Tariffs, vendor financing and beggar thy neighbor trade policy
Normally, we think of trade as a story of spendthrift nations ‘living beyond their means’ and saver nations being productive. In this view, savers are virtuous and spenders are sinful. And the easiest way to see who the saints and sinners are is to look at trade flows. Nations with deficits are sinful spendthrifts. Nations with trade surplus are virtuous savers. But what if it is the capital flows driving all of this? That will completely change how we think about trade relationships.
The title of this post is pretty wonkish. But let me break it down for those of you not versed in trade policy discussions over the past decade. And a lot of what I want to say will focus on capital flows instead of trade flows.
Now, Donald Trump is threatening to impose tariffs on China and other nations to prevent middle-class Americans from losing jobs. He believes China is an unfair trader. And he believes that the threat of tariffs will open China up to US products, bringing back American jobs. Fair enough.
However, the reality is that tariffs won’t get the job done. The imbalances between China and the US are driven by policies in China that suppress domestic consumption. This boosts Chinese saving and creates a flood of money looking for a home to invest. The problem, then, is in capital flows.
The same thing is true for Germany, by the way. German policies suppress domestic consumption in favour of boosting export demand. For Germany, the problem came to a head in the European sovereign debt crisis. But Europe has doubled down on the German model And the European periphery is more like Germany, but at the expense of domestic demand growth.
And so, the solution to this problem is not tariffs, which will hurt growth. It is in policies that encourage domestic growth rather than export growth.
Now, back in the early days after the Great Financial Crisis, a lot of people were talking about the term, “Chimerica”. Niall Ferguson and Moritz Schularick invented the term “Chimerica” in 2006 to describe a mutually-dependent America and China. Americans were the spenders and the Chinese were the savers and producers.
I wrote about a potential murder-suicide in Chimerica back in 2009 to describe the unravelling of that relationship. Eventually, China and the United States patched things up and trade resumed normally. But the same old relationship continued, with the US as the capital surplus nation and China as the capital deficit nation. This capital account framing – the opposite of the usual trade flow framing – is something I will come back to.
Nine years later, here we are, back talking about mutually assured destruction. The US and China are potentially on the verge of a tit-for-tat with tariffs. That’s because when Donald Trump became President in the US, the murder-suicide possibility returned; tariffs lower growth by re-allocating GDP share less efficiently. They are a tax. They tax households by raising the cost of imports. So, a tariff is just a subsidy to local producers, not a job creation machine for the US middle class. And so a tit-for-tat trade war will kill growth and destroy jobs.
It is capital flows driving Chimerica
Normally, we think of this relationship as spendthrift Americans ‘living beyond their means’. Let’s call this framing ‘morality-play economics’ or MPE. In MPE, savers are virtuous and spenders are sinful. And the easiest way to see who the saints and sinners are is to look at trade flows. Nations with deficits are sinful spendthrifts. Nations with trade surplus are virtuous savers.
But what if it is the capital flows driving all of this?
Think of it this way: using MPE, a government creates a policy framework which encourages saving and discourages spending. At the same time, in the economy, there are only a limited number of profitable investment projects one can undertake. And so the balance between domestic savings and investment gets out of whack. The domestic savings far exceeds profitable domestic investment opportunities.
Now, the government could lower interest rates to help ‘unprofitable’ domestic investment appear more profitable. Or maybe the government itself could take on the role of spending some of the excess saving by building bridges to nowhere. It could build shiny, new airports in second- or third-tier cities. And all that spending would boost growth.
But smart capital allocators will come to see all of these projects as ‘malinvestment’, wasted spending. And they will look abroad to make their profit. The result is an outflow of capital in search of a return. That means a capital account deficit.
And given the free movement of capital in today’s global economy, a lot of that capital is going to end up in the largest, most attractive and deepest investment markets. Inevitably, this means the US will be a destination for this ‘global savings glut’.
The global savings glut and US Treasuries
Notice, however, that the wall of money doesn’t have to actually result in real economy investments. Capital allocators could simply park their money in financial assets abroad. And again, large, deep, transparent markets are a haven for this kind of investment. That’s why you have seen so much Chinese investment in Treasury securities and in the securities of US government-sponsored enterprises like Fannie Mae and Freddie Mac.
In China’s case, the currency is pegged. And Chinese vendors sell their US dollars accumulated from trade for Yuan. And since the Chinese central bank is committed to a specific exchange rate, the People’s Bank of China ends up buying the US dollars and increasing their foreign currency reserves. The PBoC then goes out and purchases US Treasuries and mortgage-backed securities, which pay the holder a return much greater than cash.
