Chapter OneTrade Imbalances and the Global Financial Crisis
The source of the global crisis through which we are living can be found in the great trade and capital flow imbalances of the past decade or two. Unfortunately because balance of payments mechanisms are so poorly understood, much of the debate about the crisis is caught up in muddled analysis.
Ever since the U.S. subprime crisis began in 2007–8, caused in large part by an uncontrolled real estate boom and consumption binge, fueled in both cases by overly abundant capital and low interest rates, the world has been struggling with a series of deep and seemingly unrelated financial and economic crises. The most notable of these is the crisis affecting Europe, which deepened spectacularly in 2010–11.
For reasons we will see in chapter 6, Europe's crisis will probably lead to a partial breakup of the euro as well as to defaults or debt restructurings among one or more European sovereign borrowers. The only things likely to save the euro—fiscal union or, as I discuss in chapter 6, a major reversal of German trade imbalances—seem politically improbable as of the time of this writing.
But it is not the just the United States and Europe that have been affected. The global crisis has also accelerated pressure on what was already going to be a very difficult transition for China from an extremely imbalanced growth model to something more sustainable over the long term. For political reasons the adjustment had to be postponed through 2012 because of the leadership transition and the need to develop a consensus, but the longer the postponement the more difficult the transition will be.
The events surrounding the ouster from the Politburo in early 2012 of Bo Xilai, the former mayor of Chongqing, show just how difficult the impact of the transition is likely to be on the political elite, who have benefitted most from the existing growth model. But as difficult as it will undoubtedly be, one way or another, for reasons that will be explained in this book, China must make the transition. As a consensus about the need for a radical transformation of the growth model develops, and China begins adjusting over the next two or three years, the impact of the global crisis will probably manifest itself in the form of a "lost" decade or longer for China of much slower growth and soaring government debt.
What's more, a Chinese adjustment will necessarily bring with it adverse and perhaps even destabilizing shocks to developing countries heavily reliant on the export of commodities, especially nonfood commodities. Countries as far apart as Brazil and Australia, that have bet heavily on continued growth in China and the developed world, will be sharply affected when Chinese investment growth, which was ramped up dramatically in 2009 and 2010 after the United States and Europe faltered (and so more than compensated for the initial impact on commodity prices of reduced American and European demand), itself begins to falter. The crisis that began in the United States, in other words, has or will adversely affect the whole world, although not at the same time.
But for all their complex global impact, it is worth pointing out that from a historical point of view there is nothing mysterious about the various crises and their interconnections. For almost any serious student of financial and economic history, what has happened in the past few years as the world adjusts to deep imbalances is neither unprecedented nor should have even been unexpected. The global crisis is a financial crisis driven primarily by global trade and capital imbalances, and it has unfolded in almost a textbook fashion.
There is nonetheless a tendency, especially among Continental European policymakers and the nonspecialized Western media, to see the crisis as caused by either the systematic deregulation of the financial services industry or the use and abuse of derivatives. When this crisis is viewed, however, from a historical perspective it is almost impossible to agree with either of these claims. There have been after all many well-recorded financial crises in history, dating at least from the Roman real estate crisis of AD 33, which shared many if not most characteristics of the 2007 crisis.
Earlier crises occurred among financial systems under very different regulatory regimes, some less constrained and others more constrained, and in which the use of derivatives was extremely limited or even nonexistent. It is hard to see why we would explain the current crisis in a way that could not also serve as an explanation for earlier crises. Perhaps it is just easier to focus on easily understandable deficiencies. As Hyman Minsky explained,
Once the sharp financial reaction occurs, institutional deficiencies will be evident. Thus, after a crisis, it will always be possible to construct plausible arguments—by emphasizing the trigger events or institutional flaws—that accidents, mistakes, or easily correctible shortcomings were responsible for the disaster.
Minsky went on to argue that these "plausible" arguments miss the point. Financial instability has to do with underlying monetary and balance sheet conditions, and when these conditions exist, any financial system will tend toward instability—in fact periods of financial stability, Minsky argued, will themselves change financial behavior in ways that cause destabilizing shifts and that increase the subsequent risk of crisis.
Why do underlying monetary conditions become destabilizing? Charles Kindleberger suggested that there are many different sources of monetary shock, from gold discoveries, to financial innovation, to capital recycling, that can lead eventually to instability, but the classic explanation of the origins of crises in capitalist systems, one followed by Marxist as well as many non-Marxist economists, points to imbalances between production and consumption in the major economies as the primary source of monetary instability.
