment. This has been described as a "beggar my neighbor" policy because it increases domestic employment at the expense of rising unemployment in the trading-partner countries.
The Chinese government has taken the exchange rate undervaluation strategy to an extreme in order to provide enough employment for its labor force, the world's largest. By keeping exchange rates between its currency (the yuan or renminbi) and other currencies fixed at sub-market levels, the government of China has created an artificial advantage for its manufacturing enterprises. This artificial advantage has sustained Chinese employment by enabling perpetual trade surpluses for China and corresponding trade deficits vis-a-vis China for many of its trading partners, including the US and many EU member countries. Since such a strategy tends to cause unemployment in the trading partners, US and EU officials have pressed Chinese officials to cease fixing yuan exchange rates, thus allowing the yuan to appreciate relative to the currencies of its trading partners. Yuan appreciation would discourage imports from China and encourage Chinese imports of goods and services from the trading partners, thus alleviating the trade imbalances with China and unemployment in the trading partners. At the behest of its trading partners, during the early years of the twenty-first century China has begun to allow its currency to appreciate in stages.
Given the deleterious effects of government efforts to contravene comparative advantages with protectionist policies and exchange rate manipulation, most economists (other than those who are on the payrolls of government agencies and labor unions) come down on the side of free trade and advocate trade liberalization, i.e., the elimination of tariffs, subsidies, and other NTB constraints on trade.
I’m proposing new legislation to take a big first step: the Make in America to Sell in America Act. Under this plan, officials at the Department of Commerce and the Department of Defense will identify goods and inputs they determine to be critical for our national security and essential for the protection of our industrial base. These goods would then become subject to a new local content requirement: if companies want access to the American market for these critical and essential goods, then over 50 percent of the value of those goods they sell in America must be made in America. https://www.nytimes.com/2021/10/29/opinion/hawley-supply-chain-trade-policy.html?campaign_id=39&emc=edit_ty_20211029&instance_id=44082&nl=opinion-today®i_id=74240569&segment_id=72979&te=1&user_id=86b0d837dd357b2a6e0e749321f6ed7f
Nick Timiraos, writing in The Wall Street Journal, March 6, 2017, notes that Mr. Trump's trade advisor, Peter Navarro, the director of President Donald Trump’s newly-formed National Trade Council, advocates reducing bilateral trade deficits. Speaking to a conference of business economists, Mr. Navarro said:
Bilateral trade deficits do
indeed matter, and it is a critical economic goal and in the interest of
national security to reduce these deficits in a way that expands overall trade.
(https://www.wsj.com/articles/trump-trade-adviser-peter-navarro-makes-cutting-trade-deficit-top-priority-1488815842)
Many economists on different
sides of the ideological spectrum, including former advisers to Mr. Trump,
have been critical of the administration’s narrow focus on trade deficits,
which they say aren’t categorically bad. Trade deficits generate current-account
surpluses by which foreign savings finances U.S. real estate and investment.
Economists have also warned against assuming that cutting trade deficits
alone will boost growth, as Mr. Navarro has proposed, because they say it
promotes a flawed understanding of economics.
In Monday's speech, he echoed
many of those concerns, warning trade deficits risked U.S. security because
they had ceded foreign ownership of the nation's food supply chain, technology
companies and large manufacturing operations.
A bilateral merchandise trade deficit with any particular nation, e.g., China, is irrelevant for at least two reasons. One is that the U.S. enjoys a substantial services surplus with China. A second is that the U.S. runs trade surpluses with other nations while China runs trade deficits with many of those same nations. Bilateral trade balances are increasingly irrelevant in a multilateral trading world. In an open global economy, what matters for each nation is its overall Current Account and Capital Account balances vis-a-vis the rest of the world.
Bilateral trade balances with respect to particular categories of goods or services also are largely irrelevant. While the U.S. runs a cotton textile trade deficit with the rest of the world, the U.S. runs trade surpluses with the rest of the world in many other goods and even more so in services. Specific service or commodity trade imbalances are natural concomitants of specialization by comparative advantages. The relevance of such commodity or service trade imbalances lies with the vested interests who perceive themselves to be harmed by the nation's despecialization in producing a commodity or providing a service for which they no longer have a comparative advantage.
A trade deficit in the Current Account of a nation's balance of payments is the natural concomitant of a surplus in the Capital Account of its balance of payments. Indeed, a Capital Account surplus is necessary to "pay for" the trade deficit. A Capital Account surplus occurs when citizens and companies of the nation incur liabilities to foreigners and export the ownership of the nation's real and financial assets to foreigners.
A substantial portion of the Capital Account activity of any nation, whether involving short- or long-term financial instruments, is discretionary. A discretionary Capital Account surplus (a capital inflow involving an export of the ownership of domestic assets) may require a Current Account deficit (e.g., an excess of merchandise and service imports over exports) to off-set the Capital Account surplus.
The "upside" of a trade deficit is that we are consuming a lot of "stuff" that we do not have to produce, and that would cost us more to produce. The U.S. is producing and exporting more goods, services, and financial instruments for which we have production comparative advantages, and we are importing more goods, services, and financial instruments from others in the rest of the world who have comparative advantages in producing those things. The higher-wage jobs are in the U.S. industries that are able to exploit comparative advantages; the lower-wage jobs have migrated to the foreign producers who have comparative advantages in those industries. Both American and foreign consumers enjoy gains from this trade in the forms of lower delivered prices of the products that they consume. Someone needs to emphasize to the Trump administration that trade can be a positive-sum game.
A "downside" of trade deficits that must be financed by Capital Account surpluses is that Americans incur more liabilities to foreigners and foreigners are acquiring titles to more U.S. assets as trade deficits continue year after year. Another downside is that employees of American firms producing non-comparative-advantaged goods and services may lose their jobs, but many of the jobs lost are lower-productivity and lower-wage jobs.
In following Mr. Navarro's autarkic advice, Americans may become more secure in a political sense, but they will suffer diminished security in an economic sense. American consumers will become impoverished by having to pay higher prices for domestically-produced goods and services, and American workers will suffer lower incomes by employment in less-productive, non-comparative advantaged industries.
Rather than obstructing this international productive realignment process, the Trump administration should facilitate this global adjustment while assisting those Americans who suffer dislocations by providing retraining and income assistance.
In a wide-ranging testimony before the Senate Commerce Committee, Wilbur Ross, President Trump's first choice for Commerce Secretary, revealed his views about trade and protection of domestic industry. Mr. Trump has advocated a broad tariff of 35% on all imported merchandise. William Mauldin and Ben Leubsdorf, writing in The Wall Street Journal, January 18, 2017, note that
. . . .
“One of the things that we do need very careful attention to is more tariff activity, the anti-dumping requirements that we should impose on the steel industry and on the aluminum industry as well,” he [Mr. Ross] said, blaming China for excess metals capacity.
(http://www.wsj.com/articles/commerce-secretary-nominee-wilbur-ross-set-for-confirmation-hearing-1484735400)
Mr. Ross's allusion to protecting particular U.S. industries is suggestive of a European-style "industrial policy," i.e., government authorities picking winners and losers. Historically, American administrations have shied from implementing industrial policies in recognition that authoritarian selection of industries to support is usually inferior to the wisdom of markets. This is because markets are usually superior to political authorities at identifying competitive advantages among firms.
Further consideration of trade specifics are in order in light of Mr. Ross' comments. In short, the argument for free trade is that if all regions can discover and specialize in their so-called "comparative advantages" and trade with other regions for goods for which the others have comparative advantages but they do not, all regions that trade with one another can enjoy increasing welfare. And anything that inhibits free trade or the discovery or development of natural comparative advantages can be expected to diminish welfare among the trading partners.
We should note that competitive advantages are firm-specific, but comparative advantages are region-specific. Regional comparative advantages may be inherent in resource endowments, but they may be difficult to identify by simple observation. Often, it is the discovery or development of competitive advantages by the business firms in a region that can confer comparative advantages upon the region.
When a government implements protectionist measures, either across the board or targeted at particular nations or industries, it risks eliciting increasing protectionist pressures in its trading partners. Rising protectionism is dangerous because it tends to induce reciprocal protectionist responses by trading partner governments. The U.S. Smoot-Hawley Tariff Act of 1930 did just this, and it spawned global protectionism that aggravated (some say "caused") the Great Depression.
Although Mr. Trump has said (or implied) that he favors broad (across-the-board) tariffs, Mr. Ross appears to be interested in implementing a more targeted approach that is focused upon particular industries or trading partners. Governments often attempt to contravene the comparative advantages of their trading partners by neutralizing their comparative advantages or by creating artificial advantages for their domestic producers. They do this with protectionist measures that are implemented by imposing tariffs on imports, providing subsidies for domestic producers, and erecting so-called “non-tariff barriers” (NTBs, e.g., quotas on imports, health and safety restrictions on imports, import packaging and labeling requirements, discriminatory performance standards for imports, etc.) that are intended to curb imports or raise their delivered prices.
A tariff is a tax that is usually applied to imported merchandise as it enters the nation. Since a tariff increases the delivered price of the imported good, the quantity demanded of it likely will decrease. Tariffs may be applied to exports as well, but this is rarely done except by governments desiring to capture revenue from the export of a commodity that is highly demanded on world markets (e.g. petroleum).
A subsidy, the conceptual opposite of a tariff, is a benefit, usually in financial form, that is provided by the government of a region to local producers of goods or services to offset part of the costs of production, and therefore to decrease their export prices. An implicit form of subsidy may be provided by income or property tax relief for some period of time. U.S. states often compete with one another for companies to locate plants in their states by providing "tax holidays" for some number of years. Foreign competitors may claim that subsidies, both explicit and implicit, violate trade agreements.
Protectionist policies may be intended to expand or preserve employment and enterprise opportunities for the nation's own workers and companies, but they diminish freedom of enterprise and employment opportunities within the trading partners. Economists have labeled such policy approaches "beggar-thy-neighbor" protectionism. Labor unions are almost universally in favor of “leveling the playing field” (i.e., neutralizing the foreigners' competitive advantages) by implementing protectionist policies. An unintended side effect of protectionist policies is that they may also limit the consumer sovereignty of the government's own citizens by narrowing their range of consumer choice.
Domestic producers' pleas to their government to level the playing field with foreign competitors is a de facto admission that the domestic producers lack competitive advantages that the foreign competitors possess, and that the region may lack comparative advantage in the production of the product relative to other regions.
Since Mr. Ross has mentioned the possibility of providing subsidies to selected industries or specific companies, he is likely to receive many such petitions during his tenure as Commerce Secretary. The intent of a subsidy is to offset a foreign competitive advantage by defraying some of the costs of production of the product incurred by local producers. The effect of a subsidy to domestic producers is to create an artificial competitive advantage for them, and thus to neutralize the foreign producers' competitive advantages. Once regional comparative advantages are neutralized by subsidies, consumers in all of the trading partners pay higher prices for similar products, and tax payers have to foot the bill for the subsidies.
Mr. Ross is also concerned about foreign dumping in U.S. markets. Foreign producers are often perceived to "dump" their products in domestic markets as a means of driving domestic producers from the market, thereby conferring monopoly power upon the foreign producers. Technically, "dumping" means that a foreign producer is selling in a domestic market at a price below the foreign producer's full cost of production. Subsidies by foreign governments to their export producers may be the condition that enables them to dump products in foreign markets at prices below true costs of production.
Mr. Ross may suffer some difficulty with dumping issues because it is almost never possible for one who charges another with dumping to gain adequate information about the other's costs of production. And it may be difficult to discern whether explicit or implicit subsidies have been provided by their governments. For this reason, a "political" definition of dumping has come into common use. On this definition, dumping is the sale by the foreign producer in the domestic market at a "fair value," usually specified as a price below the domestic producer's full cost of production. Sometimes domestic producers claim that the foreign producer is dumping when the price is simply below prices of domestically-produced substitutes. This is a "political" definition because it often serves as the basis for an appeal by domestic producers to their governments for protection from the foreign producers who are reputed to be engaged in dumping.
The problem with the political definition of dumping is that it really cannot be distinguished from the phenomenon of competitive pricing unless the provision of subsidies by the foreign government to its producers can be verified. For example, if another domestic producer were selling at a price below our own preferred price, or even at a price below our own per-unit cost of production, we could hardly charge our domestic competitor with dumping. The most that we could do is complain about competitive pricing which may be predatory in nature, or which may be enabled by discriminatory subsidies. But if a foreign firm engages in the same behavior, domestic producers are quick to charge dumping and appeal to their governments for relief. Even so, since Mr. Ross has mentioned dumping during his testimony before the Senate Commerce Committee, he can expect to hear numerous claims of dumping (on the political definition) during his tenure as Commerce Secretary.
Mauldin and Leubsdorf note Mr. Trump's concern about the U.S. trade imbalance with China:
The balance of trade between any two countries is largely irrelevant. Since global trade in a multilateral trading system has to be approximately balanced (except for errors and omissions) during any time period, any nation's trade deficit with another particular nation is offset by trade surpluses between that nation and other nations. Also, nations import and export more things than just merchandise and services. If a nation imports more goods and services from a particular trading partner than it exports, it has to export enough of other things to that trading partner to "pay for" the excess goods and services that it imports. The trade balance shows up in the Current Account of the nation's Balance of Payments.
The "other things" that the U.S. may export to China include currencies, financial instruments (stock shares, bonds), claims against real American assets (real estate, plant, equipment), and increasing liabilities owed to foreigners (loans from foreign banks or international agencies). These other-things exports are recorded in the Capital Account of the nation's Balance of Payments. If Mr. Trump understands that a nation's Balance of Payments for any time period must actually balance (except for errors and omissions), his real concern may be with increasing American liabilities to the Chinese or the export of the ownership of American assets to the Chinese that pay for a trade deficit with China.
If the Trump administration delivers on its threats to impose or raise tariffs, or to provide subsidies to selected export industries, consumers in both the U.S. and its trading partners will suffer welfare losses. Rather than acquiesce in pleas by domestic firms for protection, Mr. Trump's administration would do well to encourage efforts by domestic firms to discover local competitive advantages or to engage in research to develop (R&D) competitive advantages that can be implemented by capital investments. In so doing, U.S. producers may be able to acquire competitive advantages that confer comparative advantages upon the U.S. economy. If his administration persists in imposing tariffs and NTBs with respect to goods exported to the U.S. by our trading partners, both we and our trading partners can expect to lose, i.e., to suffer welfare losses.
Ip takes us through a hypothetical exercise to show that capital and labor will shift away from U.S. industries producing non-tradeable products, and toward a U.S. industry (lumber) that produces exportables which are not taxed but face competition from a foreign-produced perfect-substitute (Canadian lumber) which is taxed when it is imported into the U.S. His exercise also shows that in a foreign trading partner country, capital and labor will shift away from the industry producing the perfect-substitute item which is exported and taxed when it is imported into the U.S., and toward other industries producing lower-productivity non-tradeables in the trading-partner country.
Ip details the effects on the allocation of resources in the U.S.:
Ip implicitly assumes that as capital shifts to the more profitable U.S. lumber industry, the U.S. producer will expand capacity by investing in same-technology (original) equipment. Since the economy is assumed to be at full employment, what if the U.S. producer invests in greater automation to increase productivity and expand capacity? With increased automation, fewer (not more) workers may be employed in processing timber into lumber. Workers who are still employed in the lumber industry may earn more, but with greater automation it is doubtful that many workers can move into the lumber industry from other industries. Workers who are disemployed by automation in the lumber industry will shift to less capital-intensive industries where productivity and wages are lower, and the shift will tend to further depress wages and returns in those industries.
If with automation investment fewer workers are employed in the lumber industry, the import tax will have impoverished a portion of the U.S. labor force. Whether U.S. Gross National Income increases or decreases depends on whether the income gains to the still-employed workers in the U.S. lumber industry exceed the income losses to those workers who are disemployed from the U.S. lumber industry but gain lower-wage employments in less capital-intensive industries producing non-tradeables. U.S. GNI certainly will decrease if some of the disemployed workers fail to find jobs that are compatible with their work experiences and skills, and thus become discouraged from seeking other employments.
As Ip notes, in Canada returns to the lumber industry will decline, capital will shift away from lumber producers, and employment in the lumber industry will decrease as workers seek employments in other, even less-productive Canadian industries. Yet other things may not remain the same. Canadian lumber producers may attempt to offset the U.S. import tax by lowering their prices and accepting smaller profits. Or they too may try to increase productivity and lower costs by investing in automation technology. With increasing automation, the U.S. tax on lumber imports may impoverish workers and reduce GNI in both countries, even if the U.S.-Canadian exchange rate doesn't change.
What if the U.S. economy is not at full employment? The imposition of the import tax on Canadian lumber will render U.S. lumber processors more profitable and they will be able to expand capacity by hiring more labor at the same wage rates that they have been paying. But Canadian lumber processors will find their exports of lumber to the U.S. to be decreasing at the higher delivered prices (including the import tax), so now with excess capacity they will lay-off workers. The imposition of the U.S. import tax is a "beggar-my-neighbor" policy that increases employment at home at the expense of employment in Canada.
Another situation in which other things may not remain the same is that Canada may choose to retaliate by imposing a tax on U.S. goods imported into Canada. Since both U.S. and Canadian import taxes raise the delivered prices of their respective imported products (unless importers choose to absorb the tax increases in lower profits), consumers in both countries will suffer higher prices and smaller import volumes in both countries. Export industries will experience declining sales and become less profitable, capital and labor will shift away from export producers to less capital-intensive producers of non-tradeables, and GDP in both countries will decline. The moral of this story is that everybody loses with the imposition of an import tax that sparks a trade war.
Martin Feldstein, writing in The Wall Street Journal, January 5, 2017, discusses the border adjustment tax proposed in the U.S. House of Representatives (http://www.wsj.com/articles/the-house-gops-good-tax-trade-off-1483660843). This proposal would tax imports but exempt exports. It would allow the costs of production of exports to be deducted from the U.S. export-producer's corporate profits tax bill. The cost of production of an import could not be so deducted from the tax bill of the U.S. importer or any other U.S. corporation. Feldstein says that such a border adjustment tax would have the effect of a value-added tax implemented in countries that export to the U.S.
Feldstein explains that the application of the tax to imports would induce an appreciation of the dollar that is just enough to offset the tax so that the delivered prices of imports would not change, but the government would collect the tax revenue. The burden of the border tax on imports would be born entirely by foreigners who import U.S. exports because the purchasing powers of their currencies would diminish as the dollar appreciates.
The dollar cannot be counted on to appreciate in response to the imposition of a border tax on imports because financial transactions occur in the Capital Account of the Balance of Payments that are autonomous of the trade balance in the Current Account. These Capital Account transactions may affect the demand for and supply of dollars to the foreign exchange markets, and therefore may cause appreciation or depreciation of the dollar quite apart from what is happening in the trade balance. Because such autonomous financial transactions occur during every accounting period and have been increasing in volume relative to merchandise trade in recent decades, there is no reason to expect that the imposition of a border tax on imports will necessarily cause the dollar to appreciate, or by just enough to offset the tax.
In his example, Feldstein assumes an export of a product priced at $100 with a cost of production of $100:
This is a simplistic example that doesn't take into account a number of conditions that may not obtain. First, the tax deduction won't be of full value ($20) to the producing corporation if it is operating at a loss, or if its pre-tax profit is less than the cost of production. Second, the tax deduction might simply enable the corporation to increase its after-tax profit (its retained earnings) without translating into reducing the price of the product. So, there's no guarantee that there is a $20 tax saving or that it would reduce the price of the exported product to $80.
Ignoring these possibilities, Feldstein goes on to describe the effects on the delivered prices of the export and the import:
The problem here is the assumption that the delivered U.S. price of the import would rise to $125 so that 20% corporate profits tax payment would be $25, leaving $100 payable to the foreign exporter. A couple of things might prevent this outcome. One is that the quantity of the import demanded at the higher price likely would decrease relative to supply so that price doesn't rise to $125. Another is that importers might choose to accept lower profit by absorbing some (or all) of the import tax in order to sustain sales volume. So, there is nothing that automatically causes the price of the import to jump to $125.
Feldstein assesses the effect of the border tax adjustment on the trade balance:
He then notes the sources of possible saving in a nation,
This statement would be true if "trade deficit" included everything in the economy that is exported and imported. However, "trade deficit" includes only merchandise and services exports and imports. It does not include either real assets (plant, equipment, real estate, etc.) or financial assets (currency, stock shares, bonds, etc.), the ownership of which can be exported and imported. This omission renders untrue Feldstein's statement that a country's trade deficit depends only on the difference between total investment and the saving done in the country because international transactions can supply savings to its economy or absorb savings from its economy.
Feldstein mentions the government, but he then appears to forget (or ignore) it as a part of the mix:
A statement like this is incomplete because it doesn't identify the government as a possible source of saving or dissaving. And it doesn't acknowledge financial transactions that are completely within the Capital Account of the Balance of Payments. Government may be a source of saving to the economy if it runs a budgetary surplus, i.e., if tax revenues exceed expenditures (however unlikely). If the government budget exceeds tax revenues (more likely), the government dissaves and thereby absorbs savings from the private sector or some other source.
With an active government that can both raise tax revenues and spend them, it doesn't necessarily follow that when a nation invests more than it saves, it will run an equivalent trade deficit. An excess of gross private domestic investment (GPDI) over personal plus business saving may be financed by government saving, with little effect on the trade balance. Since the U.S. government typically dissaves by running budgetary deficits, it absorbs some of the U.S. personal and business savings. An excess of personal and business saving over GPDI may only finance a government deficit, again with little effect on the trade balance.
A trade deficit may serve as a source of saving to an economy by eliciting a financial inflow by either incurring liabilities to foreigners, or by the export of the ownership of financial assets such as bank balances, currencies, government bonds, or private sector bonds and equities to "pay for" the trade deficit. The difference between GPDI and private sector saving does not automatically result in a trade balance of equal magnitude. Indeed, the total domestic saving deficit (including government dissaving) would require a trade deficit greater than personal plus business saving by enough to finance the government budget deficit.
1 Personal Saving, https://fred.stlouisfed.org/series/A071RC1A027NBEA.
2 Undistributed Corporate Profits, https://fred.stlouisfed.org/series/B057RC1A027NBEA?utm_source=series_page&utm_medium=related_content&utm_term=other_formats&utm_campaign=other_format;
undistributed corporate profits measures corporate saving from book profits
(https://www.bea.gov/national/pdf/chapter13.pdf).
3 Corporations, Depreciation and Amortization,
4 Gross Private Domestic Investment, https://fred.stlouisfed.org/series/GPDIA.
5 Sum of columns 1, 2, and 3, less column 4.
6 Federal Deficit, http://www.usgovernmentspending.com/spending_chart_1960_2021USb_XXs2li111mcn_G0f#copypaste.
7 Sum columns 5 and 6.
8 U.S. Trade in Goods and Services, https://www.census.gov/foreign-trade/statistics/historical/gands.pdf.
The identities of imports and exports really don't mater. If the U.S. runs a trade deficit by importing more merchandise and services than it exports, then it has to export something else like financial assets to pay for the trade deficit. The trade balance is the largest part of the Current Account in the Balance of Payments, but the payment for the trade deficit occurs by international financial transactions in the Capital Account. And international financial transactions in the Capital Account can supply savings to the economy quite apart from the need to finance a trade balance.