Former Federal Reserve Chairman Ben Bernanke talked about this ‘savings glut’ more than a decade ago. His conclusion was that the flood of money had driven down interest rates globally. He said:
I will argue that over the past decade a combination of diverse forces has created a significant increase in the global supply of saving–a global saving glut–which helps to explain both the increase in the U.S. current account deficit and the relatively low level of long-term real interest rates in the world today. The prospect of dramatic increases in the ratio of retirees to workers in a number of major industrial economies is one important reason for the high level of global saving. However, as I will discuss, a particularly interesting aspect of the global saving glut has been a remarkable reversal in the flows of credit to developing and emerging-market economies, a shift that has transformed those economies from borrowers on international capital markets to large net lenders.
How central banks influence interest rates
Of course, this thinking caused Bernanke to dismiss the inversion of the US Treasury yield curve as a sign of impending economic weakness. And so, the Fed continued to raise rates right up until the yield curve inverted. That’s something I wrote about yesterday.
However, let’s remember that the savings glut is not a good excuse for dismissing a flattening yield curve. And that’s because when a seller wants to sell Treasury securities, it will transact at a price that reflects the market view for expected future federal funds rates. Buyers will step in at the price that the market collectively deems appropriate given likely future overnight rates.
After all, if a savings glut was depressing yields globally, why wouldn’t it depress rates right across the curve including short-term yields too? Foreign central banks aren’t buying only long-dated US government paper.
The currency is the release valve. If the currency is free-floating, the ‘savings glut’ depresses the domestic currency and bids up foreign currencies as capital looks for a home abroad. In China’s case, the currency is pegged. So, a lot of the Chinese external account imbalance is currency-related.
Vendor financing in the eurozone
Morality play economics that encourages excess savings doesn’t just create external imbalances though. The mercantalism of MPE also represents a vendor-financing relationship. You buy my stuff and I’ll take your credit. Or I’ll take your money, which is just a government IOU, another form of credit.
That’s what China is doing with the US. But it is also what the eurozone was doing internally which led to the sovereign debt crisis. And it is what the eurozone is doing externally now with the rest of the world.
I wrote about this in 2011. Before the sovereign debt crisis, the eurozone was one giant vendor financing scheme. The surplus euro nations essentially gave the deficit euro nations credit. And after the Great Financial Crisis, those deficit nations ran into problems paying that credit back.
So what did the Europeans do?
Internal devaluation comes to Europe
Because the euro is one currency area, devaluation was never an option. Default was one option. But Europe has mostly avoided this outcome. Instead, the EU has forced the deficit nations into ‘internal devaluation’ policies to pay back the credit they had taken on. That means suppressing domestic wages and consumption, and, thus lowering growth but making good on their debt.
In the meantime, the European surplus nations like the Netherlands and Germany have not become more free-spending. MPE says this is reckless. How did former Dutch finance minister Jeroen Dijsselbloem put it? “I can’t spend all my money on liquor and women and afterwards expect your support.”
So the deficit nations became more ‘virtuous’, with the surplus nations remaining ‘virtuous’. Voila, we now have a massive eurozone current account surplus.
Source: Trading Economics
The area’s current account has gone from basically balanced to deeply in surplus. And of course, Germany, the largest eurozone economy, has the largest current account surplus in history.
Where do we go from here?
I don’t like morality play economics. I am sure that’s clear from everything I have written here. But I am not going to suggest alternatives. And that’s simply because I don’t believe it’s worthwhile doing so. MPE is deeply engrained in the psyche of too many people making public policy to dislodge it.
So instead of a suggestion, let me make a prediction. I predict that China will attempt to speed up its move to a consumption-led economy. And by doing that, perhaps it can avoid an all-out trade war with the US. Xi Jinping has already made conciliatory statements on this front. So I am optimistic that we have not yet arrived at a murder-suicide moment for Chimerica.
At the same time, I am not optimistic about Europe’s desire to bolster domestic demand. MPE is so deeply engrained in the eurozone that even socialist politicians like Jeroen Dijsselbloem follow its model. So I see the European current account remaining positive. In fact, I see the eurozone’s current account surplus potentially increasing.
Right now, this is mostly sustainable on a political level. We are still in a global growth phase. But we are very late in this cycle. And when the economy turns down, that’s when the acrimony will be greatest. And that’s when I would worry about really bad outcomes.