DVD, a blogger, writes:
Yes, the US must go deeper and deeper into debt if it has to issue more and more $ as international reserve currency to the rest of the world that grows faster than itself, if for no other reason than because it is less advanced. This is clear for over 30 years already.
Yes, China – among other countries but on a different scale given it sheer size – has gamed the system in the 1990’s and 2000’s by joining the global trade system while undervaluing its currency relative to the $ and suppressing domestic consumption so as to accelerate its economic development at the expense of the US and of developed countries in general.
But if you are aiming to resolve the situation, it is critical to realize that China has done so under the intellectual authority of anglo-saxon theoricians and with the very interested complicity of Western multinational corporations and banks. US ideologues and big business interests have been China best allies in gaming the system.
You have reminded us that if China sells more goods to the US than it purchases from the US, it ends up with a credit on the US for the surplus. In other words, goods are exchanged not for other goods (via money as a medium) but for credit.
This is very directly in contradiction with the theory which has served and still serves today (you have of course used it in your article) as the justification for the push towards free trade globalisation since the 1970’s, namely David Ricardo’s theory of comparative advantage.
Ricardo’s theory of comparative advantage states that countries will mutually benefit if they exchange finished products for which they have a relative cost advantage, leading to a specialisation of said countries in the production of said finished products, leading to a rising standard of living in all participating countries. This conclusion is reached under the assumption that countries trade finished goods for finished goods, for instance Portugal sells wine to England in exchange for cloth. This goods for goods exchange means that, in Ricardo’s framework, trade balance remain balanced. Said differently, Ricardo’s theory is not supposed to be valid if a country exchange goods for IOUs issued by another country. Oops! In a monetary environment, the corresponding assumption would be that exchange rates are set at levels that, on average, makes the respective trade balance be at equilibrium. There is no doubt that this mutual benefit is the intention of the founding fathers of the GATT as it is explicitly and solemnly indicated in the preamble to the original 1947 agreement. However, to my knowledge, nowhere in the various GATT / WTO agreements that have been signed over recent decades to liberalise international trade is there any mention of the fact that exchange rates should be set at levels that make trade flows balanced across participating countries. The WTO has pushed free trade globalization without any consideration for exchange rates. As if international trade and exchange rates were two completely different things, while of course they are the two inseparable sides of the same coin. Re-oops!
Instead, Milton Friedman theory of floating exchange rates has been added to Ricardo’s theory of comparative advantages as the second intellectual backbone of the push towards trade globalisation in the post Bretton Woods world unilaterally decided by the US in 1971.
Milton Friedman’s theory states that market forces will ensure that exchange rates adjust at levels which, on average, make trade balances balance. This conclusion is reached under the assumption that there is no official intervention in FX markets. Of course, this assumption has never been valid in the real world. In practise, surplus countries recycle their accumulated monetary reserves back into the deficit countries, thereby bidding up the currency of the deficit country relative to their own, thus completely negating the adjustment envisaged by Friedman. Re-re-oops!
So, in the current system, trades flows result in large and persistent imbalances and goods are not being exchange for other goods but increasingly for credit. Like global trade has been growing faster than GDP from the early 1980’s, so has global debt. If this continues long enough, of course debtor countries will eventually reach a point where they are no longer solvent and creditor countries will eventually pay the price by holding worthless bonds. The mutually beneficial outcome initially envisaged by the theory will end up being mutually detrimental in practise. Bravo!
In the meantime, rising debt is a blessing for banks which see the cake on which they charge interest and / or trading commissions grow, further compounded by countless derivatives and repackaging opportunities on these securities. Exchange rate volatility is also a blessing for banks as it means much more commissions on FX trades and related derivatives than in a world of fixed but adjustable exchange rates like pre-1971. Financial profits as % of GDP have increased dramatically since the early 1980’s.
There is more still. Ricardo’s theory also assumes that there is no relative technological change between countries engaged in trade. But, in the current system, US firms can set up in China via FDI with their own equipment, technology and range of intermediary products. Said differently, US firms can import US relative advantage (ie. its modern production technology) to China and combine it with China relative advantage (ie. its cheap labor). At the end, the technological transfer means that the initial relative advantage between countries is altered. China ends up with both efficient production methods imported from the US – which means that its initially lower productivity can quickly catch up – and cheap labor. The overall balance of relative advantages is firmly tilted into China’s favor. Under this condition, it is no surprise that trade becomes unbalanced and that China becomes net exporter to the US. To my knowledge, nowhere in the GATT / WTO agreements is there any restrictions on cross-border investments that alter the initial conditions of production, ie. the comparative advantages in Ricardo’s sense, between participating countries. Re-re-re-oops!