Feldstein asserts that although the border adjustment tax would not change the nation's saving and investment, it would precipitate an exchange rate adjustment:
That might be true if there were no influences on the forex markets apart from the transactions to finance the trade balance. But both domestic and foreign investors are active in forex markets to demand or supply their own or foreign currencies in transactions involving financial instruments in response to yield rate or price differentials, quite apart from transactions that finance a trade balance. Capital Account transactions that export the ownership of American assets or increase the liabilities of Americans to foreigners result in financial inflows that can supply savings to the U.S. economy beyond those supplied by transactions which simply pay for the trade balance. Since these Capital Account transactions can influence exchange rates, there is no automatic adjustment that makes the dollar appreciate by 25% in Feldstein's example.
The Capital Account may drive the Current Account, rather than the reverse. For example, if foreign owners of U.S. debt experience uncertainty and decide to unload a substantial portion of their holdings, the dollar may not appreciate as much as Feldstein's example requires, and it may even depreciate relative to other currencies. This may cause a smaller Capital Account surplus to finance a commensurately smaller trade deficit in the Current Account than necessary to cover the private plus public sector savings deficits. Government may experience difficulty in selling enough in bonds to finance its deficit, and private sector investment may be curtailed as bond prices fall and yield rates rise.
Feldstein ends his discussion by advocating inclusion of a border tax adjustment in a forthcoming tax system overhaul:
Maybe, but Feldstein neglects to acknowledge the possibility that foreign governments are likely to reciprocate by imposing their own border taxes to counter the U.S. border tax. The real world is far more complex and messier than depicted in Feldstein's example, and the precise outcomes that he depicts are unlikely to happen. With dollar appreciation less than the example requires, U.S. consumers may indeed suffer rising prices of imports and government's revenue collection from the border tax may not rise to the level indicated in Feldstein's example. Feldstein's example is a neat exercise that ignores too many influences on the global economy other than those involved in international trade. These other possibilities significantly erode the case for including a border adjustment tax in the forthcoming tax overhaul process.
President Trump has thoroughly castigated the Ford Motor Company for shifting production of its small vehicles to Mexico, even as Ford continues to sustain employment and make substantial investment in large-vehicle production facilities in the United States. John Rosevear writing on The Motley Fool website on September 18, 2015, describes the dustup as a "war of words" with Ford:
(http://www.fool.com/investing/2016/09/18/what-donald-trump-is-missing-about-ford-motor-comp.aspx)
But Ford is not alone in shifting some vehicle assembly to Mexico. There are eighteen motor vehicle production sites in Mexico, including assembly plants owned by Ford, General Motors, Fiat-Chrysler, Volkswagen, Nissan, Honda, BMW, Toyota, Volvo, and Mercedes-Benz.
At more than 4 million units per year, Mexico is the seventh largest producer of light motor vehicles in the world. It is the sixth largest producer of heavy motor vehicles with around 140 thousand per year, and it is the eighth largest producer of motor vehicle components. Foreign direct investment by motor vehicle manufacturers in Mexico exceeded 30 billion dollars between 1999 and 2013. Although the main export market for Mexican-assembled motor vehicles is the United States, nine percent of its output goes to other South American countries, and 4 percent goes to Europe. (http://www.automotivemeetings.com/mexico/index.php/en/automotive-industry-in-mexico)
So why isn't Trump coming down just as hard on GM and Fiat-Chrysler? And why are they also producing in Mexico some models for sale in the U.S. market?
There are several reasons that automobile manufacturers might "offshore" some production to other countries, among them are to:
- achieve lower production costs;
- seek higher rates of return than can be achieved elsewhere or by
local competitors;
- internalize control of knowledge assets while exploiting them;
- acquire new knowledge resources;
- surmount nationalistic preferences for domestically made goods; and
- circumvent trade barriers.
Profit margins typically are bigger in the production of larger vehicles, particularly "pick-up" and large trucks and sports utility vehicles (SUVs), which Ford and others continue to produce in the U.S. Ford is returning F-650 and F-750 production to the U.S. after a joint venture with Navistar in Mexico was shut down in 2014. Ford is actually creating more jobs in its U.S. truck production facilities than are being "lost" from its small vehicle production facilities. In fact, no jobs are being lost from those facilities since they are being changed over to producing other Ford models, and Ford likely will be increasing employment in those facilities as the economy continues to recover from the 2008 "Great Recession."
A problem for U.S. automobile manufacturers is that small-vehicle sales competition often is more intense and the profit margins usually are slim at best. With periodic union negotiations for wage increases, the net incomes from small-vehicle production at domestic sites easily may become negative. Business firms usually do not choose to produce their products at a loss, but changing conditions may render continuing production of a formerly profitable product to become unprofitable.
This is likely the case with small-vehicle production in the United States, and for all domestic vehicle manufacturers, not just Ford. Small vehicles typically are demanded by people toward the lower end of the income spectrum. If an automobile manufacturer is to have any small vehicles to offer in its product line, it may have to shift production to countries or regions where lower wages allow costs to be less than revenues, and import the vehicles. Exports of bigger-margin large vehicles from the U.S. may more than offset the import of lower-margin small vehicles from Mexico. Rosevear says,
Bavarian Motor Works (BMW) may provide a study in contrasts. With original production facilities in Germany, BMW has invested in assembly plants in several countries, including the United States where the wage level is comparable to that in Germany. The BMW manufacturing facility in South Carolina soon will become the largest volume producer of BMW vehicles in the world. The larger BMW automobiles are higher-value vehicles with bigger profit margins that can stand the higher wages. BMW's motivation to produce in the United States is to minimize parts and final product shipping costs to its largest market, and to jump inside the U.S. tariff fence as well. But BMW also produces some of its smaller and lower-margin vehicles in Mexico and other lower-wage regions for import to the United States and to Germany.
Brandon Morse, writing on September 19, 2016, on the RedState website, says,
(http://www.redstate.com/brandon_morse/2016/09/19/donald-trumps-blatant-lie-ford-motors-moving-everything-mexico-gets-destroyed/)
Mike Fields, Ford's CEO, speaking with Hoppy Harlow on CNN, said,
Although it is highly unlikely, Mr. Trump would do well to revise his stance in regard to Ford's ventures in Mexico.
Globalization is not a new phenomenon. The ancient Greeks followed by the Romans effected early globalizations of their known worlds. Genghis and Kublai Khan accomplished globalization from Austria to the Pacific Ocean. A clearly identifiable globalization ensued with British colonialization. The Soviets and the Nazis attempted their own versions of globalization via invasion and/or subjugation. The post-WWII American dominance effected the recent form of globalization through trade and investment.
The dispersion of the Jewish diaspora through Europe and much of the rest of the world has been a form of globalization effected by migration. Both the Catholic Church and Protestant churches have conducted their own versions of globalization through missionary efforts. ISIS is attempting globalization of its version of Islam via migration and terrorism.
The latest episode of globalization has occurred via education, the spread of technological advance, and the internet. These phenomena have elicited immigration of more intellectually/scientifically/mathematically capable people from India, China, and other regions to the U.S.
All of these episodes of globalization induced mass migrations of various magnitudes, and all of them elicited popular reactions, often by "nationalists and nativist populists."
Should the survival of every or any particular human be guaranteed? Who is the guarantor? Would we rather have least or most capable ("fittest") humans to survive? In terms of migrations, it is clear that the capable and fittest (i.e., the risk-assuming entrepreneur types) get up and go, leaving the aged, incapable, and risk averse to fend for themselves. Should some super-decider choose who migrates or who survives, and thus who remains and fails? Who should we trust to be the super-decider?
Globalization-induced migrations cause least social disruption when the migrants willingly and quickly become acculturated to their new environments. Frictions occur when the migrants insist upon maintinaing their own cultures and the recipient societies continue to tolerate multiculturalism. Public policy should be designed to facilitate early absorption and acculturation of recent immigrants to the culture and language of the recipient society.
(https://www.washingtonpost.com/news/wonk/wp/2017/01/20/president-trump-just-outlined-his-top-priorities-for-trade-and-the-economy/?hpid=hp_hp-cards_hp-card-business%3Ahomepage%2Fcard&utm_term=.ff45c28e0554)
Mr. Trump elevates revival of manufacturing industry as a top priority, above free trade and globalization. This implies that he is willing to forego the welfare benefits of specialization by comparative advantages and trade in favor of manufacturing job preservation and creation.
The U.S. economy undoubtedly possesses comparative advantages in a number of manufacturing industries, prominent among which are chemicals, pharmaceuticals, and aircraft. But manufacturing comprises a small and declining share of U.S. economic output and employment. Mr. Trump seems to be unaware that the U.S. now employs fewer than 20 million workers (under 13 percent of its labor force) in manufacturing but more than 120 million workers (over 80 percent of the labor force) in service establishments (https://www.bls.gov/emp/ep_table_201.htm). In 2014, the U.S. exported $1.6 trillion worth of manufactured goods while importing nearly $2.4 trillion of manufactures (https://www.census.gov/foreign-trade/Press-Release/current_press_release/ft900.pdf). It exported $743 billion of services while importing $481 billion of services. So, in 2014 the U.S. ran a trade deficit of $752 billion in goods, but a surplus of nearly $262 billion in services. The U.S. is in process of shifting from its historic identity as an industrial economy to its future identity as a service economy.
What's the difference between a good and a service, anyway? A good has tangible characteristics and a life of some duration depending on whether it is immediately consumable, a non-durable (by convention, with life up to about three years), or a durable good (with life longer than three years). The typical life of a service is the instant that it is rendered. A service may exhibit no tangible characteristics although the provision of the service has tangible effects. Except for things like antique furniture, old-master paintings, classic cars, and other things that may convey impressions of wealth or elitism, people want goods not for themselves but rather for the stream of services that they can render over their lifetimes. It's really all about services, irrespective of tangible characteristics or duration of life.
Mr. Trump seems willing to sacrifice the welfare gains of free trade for a population of 320 million souls to the revival of manufacturing industries for which the U.S. no longer has comparative advantages. So why is Mr. Trump putting such emphasis on bringing sweaty, low-wage manufacturing jobs back to the U.S.? Most of the jobs lost to foreign manufacturers were not "good" (high-wage) jobs anyway. The Trump administration's emphasis on reviving a declining manufacturing sector is unlikely to increase labor force participation or to bring about wage increases.
The U.S. economy exports services to pay for many manufactured goods which it imports from foreign suppliers that possess comparative advantages relative to the U.S. Rather than promote the revival of manufacturing industries for which the U.S. lacks comparative advantages, the Administration would do well to encourage the growth of higher-wage U.S. service employments (e.g., in information technology, logistics, education, finance, insurance) for which the U.S. does possess comparative advantages so that their services can be exported to pay for manufactured imports.
Industrial policy has been described as government picking winners
and identifying losers among the resident industries within the nation,
and
then acting to encourage and support the chosen winners. A special
variant
of industrial policy that has been practiced in several so-called
"third-world"
nations is "import-substitution industrialization" under which the
government
of the nation promotes the development of domestic industries with the
intention of decreasing imports, acquiring comparative advantages, and
modernizing its economy.
The idea of an industrial policy has been mostly dormant in American political
thought and policy discussions now for nearly thirty years. Historically,
American presidential administrations have shied from implementing industrial
policies, although until recently Democrats seem to have been more open
than Republicans to discussing the possibility. But the election of Republican
Donald J. Trump to the U.S. presidency in 2016 has brought industrial policy
to the fore again.
Ideas about governmental implementation of some sort of industrial policy
may be dated to as early as the pre-Industrial Revolution eighteenth century
era of mercantilism. Mercantilist policy, though represented in no single
coherent statement or document, stood upon three pillars: detailed regulation
of domestic crafts and emerging industry, maintenance of colonies, and pursuit
of a favorable balance of trade to accumulate wealth. Jean-Baptiste Colbert
was France's finance minister under Emperor Louis XIV. Through Colbert's
dirigiste policies, the French
government supported domestic manufacturing enterprises in a wide
variety of fields. The authorities established new industries, protected
inventors, invited immigration of workers from foreign countries, and prohibited French
workers from emigrating (https://en.wikipedia.org/wiki/Jean-Baptiste_Colbert).
The approach pioneered by Colbert in France came to be known as the "Colbertist model" of industrial intervention (http://www.elie-cohen.eu/IMG/pdf/Industrial_policies_France.pdf).
It was practiced as well during the Industrial Revolution by German, Japanese,
Russian (later Soviet), and other governments from the mid-nineteenth century
forward. It became the main vehicle of European industrialization leading
up to World War I and continued as such between the world wars. It became
a tenet of European development policy in the post-World War II era (https://ec.europa.eu/growth/industry/policy/eu_en).
Although several U.S. presidential administrations have been tempted to
adopt a European-style of selective industrialization, they generally have
eschewed a national industrial policy. Nineteenth-century progressives seemed
to have been favorably disposed toward implementing an industrial policy.
The Progressive Era of political thought dates form the early post-Civil War
period to around 1920. The following list of tenets of progressive thought
pertaining to the role of government is abstracted from a 2007 paper by Thomas
West (http://www.heritage.org/research/reports/2007/07/the-progressive-movement-and-the-transformation-of-american-politics):
- trust should be placed in unlimited political authority;
- government should protect the poor and other victims of capitalism
through redistribution of wealth;
- government should manage the corporate sphere to avert victimization
of the poor by the wealthy;
- government should exercise control over the details of commerce
and production by dictating prices, methods of manufacture, and practices of the banking system;
- government should protect the environment through conservation of
resources;
- government should provide "spiritual uplift" through subsidy and
promotion of the arts and culture.
That progressivism is associated with the liberal wing of the Democrat Party may explain why Democrats historically have been more favorably disposed than Republicans toward implementing an industrial policy. During the U.S. presidential campaign of 1984, Democratic candidates came out in favor of implementing some form of national industrial policy, but Ronald Reagan's election to the U.S. presidency quelled such interest at the national level (http://www.econlib.org/library/Enc1/IndustrialPolicy.html). More recently, Democrat Barack Obama's administration engaged in implicit industrial policy during the so-called "Great Recession" of 2008 and the follow-on period of recovery by bailing-out certain financial institutions and automobile manufacturers that were deemed "too big to fail."
Various U.S. states have practiced forms of industrial policy in their efforts to attract industry or particular firms to locate plants within their borders. The economic principle underlying state-level industrial policy is the contention that since capital is generally more mobile geographically than is labor, capital should move to sites where it can employ capable and well-trained labor. States vie with one another to demonstrate that their labor forces are capable and well-trained, and that they possess the physical and financial infrastructure to support the sought-after industry.
Most recently, newly-elected Republican President Trump has taken up industrial policy via tweeting and shaming specific companies for proposing to move production to Mexico. Vikas Bajaj, writing in The New York Times, December 8, 2016, says that
In a flurry of tweets, interviews and deal making, President-elect
Donald Trump has made clear that he will take an active role in shaping
industrial policy" one business at a time. He's already shown off this
approach with United Technologies, Boeing and SoftBank.
. . . .
Michael Useem, a management professor at the Wharton School at the
University
of Pennsylvania, said he couldn't think of any president in recent
memory
who targeted companies individually. “The president-elect's
intervention
is a violation of a freely-functioning economy,” he said, adding: “It is
singling out a particular company for a particular management decision
or practice.”
(https://www.nytimes.com/2016/12/08/opinion/donald-trumps-company-by-company-industrial-policy.html)
But Justin Wolfers, writing in The
New York Times, January 27, 2017, says that
Even if President Trump's industrial-policy-by-Twitter-post fails over
the long run to create jobs or prevent companies from moving offshore,
there's a good chance that it will appear, at first, to be a success.
But this is a dangerous illusion, the result of companies responding
strategically to the new president's threats. And it could lead to more
bad policy if voters or policy makers draw the wrong conclusions.
(https://www.nytimes.com/2017/01/27/upshot/donald-trump-offshoring-factory.html)
Why might President Trump's industrial-policy-by-twitter-post fail?
Or if it initially appears to succeed, why might it lead to more bad
policy?
Prior American administrations generally have shied from implementing
industrial policies in recognition that bureaucratic selection of
industries to support is usually inferior to the "wisdom of markets."
This is because competitive advantages among firms often are
prerequisites to discovery of comparative advantages of regions, and
markets usually are superior to political authorities at identifying
competitive advantages among firms.
The most likely reason for an industrial policy to fail is
that bureaucratic choices of national-champion industries may not correspond
to the nation's natural or acquired comparative advantages. If an administration
chooses to support non-comparative-advantaged domestic industries, production
costs will be higher than in potential trading-partner nations that do possess
the respective comparative advantages. Consumers of the nation will pay
higher product prices for domestically-produced goods and enjoy lower levels
of welfare than they might have enjoyed if they had consumed comparable imports
from regions possessing the respective comparative advantages.
A reason that an initially successful industrial policy might lead to
more bad policy is that the initial successes may encourage the administration
to try to acquire or develop comparative advantages by deliberately choosing
to support non-comparative-advantaged industries within its borders. The
hope is that the "infant" industries may "grow up" to the point that they
eventually becomes globally competitive and achieve comparative advantage
status. This hope may motivate government to fund research, to subsidize the
chosen industries, and to implement tariff and NTB protections of them. Until
the comparative advantages are achieved (if ever), its domestic consumers
will suffer welfare losses because it is not importing lower-priced goods
from regions that do possess the respective comparative advantages.
So, the crucial question for businessman Trump is whether he
possesses
the requisite acumen to pick actual or potential comparative-advantaged
industries for the U.S. If not, he may only be protecting and supporting
non-comparative-advantaged U.S. industries and preventing them from
offshoring new production facilities to foreign sites where the true
comparative advantages lie.
Bob Davis and Jon Hilsenrath, writing in The Wall Street Journal, March 29, 2017, say that
In wealthy nations, the big hope is that a reversal in globalization
will lift wages of unskilled workers by reducing competition from
low-wage nations. That hasn't been the case so far. Globally, wage
growth slowed to an average 2.1% in the past five years, compared with
2.4% in the five years leading up to the 2007-2009 financial crisis,
according to the International Labor Organization.
(https://www.wsj.com/articles/whatever-happened-to-free-trade-1490800293?mod=djemalertNEWS)
The process of globalization over the past half century has enabled
nations to increase production specialization in their comparative
advantages and to enjoy the fruits of comparative advantage
specialization by trading with one another. A nation's possession of a
comparative advantage means that less has to be given up to produce an
item than has to be foregone in another nation that doesn't possess the
comparative advantage. When a nation specializes production in a
comparative-advantaged item, it shifts from lower-productivity
employments to higher-productivity employments within the nation.*
The reason that wage growth has slowed lately is that a recent reversal
of globalization has led to comparative-advantage despecialization in
many nations. Despecialization shifts domestic production away from
higher-productivity employments to lower-productivity domestic
industries producing non-comparative-advantaged import substitutes.
Wage increases are enabled by productivity increases. Shifting
production to lower-productivity industries portends falling (or
stagnant) wages, not rising wages. There is little reason to expect
domestic wages to rise when globalization is reversed, especially if
there is a surplus of low-skilled labor.
Import-substitution industrialization (ISI) strategies were adopted as
development vehicles in several lower-income nations during the second
half of the twentieth century. The idea was to try to "birth" and
protect from global competition non-comparative-advantaged "infant"
domestic industries until they could "grow up" and somehow attain
comparative advantages on world markets. In the meanwhile, domestic
consumers would pay the price of protection in the form of higher prices
of domestically-produced goods compared to the lower prices of imports.
But the ISI strategy has been discredited in favor of export-oriented
development (EOD), i.e., identifying and pursuing development of
nations' actual comparative advantages in producing both industrial
goods and primary products that can be exported to pay for lower-priced
imports.
Yet what we are now seeing among some of the world's wealthier nations
is the revival of this same strategy that has been discredited for
lower-income nations. But now it is advocated for higher-income nations
in the interest of alleviating domestic unemployment among their
lower-skilled workers. The domestic industries that are being preserved
and protected from import competition are not "infants" trying to "grow
up." Rather, they are old and contracting (if not dying) industries
because they no longer possess comparative advantages relative to their
trading partners.
What the adoption of an ISI strategy actually does is to trade the
welfare of domestic consumers for employment benefit to low-skilled
domestic labor. It appears that the need to ensure domestic tranquility
within the lower-skilled segment of the labor force trumps (no pun
intended) the welfare of domestic consumers.
____________
*We are comparing productivity among employments within a nation, not
between nations. To observe that one country has a comparative advantage
over other nations in producing an item does not necessarily mean that
its labor is also more productive. Productivity and comparative
advantage are different concepts. Productivity is measured as some ratio
of output (value or quantity) of an item per unit of input, e.g., labor
hours. Comparative advantage is a matter of opportunity costs, i.e.,
the resources or other products that must be given up to produce an
item. Even though labor in one nation may be less productive than in
another nation, it may possess the comparative advantage because the
opportunity cost of producing the item may be lower than in the other
nation. For example, Ethiopia (also noted in the Davis and Hilsenrath
piece), with its large unskilled labor force, probably has a comparative
advantage relative to the U.S. in producing textile products even
though labor employed in the U.S. textile industry is much more
productive. It may also be true that a nation lacks a comparative
advantage relative to other nations because more resources must be given
up to produce an item even though its labor is more productive. Some of
the U.S. industries that President Trump wants to revive and protect
may fall into the latter category.
Neil Irwin, writing in The New York
Times, January 25, 2017, says that
Economists broadly supportive
of free trade deals argue that Nafta essentially encouraged a shift of jobs
in the United States toward higher-value, more productive work, raising
wages and having negligible impact on the total number of jobs. Those more
skeptical of the deal view it as having created low-wage competition across
the border in Mexico that accelerated the loss of manufacturing jobs.
(https://www.nytimes.com/2017/01/25/upshot/what-can-trump-do-to-overhaul-nafta-quite-a-lot.html?ref=economy)
Why can economists argue that Nafta provided this benefit for American
workers? Prior to the North American Free Trade Agreement, tariffs inhibited
trade so that both the U.S. and Mexico (and Canada as well), by failing
to exploit many of their comparative advantages, produced more of the goods
and services that they consumed. The answer to the question is that Nafta
has enabled the U.S. to exploit its comparative advantages in higher-value,
more-productive, and higher-wage industries. Trading goods produced by those
industries for lower-priced imports has enabled an increase of the welfare
of American consumers.
By the same token, the skeptics who argue that low-wage manufacturing
jobs have been lost to Mexico are implicitly admitting that the U.S. no
longer possesses comparative advantages in industries providing those jobs,
and that Nafta has enabled Mexico to exploit its comparative advantages in
those industries. Both nations have gained by trading their comparative-advantaged goods with each other.
The comparative advantage shift enabled by Nafta has provided
many Mexican workers with income-earning opportunities that they never before
could have imagined except by immigrating to the United States. Nafta may
have actually diminished the flow of immigration (legal and illegal) from
Mexico to the U.S. by providing higher income-earning opportunities for
Mexicans at home, and the flow of illegal immigration from Mexico has indeed
diminished recently (http://www.pewhispanic.org/2015/11/19/more-mexicans-leaving-than-coming-to-the-u-s/).
If President Trump follows through on his stated intent to cancel or
renegotiate the terms of Nafta agreement, we should not be surprised to
see an increasing flow of Mexicans attempting to immigrate to the U.S.
