Editors note: Ken Austin, a former treasury official, explains the intricacies of capital flows, exchange rates, and the trade deficit.
Blame U.S. Policies – Starting With Tax Laws
By Ken Austin
For over 15 years, the United States has been locked in an escalating and seemingly endless trade war with political allies and adversaries. The ostensible cause is what American officials call, with varying degrees of fervor, “currency manipulation” or “unfair trade practices.” Whatever the cause, the consequences are obvious. U.S. trade deficits helped hollow out its industrial capacity and substantially reduced job creation during this century.
Economics, unlike physics, has few universal and eternal laws. But one such law is that trade imbalances must equal their financing. That cannot change. One thing that has changed over the last century is the direction of causality. Today, America’s trade deficits are caused by large and persistent inflows of foreign financing. Because the economics profession has lagged behind events, the perceptions of policy makers and the public are misguided.
Americans, including President Trump and his advisors, do not realize the role U.S. policies play in creating American trade deficits. Nor, apparently, do they appreciate that they can reverse the process unilaterally. Those countries who abused the system, to America’s economic detriment, walked through an open door. However, it is actually the American Government that left the door open and adamantly refuses to allow it to shut. The best examples are perverse tax incentives, such as 26 CFR §1.895-1 and 26 U.S.C §871(h)(1), which provide tax breaks to foreigners that increase the trade deficit. We even attract these inflows by helping foreigners conceal their American income from their own tax authorities. Nobody’s fault but our own.
FINANCIAL FLOWS AND TRADE IMBALANCES
Non-economists, if they think about it at all, might believe that international financial and trade flows are unrelated to one another. Nothing could be further from the truth. Without financing, the only way to pay for imports is with exports and the only way to accept payment for exports is by accepting imports: trade must be balanced to the penny.
We intuitively understand that if we spend more than we earn, we must borrow the difference. What is very surprising and counterintuitive is that trade surpluses must be financed by lending the difference. If a trade-surplus country spends all of its export revenues on imports, its trade surplus vanishes. That is why trade surpluses must be financed. But the exporter keeps any export revenue, even as dollars saved under mattresses, that is a form of lending. (Look at the cash in your wallet. “Federal Reserve Notes” are debts of the Federal Reserve System, a U.S. Government agency; the greenback is a loan to the U.S. Government.) If, and when, the exporter spends the cash, it calls in the loan. Conversely, if a foreign country wishes to save dollars (or repay dollar debt), it must run a trade surplus to obtain the dollars.
When foreigners lend to America, they exchange their own currency for dollars or use their dollar export earnings to buy U.S. bonds or make deposits in U.S. banks. This finances the U.S. trade deficit and, by one mechanism or another, the trade deficit will adjust to match its financing. Most commonly, the financing raises the relative value of the dollar and American goods, and makes American manufacturing less competitive.
Subsidies, trade deals, import quotas and tariffs can change the commodity composition of trade, protect key industrial sectors, and alter bilateral balances, but cannot reduce trade deficits unless they reduce financial inflows. Similarly, one cannot have net financial inflows without incurring trade deficits. Assertions to the contrary are fantasy.
SAVINGS AND INVESTMENT
What distinguishes capitalism from other economic systems is its ability to mobilize savings into productive capital (goods and services that produce more goods and services); hence the name “capitalism.”
Capital investment, and the technologies embodied in it, have been major drivers of economic growth for at least the last 300 years. Not only does capital contribute to the income of its owners, but according to standard economic growth theory, it increases the productivity and income of workers, as well as labor’s share of total income. Thus, the more capital that is accumulated, the greater the general prosperity.
“Investment” is defined here as spending on productive capacity. This strict definition excludes many things called “investment” in common parlance. Buying existing capital or land simply transfers the ownership of capital, rather than creating more. Paper investment, buying financial assets, including loans, bank deposits, stocks, and government or corporate bonds, only transfers money (purchasing power) to someone else. If you “invest” in a bank certificate of deposit, you don’t buy goods. You just lend money to the bank, which may or may not use it to finance productive business investment. Instead, the bank may just finance the purchase of imported cars. These things do not meet the strict definition of investment.
“Saving” is that portion of production and income that is not immediately consumed. It provides the financing and resources to create capital. Low saving restricts investment.
Economists have traditionally regarded capital and savings as perpetually scarce. “Tradition” is used literally here, “the transmission of customs or beliefs from generation to generation, or the fact of being passed on in this way.” Historically, capital scarcity was the normal condition of society as observed by the classical economists, such as Adam Smith. Over the generations, capital scarcity has become essentially folk wisdom among many economists and policy makers.