Developed countries multinational firms and their shareholders are happy as the product of this arbitrage (labor costs / productivity x exchange rate) goes straight to their profits. Like global trade has been rising faster than global GDP since the early 1980’s, so has global profits. Symmetrically, global wages have grown more slowly than GDP. Here is the source of the weak aggregate demand. Here is the source of deflationary forces. As discussed in “Economic Consequences of Income Inequality”, soaring global debt has been the price to pay for global demand to keep up with global production despite global labor share of production falling materially.
So, we see that the intellectual foundation and justification for the current international trade and monetary system in place since the 1970’s are very weak and essentially non-existent. Certainly, things have not been working according to these David Ricardo and Milton Friedman theories. They have been contradicted by the facts, either because they are wrong or because they are only correct under certain assumptions that are not met in the real world. Remember, when the theories and the facts are not in accordance, it is always the facts that are correct.
Global trade has not been mutually beneficial. Under-employment (official unemployment + part time for economic reasons + dropping out of labor force for reasons unrelated to demographics + disability) has skyrocketed in developed countries, in parallel with debt. Floating exchange rates, while they have certainly been very volatile, have not pushed trade balances any closer to equilibrium, quite the opposite.
All of this is perfectly understood by all the managers of multinational companies that evaluate precisely all these factors when they decide to set up, acquire a local company or expand in developing countries and assess the “value creation” potential of such a move. Of course, in such a system, the value creation accruing to the shareholders of the multinational companies is compensated by the value destruction for developed countries via the mutualisation and socialisation of jobs losses, salary losses and bad debts losses. That’s why profit share of GDP and total-debt-to-GDP have been rising in tandem on a global basis since the early 1980’s. The system results in private profits being funded by socialized losses. Income and wealth inequality within countries have been soaring since the early 1980’s even as the average gap between countries has been narrowing. Not quite the definition of mutually beneficial.
While all of this is very well understood by managers of large companies (who are in it big time “gaming the system” with China) it remains poorly understood or at least not publicly recognized by many economists (yourself are part of a small minority) and virtually all policymakers that continue to use Ricardo’s comparative advantage and Friedman’s freely floating exchange rate theories as justification for a system that is dangerously unbalanced and leveraged and behaving in complete contradiction to the predicted results. Whether these ideologues and policymakers are completely blind to facts, or whether they are in the pocket of big business, or both, remains a matter of speculation for the time being.
Maurice Allais was already using the prestige of his 1988 Nobel Prize to explain in the early 1990’s what you are now explaining. He was not only ignored but ridiculed despite his explanations making complete sense and never being seriously challenged. In that case, the propagandists know what to do: attack the person if you can’t attack his ideas. By the time what he had long predicted finally occurred in 2008, he was 97 years old and was no longer intervening in the public debate. He became bitter and disillusioned and concluded that “it’s impossible to make the blind see and the deaf hear”. Now, it’ your turn to try. While 2008 might have shaken a few beliefs and might have raised the critical spirit of many ordinary people towards the official party line, you can’t underestimate the interests that you are taking on. You are asking big corporations and big banks to lower their share of profit. Of course, it is in their interest to have a gradual relative drop over time rather than a complete, sudden and absolute collapse as in the early 1930’s but don’t believe that they are so reasonable.
In any case, thank you for yet another stimulating article. Beyond the very clear explanation of the mechanisms at play, what is missing in my opinion is still the same: what is the solution? I mean other than letting the system go to the wall. There is, i think, a way to keep international trade open while preventing the development of debt-funded imbalances and while closing these labor arbitrage opportunities that are eroding aggregate demand and feeding the debt snowball. It seems logical to me that this is where your so far largely descriptive work leads to.
In any case, it is very clear from the on-going response to 2008-2009 that we shouldn’t count on G20 officials to change the system. They are the system. Developing countries officials are happy as they provide jobs for their people. Developed countries officials are happy as they provide profits to their corporate and financial benefactors (who cares if they effectively let down large parts of their population as long as they can plausibly deny it and issue empty words to the contrary?). The world continues to releverage at an even steeper pace than pre-2007 (thanks to China in no small measure), which is precisely the point of the “credit easing” policy applied everywhere. Speculative bubbles are bigger and more widespread than in 2000 ad 2007. Under-employment remains unbearably high many developed countries. Profit share continues to go up. Labor share continues to go down. Income and wealth inequalities are stretched beyond merit. Social tensions are rising. Currency wars are raging. One would be forgiven to think the G20 has been actively preparing the next crisis.
Any chance of resolving this peacefully now rest on people like you with a clear grasp of what’s going on, an understanding of the lessons of history, a passion and a talent for explaining it and the great ability to get an audience.