Such a comparative advantage shift may be more of a problem in a
higher-income nation like the United States than in a lower-income
nation like Mexico.
American workers have become conditioned to higher-wage occupations in
which
they have become comfortable and are not particularly looking to shift
to
other occupations, even if they offer the possibility of capturing
higher
incomes.
In an ideal world, the U.S. workers displaced from the lower-wage
manufacturing jobs would be retrained for more productive and
higher-wage jobs in the industries or services for which the U.S. does
have comparative advantages relative to Mexico. The pain of adjustment
to such a comparative advantage shift could be ameliorated by providing
workers so displaced with income supplements during their retraining
periods.
But the real world is not so ideal because workers who train for jobs
in certain occupations and gain experience in their employments begin to
regard themselves as having life-time rights to those jobs, irrespective
of changes in technology or international trading realities. By the time
that a worker so-trained for jobs in a specific industry reaches an age
in the mid-late thirties, he or she tends to become highly resistant to
any need or opportunity to shift to a different occupation, even if there
is a possibility of capturing greater income. They may be especially resistant
to occupational change if automation is perceived to diminish the number
of more-productive and higher-wage jobs.
Since it is rare for great social transformations to be completed
within
a generation, the solution to this conundrum may lie in the passing of
those
of the present generation who resist retraining to take advantage of
comparative-advantage shift and technological change opportunities. Two
historical examples should be sufficient to illustrate this point.
The first is about technological change. With the introduction of
more
productive mechanical motive power in agriculture around the turn of the
twentieth century, many farmers resisted adopting tractor technology,
preferring to stay (and die) on their farms while continuing to use
animal motive power.
The proportion of the U.S. labor force engaged in agriculture fell from
more
than half at the turn of the twentieth century to less than two percent
by
the turn of the twenty-first century. It was not the farmers who walked
off
their farms, but rather their children who left the farms for factory
employments.
The second historical example is about shifting comparative
advantages.
Around the middle of the twentieth century, American textile workers
fought
to retain their jobs in the mills even as the comparative advantage in
textile
weaving shifted first to East Asia, then to South Asia, and subsequently
to
Africa. It was not those American textile mill workers who left the
mills,
but rather their children who trained for more technologically advanced
occupations. By the same token, here in the twenty-first century it will
be the children of today's American factory workers who will train for
technologically more productive and potentially higher-wage jobs, many
of which will be found
in the service sector.
But the big challenge to this great social transformation may be
robotization
that displaces menial labor occupations that might have been filled by
those
members of American society who are less capable or who take early
leave
of the educational and training possibilities that are open to them.
Those
who are resistant to accommodating technological change and comparative
advantage shifts will be relegated to the remaining lower-wage menial
occupations, and wages in those occupations will be depressed as ever
more workers crowd into them. Or they may be unemployable and have to be
supported by the more-capable and better-educated members of society
who can find income-earning employments in the more-productive and
higher-wage occupations.
Under a fixed exchange rate regime, exchange rates are determined by government fiat or by agreement of nation states in an economically integrated region to use a common currency. Exchange values are fixed or stabilized either by intervention of a government agency in exchange markets, or by exercise of the police power of the state to dictate official rates and punish transactions at rates other than the official rates.
In a fixed exchange rate regime (such as the Gold Standard or the Bretton Woods System), the principal responsibility of the monetary authority becomes the control of the exchange rate within narrow tolerances of a target rate. In such a situation, monetary policy cannot be directed toward domestic problems, and the "tail wags the dog," i.e., the interest of the domestic economy is made subsidiary to the need to stabilize the exchange rate.
Under a flexible exchange regime, exchange rates are determined in foreign exchange ("forex") markets by interaction of suppliers and demanders. Exchange rates vary in response to changes of demand for and supply of foreign exchange (i.e., shifts of demand and supply curves).
Monetary authorities may at times attempt to influence the direction of exchange rate change by purchasing other currencies (i.e., supplying the domestic currency) to induce depreciation or prevent appreciation of the domestic currency. Or they may sell other currencies (i.e., demand the domestic currency) to induce appreciation or prevent depreciation of the domestic currency. When they do either they may forego the ability to exert monetary policy in pursuit of domestic goals.
As the world economy becomes progressively more open and economically integrated, macroeconomic adjustments to internationally-sourced disturbances attain ever greater significance. Basically, there are only three macroeconomic adjustment vehicles: exchange rates, domestic prices (including interest rates), and domestic employment (and incomes). A progression of "if statements" identifies the relevant adjustment possibilities:
1. If exchange rates are allowed sufficient flexibility, they may serve as "shock absorbers" for the domestic economy against internationally-sourced disburbances.
2. If exchange rates are fixed by government authorities, domestic prices and incomes assume the burden of adjustment.
3. If domestic prices are insufficiently flexible, the adjustment process must descend upon domestic employment and incomes.
4. If government authorities employ macropolicy to stabilize domestic prices and incomes, exchange rate flexibility must serve as the adjustment vehicle.
5. If government authorities attempt both to stabilize domestic prices and employment and to fix exchange rates, there is no effective vehicle of macroeconomic adjustment to international disturbances. In the absence of an effective adjustment vehicle, payments imbalances will persist.
An important conclusion emerges from these considerations: the degree of domestic macroeconomic stability of a nation may depend upon the degree of flexibility that its government accords to rates of exchange between its currency and other currencies. As a general rule, we may expect domestic macroeconomic conditions in any economy to be more volatile in response to international disturbances the less flexible are its exchange rates. Fixing or stabilizing exchange rates forces the adjustment to international disturbances upon domestic macroeconomic conditions of prices and employment.
Jon Sindreu and Christopher Whittall, writing in The Wall Street Journal, October 10, 2016, say
. . . .
But suffering Brexit's pain through the currency may be more comfortable than through higher unemployment or other ills, a luxury that wasn't available to eurozone countries during the currency bloc's debt crisis. Over the longer term, economic wisdom holds that a weaker currency will boost a nation's sales abroad, so what the economy loses in the form of lower consumption because consumers are poorer will be recovered through higher exports.
(http://www.wsj.com/articles/pounds-pounding-helped-u-k-absorb-brexit-shock-1476055421)
Can exchange rate flexibility insulate the domestic economy from either international disturbances or the international effects of domestically-sourced disturbances? The uncertainty in Europe about what the Brexit vote would entail resulted in an immediate externally-sourced decrease of demand for U.K. produced "things" (merchandise, services, financial instruments, direct investments, etc.).
Such a decrease of demand impacts primarily the current account (merchandise and services) of the U.K. Balance of Payments, resulting in a decrease of net exports (exports less imports) and causing a decrease of domestic aggregate demand. If exchange rates are fixed, as they implicitly are among the nations within the Eurozone, real output can be expected to fall and unemployment to rise.
But if exchange rates are flexible, as in the case of the U.K. pound sterling vis-a-vis the euro and other currencies, the resulting decrease of the demand for pounds relative to the supply of them on foreign exchange markets precipitates a balance of payments deficit and a depreciation of the pound relative to other currencies.
If depreciation occurs concurrently with the decreased demand for exports (or an increased demand for imports), the lower foreign price of the domestic currency makes domestic goods appear cheaper to foreigners and foreign-made goods appear more expensive to domestic consumers. Both effects offset the decrease of aggregate demand, and ideally will prevent any net decrease.
In this best-case scenario, the exchange rate depreciation would serve as a shock absorber to insulate the domestic economy completely from the effects of decreased demand for domestically produced things or the effects of increased domestic demand for foreign-made things. Output need not fall and unemployment doesn't have to increase.
We appear to be witnessing just such a response in the wake of the Brexit vote in U.K. This response may provide incentive to political decision makers in other E.U. countries to contemplate leaving the Eurozone and (re-)establishing their own currencies. Those currencies could then depreciate or appreciate as needed in response to external disturbances, or they could allow national macroeconomic policy makers to be unconcerned about international effects of needed domestic macroeconomic adjustments.
For example, the depressed Greek economy seems unable to recover and surface from its burden of external debt as long as it continues to use the euro, it is subject to the European Central Bank's one-size-fits-all interest rate policy, and lenders continue to impose various austerity measures as conditions for refinancing or increasing loans.
Exit from the European Union (including the Eurozone) and reestablishment of the Greek drachma may be just the medicine that is needed. With flexible drachma exchange rates vis-a-vis the euro and other currencies, the Greek central bank could reduce its lending rate and increase the drachma money supply, and the Greek government could implement fiscal policies to stimulate economic activity.
Although the Greek population might prefer that any increased government spending be devoted to social welfare programs (e.g., unemployment compensation, poverty relief, health care, etc.), additional government spending should focus upon productive activity and infrastructure construction that might increase employment and income generation.
Substantial domestic inflation likely would ensue, but appropriately-focused macroeconomic stimulation could increase output and employment to accelerate the Greek rate of economic growth. The domestic inflation would be accompanied by drachma depreciation that would decrease imports and increase exports, thereby adding to aggregate demand in the Greek economy. With rapid enough economic growth, tax revenue collections could increase, thereby providing the where-with-all to pay down the Greek external debt.
An editorial in The Wall Street Journal, October 13, 2016, disputes the likelihood that the volume of British exports will increase because pound depreciation makes British goods appear less expensive to foreigners. The demand for British exports depends now on more than price competition because over the past several decades British manufacturers have shifted from producing price-sensitive commodities to making high-tech items like pharmaceuticals and precision tools that are not available from other suppliers. British exporters recently have been raising pound-denominated prices of their high-tech products. This diminishes the potential benefit of pound depreciation and decreases the likelihood that the volume of British exports will increase. When domestic producers raise export-good prices denominated in the domestic currency while their currency depreciates, this weakens the potential for exchange rate flexibility to serve as a shock absorber for their economy.
(http://www.wsj.com/articles/a-pound-of-worry-1476315202)
Note that devaluation and depreciation are different phenomena. The devaluation of a currency is implemented by government fiat and must be maintained or enforced by government authority. Depreciation of a currency vis-a-vis other currencies is a market response to changing international economic conditions.
Viktoria Dendrinou, writing in The Wall Street Journal, October 24, 2016:
Note that none of this bailout amount is destined for investment in productive activity or infrastructure construction.
Wiktor Szary and Jason Douglas, writing in The Wall Street Journal, October 27, 2016:
(http://www.wsj.com/articles/u-k-economy-sees-third-quarter-growth-of-0-5-after-brexit-vote-1477557714?mod=djemalertEuropenews)
Domestic inflation and currency depreciation are intertwined. Depreciation of a nation's currency vis-a-vis foreign currencies will make the delivered prices of imported goods higher. This has a greater impact on the nation's consumer-goods inflation rate the larger the proportion of consumables that consists of imports. A shift by domestic consumers from purchasing higher-priced imported goods to comparable domestically-produced goods could also cause their prices to increase as well if the economy is close to full employment and there is little slack productive capacity. But inflation of the prices of domestically-produced goods that are exported is a likely cause of depreciation of the nation's currency in the first place.
Stephen Fidler, writing in The Wall Street Journal, December 4, 2016, says that
(http://www.wsj.com/articles/italys-no-poses-trouble-for-eurozone-1480897269?mod=djemalertEuropenews)
Georgi Kantchev, writing in The Wall Street Journal, December 5, 2016, notes that
. . . .
Born in 1999, the euro has survived tougher trials. In 2010, its member countries set aside deep resistance to paying for each others' debts and bailed out Greece and then Ireland. The next year, Portugal. And in following years, Spain, for its banks, and Cyprus. The left-wing Syriza party took control of Greece in 2015 full of rumblings about a return to the drachma. Yet Greece stomached capital controls and a new bailout and didn't leave the euro.
. . . .
An eventual fracturing of the common currency would likely be a calamitous event for financial markets. Widespread capital controls would be needed to prevent destabilizing rushes of money from countries deemed likely to have a weak posteuro currency to those expected to have a strong one. Huge swaths of financial infrastructure, including derivatives markets and common banking systems, would need to be disaggregated.
(http://www.wsj.com/articles/euro-claws-back-losses-after-italys-no-vote-1480934548)
Ian Talley, writing in The Wall Street Journal, March 31, 2017, says that
Mr. Gagnon [Joseph Gagnon, a senior fellow at the Peterson Institute of
International Economics] and Peterson colleague Fred Bergsten say the
Trump administration may have to push down the value of the dollar to
cut an expanding U.S. trade gap.
. . . .
But raising trade barriers would likely be economically harmful and have
little effect on the trade deficit, Mssrs. Gagnon and Bersten argue.
Instead, the U.S. should encourage an orderly decline in the foreign
exchange value of the dollar, they say. Other countries may not
initially be keen to join a coordinated intervention because it would
mean their currencies would appreciate.
(https://blogs.wsj.com/economics/2017/03/31/americans-owe-other-countries-far-more-than-they-owe-us-and-its-getting-serious/)
President Trump has threatened to impose trade barriers to imports in
order to reduce the U.S. trade deficit, and he has threatened to label
China a currency manipulator. Recently he has backed off of his currency
manipulation labeling threat in expectation that China will help to
restrain the militaristic behavior of the North Koreans.
How the Trump administration might "push down the value of the dollar"
is unspecified. Efforts to "talk-down" the value of the dollar may have
some modest and temporary effects, but market realities (exchange demand
and supply) soon would dominate. The administration might specify an
"official" dollar exchange rate vis-a-vis some other currency and then
punish parties who trade at rates other than the official rate. Such an
approach would elicit "black market" transactions above or below the
official rate, depending on supply and demand conditions in exchange
markets. Also, a democratic society is likely to have an aversion to
such an authoritarian approach.
A market approach to decreasing the exchange value of the dollar would
entail either the Treasury or the Federal Reserve entering the foreign
exchange markets to sell dollars in exchange for selected foreign
currencies. This method is feasible, both because the Fed can create as
much dollar money as it wishes, and because the Fed presently has a
swollen asset portfolio exceeding $4 trillion that it is talking about
"winding down."
In the market approach, the Fed would increase the supply of dollars
relative to demand on forex markets, thereby "pushing down the value of
the dollar" and increasing the dollar-prices of the selected currencies
that are purchased. But if the Trump administration does act to push
down the value of the dollar using either of these approaches, it will
give reason to our trading partners to label the U.S. a currency
manipulator no less so than China has been in the past.
The trade deficit is the largest part of the Current Account in the U.S.
Balance of Payments. It accounts for only about a third of the net
international investment position of the U.S. Most of the changes in the
net international investment position result from financial
transactions in the Capital Account of the Balance of Payments. These
transactions, which have effect on the value of the dollar on foreign
exchange markets apart from the trade balance, are heavily influenced by
yield rates on the financial instruments that are traded
internationally.
As of April 18, 2017, the 10-year U.S. government bond yield (2.18%) was
more than double the yields of comparable bonds issued by governments
in U.K., Japan, and Germany (http://www.tradingeconomics.com/bonds).
"Encouraging an orderly decline" in the foreign exchange value of the
dollar is unlikely to work as long as yield rates on U.S.
government-issued bonds are higher than yield rates on comparable bonds
issued by U.S. trading partners.
The dollar might depreciate in spite of higher yield rates on U.S. government-issued bonds. If foreigners become ever more concerned about the stability of the U.S. economy or the U.S. presidency, or if they begin to fear further loss of asset value of the U.S. bonds that they hold, they may begin to unload their holdings of U.S. bonds. An increasing supply of U.S. bonds relative to demand for them on international financial markets would result in an increase in the supply of dollars relative to dollar demand on the forex markets, thereby producing dollar depreciation. But if this happens, it is unlikely to be "an orderly decline."
A substantial portion of the U.S. public debt is held by foreign interests in Asia and the Middle East. A rising concern is that Asian and Middle East holders of U.S. debt may become "spooked" to unload some (or all) of their holdings and wreak havoc on global financial and currency markets. Or, their governments may choose to unload some of their U.S. debt in order to curb depreciation of their own currencies relative to the dollar. The increasing supply of such debt instruments coming onto the financial markets would be expected to depress their prices (and raise their yield rates).
Chelsey Dulaney, Ben Eisen, and Ira Iosebashvili, writing in The Wall Street Journal, November 18, 2016, note that
. . . .
Central banks have acted to slow declines in their currencies since the election. The Bank of Mexico on Thursday raised interest rates to support the battered peso, while traders say central banks in Indonesia, South Korea and Malaysia also stepped in since the election to support their falling currencies.
(http://www.wsj.com/articles/strong-dollar-could-be-rallys-weak-link-1479474002)
Adam Shell, writing in USA Today, December 16, 2016, notes that as the dollar has appreciated,
. . . .
As more cash flees China, the Chinese government must raise cash by selling its holdings of U.S. bonds to support the yuan, explains Joseph Quinlan, chief market strategist at U.S. Trust, an arm of Bank of America Private Wealth Management.
. . . .
China's holdings of U.S. bonds fell by more than $4 billion from September to October and are down roughly $14 billion since October 2015, Treasury data show. The main reason China is liquidating part of its huge stake in U.S. debt is to prevent a sizable decline in the yuan.
(http://www.usatoday.com/story/money/markets/2016/12/16/japan-not-china-biggest-us-debt-holder/95512328/)
How can the Chinese government alleviate yuan depreciation by selling some of its U.S. debt holdings? If the Chinese government receives the sale proceeds in any currencies (including dollars) other than yuan, it likely would sell those currencies (including dollars) on foreign exchange markets to acquire yuan or other non-dollar currencies or assets. This increased demand for yuan relative to its supply on the forex markets would at least slow the yuan depreciation, and possibly could cause it to appreciate if enough of the U.S. debt is unloaded.
Other things remaining the same, the increased supply of dollars relative to dollar demand on foreign exchange markets would slow on-going dollar appreciation. If the Chinese unload enough U.S. debt, it could precipitate actual dollar depreciation relative to the yuan. Dollar depreciation would make Chinese goods more expensive to Americans and American goods and services less expensive to Chinese importers, thereby diminishing the trade deficit with respect to China.
In either case, the increased supply of U.S. debt coming onto the global bond markets will tend to depress U.S. bond prices and increase yield rates, but Shell says that
However, if President Trump's proposed fiscal stimulus programs for the U.S. economy succeed in accelerating the U.S. growth rate compared to those of our trading partners, the dollar could continue to appreciate relative to the yuan (and other currencies). This could further widen the trade gap with China. And continuing yuan depreciation relative to the dollar could induce the Chinese government to unload even more U.S. debt which might begin to pose a bigger risk to the U.S. bond market in terms of rising interest rates.
Several southern European nations (Greece, Spain, Italy) have
run large and persistent Current Account deficits. These deficits have had
to be covered by Capital Account surpluses as ever more government bonds
have been issued and sold to foreigners. European holders of large portions
of their bonds (Germany, the Netherlands) have balked at holding yet more
of the bonds, and they have become concerned about sovereign debt defaults.
A default likely would precipitate collapse of the bond prices and possible
suspension of the use of the euro in the defaulting country.
A possible solution to the sovereign debt problem is for the high-debt countries to exit the eurozone and reestablish national currencies. The national currencies then could be increased without limit to stimulate business activity which would increase employment and generate rising incomes. The currencies likely would depreciate as their economies suffer persistent inflation brought about by monetization of their public debts. This might precipitate flight from the euro in the run up to reestablishing national currencies because holders of the sovereign debt would be concerned that their debt holdings might diminish in value so far as to become worthless.
A possible alternative solution is to leave the euro in place as a currency in use by the high-debt European countries, while the solvent European countries establish an alternate currency or resurrect one of their heritage currencies. The German deutsche mark has been mentioned most often for this purpose.
The short explanation for why payments imbalances persist in the Eurozone is that there are no effective adjustment mechanisms that are at work in the Eurozone.
From 2005 through 2015, two Eurozone countries, Germany and Netherlands, enjoyed persistent Current Account surplus balances which tended to grow larger over the period.
(http://ec.europa.eu/eurostat/statistics-explained/index.php/File:Current_account_balance_with_the_rest_of_the_world,_2005%E2%80%9315_(%C2%B9)_(EUR_billion)_YB16.png).
Luxembourg and Austria succeeded in maintaining relatively small Current Account surpluses, and Belgium's Current Account hovered around balance through the entire period. Portugal and Italy were able to shift from deficits (negative signs) to surpluses (positive signs) by 2012 and 2013, respectively, and Greece whittled its Current Account deficit balances down toward zero by the end of the period. Many of the rest of the nineteen Eurozone countries suffered persistent Current Account deficits which also tended to grow in magnitude over the period. Outside the Eurozone, Sweden maintained large Current Account surpluses, but the United Kingdom suffered large and growing Current Account deficits through the entire period. Why do Current Account imbalances seem to persist for long periods of time?
When exchange rates are allowed sufficient flexibility, international payments imbalances may be automatically corrected by depreciation or appreciation of the domestic currency relative to foreign currencies. But when exchange rates cannot change, payments imbalances may persist.
Suppose that a nation is suffering a Current Account deficit (i.e., a corresponding Capital Account surplus). The quest to buy more of the foreign currency to pay for imports will elicit an increase of the supply of the nation's currency relative to the demand for it on the foreign exchange markets, causing the nation's currency to depreciate relative to trading partner currencies. Depreciation of the domestic currency means that the foreign currency price of the domestic currency (e.g., the lira price of the dollar) falls as the domestic currency becomes cheaper to foreigners. It also means that the domestic currency price of the foreign currency (the dollar price of the lira) rises, making foreign goods and services appear more expensive to citizens of the nation. The currency depreciation will tend to diminish the Current Account deficit and may nudge the nation's payments toward a condition of balance as foreigners purchase more of the nation's goods and services and citizens of the nation import fewer goods and services from foreigners.
Alternately, suppose that another nation is enjoying a Current Account surplus (i.e., a corresponding Capital Account deficit). Foreign importers must increase their demands for the domestic currency on foreign exchange markets to pay for imports from the nation. This increase of the demand for the domestic currency relative to its supply on foreign exchange markets causes the domestic currency to appreciate relative to its trading partners' currencies. This means that the foreign currency price of the domestic currency (e.g., the peso price of the dollar) rises as the domestic currency becomes more costly to foreigners. It also means that the domestic currency price of the foreign currency (the dollar price of the peso) falls, making foreign goods and services appear cheaper to citizens of the nation. The currency appreciation will tend to diminish the Current Account surplus and may nudge the nation's payments toward a condition of balance as foreigners purchase less of the nations goods and services and citizens of the nation import more goods and services from foreigners.
However, if a nation's currency value is fixed by government action, Current Account imbalances cannot be relieved by exchange rate changes. Unless prevented by government exercise of domestic macropolicy, the adjustment to the Current Account deficit must be brought about by some combination of domestic price deflation and contraction of output and employment. If government succeeds both in fixing its currency values on foreign exchange markets and employing macropolicy to stabilize domestic prices and incomes, there can be no adjustment to the Current Account deficit. Under these circumstances, a Current Account deficit may persist indefinitely, with consequent increases of international indebtedness.
This problem may also manifest itself if there is agreement to use a common currency in an economically integrated region, e.g., the Eurozone. Use of the common currency imposes an implicit 1:1 fixed exchange rate among the nations of the common-currency region so that payments imbalances cannot be alleviated by exchange rate changes. And since governments of the constituent nations of the Eurozone often implement macropolicy in efforts to stabilize incomes and employment, payments imbalances among the nations of the Eurozone may persist indefinitely.