According to this view growing income inequality and wealth concentration leave household consumers unable to absorb all that is produced within the economy. One of the consequences is that as surplus savings (savings are simply the difference between total production and total consumption) grow to unsustainable levels, and because declining consumption undermines the rationale for investing in order to expand productive facilities, these excess savings are increasingly directed into speculative investments or are exported abroad.
Most economists, including Marxists, have tended to see these imbalances between production and consumption as occurring and getting resolved within a single country, but in fact imbalances in one country can force obverse imbalances in other countries through the trade account. In the late nineteenth century economists like the Englishman John Hobson and the American Charles Arthur Conant, both scandalously underrated by economists today, explained how the process works. Although neither was a Marxist, it is worth noticing that Hobson did heavily influence Lenin's theory of imperialism, and this influence was felt all the way to the Latin American dependencia theorists of the 1960s and 1970s.
Hobson and Conant argued that the leading capitalist economies turned to imperialism primarily in order to export surplus savings and import foreign demand as a way of addressing the domestic savings imbalances. This has become widely accepted among economic historians—Niall Ferguson wrote pithily in his biography of Siegmund Warburg, for example, that "late 19th Century imperialism rested above all on capital exports." So, perhaps, does its modern equivalent. As Charles Arthur Conant put it in 1900,
For many years there was an outlet at a high rate of return for all the savings of all the frugal persons in the great civilized countries. Frightful miscalculations were made and great losses incurred, because experience had not gauged the value or the need of new works under all conditions, but there was room for the legitimate use of all savings without loss, and in the enterprises affording an adequate return.
The conditions of the early part of the century have changed. Capital is no longer needed in the excess of the supply, but it is becoming congested. The benefits of savings have been inculcated with such effect for many decades that savings accumulate beyond new demands for capital which are legitimate, and are becoming a menace to the economic future of the great industrial countries.
Conant went on to say that as we consumed ever smaller shares of what we produced—perhaps because the wealthy captured an increasing share of income and their consumption did not rise with their wealth—domestic savings eventually exceeded the ability for domestic investment to serve "legitimate" needs, which was to expand domestic capacity and infrastructure to meet domestic consumption. This happened at least in part because the excess savings themselves reduced domestic consumption, and so reduced the need to expand domestic production facilities. When this happened the major industrialized nations had to turn abroad. In that case these countries exported their excess savings, thereby importing foreign demand for domestic production.
Like in the past two decades, this need to export savings was at the heart of trade and capital flow imbalances during the last few decades of the nineteenth century and the first few decades of the twentieth century. It was however the most industrialized countries that were the source of excess savings in Conant's day, whereas today the major exporters of excess savings range from rich countries like Germany and Japan to very poor countries like China.
In a 2011 article Kenneth Austin, an international economist with the U.S. Treasury Department, made explicit the comparison between the two periods. He wrote, speaking of the earlier version,
The basic idea is that oversaving causes insufficient demand for economic output. In turn, that leads to recession and resource misallocation, including excessive investment in marketing and distribution. This was a direct challenge to a core thesis of the classical economists: "Savings are always beneficial because they allow greater accumulation of capital."
....Hobson took his excess savings theory in another direction in Imperialism: A Study, first published in 1902. In a closed economy, excess savings cause recessions, but an open economy has another alternative: domestic savers can invest abroad. Hobson attributed the renewed enthusiasm for colonial conquest among the industrial powers of the day to a need to find new foreign markets and investment opportunities. He called this need to vent the excess savings abroad "The Economic Taproot of Imperialism."
However, increasing foreign investment requires earning the necessary foreign exchange to invest abroad. This requires an increase in net exports. So foreign investment solves two problems at once. It reduces the excess supply of goods and drains the pool of excess saving. The two objectives are simultaneously fulfilled because they are, in fact and theory, logically equivalent.
When domestic consumption has been insufficient to justify enough domestic investment to absorb the high savings that were themselves the result of low consumption—usually because the working and middle classes had too small a share of total income, and we will see in chapter 4 how this happened in China—countries have historically exported capital as a way of absorbing foreign consumption. With the exporting of these excess savings, and the concomitant importing of foreign demand, international trade and capital flows necessarily resulted in deep imbalances.
The Different Explanations of Trade Imbalance
This argument, which we can call the "underconsumptionist" argument, is of course not the only theory that explains trade imbalances. There are at least two other theories of trade imbalance that share a number of features but are fundamentally different.