This has important policy implications. If saving rates are low, then policies that boost savings promote growth. Such policies match the self-interest of those who need to save or normally are able to save a very large proportion of their income and those who derive a large portion of their income from previous savings (including inheritances).
TOO MUCH SAVING
But historical conditions may not be eternal conditions. Until the Great Depression and John Maynard Keynes, any economist who doubted the “more saving is better” doctrine was considered a crackpot or heretic. But in a Keynesian world, high savings are a risk. Invest them all, and the economy thrives and grows quickly. Fail to invest them all and the economy may stall. Keynes’ General Theory argued that an increase in collective saving (spending less) can reduce the need for additional productive capacity. Thus, an increase in saving might actually reduce investment. Money is withdrawn from circulation – tipping the economy into recession.
Even some investment is problematic. Business inventories count as investment. If inventories of unsold goods build because of weak sales, firms will cut production (and payrolls). Similarly, if business optimism results in over-investment and losses, then firms may pull back. Only profitable investment is sustainable.
If capital and savings are scarce, these problems and ensuing recessions are usually temporary and mild. The standard Keynesian remedy for recession is fiscal policy: the government borrows and spends the surplus savings. Borrowing and spending is the opposite of saving: dissaving. So the government’s dissaving cancels out the private sector’s surplus saving. But governments fear that high levels of debt are unsustainable.
GIVE US YOUR TIRED, YOUR POOR, YOUR SURPLUS SAVINGS
There is an alternative to recessions: vent the surplus savings abroad. If there are capital scarce countries, this can work out well. As the stream of surplus savings flows (is lent) from one country to the next, two things happen. Most or all of the savings can be channeled into new, productive investment in the (willing) recipient country. Simultaneously, the lending will finance (cause) trade imbalances. The lending country runs a trade surplus and the borrower runs a trade deficit. The trade surplus transforms the lender’s surplus goods and savings into exports. The trade deficit will allow the borrowing country to temporarily consume and invest beyond its own productive capacity. This can be mutually beneficial for both countries. But what if, globally, there are not enough qualified and willing borrowers to absorb the surplus savings?
In 2005, Ben Bernanke, prior to becoming Federal Reserve Board Chairman, coined the term “Global Savings Glut” to explain of America’s unprecedentedly large current account deficits. Bernanke described his analysis as “somewhat unconventional,” although it was actually just a consistent application of textbook theory. He stated that the root cause of U.S. current account deficits was surprisingly high levels of savings in some developing countries, primarily Asian, that pursued export-led growth strategies. Bernanke argued that because the origins of the problem were external to the United States, there were few effective U.S. policy responses available. America, and other trade deficit economies, needed to endure and wait for poorer countries to resume their theoretically expected role of international borrowers.
The analysis was accepted by most mainstream economists. A cynic might argue that this was because Bernanke had not challenged the norms and conventions of polite economists and had avoided advocating any difficult policy decisions. Thus, the status quo would not be disrupted.
We now know that the adverse consequences of these savings inflows on the U.S. would manifest themselves in the Great Recession and Financial Crisis. This happened with a speed and scale that none would have guessed two years earlier in 2005. The trade surplus countries had not only transferred their surplus savings to the United States; they had transferred the consequences: financial imbalances and a powerful recessionary impulse.
If the idea of surplus savings seems counterintuitive, desiring a trade surplus should be even more counterintuitive. First, a trade-surplus country consumes less than its income allows: it has a lower standard of living. Second, asserting that a trade surplus is good is the logical equivalent of “there is an economic benefit to exporting savings (lending to the rest of the world).” If economies always need more savings, then exporting precious savings is a burden. So, a trade surplus cannot be good if an economy actually needs the savings. The true benefit of the trade surplus is the economic stimulus that comes from exchanging the surplus savings and getting the foreign customers. In short, if a country cannot productively invest its savings they are toxic industrial waste that causes recession.
THE DOLLAR’S ROLE AS “EXORBITANT PRIVILEGE”
The dollar plays several international roles. Because the dollar is commonly used in international transactions, international contracts are denominated in dollars, American individuals and firms conveniently avoid changing money. That role is what allows the United States to impose economic sanctions on countries like Iran. These other roles are often conflated with the dollar’s reserve currency role, but the dollar’s reserve currency role strictly speaking, only means that foreign central banks buy and hold dollars. The direct effects are lower U.S. interest rates, an overvalued dollar and trade deficits. The indirect effects may include instability in American financial markets when interest rates become too low and liquidity too great .