These same principles apply to payments imbalances among the fifty states of the United States since the dollar is a common currency among the states with an implicit 1:1 fixed dollar exchange rate. However, since state governments have little ability to implement macropolicy, most of the adjustment to interstate payments imbalances must be accomplished by income and employment changes. For example, states running Current Account deficits with respect to other states can expect declining employment and incomes, and possibly also falling prices until the deficits are eliminated. States enjoying Current Account surpluses likely will experience increasing employment and incomes, and possibly also rising prices until the surpluses are eliminated.
Macropolicy tends to be asymmetrical with respect to Current Account deficits and Current Account surpluses. There is little incentive for a government to address a Current Account surplus which injects spending into the national (or state) income stream, but a Current Account deficit entails a leakage of spending from the income stream. Unless the leakage is offset by investment injection in excess of saving, a nation (or a state) suffering a Current Account deficit under a fixed exchange rate regime can expect output to contract, unemployment to rise, incomes to fall, and its domestic price level to fall. Governments are likely to employ any macropolicy tools at their disposal in efforts to stimulate their economies, prevent unemployment from worsening, and avert deflation.
A Current Account surplus results in an injection of spending into the income stream. Unless the injection is offset by a saving leakage in excess of investment, a nation (or state) enjoying a Current Account surplus under a fixed exchange rate regime can expect its domestic price level to rise as output expands, unemployment to decline, and incomes to increase. In this case, government may employ macropolicy tools in the effort to avert price inflation, but otherwise may be happy to allow the ensuing expansion to correct the surplus.
So, to reiterate the opening statement in this comment, the explanation for why payments imbalances persist in the Eurozone is that no effective adjustment mechanisms are at work in the Eurozone.
Mike Bird, writing in The Wall Street Journal, November 19, 2016, notes that
. . . .
Following Donald Trump's victory, Citigroup . . . predicts the euro will tumble to just 98 cents in the next six to 12 months. This week others have joined the bank in predicting parity.
. . . .
Launched in 1999, the single currency spent much of its early years below parity, falling to as low as 83 cents in 2000, when there was a strong U.S. economy and a weak one in Europe. But the currency has traded above $1 since late 2002, climbing to a high of $1.60 as the U.S. struggled with the financial crisis in 2008.
(http://www.wsj.com/articles/euro-dollar-flirt-with-parity-1479565238)
The fact that a unit of one currency might become equal to a unit of another currency is of no greater significance than any other ratio of the units of the two currencies, and of itself is hardly worth mentioning in the press. What is of significance and worth commenting on is the direction of an exchange rate change as it approaches or passes through any particular currency ratio, e.g., 0.83:1 or 1.6:1, or 1:1.
A decrease in value of the euro relative to the dollar on forex markets is of importance to both European consumers and European producers of goods for export. European consumers will find the delivered prices of goods imported from U.S. suppliers to be higher. If European demand for U.S. imports is sufficiently elastic with respect to the euro:dollar exchange rate, the euro depreciation (i.e., dollar appreciation) should cause European spending on imports from the U.S. to decrease.* Of course, this may not happen if European demand for U.S. imports is inelastic with respect to the euro:dollar exchange rate, or if European importers choose to absorb the price increases in order to keep their dollar-denominated delivered prices constant. Absorption of price increases of course will cause their profits to decline.
European producers of goods for export to the U.S. should benefit from euro depreciation because their goods will be less expensive to American importers. Assuming that the American importers pass along the lower prices to American consumers, they can enjoy lower delivered prices, and this should increase spending on European imports if American demand for European imports is sufficiently elastic relative to the dollar:euro exchange rate.** European exporters will benefit from a boost in their sales to Americans. However, if American demand for European imports is inelastic with respect to the dollar:euro exchange rate, euro depreciation may cause spending by American consumers on European imports to actually decrease even as the volume of imports increases. Or, if American importers chose to keep their delivered prices constant in order to enjoy increasing profits, British export sales to Americans will remain stagnant.
The previous two paragraphs may be recast to be from the perspective of Americans. A dollar appreciation in value relative to the euro on the forex markets is of importance to both American consumers and American producers of goods for export. American consumers will find the delivered prices of goods imported from Europe to be lower, and American producers of goods for export to Europe will suffer declining sales because the delivered prices of their goods in Europe will be higher. Elasticity conditions and the pricing behavior of European importers will govern whether either American consumers or American producers benefit from the dollar appreciation.
All of these comments could be recast for an episode of depreciation of the dollar vis-s-vis the euro, i.e., appreciation of the euro relative to the dollar.
Data on the exports by American and European goods producers will reveal the impacts of euro depreciation, i.e., dollar appreciation. But to reiterate a previous assertion, the fact that the dollar:euro exchange rate is 1:1 is of no particular significance. What is important is the direction of change of the exchange rate ratio as it passes through the 1:1 ratio.
_____________
*The European exchange rate elasticity of demand is the responsiveness of the European demand for imports from the U.S. relative to the euro:dollar exchange rate (i.e., the euro price of the dollar since European importers have to buy dollars to pay for U.S. imports). If European import demand is sufficiently elastic with respect to the depreciating euro, i.e., if the percentage decrease of import volume is greater than the percentage increase of the euro:dollar exchange rate, European expenditures on imports from the U.S. will decrease. Else, if European demand for U.S. imports is inelastic with respect to the euro:dollar exchange rate, i.e., if the percentage decrease of import volume is less than the percentage increase of the euro:dollar exchange rate, the European expenditures on imports from the U.S. could actually increase.
**This too is a matter of elasticity of demand, this time the responsiveness of American demand for European imports relative to the dollar:euro exchange rate (i.e., the dollar price of the euro since American importers have to buy euros to pay for European imports). The explanation in the * note above may be recast to recognize this elasticity relationship.
The dominating factor of the late 1990s in the U.S. economy appears to have been a communications and computing revolution of force similar to that of the Industrial Revolution in late nineteenth-century England. The salient economic feature of this "New Industrial Revolution" was an ever-growing U.S. saving deficit relative to U.S. gross private domestic investment, i.e., I > S so that (I - S) > 0. Early in the twenty-first century, the measured U.S. saving rate approached historic lows (negative during some quarters) even as investment boomed. In a closed economy (no international trade), a saving deficit could be financed by a government budget surplus, i.e., T > G so that (T - G) > 0. But as U.S. government spending has increased relative to tax revenues, U.S. federal budgets have exhibited deficits of ever increasing magnitudes. And since the U.S. economy is an open-economy with flows of both imports (M) and exports (X), the two growing deficits, saving and budget, have had to be financed by ever-increasing trade deficits, i.e., M > X so that (X - M) < 0.
It may be obvious how a government budget surplus could help to finance a saving deficit, particularly when the surplus is used to retire public debt, but how can a trade deficit help to finance a saving deficit or a budget deficit? In order to explain this, it would be a convenience to interpret the trade balance as the Current Account in the nation's Balance of Payments. The nation's Balance of Payments is comprised of three sections, the Current Account, the Capital Account, and the Official Settlements Account. The Current Account is comprised of three subsections: the Trade Balance, Net Unilateral Transfers (i.e., the net of gifts by citizens of the nation to foreigners less foreign gifts to citizens of the nation), and Net Income Earned Abroad (i.e., the net of income earned abroad by citizens of the nation less income earned in the nation by foreigners). Since net transfers and net income earned abroad are of relatively minor magnitudes and often offset each other in the U.S. economy, the trade balance, (X - M) or -(M - X), accounts for the bulk of the U.S. Current Account. We shall thus ignore net transfers and net income earned abroad so as to treat the Current Account balance solely as the trade balance.
In a fixed exchange rate system such as the pre-Depression Gold Standard or the post World War II Bretton Woods System, flows of gold or international reserves were necessary to keep the exchange rates of the subscriber nations' currencies unchanged vis a vis gold or other currencies. A byproduct of the process of fixing exchange rates was that the Current Account and the Capital Account balances for a nation could differ in amount totals, with the difference being made up in the Official Settlements Account. Since the early 1970s, the world has been on a nominal flexible exchange rate system, though one in which governments of nations occasionally attempt to manipulate exchange rates.
If exchange rates were completely free to vary in response to market forces, the Official Settlements Account total for each nation would be zero because exchange rates would change to bring about an equivalence of the Current Account total with the Capital Account total, or vice versa. A Current Account deficit must be offset by a Capital Account surplus, and vice versa. If a nation imports more from the rest of the world than it exports to the rest of the world, the nation must export the ownership of enough capital to "pay for" the trade deficit. In fact, the U.S. has experienced trade deficits through most of the years beyond the early seventies when flexible exchange rates became a reality. The Current Account deficits necessarily have been offset by Capital Account surpluses.
A Capital Account surplus may be comprised of a combination of long term capital exports (e.g., foreign purchases of stocks, bonds, and real assets in the U.S.) and exports of short term instruments (e.g., increased foreign ownership of U.S. bank account balances and other liquid financial obligations). The Capital Account balance must be the negative of the Current Account balance when exchange rates are flexible. It is in this sense that a Current Account deficit (most of which is composed of the trade deficit) can help to finance saving and budget deficits. The corresponding Capital Account surplus involves a net export of the ownership of capital, which is the same as to say an inflow of funds from abroad. A trade deficit (a Capital Account surplus) is thus a natural concomitant of saving and budget deficits, and is necessary to finance the twin deficits.
How is this "financing" of the saving and budget deficits brought about by a trade deficit? Market economies contain within themselves adjustment forces that are invoked when prices or incomes are too high or too low for equilibrium. These forces of adjustment are the unmet intentions of market participants. Prices are the primary adjusters of the market economy, but if prices change too slowly or are fixed or manipulated by government authority, domestic income (and correspondingly output and employment) will become the shock absorbers of the market economy.
The Balance of Payments is not a popular topic for news reporting and blog commentary, but when it does surface, the focus usually is upon the trade balance, especially if it is in deficit, i.e., when imports exceed exports and the difference is growing. The trade balance is the largest subsection of the so-called Current Account.
Even though a Balance of Payments statement makes distinction between Current Account transactions (imports and exports of merchandise, services, and gifts) and Capital Account transactions (changes in the international ownership of its assets and liabilities), implicitly everything listed in a nation's Balance of Payments is some form of export or import. Nations may export and import a variety of things. "Things" include tangible merchandise, intangible services, gifts, currencies, the ownership of assets, claims against itself (liabilities), and commodities (e.g., gold). What matters for a nation's continued operation in the world's global trading system is that its imports (of all types) have to be paid for by exports (of a variety of types) of equivalent value.
In principle, the composition of things comprising the nation's imports or exports does not matter. If the nation imports more of one type of thing, say merchandise, than it exports, it follows that it in order to pay for its excess of merchandise imports over merchandise exports, it must export enough of other types of things, like services, the ownership of real assets, equity interests in its commercial enterprises, claims against its enterprises or government units (liabilities), its own currency (claims against its central bank), foreign currencies that it may hold, or gold. Although often reported with alarm in the media, the trade balance on any one type of exportable or importable thing is largely irrelevant.
While the focus of the previous paragraph was upon the merchandise trade balance, it is important to note the same relationship with respect to Capital Account transactions. Suppose that a nation exports the ownership of more of its assets to foreigners (a capital inflow) than it imports from foreigners (a capital outflow) so that there is a net surplus on Capital Account during the year. It follows that the nation must import enough of other things, say merchandise and services, to compensate itself for its capital exports. A merchandise and services import deficit is a natural concomitant of a capital export surplus.
Since the discussions in the previous two paragraphs are congruent, we can say that it is possible that at times what happens to the trade balance (the largest part of the Current Account) “drives” the Capital Account balance, but at other times what happens in the Capital Account drives the trade balance.
Much anxiety has been vented lately during the 2016 presidential campaigns about the loss of manufacturing jobs to overseas producers. But is such anxiety warranted?
U.S. official Balance of Payments statements show balances on goods (merchandise trade or "visibles"), on services (or "invisibles"), and on trade (the sum of the balances on goods and services). During the last quarter of the twentieth century and on into the twenty-first century, the U.S. has incurred substantial and growing deficits on merchandise trade as U.S. merchandise imports have increased even as U.S. merchandise exports have declined. Concomitant with growing U.S. merchandise trade deficits has been declining U.S. employment in merchandise manufacturing industries as U.S. manufacturers have shifted increasing amounts of production to overseas sites. Presidential candidates have promised to bring manufacturing jobs "back home" to the U.S. even through many of the jobs "lost" to foreign producers and sites are of the low-wage variety.
The increasing merchandise trade deficits as yet have been only partially offset by growing surpluses on trade in services. But prospects are for service trade surpluses to continue to grow and eventually to eclipse the merchandise trade deficits during the twenty-first century. The phenomenon is part and parcel of a long-term transition of the U.S. economy from an industrial economy to a service-based economy. Historically, merchandise trade has been focal and services trade has been discounted in the U.S. press. The print and video media today often report and despair over what are perceived to be adverse changes in the balances on merchandise trade.
The only relevant distinctions between a good and a service are the tangible characteristics and the duration of life of a good compared to the intangible nature and shortness of life (approaching zero) of a service. These distinctions can be reconciled by noting that few goods are desired for themselves or their innate characteristics (examples might be antiques and other collectibles); most are wanted for the stream of services that can be rendered over the lives of the goods.
Services have to be produced (or provided) no less so than do goods. People are employed and costs are incurred in rendering and delivering the services, just as in the production and delivery of goods. While goods are produced by the exertion of physical human effort, i.e., the "sweat of the brow," services are produced with less sweat, "work" just the same, but usually of a more cerebral type. This is to suggest that the distinction between goods and services in Balance of Payments accounting is an irrelevancy. Americans should not bemoan the passing of the industrial economy or the rising merchandise trade deficit. They should celebrate the emergence of the service economy and a growing surplus on trade in services.
An even greater irrelevancy, but one which often is reported and disparaged in the media is the bilateral trade balances between pairs of countries or with respect to particular categories of goods or services. While the U.S. runs a cotton textile trade deficit with the rest of the world, the U.S. runs trade surpluses with the rest of the world in many other goods and even more so in services. Specific service or commodity trade imbalances are natural concomitants of specialization according to comparative advantages. The relevance of such commodity or service trade imbalances lies with the vested interests who perceive themselves to be harmed by the nation's despecialization in producing a commodity or providing a service for which they no longer have a comparative advantage.
It is irrelevant that the U.S. runs a bilateral merchandise trade deficit with China for at least two reasons. One is that the U.S. enjoys a substantial services surplus with China. A second is that the U.S. runs trade surpluses with other countries while China runs trade deficits with many of those same countries. Bilateral trade balances are increasingly irrelevant in a multilateral trading world. In an open global economy, what matters for each country is its overall Current Account and Capital Account balances vis-a-vis the rest of the world.
So why are presidential candidates putting such emphasis on bringing sweaty, low-wage manufacturing jobs back to the U.S.? Most of the jobs lost to foreign manufacturers were not "good" (high-wage) jobs anyway. Why are the candidates not encouraging the growth of higher-wage U.S. service industries and the export of their service products?
President Trump seems obsessed with taking action to diminish
the U.S. trade deficit. Tariffs, non-tariff barriers, and currency
market
interventions may reduce the trade deficit, but the Trump
Administration seems to be unaware of the automatic mechanisms inherent
in the global economy that eventually might lead to correction of
international imbalances if they were allowed to work.
Policy makers may simply be ignorant of the potential for market mechanisms
to self-adjust, or they may doubt that the self-adjustment characteristics
are strong enough to alleviate a deficit and bring about balance. Policy-maker
distrust of the self-adjusting nature of market mechanisms may be a legacy
of Keynesian thought, or it might simply indicate impatience on the parts
of policy makers who perceive that automatic mechanisms take too long to
work or won't work to achieve their political objectives.
To illustrate how the self-adjusting mechanisms might work, suppose that
for whatever reason the dollar has been appreciating on forex markets, and
that the lower dollar prices of foreign currencies make imports cheaper,
contributing to a persistent or growing U.S. trade deficit which is the largest
part of the Current Account. This is approximately the circumstance that
Mr. Trump wants to address. For purpose of argument, let's also assume that
there are no other types of exports and imports than goods and services
(i.e., there are no Capital Account transactions that are autonomous of the
trade balance). This assumption will be dropped later.
If the U.S. government takes no action to prevent the dollar appreciation,
the growing trade deficit will increase the supply of dollars by American
importers to the forex markets to buy foreign currencies that pay for the
excess of imports. The increasing dollar supply relative to dollar demand
on the forex markets will slow dollar appreciation and eventually induce
depreciation of the dollar (unless prevented by the Federal Reserve or the
Treasury). The dollar depreciation will make U.S. exportables look cheaper
to foreigners and imports from abroad appear more expensive to U.S. citizens,
thereby alleviating the trade deficit.
If government lets the exchange-rate adjustment mechanism work
without intervention, how long will the dollar keep depreciating?
Depreciation
will ensue until imported merchandise is no longer less expensive than
comparable domestically-produced goods, and until exportables no longer
look cheaper to foreigners than the comparable goods that they can
produce, i.e., until exports are approximately equal to imports so that
the trade deficit is eliminated.
But there is also an internal mechanism that should work (if allowed by
government) to augment the external exchange-rate adjustment mechanism. As
foreign interests acquire dollar-denominated money balances from U.S. citizens
who are purchasing the foreign-made goods, the U.S. domestic money supply
(that which motivates the behavior of U.S. citizens) decreases unless prevented
by the Fed.
As the domestic money supply decreases relative to demand for it, domestic
prices will fall (i.e., deflation will ensue), unemployment will increase,
and domestic interest rates will rise. The falling prices of U.S.-produced
tradeables will tend to increase the volume of exports and reduce the volume
of imports. The rising domestic interest rates will decrease the volume
of (portfolio) investment by U.S. citizens in other countries and increase
the volume of investment by foreigners in the U.S. The increasing unemployment
will decrease incomes of U.S. citizens, further curbing imports.
One view is that the burden of adjustment borne by currency depreciation
to alleviate the Current Account deficit may be lessened
by changes of domestic prices, interest rates, and employment. Another view
is that the burden of adjustment born by these three phenomena is lessened
by depreciation of the domestic currency. The most immediate response to
a trade deficit is likely to be depreciation of the domestic currency. To
the extent that depreciation suffices to alleviate a trade deficit, there
is less need for domestic prices to fall, interest rates to rise, or employment
to decrease.
But if depreciation of the domestic currency is prevented by
government
authorities who are resolved to "defend the currency" from further
"weakening,"
the full burden of adjustment to the Current Account deficit will
descend
upon domestic prices, interest rates, and employment. If the government
is
also acting to avert deflation, cap interest rates, and prevent
unemployment,
there is no operable internal or external adjustment mechanism that can
alleviate a trade deficit, and trade deficits may persist indefinitely
unless suppressed by such strong-arm tactics as imposing tariffs,
quotas, or other NTBs.
If these automatic adjustment mechanisms are at work in the global
economy, why have U.S. trade deficits persisted in varying magnitudes during
the post-World War II era? One explanation is that governments have acted
to prevent them from working, but another explanation is that there have
been financial and real transactions (in the Capital Account of the Balance
of Payments) that are autonomous of the trade balance (in the Current Account).
These Capital Account transactions may affect the demand for and supply
of dollars to the forex markets, and therefore may cause appreciation or
depreciation of the dollar quite apart from what is happening in the trade
balance.
William Mauldin and Devlin Barrett, writing in The Wall Street Journal, February 19, 2017, note that
The Trump administration is considering changing the way it calculates U.S. trade deficits, a shift
that would make the nation's trade gap appear larger than it had in past
years, according to people involved in the discussions. The leading idea
under consideration would exclude from U.S. exports any goods first imported
into the nation, such as cars, and then transferred to a third nation
like Canada or Mexico unchanged, these people told The Wall Street Journal.
Economists say that approach would inflate trade deficit numbers because
it would typically count goods as imports when they come into the nation
but not count the same goods when they go back out, known as re-exports.
(https://www.wsj.com/articles/trump-administration-considers-change-in-calculating-u-s-trade-deficit-1487523299)
Nations may export and import a variety of things. "Things" include tangible merchandise, intangible services, gifts, currencies, the ownership of assets, claims against itself (liabilities), and commodities (e.g., gold). What matters for a nation's continued operation in the world's global trading system is that its imports (of all types) have to be paid for by exports (of a variety of types) of equivalent value.
Mauldin and Barrett also note the political intent of this proposal to recompute the trade balance:
A larger trade deficit would
give the Trump administration ammunition in arguing that trade deals need
to be renegotiated, and might help boost political support for imposing
tariffs.
The long-run significance of chronic and increasing trade balance deficits is that they will be paid for in the Capital Account by increasing liabilities to foreigners and increasing foreign ownership of American assets. But the actual liabilities owed to foreigners and assets owned by foreigners will not be affected whether re-exported goods are or are not included in an inflated trade deficit statistic.
It seems that some nations, notably the United States and the United
Kingdom, have been able to sustain Current Account deficits for decades,
at least since the end of World War II. But most other nations are unable
to sustain Current Account deficits for very long.
Are Current Account deficits "good" or "bad?" How about Current
Account surpluses? And is either condition sustainable in the long run (i.e., over years stretching into decades)?
Eighteenth century mercantilists might have answered that a
Current Account surplus is good because it increases the "wealth of the
nation" by enabling citizens to acquire foreign assets (like gold) in exchange
for domestic goods that can be exported. Correspondingly, a Current Account
deficit would be bad because it decreases the wealth of the nation by enabling
foreigners to acquire more of the nation's assets in exchange for goods
exported to the nation. The modern answer is that, with caveats to be noted,
neither imbalance condition is good. However, it does not necessarily follow
that either imbalance condition is unequivocally bad. And for most nations,
neither imbalance situation is sustainable in the long run. There appear
to be at least a few exceptions to this generalization.
An "up-side" of a Current Account deficit is that citizens of the nation are able to consume (or absorb) a larger portion of the world's output of goods and services than they are able to produce. Another positive is that the Capital Account surplus that must accompany a Current Account deficit supplies savings to the nation from foreign sources. This is especially important if the nation has been experiencing savings deficits (relative to investment requirements) because domestic saving rates are especially low. Since this situation has been typical of the U.S. economy during the last decade of the twentieth century and the early years of the twenty-first century, the foreign savings supplied via the Capital Account surplus (i.e., the Current Account deficit) have sustained the phenomenal growth of the U.S. economy until the onset of the Great Recession in 2008.
The sustainability of a Current Account imbalance of any nation
ultimately depends upon the global demand for and supply of financial instruments
issued by citizens (including businesses, financial institutions, and government
units) of the nation. If the global demand for the nation's stocks and bonds
continues to keep pace with the increasing supply of them, it is possible
for the nation's Current Account deficit (its Capital Account surplus) to
persist indefinitely. However, once the global financial markets become
saturated with the nation's debt and equity issues, the Current Account
deficit (Capital Account surplus) imbalance is no longer sustainable, and
international adjustment mechanisms (either exchange rates or domestic price
level and incomes) will come into play to alleviate the imbalance.