The most common explanation for trade imbalances is "mercantilism." Broadly speaking mercantilist countries put into place policies, including most commonly import restraints and export subsidies, aimed at generating a positive balance of trade in which the country exports more than it imports. The defense of mercantilism is that it permits the practitioner to generate net inflows of assets that can be accumulated for a number of purposes.
It isn't always clear exactly what these purposes are, but the main justification, historically, seems to have been the ability to wage war. During the classic mercantilist age a positive balance of trade resulted in the accumulation of gold and silver, and this hoard of treasure assured the monarch of the ability to hire soldiers and sailors, pay for armaments, and afford costly foreign engagements.
Today, of course, countries are more likely to accumulate assets mainly in the form of foreign exchange reserves at the central bank or in the form of private ownership of foreign assets. The hoard of central bank reserves is driven not so much by military needs as by the need to defend the stability of the currency, maintain payments on foreign loans and obligations, and, most important, guarantee access to imported commodities in times of financial stress.
Although countries like China, Japan, Korea, and Germany have been accused of mercantilism for many years, this particular charge isn't really a satisfactory explanation of what they do and why. Clearly for a highly volatile developing country there are benefits to accumulating a certain amount of foreign reserves. This cannot be the whole explanation, however. Given how domestic monetary policies are distorted by the accumulation of reserves, it is hard to explain why rich countries employ mercantilist policies, or why poor countries like China accumulate levels of foreign exchange reserves that far exceed even the most generous estimate of what would be appropriate. In either case mercantilism simply does not make sense.
A better explanation of what they do, interestingly enough, may be found in what many consider to be one of the classic documents of mercantilism, Thomas Mun's England's Treasure by Foreign Trade, published posthumously in 1664. In his tract, rather than encourage trade intervention simply for the sake of state accumulation of specie, he proposed a much more sophisticated argument, based not so much on direct intervention to achieve a positive trade balance but rather on measures to "soberly refrain from excessive consumption." For Mun, the accumulation of specie would lead to greater availability of capital domestically, and so would lower costs of capital for businesses. It was this lower cost of capital that would promote domestic economic growth.
With this argument we are back, it seems, to a version of John Hobson's underconsumptionist argument. Although Mun didn't state this explicitly, what we often think of as trade intervention, as I will show in chapters 2 and 3, is often just policies that effectively force up a country's savings rate by transferring income from household consumers to the tradable goods sector, thereby creating a gap between GDP growth and consumption growth. By forcing up the savings rate through consumption-constraining policies, these policies lower the domestic cost of capital and encourage investment.
We will come back to this several times over the next few chapters, but it is worth mentioning that countries like China, Japan before 1990, South Korea, and other Asian Tigers are, properly speaking, neither mercantilist nor export driven. They are, as we will see in chapter 4 in the case of China, investment-driven economies. Their large trade surpluses were or are simply a necessary residual of policies that consciously or not forced up the savings rate to fund domestic investment. As I will also show, the subsequent imbalances that are created by structural constraints to consumption can become seriously destabilizing, both for the world and for the countries that employ these policies.
For the sake of completion we should mention that the third theory that justifies trade intervention is the "infant industry" argument, whose most brilliant exponent, and who probably first came up with the phrase, is the first American treasury secretary Alexander Hamilton. In his Report on the Manufacturers to the U.S. Congress in December 1791, Hamilton argued that it was in the best interests of the United States that certain industries be encouraged to develop quickly because the externalities (although of course he did not use this word) associated with these industries were significant:
And if it may likewise be assumed as a fact that manufactures open a wider field to exertions of ingenuity than agriculture, it would not be a strained conjecture, that the labor employed in the former being at once more constant, more uniform and more ingenious, than that which is employed in the latter, will be found at the same time more productive.
The problem, according to Hamilton, was that because British and other European industrialists were so far advanced in terms of productivity and organization, Americans simply would not be able to compete for many years unless the government imposed tariffs on foreign-made goods. The goal of protection, in this case, was primarily to create enough space for American industrialists to catch up to Europeans. Once they did so, the tariffs could be removed.
Although the infant industry argument has been and still is used often to explain trade intervention, it is also an unsatisfactory explanation for current imbalances. Of the three largest surplus nations, two of them, Germany and Japan, can hardly be said to be technologically backward and in need of protection. The third, China, discourages the brutal domestic competition that is necessary to drive technological innovation and productivity growth behind protectionist barriers, so trade protection in China is unlikely to lead to rapid growth in innovation. It is at best an infant industry policy that strangles the infant by trying to create state-protected national champions.