Some call the dollar’s reserve role an “exorbitant privilege.” No one else wants that “privilege.” It’s the same con that Tom Sawyer used to get the other kids to do his work, paint his fence, and pay for the honor. It was amusing, but Tom played them for fools. Is it really a privilege or just a vain man’s status symbol? Is everybody else happy to let us have the honor of sitting at the head of the table so that we can pick up the check? Is it really a privilege to borrow and spend the money instead of earning the money yourself by making the things you spend on?
A contrary analysis is offered by Hank Paulson, George W. Bush’s last Treasury Secretary. Paulson was in command from 2006 until through the initial stages of the Great Financial Crisis in 2007-8. He enumerates the benefits of the dollar’s role as the primary global reserve currency as lower interest rates, more liquid financial markets, cheaper funding for American banks, and the ability to run larger trade deficits. The first three pump up the financial system’s profits until they trigger a crisis. The trade deficits slow the economy, decrease employment, and hollow out the industrial base (or just moves it to China). Paulson does not acknowledge the consequences of the dollar’s role. Or maybe we could speculate that Paulson has to say those are good things because they happened on his watch. Or possibly Paulson’s history at Goldman Sachs blinds him to American interests other than his own.
WHY AMERICA CANNOT JUST STOP BORROWING
President Trump rails against trade deficits. It is in U.S. economic interests to stop borrowing. So the continued borrowing seems paradoxical. The short explanation is other countries want to lend and rid themselves of surplus savings. A complete inventory of reasons for the ongoing American borrowing would be rather long and complicated. So, let us focus on two reasons, especially a very surprising one.
Reason #1 is that the mechanics of international borrowing and lending, especially in the U.S. case, are very different from the individual and private credit transactions with which we are all personally familiar. A private credit transaction is a deliberate and consensual act by both borrower and lender. However, Uncle Sam does not go to the People’s Bank of China and fill out a loan application.
Instead, anyone not under U.S. Government sanctions can put their savings in the American financial system unimpeded. Foreigners have more options than burying their dollars in coffee cans. For example, they can buy U.S. stocks or bonds (using their savings to exchange bank deposits for stocks or bonds) or they can just deposit their savings in U.S. banks. The transferred savings will earn income as well as finance their trade surpluses and America’s trade deficits. Private foreign individuals may not care about trade surpluses. They may send their money abroad because it is the proceeds of criminal activity, to earn a better return, because they cannot find suitable investment opportunities at home, or to evade taxes. For any reason, that they save their money in America, foreigners choose to lend to us and thereby deciding that we will borrow from them.
Foreign governments may want trade surpluses for economic policy reasons. They can intervene directly to maintain their trade surpluses by buying dollars and safe American financial assets, such as Treasury bonds. This finances their trade surpluses and keeps the U.S. dollar prices of their currency and exports cheap. This is called “exchange-rate management,” or less favorably “exchange rate manipulation.” This transfers surplus savings to the American seller of the bonds as a bank deposit. The bond is essentially a loan from the foreign government to the American bond issuer. If the surplus savings could not be invested, that problem and its consequences, have been relocated to America. Again, the decisions are made externally without regard for the needs of the American economy. The U.S. Government passively accepts those decisions and tries to adjust and compensate as best it can, often by running larger budget deficits.
It cannot be over-emphasized that it is misleading to call this transfer of savings “investment.” Very little of this money actually finances productive investment in the United States such as factories or office buildings. Even what the United States statistically classifies as “Foreign Direct Investment” (FDI) is largely something else. Only four percent of FDI involves the establishment or expansion of U.S. businesses. The rest is “paper investment,” largely bank deposits used to acquire control of existing U.S. businesses and their capital.
The U.S. Government has actively refused to prevent or regulate these inflows. Doing so would require a full re-examination of conventional economic doctrine. Mainstream American economists, on both sides of the political spectrum, have championed free movement of “capital” across borders. Often the issue of free capital movement is conflated with the issue of free trade. But the two are not the same. David Ricardo’s Theory of Comparative Advantage was about balanced trade. He never attempted to prove the benefit of free global finance.
When the post-Second World War financial system was created, Keynes strongly advocated stringent controls on capital movement. The International Monetary Fund’s (IMF) Articles of Agreement include an explicitly enumerated right to control flows of international capital. But the United States, then the world’s paramount exporter and industrial power opposed restrictions. Over time, the U.S. position predominated. Just prior to the Asian Financial Crisis of 1997, the U.S. and other industrial countries nearly succeeded in restricting the formal right of IMF members to use capital controls. But whatever the written rules, the unwritten rule prohibiting restrictions on international capital movements has been vigorously enforced with a few grudging exceptions for developing countries.