When exchange rates are allowed sufficient flexibility, a Current
Account deficit (a Capital Account surplus) may be automatically
corrected by depreciation of the domestic currency relative to foreign
currencies. So a clue as to the sustainability of a Current Account
deficit (a Capital Account
surplus) may be found in how its exchange rates are changing. As long
as
the world is willing to accept ever more of the nation's debt
and equity issues, its currency may be stable or appreciating
on foreign exchange markets, and its Current Account deficit (its
Capital Account surplus) is sustainable. Once its currency begins to
depreciate, the implication
is that the global demand for the nation's financial issues has slowed
or
begun to decrease relative to the supply of them, and the Current
Account
deficit (Capital Account surplus) is no longer sustainable.
The comments in the previous paragraphs that have pertained
to the sustainability of Current Account deficits (Capital Account surpluses)
may of course be recast as to the sustainability of Current Account surpluses
(Capital Account deficits) as are commonly experienced by certain European
and East Asian countries.
The United States and the United Kingdom may be exceptions
to the generalization that a Current Account deficit cannot be sustained
indefinitely. This is due to the fact that both the U.S. dollar and the
U.K. pound sterling have become international reserve currencies that are
being used not only to effect both bilateral trade and financial transactions
between their citizens and foreign interests, but also as global currencies
to effect transactions among third parties. Also, the global demand for
debt instruments issued by U.S. and U.K. governments has increased during
times of uncertainty due to their safety and reliability in spite of their
relatively low returns because neither government has ever defaulted on
its debt issues.
The U.S. trade balance is the largest portion of its Current
Account. The U.S. has experienced a chronic trade deficit through much of
the post-World War II era. With slowing growth in many of its trading partners
in the post-2009 recession era, U.S. imports have continued to exceed its
exports, but both have decreased gradually since December 2014. The U.S. trade
gap (imports less exports) narrowed in July 2016 to $39.47 billion (http://www.census.gov/foreign-trade/Press-Release/current_press_release/ft900.pdf).
U.S. exports rose by nearly 2 percent in July over June's exports (a huge
one-month increase), even as the dollar appreciated on foreign exchange
markets, likely in response to the U.K. "Brexit" vote in June. The dollar
appreciation coupled with rising exports and persistence of the U.S. trade
deficit suggests that the U.S. Current Account deficit (Capital Account
surplus) continues to be sustainable.
Reinforcing this phenomenon is the fact that the dollar unofficially
has become the preferred currency in a number of nations (e.g., Peru, Cuba),
and the "dollarization" currency specified by government authority in some
nations (Argentina, Ecuador). As the deliberate or de facto dollarization processes ensue,
the global demand for U.S. currency (i.e., dollar-denominated short-term
debt issued by the U.S. central bank) will continue to rise, thereby accommodating
sustained U.S. Current Account deficits (with corresponding Capital Account
surpluses).
Few other nations in the world are so fortunate as the United
States in this regard, and the U.S. good fortune may evaporate in the future.
If the former debt holders receive the sale proceeds in any currencies
(including dollars) other than their own, they likely would sell those currencies
(including dollars) on foreign exchange markets to acquire their own or other
non-dollar currencies or assets. The increased supply relative to demand
for dollars on foreign exchange markets would precipitating dollar depreciation.
The dollar depreciation would make foreign goods and services more expensive
to Americans and American goods less expensive to foreigners, thereby diminishing
the trade deficit.
The conventional approach to analyzing a nation's Balance of Payments has been to presume that trade decisions are discretionary and that they dominate the nation's international payments situation, i.e., the Capital Account must accommodate to "pay for" whatever happens in the Current Account. In this case, it might be appropriate to say that the Current Account "drives" the Capital Account. It is indeed true that the act of importing goods and services requires payment to foreign exporters. To the extent that foreign exporters are willing to accept domestic currency or bank balances denominated in domestic currency units, there is a short-term capital inflow (an outflow of funds) that increases the indebtedness of the nation to foreign interests.
But it is also true that a substantial portion of the Capital Account activity of any nation, whether involving short- or long-term financial instruments, is discretionary. Citizens and foreigners make deliberate decisions to acquire or sell financial instruments irrespective of where they were issued and irrespective of the need to finance trade (Current Account) activity. This discretionary Capital Account activity causes changes of demand for and supply of currencies on foreign exchange markets, with consequent changes of exchange rates (if they are not fixed).
For example, if citizens of a nation decide to acquire bonds issued by a foreign government or corporation, they may sell their own currency in foreign exchange markets in order to acquire enough of the foreign currency to purchase the bonds. Alternately, the foreign bond sellers may accept enough of the domestic currency in exchange for the bonds sold, in which case they will probably sell the acquired currency on the foreign exchange markets. In either case, the increased supply of the domestic currency coming onto the foreign exchange markets relative to the demand for it will tend to depreciate the domestic currency, i.e., appreciate the foreign currency.
A discretionary Capital Account surplus (a capital inflow involving an export of the ownership of domestic assets) may require a Current Account deficit (e.g., an excess of merchandise and service imports over exports) to "pay for" the Capital Account surplus. A nation with a discretionary Capital Account deficit requires a Current Account surplus to offset the Capital Account deficit. To the extent that discretionary Capital Account activity outweighs that which is necessary to accommodate the trade balance in the Current Account, it may be said that the Capital Account "drives" the Current Account rather than the converse.
This may have been the case for the United States through much of the post-World War II era as American companies invested heavily in production and distribution facilities in the outside world. The early-twenty-first century “offshoring” phenomenon may be instrumental in contributing to Capital Account surpluses that require offsetting Current Account deficits to “pay for” new foreign direct investments.
Ben Leubensdorf and Josh Mitchell, writing in The Wall Street Journal, December 6, 2016, note that
The U.S. trade deficit widened sharply
in October as exports weakened following a summer surge, and imports jumped,
a likely drag on overall economic growth in the final months of 2016. The
trade gap for goods and services increased 17.8% from a month earlier to
a seasonally adjusted $42.6 billion in October, the Commerce Department said
Tuesday. That was the steepest one-month rise since March 2015 and took
the deficit to its highest level since June.
(http://www.wsj.com/articles/u-s-trade-deficit-widened-sharply-in-october-1481031358)
This widening of the U.S. Trade gap has occurred at the same time that foreign purchases of U.S.-issued bonds have increased in response to various sources of global uncertainty. If a nation's payments are to balance, a trade deficit requires an offsetting capital inflow (i.e., an export of the ownership of U.S. assets) to pay for the net import balance. But an export of the ownership of U.S. assets enables (or requires) an offsetting import of merchandise and services. Since trade is the largest part of the Current Account, and foreign purchase of U.S. bonds is a component of the Capital Account, how can we tell whether the Current Account deficit is driving the Capital Account surplus, or the converse? All else equal, a trade deficit would portend depreciation of the dollar as importers supply dollars to the forex markets in purchasing other currencies to pay for imports. Other things unchanged, an export of the ownership of U.S. assets would cause appreciation of the dollar as foreigners purchase dollars to pay for the assets. Since the dollar has been appreciating on net balance against most other currencies for the past several months, the implication is that the Capital Account surplus is driving the Current Account Deficit.
In the wake of Mr. Trump's election to the U.S. presidency, the dollar
has been appreciating on foreign exchange (forex) markets relative to other
currencies, and the appreciation has sustained the U.S. trade deficit by
making foreign-made goods cheaper to American consumers while increasing
the prices of U.S.-made goods to foreigners. The trade deficit might shrink
if the dollar were to depreciate, but in the absence of dollar depreciation,
the Trump Administration is casting about to find other ways to decrease
the deficit. In a New York Times
op-ed about President Trump's intent to diminish the trade deficit, January
24, 2017, Jared Bernstein says that
Ripping up trade deals won't achieve much. A new study by the
nonpartisan Congressional Budget office found that estimates of the
impact of “trade agreements on the U.S. trade balance are very small
and highly uncertain.” Large tariffs are also unlikely to help. Yes,
they'll lower imports, but they'll probably lower exports as well, both
through a stronger dollar and through retaliatory tariffs from our
trading partners.
(https://www.nytimes.com/2017/01/24/opinion/ditching-tpp-wont-solve-the-trade-deficit.html?action=click&pgtype=Homepage&clickSource=story-heading&module=opinion-c-col-right-region®ion=opinion-c-col-right-region&WT.nav=opinion-c-col-right-region)
A nation's balance on goods-and-services trade is only a part of
all of the things that can be exported or imported. The U.S.
goods-and-services trade deficit is largely irrelevant because other
things may be exported to offset (or pay for) the trade deficit. A
nation's Balance of Payments must balance (except for minor errors and
omissions) during each accounting period, so if there is a deficit in
part of it, there must be a surplus in another part of it to pay for
the deficit.
For example, an excess of American goods-and-services imports over
its
exports in the Current Account of the Balance of Payments must be offset
(paid
for) in the Capital Account by an increase in debt owed to foreigners,
or
by the export of the ownership of American assets such as currency,
financial
instruments (stock shares, bonds), real estate (land, buildings, plant,
equipment), etc. Also, there may occur Capital Account transactions
involving international indebtedness and the ownership of American and
foreign assets apart from those that are necessary to offset the trade
balance. The trade balance of a particular type of things (goods and
services) is largely irrelevant to the overall balance of things that
might be imported and exported.
An American trade deficit may attain some policy significance if it is
accompanied by American job losses to foreign producers who possess comparative
advantages relative to American producers. But a trade deficit
may enable American consumers to enjoy lower prices of imported goods produced
under comparative advantage conditions (whether natural or contrived) by our
trading partners than they would have to pay for goods produced in the U.S.
under comparative disadvantage conditions.
The job losses attributable to comparative disadvantages need to be
weighed
against the benefits to consumers of lower-priced imports, and there
are better ways than tariffs to help workers displaced by comparative
advantage, e.g., income assistance and retraining. Otherwise,
alleviation
of a trade deficit attributable to authentic comparative advantage
differences
should not in principle be an object of government policy.
If averting job losses is deemed more important than increasing
consumer welfare, then reducing the trade deficit may appear to be a
good thing to undertake. Bernstein poses the question, "So what would
work?"
Factors in the trade deficit include how much countries save and invest,
the demand for traded goods and services, the relative competitiveness
of the companies that produce them and, most important, exchange
rates. Even as productive as they are, our manufacturers can't compete
in foreign markets if exchange rates ("the value of the dollar in terms
of the currencies of our trading partners") are tilted against them.
Mr. Trump has threatened to classify China as a currency manipulator that
has deliberately caused its currency to depreciate by selling yuan on forex
markets to buy dollars in order to sustain exports to the U.S. Bernstein
describes an approach advocated by C. Fred Bergsten for countering currency
manipulation:
A more sweeping way to level the playing field is a plan by the trade
expert C. Fred Bergsten for “countervailing currency intervention. ”In
simple terms, it would allow American economic, authorities to purchase
the currency of the manipulating country “to neutralize the impact of
that country's own intervention in the foreign exchange markets. ”This
idea hits a sweet spot: It could be more effective against currency
manipulation and wouldn't interfere with trade flows and market-driven
(versus orchestrated) moves in the dollar.
The U.S. government has only upon occasion acted in concert with some
"Group of" six or seven or ten other governments to "stabilize" forex markets,
but for the most part its recent history has not involved dollar manipulation.
However, Bergsten's proposal to use “countervailing currency intervention”
would render the U.S. a currency manipulator as well.
If the U.S. government
were to take no action to prevent the dollar appreciation, the growing trade
deficit would increase the supply of dollars by American importers to the
forex markets to buy foreign currencies that pay for the excess of imports.
The increasing dollar supply relative to dollar demand on the forex markets
should slow dollar appreciation and possibly induce depreciation of the
dollar (unless prevented by the Federal Reserve or the Treasury). Dollar
depreciation would make U.S. exportables look cheaper to foreigners and
imports from abroad appear more expensive to U.S. citizens, thereby alleviating
the trade deficit.
If government were to let the exchange-rate adjustment mechanism
work without intervention, how long would the dollar keep depreciating?
Depreciation would ensue until imported merchandise is no longer less
expensive
than comparable domestically-produced goods, and until exportables no
longer
look cheaper to foreigners than the comparable goods that they can
produce,
i.e., until exports are approximately equal to imports so that the trade
deficit is eliminated. But if the Trump Administration begins to
intervene in currency markets to avert further dollar appreciation and
prevent dollar depreciation, the exchange rate adjustment mechanism will
not work to diminish the trade deficit.
So, why have U.S. trade deficits persisted in varying magnitudes during
the post-World War II era? One explanation is that governments have acted
to prevent automatic adjustment mechanisms from working,
but another explanation is that there have been financial and real transactions
(in the Capital Account of the Balance of Payments) that are autonomous of
the trade balance (in the Current Account). These Capital Account transactions
may affect the demand for and supply of dollars to the forex markets, and
therefore may cause appreciation or depreciation of the dollar quite apart
from what is happening in the trade balance. Because such autonomous financial
and real transactions do occur during every accounting period and have been
increasing in volume relative to merchandise trade in recent decades, there
is no reason to expect goods-and-services trade ever to balance.
This inevitably leads to the conclusion that the effort to alleviate a
trade deficit is a fool's errand.
Desmond Lachman, writing in The New York Times, December 20, 2016, says that
(http://www.nytimes.com/2016/12/20/opinion/which-trump-will-the-world-see.html?em_pos=large&emc=edit_ty_20161220&nl=opinion-today&nlid=74240569&ref=headline&te=1&_r=0)
This statement is incomplete and needs further elaboration. It is incomplete because it ignores a third source of saving (or dissaving), i.e., the government. When there is an active government that can both raise tax revenues and spend them, it doesn't necessarily follow that when "a country saves more than it invests, it will run a trade surplus." The excess saving may only finance a government deficit, with little effect on the trade balance. Or, an excess of investment over household saving may be financed by government saving, again with little effect on the trade balance.
The private sector may save on net balance when household plus business saving exceeds gross investment, or it may dissave on net balance when gross investment exceeds household plus business saving (businesses save when they retain earnings). But government too may be a source of net saving to the economy if it should run a budgetary surplus, i.e., if tax revenues exceed expenditures (however unlikely). If the government budget exceeds tax revenues (more likely), the government dissaves and thereby absorbs savings from the private sector or some other source.
Since the U.S. economy typically incurs savings deficits in both the private sector and the public sector, there must be another source of savings. Lachman alludes to the third possible source of savings farther in the same opinion piece when he says
If the economy is open to international trade and financial transactions, the foreign sector is a third possible source of savings. A capital inflow is brought about when Americans export the ownership of U.S. assets (e.g., financial securities) that are purchased by foreigners. Foreigners supply savings to the U.S. economy when they purchase U.S.-owned assets. The U.S. is fortunate that foreign savings fill savings deficits in both the private and public sectors. While the U.S. is a net absorber of foreign savings, many of the U.S. trading partners must be net suppliers of savings.
But why would a widening interest rate difference among trading partners put upward pressure on the dollar? An increase of U.S. interest rates relative to those of other countries invites foreigners to seek higher returns by purchasing U.S. securities. Also, global uncertainty has induced foreign investors to seek safety by purchasing U.S. securities, especially Treasury bonds. In order to purchase U.S. securities, foreigners must sell their own currencies (or other currencies that they may have been holding) in exchange for dollars on the forex markets, increasing the supply of those currencies relative to the demand for them, causing them to depreciate. The purchase of dollars on the forex markets increases the demand for dollars relative to supply, causing the dollar to appreciate.
Lachman then notes the likely impact on the U.S. trade balance:
The composition of things comprising the nation's imports or exports does not matter. If the nation imports more of one type of thing, say merchandise, than it exports, it follows that it in order to pay for its excess of merchandise imports over merchandise exports, it must export enough of other types of things, like services, the ownership of real assets, equity interests in its commercial enterprises, claims against its enterprises or government units (liabilities), its own currency (claims against its central bank), foreign currencies that it may hold, or gold. Although often reported with alarm in the media, the trade balance on any one type of exportable or importable thing is largely irrelevant.
The recent widening of the U.S. trade deficit has occurred at the same time that foreign purchases of U.S.-issued bonds have increased in response to various sources of global uncertainty. If a nation's payments are to balance, a trade deficit requires an offsetting capital inflow (i.e., an export of the ownership of U.S. assets) to pay for the net import balance. Also, a net capital inflow supplies savings that can be used to finance investment in the private sector, or they may be absorbed by a budget deficit in the public sector.
An export of the ownership of U.S. assets enables (or requires) an offsetting import of merchandise and services. Since trade is the largest part of the Current Account in the Balance of Payments, and foreign purchase of U.S. bonds is a component of the Capital Account, how can we tell whether the Current Account deficit is driving the Capital Account surplus, or the converse? All else equal, a trade deficit would portend depreciation of the dollar as importers supply dollars to the forex markets in purchasing other currencies to pay for imports. Other things unchanged, an export of the ownership of U.S. assets would cause appreciation of the dollar as foreigners purchase dollars to pay for the assets.
Since the dollar has been appreciating on net balance against most other currencies for the past several months, the implication is that the Capital Account surplus is dominating the Current Account deficit. A trade deficit is unavoidable as long as foreign purchases of U.S. assets exceed Americans purchases of foreign assets. The nation's trade deficit will continue to widen as long as foreign purchases of U.S. assets are increasing due to widening interest rate differentials. And foreign savings will continue to be needed as long as the U.S. private and public sectors are running savings deficits.
Ben Leubsdorf and Josh Mitchell, writing in The Wall Street Journal, December 6, 2016,
note that
The U.S. trade deficit widened
sharply in October as exports weakened following a summer surge, and imports
jumped, a likely drag on overall economic growth in the final months of
2016. The trade gap for goods and services increased 17.8% from a month
earlier to a seasonally adjusted $42.6 billion in October, the Commerce
Department said Tuesday. That was the steepest one-month rise since March
2015 and took the deficit to its highest level since June.
(http://www.wsj.com/articles/u-s-trade-deficit-widened-sharply-in-october-1481031358)
Since trade is the largest part of the Current Account, and foreign purchase of U.S. bonds is a component of the Capital Account, how can we tell whether the Current Account deficit is driving the Capital Account surplus, or the converse? All else equal, a trade deficit would portend depreciation of the dollar as importers supply dollars to the forex markets in purchasing other currencies to pay for imports. Other things unchanged, an export of the ownership of U.S. assets would cause appreciation of the dollar as foreigners purchase dollars to pay for the assets.
Since the dollar has been appreciating on net balance against most other currencies for the past several months, the implication is that the Capital Account surplus is driving the Current Account Deficit.
Ian Talley, writing in The Wall Street Journal, December 12, 2016, notes William Cline's expectation that the trade gap may further widen under President Trump:
(http://blogs.wsj.com/economics/2016/12/12/how-donald-trump-may-actually-widen-the-u-s-trade-deficit/)
If Cline is right, and if the trade gap widens by enough, the depreciation effect of the trade deficit could eventually outweigh the appreciation effect of U.S. asset exports to cause the dollar to actually depreciate on net balance. Dollar depreciation then would favor U.S. producers of export goods and curb U.S. imports of foreign-made goods, with the effect of diminishing the trade gap. The process of reversal of dollar appreciation is part and parcel of the automatic and self-correcting nature of the global exchange market.
Ben Leubsdorf, writing in The
Wall Street Journal, February 7, 2017, notes that
The U.S. logged a $502.25 billion trade deficit in 2016, the largest in
four years and a gap President Donald Trump is setting out to narrow to
bolster the U.S. economy.
. . . .
In 2016, the total deficit rose modestly from the prior year to its highest
dollar level since 2012. But it shrank slightly to 2.7% as a share of U.S.
economic output after hovering at 2.8% of gross domestic product in 2013
through 2015. The gap fundamentally reflects the fact that Americans consume
more than they produce relative to the rest of the world. To shrink the gap,
they would either have to produce more or consume less.
(https://www.wsj.com/articles/u-s-trade-deficit-narrowed-in-december-totaled-502-25-billion-in-2016-1486474624)
In 2016, the U.S. exported $2,209.4 billion worth of goods and
services while importing $2,711.7 billion worth of goods and services,
for a goods-and-services trade deficit of $502.3 billion. In 2015 the
U.S. exported $2,261.1 billion worth of goods and services while
importing $2,761.5 billion worth of goods and services, for a
goods-and-services trade deficit of $500.3 billion.
(https://www.census.gov/foreign-trade/statistics/historical/gands.pdf). Much anguish recently has been expressed by the Trump administration, in
the press, and even in some quarters of the U.S. Congress about U.S. trade
deficits. So, how do we "pay for" this excess of imports over exports?
The answer is that the U.S. also exports as well as imports other things
than goods and services. Data for the 2016 Quarter IV Capital Account in
the U.S. Balance of Payments are not available as of this writing, but between
2015 QIII and 2016 QIII, U.S. holdings of international direct investment
assets increased from $6,785.0 billion to $7,349.3 billion; U.S. holdings
of international portfolio investment assets increased from $9,461.3 billion
to $10,137.1 billion. This means that U.S. investors imported the ownership
of $1,240.1 billion of foreign direct and portfolio assets. (https://www.bea.gov/scb/pdf/2017/01%20January/0117_international_investment_position_tables.pdf)
During the same period, U.S. direct investment liabilities to foreigners
increased from $6,260.2 billion to $7,193.6 billion; U.S. international
portfolio investment liabilities increased from $16,546.4 billion to $17,514.0
billion. This means that U.S. investors exported the ownership of $1,901.0
billion of American assets.
The net change in asset ownership between 2015 QIII and 2016 QIII was
an export surplus of $660.9 billion, more than enough to pay for the U.S.
goods-and-services trade deficit in either 2015 or 2016. The difference
between the trade deficit and the financial asset surplus is accounted for
by international transactions involving minor amounts of currency and deposits,
loans, trade credits, financial derivatives, and reserve assets.
What this amounts to is that the rest of the world gives U.S. consumers
more goods and services than the U.S. gives to the rest of the world, and
in exchange the U.S. covers its trade deficit by giving the rest of the world
pieces of paper printed as stock shares and bond certificates, titles to pieces
of U.S. real estate (which are not geographically mobile), and portraits of
U.S. presidents. Yes, as Leubsdorf notes, "Americans consume more than they
produce relative to the rest of the world," and this sounds like a pretty
good deal. The "upside" of this process is that we are consuming a lot of
"stuff" that we do not have to produce, and that would cost us more to produce.
So, what's the "downside" of a trade deficit paid for by a financial
transactions surplus? Mr. Trump thinks that it is the loss of "good
jobs," i.e., high-wage jobs, to foreign producers. But the reality is
that the U.S. is producing and exporting more goods, services, and
financial instruments for which we have production comparative
advantages, and we are importing more goods, services, and financial
instruments from others in the rest of the world
who have comparative advantages in producing those things. The
higher-wage
jobs are in the U.S. industries that are able to exploit comparative
advantages;
the lower-wage jobs have migrated to the foreign producers who have
comparative
advantages in those industries. Both American and foreign consumers
enjoy
gains from this trade in the forms of lower delivered prices of the
products
that they consume.
A more significant downside is that Americans are incurring more liabilities
to foreigners and foreigners are acquiring titles to more U.S. assets as
trade deficits continue year after year. Another downside is that employees
of American firms producing non-comparative-advantaged goods and services
may lose their jobs, but many of the jobs lost are lower-productivity and
lower-wage jobs. Rather than obstructing this international productive realignment
process, American officials should be facilitating this global adjustment
while assisting those Americans who suffer dislocations by providing retraining
and income assistance.
The Trans-Pacific Partnership (TPP) agreement was signed in February of 2016 by negotiators representing 11 Pacific Rim nations, notably not including China. The intent of the agreement is to
(https://ustr.gov/about-us/policy-offices/press-office/press-releases/2015/october/summary-trans-pacific-partnership).
The fact that both of the 2016 presidential candidates oppose ratification of the TPP agreement shows how little the candidates and the American public know or care about what might increase global welfare. It also demonstrates what a poor job economists have done in conveying to the American public (and to the candidates) the welfare benefits of free, unobstructed international trade.
In the early-1930s, the Republican party became highly protectionist in implementing the Smoot-Hawley Tariff Act of 1930, which economic historians credit with aggravating if not precipitating the Great Depression. Enforcement of the tariff act elicited the imposition of reciprocal tariffs by our trading partners and brought the global volume of trade to historic lows. The beginning of recovery from the Depression was facilitated in 1934 when President Franklin D. Roosevelt signed the Reciprocal Trade Agreements Act that reduced tariff levels and promoted trade liberalization and cooperation with foreign governments.
Since the end of World War II, most U.S. government administrations have appreciated how unobstructed international trade benefits all of the parties to it, and they have entered into agreements and passed legislation approving those agreements to diminish tariffs, quotas, subsidies, and other non-tariff barriers to trade. But the two main American political parties in effect have reversed positions. The Republican Party became the advocate of freer international trade even as the Democratic Party began to oppose free trade agreements, at least until recently. It is discomforting that candidates of both parties now oppose approval of the TPP agreement.
Who should care about whether international trade is free or obstructed? High school and college graduates who have been exposed to even introductory economics courses might be expected to be favorable toward open and free trade. Employees of business firms that export their products and services should favor free international trade. So also should consumers, nearly all of whom have occasion to purchase lower-priced imported merchandise which bulks ever larger in their purchases year-after-year.
Political science research suggest that consumers are too weakly organized and too unconcerned about such a marginal issue as comparative prices of domestically produced and imported goods to make their concerns felt in the political arena. Economic education research confirms that students who have taken economics courses in high school or university retain far less of the subject matter than what their teachers and professors hoped.
For the uninitiated and those who have not recalled enough of their economics course content, here is a quick and simplistic explanation of the principle of comparative advantage: It is not possible for a region to have no comparative advantage(s) since comparative advantage consists of greatest absolute advantage or least absolute disadvantage. If everyone in the world would specialize production and employment in their comparative advantages and then trade (i.e., export) their products to others who have comparative advantages in other products (i.e., imports), all would benefit by being able to consume larger quantities of products at lower costs. Any obstruction to free trade will decrease the welfare benefits of free trade.
Presidential candidates have discovered that workers who are employed in import-competing industries, many of which are unionized, generally oppose freer international trade. This is a large enough cohort of the voting public that the candidates are pitching to them rather than to the smaller cohort of high school and college graduates who might remember the logic of the comparative advantage principle and appreciate the benefits of freer international trade. It is a personal and a pocket-book issue for folks who are engaged in import-competing industries because their livelihoods are in jeopardy.
Here is the crucial contrast: For consumers, the lower prices of imported goods compared to domestically-produced goods is an issue that is too marginal to their pocketbooks for them to become active in favoring freer international trade. Most consumers give little thought to where the products that they buy come from. But for employees of companies in import-competing industries, free trade of importables threatens their jobs and thus is a major issue to them. And they are well-enough organized through their unions to make their voices heard in the political arena. Hence, political candidates pay more attention to the voices opposing free trade agreements than to the rest of society for whom product source is only of passing interest.
Even more alarming than his opposition to the TPP agreement is President Trump's assertion that NAFTA has ruined the U.S. economy. Trump says that existing trade agreements are "bad deals," and he is willing to "rip up" or renegotiate them. Gary Hufbauer, et al., in a paper published on the website of the Peterson Institute for International Economics, says that
Justin Wolfers, writing in The New York Times, September 19, 2016, says that Trump can easily start a trade war:
So it was all only saber rattling after all. Or was it? Greg Ip, writing in The Wall Street Journal, January 22, 2017, says
(http://www.wsj.com/articles/trump-on-trade-peace-through-strength-1485086400)
To make it more than just saber rattling, the Trump administration will have to identify acts of government-subsidized dumping and actually act to punish several cases by imposing prohibitive tariffs.
It is difficult to identify region-specific comparative advantages or company-specific competitive advantages, either of which may be a legitimate basis for a foreign producer to charge a lower price for a product exported to the U.S. than the prices charged by U.S. domestic producers. If a foreign producer is simply exploiting a true comparative advantage for its region or a legitimate competitive advantage for its company (i.e., without government subsidy), the Administration has no cause in principle to initiate an anti-dumping action.
Even if the foreign producer has a legitimate comparative advantage, the Administration will have a hard time deflecting complaints by U.S. producers who find themselves competitively disadvantaged. They are likely to petition the government to "level the playing field" by imposing anti-dumping tariffs to neutralize the foreigner's advantage.
Domestic producers may have a more legitimate complaint if foreign governments are subsidizing their producers. But domestic consumers should be happy that a foreign government is enabling them to purchase lower-priced imported goods that are comparable to higher-priced domestically-produced goods. The foreign government is in effect subsidizing the welfare of domestic consumers. It's a gift from the foreign government, almost a "Santa Clause" phenomenon. However, domestic producers and consumers have unequal voices when it comes to the implementation of government policy. Producers and their employees usually are much better organized than are consumers, so the producers' trade associations and employees' labor unions can be expected to lobby for anti-dumping law enforcement. Lacking effective organization, domestic consumers will remain largely silent.
Anti-dumping laws are notoriously difficult to enforce. As noted in another comment, it is difficult to acquire and confirm information about either a domestic competitor's or a foreigner producer's cost of production of a comparable product. Any initiation of an anti-dumping measure is likely to elicit the imposition of a reciprocal tariff by a foreign government if the Administration
? fails to confirm that a foreign producer is selling product in the U.S. at a price below its full cost of production (including due allowance for overhead costs),
? fails to confirm that a foreign producer is selling product in the U.S. at a price below the price that it charges in its home market, or
? initiates an anti-dumping case based on a local market definition of dumping (i.e., a delivered price in the U.S. that is only lower than prices charged by U.S. producers of comparable products, irrespective of costs of production).
Another anti-dumping issue will be identification of "due allowance for overhead costs." Both domestic and foreign companies and their respective governments may use different accounting rules to specify the economic life of their capital equipment in order to attribute overhead cost for purposes of taxing profits and thus for pricing product. And the respective governments may enforce different rules for accounting for depreciation.* The issue for the Administration to consider is whether differences among tax authority rules in accounting for depreciation constitute a legitimate basis for charging a lower delivered price of an import into the U.S.
Greg Ip is right when he says that
*For example, assuming a simple case of "straight-line" depreciation, if the capital used in producing a product is expected to have a useful life of 20 years, then 1/20 of the capital outlay will be claimed as a cost of production for determining taxable income, and product will be priced accordingly to cover the "full cost of production," including allocation to expenses for depreciation. If a foreign producer is permitted by its tax authority to claim a longer life for its capital equipment than does the U.S. producer, or if the tax authority specifies a different rate of depreciation, the producer may allocate a smaller proportion of the original capital outlay for depreciation in each accounting period, and thus may charge a lower product price. And once the foreign producer's capital investment is fully depreciated, the "full cost of production" may include no depreciation allowance at all, enabling the foreign producer to charge a lower price than the American producer that is still allocating depreciation allowances to its "full cost of production."
In efforts to explain the U.K. Brexit vote in June 2016 to leave the E.U., social scientists have offered various explanations about who favored and who opposed freer trade and immigration. Explanations have included:
- Skills levels of workers: lower-skilled workers are more protectionist; higher skilled workers are more open to freer trade and immigration.
- National affluence: workers in lower-income countries are more protectionist, workers in richer countries are more inclined to favor freer trade and immigration.
- Class divide: people in poorer urban areas generally oppose freer trade and immigration; people in the more affluent areas are more favorably disposed to freer trade and immigration.
- Social protections: workers in countries with smaller governments that provide few social protections are more protectionist; workers in countries with bigger governments that provide more social protections are more open to freer trade and immigration.
- Exposure to import competition: workers in import-competing industries are more protectionist; workers in industries and trades that are not so exposed are more open to freer trade and immigration.
It is not possible for a region to have no comparative advantage since comparative advantage consists of greatest absolute advantage or least absolute disadvantage. Economists rely on the logic of the argument that if everyone in the world would specialize production and employment in their comparative advantages and then trade (i.e., export) their products to others who have comparative advantages in other products (i.e., imports), all would benefit by being able to consume larger quantities of products at lower costs.
The reason that workers in non-comparative-advantaged industries might reject free trade is to protect their jobs against imports from regions that do have the comparative advantages. The reason that workers in industries that do have comparative advantages would be expected to favor free trade is to encourage exports of their products.
That workers in an industry oppose free trade is implicit evidence that their industry may not have a comparative advantage relative to foreign suppliers. That workers in an industry favor free trade is implicit evidence that their industry probably does have a comparative advantage relative to foreign suppliers.
Should anyone have a lifetime guarantee of employment in a particular job in an occupation in a specific industry? Who would be the guarantor of such lifetime employment? Who would suffer the collateral effects (welfare losses) of such guaranteed lifetime employment?
Do comparative advantages shift over time? Yes, for both natural and contrived reasons. In the former case, technological advances and resource discovery or depletion may cause natural shifts of comparative advantages. In the latter case, governments may attempt to neutralize foreign comparative advantages (i.e., offset domestic disadvantages) or create artificial domestic advantages by imposing or increasing tariffs on imports or providing subsidies to domestic (import-competing) industries. Such efforts inevitably diminish the potential gains from comparative advantage specialization and trade.
So, what's the solution to shifting comparative advantages, whether natural or contrived? An economic response is to promote resource discovery efforts and technological advances that create comparative advantages and job opportunities in industries that exploit them, and to assist workers in disadvantaged industries to retrain and find jobs in advantaged industries.
A political response is to try to perpetuate employment in disadvantaged industries by protecting them with tariffs and import quotas. In the latter case, both the country and the rest of the world are likely to suffer losses of consumer welfare. But then how do we weigh the welfare of consumers (practically all citizens) against the welfare of workers (those employed in disadvantaged industries)?
35. Languages and Currencies
The following two statements may at first appear to be unrelated: (1) Americans are essentially monolingual. (2) Americans use a single domestic currency throughout the nation.
Language
The American Revolution began in 1776. In 1779, the former colonials meeting in constitutional convention came very close to establishing as many as thirteen different countries rather than one. Had they done so they would probably have ended up with as many different currencies as countries, and they might have chosen a variety of languages associated with the cultural heritages of the majorities of their populations. But the decision to join together to form a union of the former colonies ensured the adoption of a single currency. They also agreed by a majority of only one vote to designate English as the common official language for the new country; German is the other language which came very close to acceptance as the official language of the United States of America.
Today English is still the predominant language in the United States even though a variety of languages may be spoken in the home and in ethnic communities. A second language, Spanish, is gaining on English as first language because of the great influx of immigrants (many illegal) from Haiti, Cuba, Mexico, and other Central American countries. In some communities (e.g., Dade County, Florida) now, many public signs and government communications are given in both English and Spanish. It may still be true that the vast majority of Americans continue to be fluent in only one language, even if they understand a little of another. High school and college curricula are designed to acquaint young Americans with other languages, but it is rare that fluency is achieved in the second language, and even rarer for fluency in a third language.
In 1986 my daughter completed third-year Spanish at her high school. Although this was her only language other than English, it enabled her to participate in a summer Rotary exchange program during which she spent five weeks in Barcelona with a Spanish family, after which the teenage Spanish daughter came to Greenville to spend five weeks with my family. Our Spanish guest enumerated her languages in descending order as Catalan, Spanish, Italian, German, French, and English. Having already incurred the costs of becoming relatively fluent in the other languages, she was keen to participate in the Rotary exchange in order to improve her English language skills. Multilinguality is the norm in Europe and through much of the rest of the world as well. Americans are well known in the world for their language illiteracy, which often is perceived to be arrogance.
Money
There are twenty-seven different countries presently in the European Union with several other possibilities waiting in the wings. Language diversity is the norm in Europe. When our students visit the European Parliament meeting in Brussels or Strasbourg, they find that translations of all discussions and debates are offered in at least ten different languages by a corps of translators. The gallery visitors must rotate headphone switches to select the language in which they wish to listen. So also must each of the MEPs on the floor of Parliament unless they are fluent in the language being spoken.
Europeans seem to have dismissed any serious effort to adopt or create a common language (Esperanto has been developed as an amalgam language for Europe much as Hindi was developed to serve the same function in India, but neither seems ever to have been taken very seriously). Europeans continue with no qualms to incur the personal costs of learning a variety of languages, and otherwise the explicit costs of translation from one language to others. Although these costs are not trivial, they often are not obvious because they are absorbed by individuals (in the learning process) and the state (in the instructional and translation processes).
Before the advent of the euro, currency diversity was the norm in Europe as each of the nation states of the EU exercised its national sovereignty to maintain and use its own national currency. This required currency conversions for purposes of international trade, investment, and tourism. The costs of such conversions included commissions and brokerage fees as well as personal nuisance values. These costs were probably more significant to tourists than to traders and investors whose banks and currency brokers were able to convert very large currency quantities at extremely low per-unit fees. There were also the risks of exchange rate fluctuations over the lives of commercial transactions (often two or three months between contract and delivery), but international financial institutions developed very efficient means (futures and options markets) to diminish or offset these risks. Since currency conversion and language translation cannot be easily compared, we can only speculate that the costs of currency conversion may have been comparatively less than the costs of language acquisition and translation.
It seems ironic that while there has been no serious movement in Europe to diminish the considerable costs of language acquisition and translation by adopting a common language, there was a concerted effort to eliminate the lesser costs of currency conversion and exchange rate variation risks by adoption of a common currency throughout the EU. The adoption of the EU-wide common currency was one of the principal tenets of the Maastrict Treaty of 1992. There is more history than we could recount here, but the drive to achieve a common currency culminated in January of 2002 with the circulation of the "euro" as a pocket and transaction currency.
Without
doubt, the use of a common currency throughout the world would be more
efficient than the use of a variety of currencies which have to be converted
into one another. The efficiencies would
be achieved in the elimination of the conversion costs and the risks associated
with exchange rate changes. This would be
true of any part of the world as well as the world as a whole. For example, the single currency used
throughout the United States of America has allowed it to enjoy the absence of
currency conversion costs and exchange risks in interstate commerce and
investment. An additional benefit is that
the balance of payments between any pair of states (e.g., South Carolina and
Georgia) is a non-issue because market mechanisms work automatically to achieve
multilateral state payments balance.
Europe likewise has benefited from the adoption of a common currency
(though perhaps not as much as from the adoption of a common language).
The Gold Standard Rules of the Game
Countries discovered during the Gold Standard era what economists call the "Gold Standard rules of the game." Rule 1 is that a trade deficit country, in order to correct its deficit, should pursue domestic policies to deflate its price level and contract its economy. The falling prices and contracting incomes and employment would result in fewer imports and more exports, thereby alleviating the deficit. If such policies were not implemented, the country would have to continue to buy its own currency (by paying out gold) in order to stay at the gold par, until its stocks of gold were exhausted. At that point the country would be off the Gold Standard and its currency would depreciate. Deficit countries attempting to remain on the Gold Standard could, as a temporary expedient, choose to devalue their currencies (i.e., change to lower par values with gold), thereby discouraging imports and encouraging exports. But a devaluation is a temporary expedient in that it only "buys time" during which the country should make the fundamental adjustments. Without such fundamental adjustments of deflation and contraction, further devaluations are needed until the stocks of gold are depleted and the country must leave the Gold Standard.
Rule 2 is a
corollary of Rule 1: A payments surplus
country, in order to correct its surplus, should inflate its price level and
otherwise pursue policies to expand its domestic economy. The rising prices and incomes would result in
fewer exports and more imports, just what is needed to relieve the
surplus. A failure to pursue such
expansionary policies would result in the continuing sale of its own currency
(by purchasing gold) in order to keep the currency at par with gold, but the
side effect of such gold purchases would be monetary expansion with
inflationary pressures (unless the monetary expansion is otherwise neutralized
by monetary policy). As a temporary
expedient, a surplus country which resolved to stay on the Gold Standard could
choose to revalue its currency (upward), which would diminish its exports and
encourage imports, thereby relieving the payments surplus. However, an upward revaluation of the surplus
country's currency no more achieves fundamental adjustment than does
devaluation of a deficit country's currency.
Two problems with these rules became evident early in the 20th century. One was asymmetry, i.e., the compulsion and burden of adjustment fell primarily upon the deficit countries, but surplus countries could "sit back" and enjoy their payments surpluses with no feelings of compulsion to adjust.
The second problem was more difficult. Government officials began to realize that their domestic economies were having to adjust to international conditions under the Gold Standard rules, i.e., the "tail was wagging the dog." This situation became less and less tolerable as time passed. The desperation of the Great Depression led governments to attempt to relieve the crisis of economic contraction. Due to great disruptions in exchange markets during the depression, most countries ceased attempting to fix their currencies to gold, and the Gold Standard came to an end by 1933.
Dirty Floating
By the end of World War II governments in North America and Western Europe were beginning to take responsibility for maintaining high levels of employment, stable prices, and economic growth, and to employ the tools of macropolicy in pursuit of these goals. The problem which became ever more apparent is that a governmental use of macropolicy to achieve domestic economic goals is incompatible with a Gold Standard and its game rules which require subservience of the domestic economy to the requirements of international payments balance and exchange rate stability.
A similar problem manifested itself in the Bretton Woods monetary system after World War II. The Bretton Woods system was designed to be similar to the Gold Standard, but with a significant difference. In this system the members of the International Monetary Fund each committed to stabilize their respective currencies to the US dollar which would serve as the anchor of the system. The US government committed to stabilize the value of the dollar relative to gold. The problem which emerged was that the anchor itself loosened its hold on gold because the government of the United States became ever more committed to the stabilization of its domestic economy, and commensurately less committed to achieving balance in its own payments or the stability of the dollar relative to gold.
During much of the post-World War II era, and in particular since the early 1970s, US trade has been in chronic deficit, which under the Gold Standard rules of the game would require deflation of prices and contraction of output and employment in the US economy. These are two conditions which are politically intolerable in the modern world, but which can be addressed with the tools of macropolicy.
Until 1971 the US economy flooded the world with dollars through several routes: the Marshall Plan, tourism, merchandise imports in excess of exports, foreign direct investments, and overseas military establishments. All of these contributed to increasing the supply of dollars to the world relative to its demand for dollars, with the inevitable conclusion that the price of the dollar had to fall. To keep the value of the dollar from depreciating with respect to gold, i.e., to maintain its Bretton Woods responsibility, the US government during the 1960s continuously bought dollars from the exchange markets by paying out gold.
By 1971 the US monetary gold stock had decreased to such a low level that it was inadequate to serve as backing for the US paper money supply under legal requirements to that date. In August of that year President Nixon suspended the convertibility of the dollar in terms of gold, and the Bretton Woods system came to an end. Since that time the world's monetary system has been characterized by exchange rate flexibility, except within currency blocs. However, to the extent that governments (or groups of them, e.g., the G7 or the G10) occasionally intervene in currency markets to arrest depreciation of one or another currency, the flexibility may be described as a "dirty float" (in contrast to a "clean float" which would occur purely in response to market forces).
Fiscal Federalism
The European Union employs a common currency that is used throughout its 27 countries. Similarly, the United States of America employs a common currency that is used throughout it 50 states. But national or state-level exercise of macropolicy is essentially incompatible with efforts to fix exchange rates within a common currency. Until such time that national governments and U.S. states are willing to surrender macropolicy prerogatives to a common supranational authority, exchange rate flexibility is needed. If countries or states continued to exercise deliberate macropolicy targeted upon domestic economic stability, exchange rate flexibility would allow each economy to continue to pursue its domestic economic agenda while international currency markets would take care of external adjustments. This would include automatic adjustment of the balance of payments of every country which is content to let its exchange rate flex vis-a-vis all other currencies.
One of the lessons of the US experience with a common currency over the past two centuries is that monetary and fiscal policy must be the preserve of the central (federal) government rather than the state (on analogy, provincial) governments. If state governments were to attempt to implement monetary or fiscal policy, then there could be no coherent economic stabilization policy for the nation as a whole. Hence, in the US no state government issues money or attempts to exercise monetary policy, although some of their activities may have monetary implications. Also, the chief fiscal preoccupation of state governments is funding their expenditures, but not a deliberate exercise of fiscal policy to affect local economic conditions. This seems to have worked well enough in the US economy for the past century.
Some would say that fiscal federalism has converted the US common currency union into a wealth transfer union, i.e., one which transfers wealth from higher-income states to lower-income states in order to achieve fiscal stability of the whole. In the EU the present national governments are analogous to state governments in the US. The implication for the EU in its quest to retain a common currency is that governments of the constituent states should give over the exercise of fiscal policy to an appropriate supranational authority of the EU. In so doing, the eurozone would function as a union to transfer wealth from the solvent northern European countries to the high-debt southern European countries.
Fiscal policy persists as a sovereignty issue in the EU, and some EU constituent countries may never be able to accept the dictates of a supranational fiscal authority. Until such time that the national governments of the EU are willing forego the exercise of discretionary macropolicy, or to relinquish fiscal policy to an appropriate supranational governmental entity, the EU might be better off with national currencies and completely flexible exchange rates. Then each national government could continue to pursue any fiscal/monetary policy mix it wished with respect to its domestic economy, and international meshing would be accomplished by market-determined exchange rate variation.
Macroeconomic Adjustment Vehicles
Basically, there are only three macroeconomic adjustment vehicles: exchange rates (the external prices of a nation's currency), domestic prices of goods and services, and domestic employment and incomes. A progression of "if statements" identifies the relevant adjustment possibilities:
1. If exchange rates are allowed sufficient flexibility, they may serve as "shock absorbers" for the domestic economy against internationally sourced disturbances, or they may serve as adjusters to existing or emerging differences among economies that interact through trade and financial relationships.
2. If exchange rates are fixed by government authorities, domestic prices of goods and services may assume the burden of adjustment to international macroeconomic disturbances or emerging economic differences with other economies.
3. If domestic prices are insufficiently flexible and exchange rates are fixed, the adjustment process must descend upon domestic employment and incomes.
4. If government authorities employ macropolicy tools to stabilize domestic prices, employment, and incomes, exchange rate flexibility must serve as the adjustment vehicle, i.e., back to #1.
5. But if government authorities resolve to
fix exchange rates and use macropolicy tools to stabilize domestic prices,
employment, and incomes, there is no effective vehicle of macroeconomic
adjustment to international disturbances or existing economic differences with
other economies. In the absence of an effective adjustment vehicle, payments
imbalances and government budget deficits will persist and debt held by other
nations will continue to accumulate.
37. Rethinking Industrial Policy
In a Washington Post opinion column on July 25, 2023, Catherine Rampell noted that
This is not just an historic Republican opposition to what is more generally called "industrial policy." A standard premise underlying the teaching of economic theory in "the West" is that markets are superior structures of economic organization for revealing and serving the preferences of populations. It is reputed to be superior for this purpose to fascism, communism, theocracy, imperial monarchy, and any other form of authoritarian governance that has been tried.