America’s position is constant from each presidential administration to the next, regardless of party. In this respect, America has shunned the routine hypocrisy that defends the self-interests of nations. Donald Trump is obsessed by the trade deficit and resulting deindustrialization of America. It proclaims an “America First” policy. Yet, the U.S. Treasury’s institutional bias for a “strong” (i.e. overvalued) dollar endures. This allows other countries to do the opposite. They undervalue their currencies to make their exports cheaper. Consequently, American wares are overpriced and uncompetitive on world markets and its factories can no longer stay in business. U.S. trade negotiators seem unaware that the financial inflows prevent any adjustment the exchange rate or trade deficit. While the Trump Administration seems to delight in violating many of the norms and conventions of American politics, including those of the old Republican Establishment, it has not actually challenged the intellectual inertia of America’s policy elites.
TAX SUBSIDIZING TRADE DEFICITS
Reason #2: Foreigners get preferential access to our financial system. A surprising reason that foreign money pours into the United States and finances our trade deficit is that American tax law subsidizes it! Putting your money in America instead of your home country is far more attractive because, if you do, you don’t have to pay U.S. taxes. As a bonus, the American Government often avoids reporting the income to your home country tax collectors (and sometimes the criminal authorities).
26 CFR § 1.895-1 exempts income of foreign central banks on obligations of the United States. Central banks (including China’s and Japan’s), buy and hold foreign financial assets as reserves when they want to manipulate their exchange rates. It’s one of the definitions of exchange rate manipulation under U.S. law. While the President fulminates and many Democrats hyperventilate over exchange-rate manipulation, 26 CFR §1.895-1 tax subsidizes it.
While it is difficult to know how much revenue repealing a tax break can produce, a quick back-of-the-envelope estimate generates a nice, round number. Foreign central banks hold roughly $5 trillion in U.S. reserves. Using the 2.5 percent average interest rate on U.S. Treasury obligations, that produces $125 billion in income. A 30 percent tax rate generates $37.5 billion (about a quarter from China and Japan each). Of course if foreigners stop keeping as much money in America, we might collect less tax revenue, but then the trade deficit will shrink.
26 U.S.C. § 871(h)(1) exempts portfolio interest income received by nonresident aliens from sources within the United States. If an American owns a corporate bond, she gets an IRS Form-1099 and pays taxes on the interest. But if she sells it to a German, the interest income disappears from the U.S. tax base and is no longer reported to the IRS. In fact, to the dismay of many other governments, the United States does not generally reciprocate the type of information gathering and sharing it demands for its own tax authorities. So that income is effectively tax free. Think-tankers on the left have criticized this provision on fairness and tax evasion grounds, but the deleterious economic effects are not fully appreciated. These exemptions are granted to foreigners who can’t even vote in U.S. elections. It chews up a large portion of the U.S. tax base and complicates tax administration. It incentivizes foreign lending into the U.S. financial system.
Ironically, although U.S. policy in recent decades has consistently opposed capital controls (controls on international financing and investment), a residency-based tax provision like §871(h)(1) is a capital control. Nobody notices that it is a capital control because we are aiming the gun backwards and defeating our own economic objectives.
Today, financing that the U.S. economy does not need flows in from foreign economies that need it even less. It causes our trade deficits. The inflows can harm the financial sector as much as the industrial sector. U.S. interest rates are at, or near, historic lows. American savers suffer (especially retirees living on their savings). Economists worry about the “zero lower bound” rendering monetary policy ineffective. And the Fed worries about ultra-low interest rates triggering financial instability. And yet American tax policy subsidizes this!
In fairness, under old, fixed-exchange-rate systems or when capital was scarce, these measures may have served legitimate national interests, even if at other countries’ expense. But today they are obsolete and destructive government economic interventions. Eliminate them and America’s trade imbalances will shrink. We have met the enemy and he is us! For America, that is good news.
Why is it good news for America? Because China and Germany have conflicting interests and no compelling incentive to help. However, America has the incentive and unilateral means to act on its own. No need to seek the cooperation of other governments. America’s problem is that we don’t even understand the consequences of our own tax code.
Ken Austin is a recently retired international economist for the U.S. Treasury Department’s Office of International Affairs. He is the author of American trade deficits and the unidirectionality error.
The term “trade deficits” is used throughout here for the sake of simplicity. The more inclusive term “current account,” includes other transactions and services, but is less intuitive for non-economists.