The historic Republican opposition to industrial policy seems to have undergone a recent transformation to embracing the approach historically associated with Democrats, at least at the state level. Rampell points out that industrial policy has become an "art form" in the State of Florida whose current governor is a Republican. Industrial policy to attract the construction of plants is standard procedure implemented by state and local governments, irrespective of political affiliations of governors, mayors, and county administrators in the United States in attempts to attract industry to their regions.
One of the tenets that follows from the economic premise is that governments should leave to market forces to discover comparative advantages and accordingly develop industrial and commercial activity across regions. A complementary tenet is that global welfare will be maximized and populations that specialize in their comparative advantages discovered by markets can enjoy each others' fruits by trade with one another.
A corollary conclusion is that political authorities (i.e., governments) should keep "hands off" of such specialization and trade processes. This means that they should not practice "industrial policy" to pick winners and suppress losers that do not correspond to comparative advantages. Interregional trade theory posits that failure to allow comparative advantage specialization will diminish the economic welfares of prospective trading partners.
The comparative advantage principle is best understood with respect to what might be called the "natural" characteristics of a region, e.g., soil, terrain, location, labor, etc. It is not so clear that the principle applies to the fluidity of technological and industrial abilities that can be established by research and investment. Two justifications for government intervention in regard to technological and industrial capabilities are to establish an advantage where none of the type previously existed, and to defend or preserve such an advantage in the face of foreign efforts to establish or pirate a similar advantage. Both the aggressive intent to establish a technological or industrial advantage and the defensive effort to prevent loss of such an advantage become matters of industrial policy.
Jeff Stein, in a Washington Post opinion column on July 23, 2023, writes that
. . . .
At a meeting the next night in Walnut [Township, Ohio], Bill Yates, one of the town’s trustees, told a representative for EDF Renewables that the plan [wind farms] was only moving forward because it was receiving federal subsidies from Biden’s plan. “If you were doing this with your own money, you would not be doing it,” Yates said. “You’re doing it with taxpayer money.” (https://www.washingtonpost.com/business/2023/07/23/biden-green-energy-local-republicans/?utm_campaign=wp_todays_headlines&utm_medium=email&utm_source=newsletter&wpisrc=nl_headlines)
Doing something only with "taxpayer money" violates the principle of comparative advantage. If Yates is right, this taxpayer money will distort "the free flow of ideas, goods and investment" as described by Rampell, but this distortion would serve a means to an end that may be desirable from a climate-change perspective. Subsidies to promote energy security may be a means to an end that outweighs economic welfare.
Several exceptions to the admonition to specialize by comparative advantage are acknowledged in international trade textbooks, including the possibility that international political circumstances may override economic preferences. This has been the case in the twenty-first century as trading nations have imposed trade restraints and pursued their own policies to subsidize the local development of industries.
An international example of industrial policy accompanied by industrial espionage is that the Chinese government has sponsored the pirating of American technologies in order to enable the development of indigenous industries employing those technologies. China also threatens the technologies implemented in Taiwan to produce and export advanced silicon chips. This has led the Biden administration to promote and subsidize the expansion of the domestic silicon chip industry. The Editorial Board of The Washington Post, writing on August 10, 2023, describes Biden administration industrial policies that counter the economic principle of comparative advantage:
Subsidized investment to promote development of an industry in one country may have the effect of altering what otherwise may have been natural comparative advantages between that country and its trading partners. A potential loss of comparative advantage to a trading partner that has implemented technological espionage and investment to capture the comparative advantage may be sufficient non-economic reason to implement a countering industrial policy. Such industrial policy in one country may be seen to justify an opposing industrial policy in another country in the effort to preserve its comparative advantage or neutralize an emerging foreign comparative advantage.
The point is that, comparative advantage to the contrary not-withstanding, a failure to implement industrial policy at critical junctures may result in loss of comparative advantage that leaves the nation with diminished employment, income generation, and production of goods deemed essential to national security.
38. A Global Depression?
Two great economic phenomena have benefitted the world over the past half century. One is economic growth that has increased per capita incomes and become the most effective alleviator of poverty that the world has experienced (see the essay at https://dickstanfordlegacy.blogspot.com/2024/02/essays-on-economic-growth-and.html#S01). The other is globalization that has enabled sharing the gains from specialization by comparative advantages among trading partners.
The curbing of foreign aid and elimination of the U.S. Agency for International Development by the Trump administration is likely to slow global growth and could result in widespread decreases of per capita incomes in developing nations.
President Trump’s 2025 tariffs will counter globalization and cause major disruption to American life. (See Justin Wolfer’s April 4, 2025, New York Times column, "Your Life will Never be the Same After These Tariffs." (https://www.nytimes.com/2025/04/04/opinion/trump-tariff-economics-cost.html?campaign_id=39&emc=edit_ty_20250404&instance_id=151827&nl=opinion-today®i_id=74240569&segment_id=195263&user_id=86b0d837dd357b2a6e0e749321f6ed7f) They also may spark a global recession that could become global depression because they affect not only lives in America; they disrupt lives in virtually all nations across the globe.
The U.S. labor force participation rate (LFPR) was 62.7% of the 2024 U.S. population (https://www.bls.gov/charts/employment-situation/civilian-labor-force-participation-rate.htm) while the proportion of the U.S. labor force engaged in manufacturing was only 7.7%. (https://www.bls.gov/emp/tables/employment-by-major-industry-sector.htm) It goes without saying that consumers constitute 100% of the U.S. population. This means that Mr. Trump is imposing tariffs that he expects to benefit less than 8% of the labor force or only 5% of the U.S. population (.627 x .077 = .048) at the expense of 100% of the population that will suffer price increases due to the tariffs.
Mr. Trump asserts that the newly imposed tariffs will cause manufacturing to "roar back" into the United States. This is unlikely for several reasons: uncertainty about how long the tariffs will be imposed; the remaining depreciable lives of existing manufacturing facilities; varying gestation times for bringing new plants online (up to 5 years for new automobile plants); and manufacturers’ prior identifications of potentially profitable site locations. I would be surprised if Mr. Trump’s tariffs increase the manufacturing proportion of the U.S. labor force much beyond 8%.
The U.S. economy, predominantly agrarian through the 18th and 19th centuries, gradually became an industrial economy from the Civil War into the 20th century.
But the proportion of the U.S. population engaged in manufacturing declined during the post-World War II era as an ever-larger proportion of the labor force engaged in the provision of services. This transformation to a predominantly service economy is a manifestation of the phenomenon of globalization as producers of manufactured products have sought the most profitable locales to site their plants.
Mr. Trump’s tariffs will destroy the regime of globalization built over the past half century. Right-leaning political interests revile globalization because offshoring of production has decreased manufacturing in the U.S. and otherwise disrupted domestic production and employment patterns even as it has increased productivity and improved welfare on global scale. The perception that globalization has been instrumental in extending global Jewish presence and control has become a subliminal tenet in the political right’s quest to reestablish white Christian nationalism. A critique of globalization is made in the transcription of a conversation between NYT columnist Ross Douthat and Oren Cass, the founder and chief economist of conservative think tank American Compass. (https://www.nytimes.com/2025/04/10/opinion/ross-douthat-interesting-times.html?campaign_id=39&emc=edit_ty_20250410&instance_id=152289&nl=opinion-today®i_id=74240569&segment_id=195723&user_id=86b0d837dd357b2a6e0e749321f6ed7f)
A genius of market economy (a.k.a. “capitalism”) is that manufacturers’ pursuit of profits have led them to develop competitive advantages that are prerequisites to discovering what economists call “comparative advantages” across geographic space. Plant site decision makers don't look for or see comparative advantages of regions, but they do seek company-level competitive advantages that serve as decision proxies for regional comparative advantages.
Comparative advantage means locating production of an item to minimize “opportunity costs,” i.e., what must be foregone (or given up) to produce the item. Comparative advantages are location-specific because resource endowments (including mastered technologies) are peculiar to each geographic locale. For example, what must be given up in a locale that is labor abundant and capital scarce may be very different to what must be given up in another locale that is capital abundant and labor scarce.
A region’s greatest comparative advantages occur in the production of items that entail its least opportunity costs. Welfare benefits of comparative advantage specialization are shared globally through interregional trade that enables people in every region to consume items that are produced by trading partners at lower opportunity costs than can be achieved in respective “home markets.”
The freer the trade among regions, the greater the welfare benefits of comparative advantage specialization that can be shared among the regions. Economists argue that if all regions were free to specialize in their respective comparative advantages and trade with one another, global welfare would be maximized. Mr. Trump appears to be oblivious to the benefits that comparative advantage specialization and trade have conferred upon the global economy.
Tariffs (and non-tariff barriers to trade) have the effect of diverting production from items that entail each region’s comparative advantages to production of items that incur greater opportunity costs in each region. This diversion may increase employment in the region, but in producing things that could have been acquired in other regions from trading partners that are exploiting their lower opportunity costs.
Mr. Trump has adopted a plan to impose a 10% minimum tariff on the goods imported into the U.S. from all trading partners, and beyond that “reciprocal tariffs” equal to about half the tariff rates imposed by America’s trading partners. Trump’s global imposition of tariffs is likely to invite reciprocity by our trading partners.
I will not be surprised if Mr. Trump’s tariffs precipitate a global depression even deeper than that occurring in the 1930s in response to the Smoot-Hawley tariff regime imposed by the Hoover administration.
April 4, 2025
39. Leveling the Playing Field
Ailia Zehra, on The Hill website 2/15/2025, reported President Trump's post of 2/15/2025 on Truth Social: “America has helped many Countries throughout the years, at great financial cost. It is now time that these Countries remember this, and treat us fairly – A LEVEL PLAYING FIELD FOR AMERICAN WORKERS.” (https://thehill.com/homenews/administration/5147602-trump-doubles-down-on-reciprocal-tariffs-vowing-a-level-playing-field/)
Leveling the playing field for American workers sounds like a good thing to do, but it comes at a cost. American manufacturing workers comprise less than 10% of the U.S. labor force, but the inevitable price increases following the imposition of field-leveling tariffs descend upon American consumers who comprise 100% of the U.S. population.
If it were a sports competition rather than global production, why stop at leveling just the playing field? Why not ensure that the rosters of all teams are perfectly equivalent in capability relative to their competitors, and why not also insist that all coaches' knowledge and experiences be equivalent? And for that matter, shouldn't every game be played on the home field of each team?
The conditions laid out in the previous paragraph are absurd for sports competitions, no less so than for global production and trade. In the latter venue, "leveling the playing field" would require neutralizing, off-setting, or eliminating every region's comparative advantages, i.e., the local "opportunity costs" of production. Doing so would eliminate any possibility of specializing by comparative advantages and sharing gains from trade. Global welfare would be diminished.
But this appears to be precisely what Mr. Trump is after. He would "bring home" to American shores the production of foreign manufactured goods consumed by Americans, not only foregoing gains from specialization and trade, but also incurring higher costs of producing non-comparative-advantaged goods at home.
Mr. Trump's intended manufacturing shift ignores the fact that many foreign-manufactured goods consumed by Americans were never manufactured in America and physically cannot be manufactured in America today. Taken to the extreme, perfectly leveled global-production "playing fields" would result in economic autarky and possibly lead to political isolation.
A region's comparative advantages may be natural due to its resource endowments, or they may be acquired. A region may acquire comparative advantages by geological research to discover previously unidentified resources, by urging and facilitating emigration of workers who possess knowledge of wanted technologies, and by original research to develop new technologies for producing products for which there may be domestic or foreign markets.
Comparative disadvantages may be alleviated by licensing technologies implemented in other regions, soliciting off-shored investments that include desired technologies, subsidizing domestic investment in technologies implemented by trading partners, or pirating technologies by industrial espionage. Paul Krugman urges use of industrial policy, particularly subsidies, rather than tariffs to encourage more domestic manufacturing:
In either case, citizens of the exporting nation are gifting citizens of the importing nation goods at prices below true costs of production. This strategy may support and expand employment in an exporting nation (e.g., China), but it may diminish employment in importing nations (e.g., the U.S.). Americans may be happy to purchase subsidized Chinese-made products, even as American labor suffers decreasing manufacturing employment. This has been labeled a "beggar-my-neighbor" strategy for acquiring an artificial comparative advantage.
The government of a region may feel justified in attempting to counter foreign comparative advantages (i.e., to "level the playing field") that it views as obtained by devious means, e.g., by subsidized investment or by espionage. But offsetting natural-endowment advantages and technologies acquired by legal and ethical competitive means can be expected to decrease gains from specialization and trade, and to diminish global welfare.
Mr. Trump's wide application of tariffs on imports from 90 or more countries does not appear to be based on perceptions of illicit acquisition of advantages, but rather on his perception that these countries have long been "ripping us off" because their tariff rates on imports of American goods have been higher than American tariff rates on imports of their goods. Now his 90-day tariff pause will hold the country and global markets in suspense for three months before he continues his tariff quest.
Before 1863 the U.S. government's revenue came mostly from tariffs and sale of public land in "the West." The first federal income tax was a temporary expedient enacted in 1861 under the Lincoln administration to assist with war finance. From 1863 to 1913 the major source of the government's revenue was excise taxes. Since 1914 the predominant source of the government's revenue has been income taxes.
Mr. Trump expects tariff revenues to help finance income tax cuts and diminish annual budget deficits. He is reputed to be toying with the notion that tariff revenue might be sufficient to replace income tax revenue. In mid-April 2025 Mr. Trump claimed that the U.S. is collecting $2 billion per day in tariff revenue (https://www.msn.com/en-us/money/markets/trump-is-very-wrong-about-how-much-the-us-is-collecting-from-tariffs/ar-AA1D3DfF?ocid=BingNewsSerp), but the Treasury Department and U.S. Customs report significantly lower amounts. Whatever the amounts, tariff revenues are being collected from American consumers in the form of higher prices of imports, not from foreign exporters. To the extent that tariff revenues help finance income tax cuts or become sufficient to replace income taxes, Mr. Trump will have replaced a progressive tax structure with regressive taxes (tariffs) that fall more heavily on consumers.
If Mr. Trump's tariffs cause the U.S. economy to go into recession as widely predicted by economists, personal incomes and taxes paid on them may decrease. If import purchases are sustained, tariff revenue indeed would be replacing income tax revenue. But import purchases are not likely to be sustained in a recession.
Whether the U.S. economy goes into a recession in response to the imposition of tariffs, quantities purchased of most goods (including imports) vary inversely to their product prices. As import prices rise due to the imposition of tariffs, quantities purchased likely will decrease. If demands for imports are sufficiently elastic (responsive) with respect to their prices, tariff revenue could actually decrease and worsen the annual budget deficits. (This view is elaborated in the April 11, 2025, Fortune.com column by Shawn Tully about his interview with economist and former Treasury Secretary Larry Summers, https://fortune.com/2025/04/11/larry-summers-financial-crisis-doge-tariffs-economic-predicions/?social_type=MSQA.)
Who bears the brunt of Mr. Trump's intended global manufacturing reallocation? American consumers as higher domestic production costs and field-leveling tariffs are passed along to them in higher prices. Rather than trading partners "ripping us off," Mr. Trump's tariffs are ripping off American consumers who are are both paying higher prices due to the tariffs and still paying income taxes!
April 9, 2025
40. Manufacturing Employment and Tariffs
President Trump has vowed that his tariff policy will bring manufacturing and "good-paying" manufacturing jobs back to the U.S.
U.S. manufacturing employment reached a peak of 19.54 million workers in July of 1979 (https://fred.stlouisfed.org/series/manemp) when the U.S. civilian labor force participation rate (LFPR) was 63.6% of the U.S. population (https://fred.stlouisfed.org/series/CIVPART/). On this date manufacturing employment accounted for 18.73% of the civilian labor force (https://fred.stlouisfed.org/series/CLF16OV/). Tariff rates averaged around 2% on the value of imported goods.
By March of 2025, U.S. manufacturing employment had fallen to 12.76 million workers as the U.S. civilian LFPR decreased slightly to 62.5% of the U.S. population. On this date, manufacturing employment accounted for only 7.48% of the civilian labor force. This occurred as average tariff rates remained around 2% until March, 2025, when the Trump administration imposed varying tariff rates that averaged above 10% on the value of imported goods.
Even though many other nations' tariff rates were higher during the past half century, the low American tariff rates facilitated the process of globalization. The decrease of manufacturing employment in the U.S. is a manifestation of globalization as employers sought to locate production facilities anywhere in the world that they find or develop competitive advantages. Company-level competitive advantages have served as proxies for regional comparative advantages, i.e., where local opportunity costs of production are lowest.
The two predominant causes of the decline of manufacturing employment in the U.S. are offshoring of production to foreign sites and technological advances that enable and facilitate automation of production processes. A significant portion of the decline probably is due to technological advance that facilitates automation, but it is not possible with currently available information to attribute portions of the manufacturing employment decline to offshoring or technological advance.
The U.S. economy can be characterized relative to much of the rest of the world as a capital-abundant, labor-scarce, high-wage region that implements capital-intensive technologies. But the U.S. economy is not a homogeneous region with respect to resource endowments. It consists of many economic sub-regions, some of which are relatively more capital-abundant and labor-scarce while others are capital-scarce and labor-abundant. The former possesses manufacturing advantages even as the latter may seem to share manufacturing (dis-)advantages with lower-income nations. U.S. examples of the former historically lay in the upper Midwest, New England, and the Ohio Valley; more-recent examples lie in Georgia, South Carolina, Alabama, and Tennessee where aerospace and automobile assembly plants have been sited. Current examples of the latter may be found in West Virginia, Arkansas, Kentucky, and Mississippi that are more suited to agriculture and mining.
It is a safe guess that most of the manufacturing employment that has been offshored by American manufacturers is of the low-wage manual-labor variety, characterized by some as "sweaty, hard-work" labor. The foreign manufacturing processes that Mr. Trump expects to bring back to U.S. shores are unlikely to return as sweaty, hard-work labor that employ lots of people. They will be replaced by technologically advanced, automated manufacturing processes that require fewer workers who are better-educated, more highly trained, and technologically experienced.
The U.S. labor force already is exhibiting a dearth of such labor, the demand for which will only increase if Mr. Trump succeeds in bringing manufacturing "back" to U.S. shores. A residual question is whether the U.S. educational system is capable of meeting that demand in the face of efforts by the Trump Administration to curb its federal functions and return them to the states.
Concomitant upon the decline of manufacturing in the U.S. has been its shift to a service-based structure that includes the provision of financial, medical, consulting, and design services as well as retail and wholesale trade and personal services. These considerations beg an important question: is manufacturing employment intrinsically superior to or more desirable than non-manufacturing employments?
The answer might be "yes" if manufacturing employment regularly yields higher wages than employments in other sectors. This might be true for an elite segment of the labor force that is well educated and highly trained in technological applications, but there is no obvious reason to expect higher average wages for assembly-line workers than for those who provide services. And increasing wages in the highly educated and technologically trained segment of the population inevitably will worsen inequality in the U.S. income distribution.
Another question is whether Americans should suffer a sense of national inferiority or shame in importing lower-value tangible goods manufactured in the rest of the world while exporting higher-value domestically produced intangible services to the rest of the world to "pay for" the imported tangibles. Should we take comfort in the fact that the outside world serves as our physical labor "workshop" while we indulge in the more leisurely employments of providing services to ourselves and the rest of the world? I'll leave these questions for the reader to mull.
Yet another question concerns the relevance of work itself. As advancing technology continues to increase the possibility of automating manufacturing processes, ever less physical "work" will be required to produce tangible products. Manufacturing will require technology astute workers to monitor and maintain machinery, but automation may result in ever fewer available jobs. James Pethokoukis, in a Washington Post column on May 5, 2025, describes the automation prospects,
It is not at all certain that with on-going technological advances and continuing automation, enough jobs can be provided by the economy or the government to ensure adequate earned incomes. In the future it may be necessary to rethink the working-income-eating nexus, with a shift from thinking about wage and employment adequacy to thinking about income adequacy that is not based on working.
Is this an argument for transition from capitalism in which products are distributed by markets that respond to consumers to a form of socialism in which output is distributed by authoritarian decision making?
April 13, 2025
41. Trade Balance Fallacies
As noted by Ana Swanson in a New York Times column on April 9, 2025, President Trump has long been obsessed with trade deficits:
....
Mr. Trump’s focus on bilateral trade deficits has meant that even close U.S. allies like Canada, Mexico and Europe are considered enemies when it comes to trade, because they sell the United States more than they buy.
(https://www.nytimes.com/2025/04/09/business/economy/trump-trade-deficit-tariffs-economist-doubts.html).
(https://www.msn.com/en-us/money/markets/trump-s-longtime-obsession-with-trade-deficits-suggests-his-tariffs-won-t-end-soon/ar-AA1Ck3Ed?ocid=BingNewsSerp)
The composition of things comprising the nation's imports or exports does not matter. If the nation imports more of one type of thing, say merchandise, than it exports, it must export enough of other types of things, like services, the ownership of real assets, equity interests in its commercial enterprises, claims against its enterprises or government units (liabilities), its own currency (claims against its central bank), foreign currencies that it may hold, or gold. The trade balance on any one type of exportable or importable thing is largely irrelevant.
Catherine Rampell writes in The Washington Post, April 15, 2025, that
Services have to be produced no less so than do goods. People are employed and costs are incurred in rendering and delivering the services, just as in the production and delivery of goods. Although goods may be manufactured by the exertion of physical human effort, i.e., by the "sweat of the brow," services may be provided with less sweat, "work" just the same, but often of a more cerebral type.
The distinction between goods and services in Balance of Payments accounting is an irrelevancy. Rather than decry the passing of the industrial economy or the rising merchandise trade deficit, Mr. Trump should celebrate the emergence of the service economy and a growing surplus on trade in services.
Bilateral trade balances between pairs of nations or with respect to particular categories of goods or services also are irrelevant. The U.S. runs deficits in trade of many goods with the rest of the world, but it runs trade surpluses in many other traded goods and even greater surpluses in services trade. Specific service or commodity trade imbalances are natural concomitants of specialization according to comparative advantages. The vested interests who perceive themselves to be harmed by the nation's despecialization in producing a particular commodity or service for which they no longer have a comparative advantage are the ones who become most agitated by commodity trade deficits.
It is irrelevant that the U.S. runs a bilateral merchandise trade deficit with China for at least two reasons. One is that the U.S. enjoys a substantial services surplus with China. A second is that the U.S. runs trade surpluses with other countries while China runs trade deficits with many of those same countries. Mr. Trump may not believe it, but bilateral trade balances are increasingly irrelevant in a multilateral trading world.
These relationships are common fare in undergraduate Econ 101 courses and courses in international trade. We don't know whether Mr. Trump took an Econ 101 course or an international trade course during his undergraduate and graduate studies, but if he did he either missed, didn't understand, or has forgotten these relationships.
Mr. Trump's insistence that bilateral trade gaps be closed by tariffs that decrease imports and increase domestic manufacturing violates basic economic principles. The reciprocal tariffs that Mr. Trump and our trading partners have imposed will descend upon consumers in America and elsewhere in the forms of higher prices. They are not likely to achieve his goal of bringing manufacturing back home to American shores. And they are likely to precipitate global recession.
April 15, 2025
42. Chaos, Uncertainty, and Risk
California Governor Gavin Newsom has labeled President Trump's tariff policy "toxic uncertainty." New Yorker columnist Susan Glasser has written a column headed "Uncertainty is Trump's Brand." James Lebenthat, writing on the Cerity Partners website, says that "The Only Certain Thing is Uncertainty." Eric Boehm, writing on the Reason.com website, observes that "Tariff Uncertainty is Stalling the Economy."
Uncertainty may be the greatest damage that the Trump administration is inflicing on the global economy. Boehm describes the tariff chaos that results in uncertainty:
Why is Mr. Trump inflicting such chaos on American society, and indeed upon the whole world? One explanation is that it is "just Trump being Trump" who has no malicious intent. An alternate theory is that it is a very deliberate strategy to weaken social cohesion and institutional trust so that Mr. Trump can aggrandize his power grab to achieve maximum authoritarian control. And there may be other explanations of Mr. Trump's chaos intent. But whatever the explanation, the chaos that he is sewing is disrupting the global economy and portends a slowdown in economic activity on global scale. (see the Foreign Policy column by Emma Ashford, April 24, 2025, https://foreignpolicy.com/2025/04/24/trump-100-days-chaos-explanatory-models-foreign-policy/?utm_medium=email&utm_source=newsletter&utm_campaign=wp_todays_worldview)
How can the uncertainty resulting from Trumpian chaos cause an economic slowdown? The linkage flows from chaos uncertainty through risk asssessment and diminishing confidence to business decisions, but also to everyday consumer decisions. This is because decision makers, either explicitly or implicitly, factor risk and uncertainty into their decisions as discount rates. How discount rates are incorporated into the decision process is illustrated with a present value formula in the Addendum to this essay.
Here are four "discount rates" that may be considered (and there may be others) in decisions about opportunities:
- the symbol i is the interest rate; it represents the risk of the loss of interest that could have been earned by investing in a financial instrument instead of choosing this decision opportunity should it fail;
- the symbol p is a deflation discount rate that represents the risk of loss of purchasing power due to inflation over the life of the decision opportunity;
- the symbol r represents a subjectively-specified risk premium that discounts the value of the opportunity due to its perceived riskiness; and
- the symbol u represents a subjectively-specified uncertainty rate that discounts the value of the opportunity due to a general sense of unease about economic conditions.
How risk is handled in decision making can be illustrated with a present value formula:
The four discount rates are added to the number "1" in the denominator of the PV formula. The "1" is there for the value of the V in the numerator of each term; if there were no discount rates, V / (1) = V. When the discount rates are present and non-zero in the formula, an increase in the value of any of them would decrease the value of PV and so could render the decision opportunity unacceptable. A decrease in the value of any of these discount rates would increase PV and so might justify its undertaking.
The Federal Reserve has targeted a 2 percent rate of inflation. The CPI measure of the U.S. inflation rate for 2024 was 2.95 percent (https://fred.stlouisfed.org/series/FPCPITOTLZGUSA). It is likely to increase with tariffs on imports during 2025. This means that the p deflation discount rate should be present in the denominator of the PV formula as 0.0295 for decision opportunities contemplated for early 2025 and can be expected to increase in the near future.
Discount rate r is a decimal equivalent between 0.0 and 1.0. It is subjectively specified by the decision maker who judges the riskiness of the decision opportunity, given his or her appetite for risk. A risk-averse decision maker might specify a risk discount rate closer to 1.0, like 0.70, for a decision opportunity. A risk-preferring decision maker might specify a risk discount rate closer to 0, e.g., 0.10, for the same decision opportunity. The lower the value of r that an investment decision maker applies to an investment opportunity that other investors might consider more risky, the greater the risk that he or she is assuming. If the decision maker thinks that an investment opportunity is a "sure thing," the r risk discount rate would be zero. A gambler who would be unhappy if a high-risk investment opportunity were removed from his consideration may apply a negative value for r . For a gambler, even negative values for r are possible.
The r discount rate is opportunity specific. The u discount rate is included in the list of discount factors to reflect the decision maker's general sense of uncertainty and unease about economic conditions. During "normal" times the u rate may be close to zero and effectively disappear from the formula. But with more uncertain conditions, the rate may be much higher, even approaching 1.0. We should note the possibility that u could take on negative values during buoyant economic times characterized by stable prices and on-going economic growth. Negative values for u would reflect general optimism and could render decision opportunities more attractive.
An increase of the sum of 1 plus the four discount rates in the denominators of the present value terms may cause the value of PV to fall for any decision opportunity.
Discount rate i usually is taken to be the best alternative interest rate for which the decision maker qualifies. Discount rate p typically is taken to be the current rate of inflation, but it may differ from period to period if inflation is thought likely to accelerate or decelerate over the life of the decision opportunity.
An ideal economic stability setting for consumer and business decision making in a market economy would entail zero inflation or deflation. The CPI measure of the U.S. inflation rate for 2024 was 2.95 percent (https://fred.stlouisfed.org/series/FPCPITOTLZGUSA). The Federal Reserve has targeted a 2 percent rate of inflation. The CPI is likely to increase with tariffs on imports during 2025. We should note that p could take on negative values if deflation should occur. A negatively increasing p could increase the attractiveness of a decision opportunity.
One of the essential functions of entrepreneurship is the assumption of risk. Business decision makers often think of risk in percentage terms, e.g., a 10 percent chance (risk) that an investment opportunity will fail. The r risk discount rate is subjectively specified by the decision maker who judges the riskiness of an investment opportunity, given his or her appetite for risk. The lower the value of r that an investment decision maker applies to an investment opportunity that other investors might consider more risky, the greater the risk that he or she is assuming. If the decision maker thinks that an investment opportunity is a "sure thing," the r risk discount rate would be zero. A gambler who would be unhappy if a high-risk investment opportunity were removed from his consideration may apply a negative value for r .
The r discount rate is opportunity specific. The u discount rate is included in the list of discout factors to reflect the decision maker's general sense of uncertainty and unease about economic conditions. During "normal" times the u discount rate may be close to zero, but with more uncertain conditions the rate may become much higher and so decrease the perceived value of an investment opportunity. The u rate could become negative if the decision maker is optimistic during buoyant times. A negative value for u would increase the perceived value of an investment opportunity. In response to Mr. Trump's chaos, business decision makers can be expected to apply positive and increasing values for the u uncertainty discount rate to their investment considerations.
These relationships enable explanations of the effects of uncertainty that follow upon Trumpian chaos. They suggest that all four of the discount rates will be increasing. The increasing discount rates may cause decreases in the perceived values of many decision opportunities. All of these decision discount rates presently (April 2025) are pointing toward recession of the U.S. economy.
Trumpian chaos has roiled financial markets, causing a "flight from bonds." As bonds are sold, the supply of bonds coming onto financial markets increases relative to bond demand, causing bond prices to fall and their yield rates to rise. Ten-year U.S. Treasury bond rates are benchmarks against which mortgage and banking decision makers set their lending rates. Increasing rates on ten-year U.S. Treasury bonds lead lenders to adjust upward their lending rates. The increasing lending rates are likely to dampen purchases and investment plans. Uncertainty about the reliability of U.S. Treasury bonds is likely to cause foreign holders to consider dumping their Treasuries, adding to the global bond supply relative to demand. Voila! The falling bond prices and rising i interest discount rates cause estimates of the values of some decision opportunities to fall.
Mr. Trump's tariff rates almost certainly will cause delivered prices of imported merchandise to increase. Tariffs on imported materials, parts, and components will be passed on to consumers of products manufactured using them. The ensuing inflation results in another Voila! The increasing p inflation discount rates cause estimates of the values of some decision opportunities to fall.
Uncertain of the consistency of Mr. Trump's executive orders, business decision makers will adjust upward their estimates of the riskiness of projects that they are contemplating. Yet another Voila! The increasing r discount rates (risk premiums) will cause decreasing estimates of the values of many decision opportunities.
The chaos inflicted on the global economy by President Trump early in 2025 has contributed to a general sense of uncertainty and unease, causing many decision makers to factor uncertainty into their decision making by including and increasing the values of u in their decision thought processes. The higher the u uncertainty discount rates applied by many opportunity decision makers, the more likely the economy will suffer a short-run slowdown and a decreasing rate of economic growth in the long run.
An increase of the sum of the four discount rates may cause the perceived value of a decision opportunity to fall. If a decision opportunity value falls below the outlay necessary to acquire the decision opportunity, or if it falls below the value estimated for any other decision opportunity, the decision opportunity will be rejected. Some planned projects will be shelved. Some projects underway but not yet completed are likely to be suspended. Older manufacturing facilities due for replacement will be shut down and not replaced. Proposed new projects will not be started. Research and development projects whose applications now are uncertain will be cancelled. This is how Mr. Trump's chaos will "stall the economy."
What about consumers who are contemplating purchase decisions? Even if we do not explicitly compute values of prospective opportunities, we implicitly do so as a matter of rational decision making when we ask ourselves whether what we are thinking about purchasing is going to be "worth it."
With all four of the discount rates increasing for decision makers across the world, it is virtually certain that recession will ensue globally, not just in the U.S.
April 20, 2025
__________
Rachel Lerman, "Which Trump tariffs are thrown out?," The Washington Post, 5/29/2025, "After months of upheaval surrounding President Donald Trump’s trade war, and the levies imposed on goods from nearly every country around the world, a court has blocked most of his tariffs. The federal Court of International Trade ruled Wednesday that Trump exceeded his authority in imposing broad tariffs on goods imported from around the world, once again throwing new uncertainty into the future of U.S. trade." (https://www.washingtonpost.com/business/2025/05/29/which-tariffs-struck-down-trump/)
Amber Phillips, "The 5-Minute Fix," The Washington Post, 5/29/2025, "Within 24 hours of that ruling, a second federal court ruled that many of Trump’s tariffs are unlawful. But by Thursday afternoon [5/29/2025], an appeals court said that Trump’s tariffs could temporarily continue while the courts litigated whether Trump overstepped his boundaries on emergency powers." (https://s2.washingtonpost.com/camp-rw/?trackId=596c29ff9bbc0f208654282b&s=6838d74c95e93627b9f56bc0&utm_campaign=wp_the_5_minute_fix&utm_medium=email&utm_source=newsletter&linknum=5&linktot=45")
Adding to the tariff uncertainty, on June 21, 2025, Mr. Trump approved the bombing of nuclear sites in Iran. Tony Romm, writing on The New York Times website on June 23, 2025, surveys the possible "blowback" economic consequences of this action:
A spike in energy costs could prove especially difficult for American consumers and businesses this summer, given that it could arrive at about the same time that Mr. Trump plans to revive his expansive, steep tariffs on nearly every U.S. trading partner. Many economists expect those levies to push up prices after years of high inflation.
(https://www.nytimes.com/live/2025/06/23/us/trump-news#trump-oil-prices-economic-fallout-iran-strike)
43. The Mystery of the Saving Surplus Gap
Macroeconomic concepts of income and expenditure reveal relationships among three deficits. The output of a nation (Y) is the sum of its personal consumption expenditures (C), its gross private domestic investment expenditures (I), its government purchases (G), and its exports (X) less its imports (M), i.e.,
The saving deficit, (I - S), alternately can be regarded as an "investment surplus." The larger the investment surplus the better because investment is the vehicle for implementing new technologies, adding to the capital stock, and generally enhancing the productivity of the labor force. But (I - S) also has a negative implication when domestic saving is inadequate to finance all of the investment that is being undertaken.
A saving deficit can be financed by a combination of budget surplus and trade deficit. But if the budget is also in deficit, there is an even greater burden on the trade deficit to finance both the saving deficit and the budget deficit. How is this "financing" of the saving and budget deficits brought about by a trade deficit? Market economies contain within themselves adjustment forces that are invoked when prices or incomes are too high or too low for equilibrium. These forces of adjustment are the unmet intentions of market participants. Prices are the primary adjusters of the market economy, but if prices change too slowly or are fixed or manipulated by government authority, income (and correspondingly output and employment) will become the shock absorber of the market economy.
The sense of equation (4') is that a combination of a saving deficit and a budget deficit must be financed by a trade deficit. Alternately, a trade deficit can finance either or both a saving deficit and a budget deficit. If the saving deficit is trivial in magnitude, it follows that the trade deficit must be approximately equal to the budget deficit. While it is not clear that either is dominant and the other accommodative, a seemingly safe presumption is that the U.S. government's post-World War II budget deficits resulted from the political process, and that the trade deficits emerged to finance the budget deficits. In any case, during the late twentieth century the two deficits appeared to be twins, with a change in budget deficit eliciting a same-direction (though not necessarily simultaneous) change in the trade deficit.
During the late 1990s, the U.S. government's budget deficits shrank with on-going economic growth (often described in the media as a "torrid pace" that exceeded 7 percent per annum during some quarters toward the end of the decade). By 1999, the U.S. government's budget came close to surplus. A budget surplus may be represented as - (T - G), so that equation (4') may be rearranged as
As the twentieth century wore on to its conclusion, the saving deficits ceased to be trivial. During the last couple of decades of the twentieth century, U.S. gross private domestic investment grew faster than domestic personal saving as officially measured. The official measure of personal saving is disposable personal income (DPI) less consumption spending (C).
Early in the twenty-first century, the measured U.S. personal saving rate approached historic lows even as investment boomed. But net private business saving (undistributed corporate profits) has increased to produce saving surpluses that more than offset the personal saving deficits. The growing saving surpluses have been accompanied by federal government budget deficits of ever-increasing magnitudes. But the saving surplus plus the trade deficit have not been sufficient to finance government's budget deficits.
In theory there are three deficits, the sum of any two of them equal to the third. This implies that the saving surplus plus the trade deficit should be equal to the government's budget deficit. Applying current U.S. data to equation (4') tests the applicability of the theory.
National Income and Product Accounts (NIPA) data at the end of 2024 have been inserted into equation (4') to compose equation (4"). Undistributed corporate profits are recognized as business saving, Sb, in addition to personal saving, Sp. Equation (4") also adds the Capital Account balance, K, to recognize that assets and liabilities are exported and imported in addition to exports and imports of goods and services.
In equation (4"), net private domestic investment ($808.8 bn) exceeds personal saving ($724.1 bn) so that there is a modest saving deficit of $84.7 bn. When business saving (undistributed corporate profits, $1637.7 bn) is added to personal saving, total private saving, $2361.8 bn, exceeds net private domestic investment by a wide margin, $1553 bn. At the end of 2024, the private business sector was largely self-financing its own investment with undistributed corporate profits. While awaiting future investment opportunities, businesses contributed to financing the government's budget deficit by holding much of the business saving in excess of net investment, ($1637.7 bn - $808.8 bn = $828.9 bn) in newly-issued U.S. government securities.
In equation (4"), the 2024 U.S. government's budget deficit was $3942.4 bn. The sum of the domestic saving and and international trade surpluses was ($1553 bn + $909.8 bn) = $2462.8 bn, covering only about 62% of the budget deficit.
For comparison with equation (4"), equation (4"') was composed with data for the end of 2016, a year with a more typical Capital Account balance:
In lieu of data for exports and imports of assets and liabilities, equations (4") and (4"') add K, the balance on the Capital Account in the U.S. Balance of Payments, to the balance of trade in goods and services (M - X) in recognition of the fact that assets and liabilities also are exported and imported. Exported liabilities include financial instruments issued by American companies, financial institutions, and governments that are purchased by foreigners; exported assets include plant and equipment purchased or built by foreigners in the United States. Imported liabilities include financial instruments issued by foreign companies and governments that are purchased by American citizens or legal residents; imported assets include offshored production facilities purchased or built by American companies in other countries.
The market for U.S. Treasury bonds is global in scope because they have a reputation for being safe investments that the U.S. government will redeem at maturity and whose yields are certain. When a foreigner purchases a newly-issued U.S. Treasury bond (a liability of the U.S. government), the ownership of the bond is exported. In paying for the bond, the purchaser supplies foreign savings that contribute to financing the U.S. government's budgetary deficit. Similarly, bonds issued by American companies are exported when foreigners purchase them, supplying foreign savings to the companies to finance investment in physical facilities (plant and equipment).
As shown in Figure 1, the Capital Account balances typically have been in the range of $0 to -$4000 million (net imports of the ownership of assets abroad or increases of liabilities owed to foreigners, both financial and physical). In this range, Americans were acquiring more assets abroad by offshored investments in production facilities than foregners were purchasing in the United States. But occasionally there occurred spikes of net exports of the ownership of assets abroad or decreases of liabilities owed to foreigners as occurred in 2017, 2022, and late-2024. These spikes usually occurred during global market disruptions when foreigners sought asset-holding safety by increasing purchases of U.S. Treasury bonds.
Figure 2 confirms that the totals of assets and liabilities that are held or owed abroad are much greater than the balance on the Capital Account which shows net changes in such holdings.
The U.S. Capital Account balance for 2024 Q4 represents a capital account surplus of $10,206 million, i.e., $10.2 bn. The balance on Capital Account, whether positive or negative, is miniscule relative to the magnitude of U.S. government budget deficits. The Q4 2024 sum of the (M - X) + K international trade surplus of $909.8 billion and the domestic saving surplus (Sp + Sb) of $1553 billion financed (paid for) about 62% of the government's 2024 budget deficit (G - T) of $3942.4 billion, i.e., $3.94 trillion.
Do the government budget and trade deficits behave as twins as Jason Furman wrote in his New York Times column? The numbers in the following table are denominated in billions of dollars.
It is apparent in equations (4") and (4"') that for recent U.S. data the sum of the saving surplus and the trade deficit do not equal the government's budget deficit. These models obviously omit additional sources of saving surplus that help to pay for the government's budget deficit. Additional sources would include anything that reduces consumer spending, C, to increase personal saving, Sp, or anything that increases business saving, Sb.
If investment in equation (4") were taken to be Gross Private Domestic Investment, Ig (instead of Net Private Domestic Investment, In), CCA might be understood to be a form of business saving. With In in equation (4"), CCA allowances that have have been deducted from Ig finance replacement investment rather than government's budget deficits.
In the same way that paying federal taxes constrains consumption spending, paying state and local taxes (income, sales, real estate, personal property) also constrains consumption spending and so yields saving surpluses, But state and local governments capture those saving surpluses for their budgets rather than for the federal budget.
Another constraint on consumption spending is debt amortization payments on outstanding home mortgages, auto loans, and credit card balances. In National Income and Product Accounting, residential construction is included in business investment; housing services, including actual and imputed rents and the interest portion of mortgage payments, are treated as consumption spending (https://www.richmondfed.org/publications/research/economic_brief/2025/eb_25-04). Payments on debt incurred in purchasing consumer goods, houses, and motor vehicles also have the effect of constraining consumption spending over the lives of the debt contracts, thus implicitly yielding a saving surplus. Data for annual totals of debt amortization payments would reveal the magnitude of such an additional saving surplus that can help to finance the government's budget deficit. This type of saving surplus may not be sufficient to fill the saving surplus gap, so yet other types of saving surplus need to be identified.
If there are no other types of saving surpluses to contribute to financing the government's deficits, inflation may force the necessary saving surplus in an economy that is near full employment (as is the U.S. economy with under 5% unemployment in early 2025). To finance its budget deficit, the U.S. government issues claims against itself (bonds). Unless bond demand also is increasing, the increasing supply of bonds on global financial markets tends to depress bond prices and cause bond yield rates (i.e., their interest rates) to rise.
In early 2025, Jerome Powell, the Federal Reserve Board chair, resisted President Trump's urging to lower interest rates to avert recession that may result from the 10% universal tariff regime imposed by Trump. Powell also appears resolved to prevent interest rates from rising to dampen inflationary pressures resulting from the imposition of tariffs. Although the Federal Reserve is prohibited by law from purchasing more than a small amount of newly-issued bonds directly from the Treasury, it can stabilize market interest rates by entering financial markets as a market trader.
The Fed can prevent market interest rates from rising by purchasing "old" (previously-issued) bonds on financial markets. When those purchase transactions have cleared, commercial bank reserves and their lending capacities will have increased. To the extent that banks use their added reserves to increase lending, the resulting money supply increases can be expected to stimulate economic activity. If the economy is already close to full employment (as is the U.S. economy in early 2025), the increasing money supply is likely cause inflation to accelerate.
Voila! Inflation diminishes the purchasing power of citizens' incomes, causing consumer purchases to decrease. All else failing, inflation is the ultimate generator of the saving surplus needed to finance s government budget deficit. The Federal Reserve is complicit in generating an inflation saving surplus if it prevents interest rates from rising when the federal government issues more bonds to finance its deficits. Mr. Trump's universal 10% tariff regime can be counted on to add to the inflation pressure.
Mr. Trump has toyed with the notion that tariff revenue may become so great as to be able to replace the income tax. But a universal 10% tariff rate will raise prices of imports and likely diminish the volume of trade in goods and services, and thus also the tariff revenue.
Mr. Trump regards trade deficits as nuisances to be eliminated with tariffs on imports. Mr. Trump fails to grasp that trade deficits are needed along with business saving surpluses to help finance the government's budget deficits. If he succeeds in reducing or eliminating the U.S. trade deficit, the business saving surplus will need to increase or the budget deficit will have to decrease to compensate for the decreasing trade deficit. If neither happens, inflation will "have its way" with the U.S. economy!
In early-May 2025 the Republican-led U.S. Congress was attempting to compose what Mr. Trump called "a big, beautiful bill" that would extend a tax cut implemented during his first term, further cut taxes for corporations and tax payers toward the upper end of the income spectrum, and decrease the size of the federal government. It appears likely that if passed by Congress the bill will increase the government's 2025 budget deficit.
Even if Mr. Trump's tariff regime succeeds in reducing the trade deficit, it also could reduce the business saving surplus by precipitating recession, causing rising unemployment, decreasing income, consumer spending, and business investment, and increasing the government's budget deficit.
May 11, 2025
Sources: As of December or 4th quarter 2024, billion USD:
Ig, Gross Private Domestic Investment: https://fred.stlouisfed.org/series/W987RC1Q027SBEA
In, Net Private Domestic Investment: https://fred.stlouisfed.org/series/W790RC1Q027SBEA
Sp, Personal saving: https://fred.stlouisfed.org/series/PMSAVE
Sb, Net Private Business Saving (undistributed corporate profits): https://fred.stlouisfed.org/series/B057RC1Q027SBEA
CFC, Consumption of Fixed Capital, Private Domestic Business: https://fred.stlouisfed.org/series/W006RC1Q027SBEA
G, Federal spending: https://fred.stlouisfed.org/series/FGEXPND
X, Exports of goods and services: https://fred.stlouisfed.org/series/EXPGS/
M, Imports of goods and services: https://fred.stlouisfed.org/series/IMPGS
K, Balance on Capital Account: https://fred.stlouisfed.org/series/IEABCP
2024 U.S. Balance of Payments, Financial and Portfolio Transactions: https://view.officeapps.live.com/op/view.aspx?src=https%3A%2F%2Fwww.bea.gov%2Fsites%2Fdefault%2Ffiles%2F2025-03%2Ftrans424.xlsx&wdOrigin=BROWSELINK
The commentaries contained in this blog should have made it clear both that inherent adjustment mechanisms govern international trading and payments systems, and that politically-inspired governmental interventions in those mechanisms both disrupt the normal workings of the mechanisms and may diminish welfare. It is also clear that political expediency often runs counter to the natural adjustment processes, and it may actually result in diminished welfare and constrained growth, both locally and internationally.
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