Of trade deficits and capital surpluses

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In the middle of 2020, foreign investors owned a little more than $13 trillion more of US assets (stocks, bonds, and brick-and-mortar) than Americans owned of foreign assets.  It is the other side of chronic current account deficits, the broad measure of trade.  By this measure, the US is the world’s largest debtor.  It spurs much teeth-gnashing angst for reformists of all stripes.  

Not so fast, says Michael Pettis and Matthew Klein in their book, “Trade Wars are Class Wars.”  They tell us that the problem is not that the US lives beyond its means, but other countries, especially Germany and China, suppress domestic-demand and buy US financial assets instead of US goods.  It produces an overvalued dollar that aggravates the trade imbalance and spurs financial crisis. 

The book is another contribution to the literary genre that externalizes America’s problems and blames others for the US’s challenges.  The genotype can be traced to the founding of the country.  Some historians have even suggested that US slavery was commercially successful and sustainable because of the UK’s demand for cotton.  In this vein, the American Civil War is understood as the third war for independence from Great Britain.  And we thought Brexit was a drawn-out affair.  

Whether in the great game of international relations or our personal lives, blaming others generates heat but not much light.  It may assuage the ego, but the course of action that follows is suspect.  On a personal level,  blaming the other produces resistance and defensive formations.  Psychologists do not recommend such a course.  One is encouraged to take responsibility and change the things within ourselves, rather than lecture the other on what s/he should be doing.  In international relations blaming others for harm is the fodder of wars, cold and hot.  The US is among the richest and most powerful countries in the world.  The gap between it and the rest of the world has been reduced. Still, in absolute terms, the US economy had never been bigger than on the eve of the pandemic, and unemployment and underemployment were the lowest in a generation.  The cloak of victimhood does not rest easily on the US shoulders.  

Klein and Pettis seek to reverse centuries of precedent driven by realpolitik.  The burden of the adjustment process falls to the debtor, not the creditor. This was a critical issue at Bretton Woods, for example.  Keynes defended the interests of the debtors.  He famously lost to Harry Dexter White, the US chief negotiator who defended creditors, chiefly America.  

Now that the US is a net debtor and a seemingly ever-increasing one, its stance must change, and the authors provide the narrative.  They complain of the injustice of the creditors, i.e. creditor countries suppress domestic demand, export their surplus, and recycle the proceeds into the US dollar and Treasuries, creating an overvalued dollar and low-interest rates, which spur serial financial bubbles.    

The book ends with an endorsement of Keynes’ bancor.  At the Jackson Hole confab in August 2019, former Bank of Canada and Bank of England Governor Mark Carney resurrected Keynes’ bancor and modernized it to propose a digital reserve asset backed by the major countries to supplant the dollar, and claimed in America’s heartland that the greenback was a “destabilizing” force.  It is splendidly politically naive.  What made Bretton Woods possible was most certainly not a kumbaya moment.  Rather, it was the asymmetries of power that allowed the hegemon to insist on new rules of engagement and the construction of post-war institutions that embodied its interests as the chief creditor. 

It is like Aesop’s fable about mice being terrorized by a cat.  The mice have a town hall meeting to look for a solution.  After much debate, one mouse shared a brilliant idea.  “Let’s tie a bell around the cat’s neck, and whenever it was nearby, we would hear it.”  The proposal was met with much favor and applause until a volunteer was sought to tie the bell to the cat.  

The many Americans who still feel uncomfortable with the idea of classes can rest assured that the class war that the title refers to is not so much a US phenomenon as it is about German and Chinese society. Indeed, the authors do not even take up the United States proper until chapter 6 (“The American Exception The Exorbitant Burden and the Persistent Deficit”) three-quarters of the way through the text.   Even then, there is little analysis of US society.  It is mostly devoted to capital market developments. Indeed one learns more about the credit booms of the 1820s and the financial crisis of 1873 and how China wrestles with the excesses of its rapid modernization that has seen per capita GDP increase by more than eight-fold in a generation than about the class antagonisms in the US. 

Despite the rave reviews, the absence of two words captures my broader argument.  Gini, which is a measure of income disparity, and Reagan, the US 40th President who presided over the shift from current account surplus to deficit, are completely missing. The “class wars” in the title is a form of click-bait.  The authors are not really interested in class analysis of German, Chinese, or American society.  They do not look at the disparities of income, wealth, or power.  Practically no time or effort is spent on analyzing the institutional strength of labor or capital. There is no assessment of unionization or strike activity or mass demonstrations.  

From reading Pettis and Klein, one would never know that medium and large German businesses must have labor representatives on their supervisory boards (up to half, which are responsible for strategic decisions include investment and senior hiring decisions, are elected by workers). Unheard of in the US, German workers also elect representatives to “work councils” that deal with the day-to-day decisions, like overtime pay, major layoffs, and evaluation.  Surely this would be included in a serious analysis of German class relations.  

The Gini ratio moves between 0 and 1, with the higher the number associated with greater income inequality.  According to this McKinsey Report, Germany may have a higher GINI ratio than the US, though it is not significant. Through progressive taxes, income distribution post-tax in Germany is less unequal than in the US.

It is difficult to talk about class wars without defining class.  Of course, there are many other ways to talk about class than the Gini Index, but the authors do not discuss them.  Ultimately, the authors vulgarize the concept of class by simply using it as a proxy for the macroeconomic identity that equates the current account with the investment-savings balance.  A country with a current account surplus has excess savings because consumption is repressed, we are told.  And therein lies the class war that is expressed as a trade war. 

We also know that the return on capital in US companies typically runs higher than on European and Japanese companies.  This is one of the considerations leading to the consistent outperformance of US shares for a generation.  

This is not what one might expect if the German current account surplus were a sign of the repression of German workers and the ability of  German employers to extract surplus profits.  Not to put too fine a point on it, but the current account position tells us nothing about the state of the class struggle.  Sometimes the current account doesn’t even tell us much about trade.  For example, Japan often runs a trade deficit but a current account surplus driven by investment income (the return on past investment).  Conflating class wars and trade wars distract us from real class issues that the pandemic appears to be exacerbating.

The fact that the US habitually experiences a current account deficit sheds no light on the struggle between the haves and have-nots in absolute terms or in comparison to Europe.  The demonstrations over the summer in the US is a more accurate indicator of the racial and class divisions in America.  And it doesn’t matter a whit that the cell phones used to mobilize and communicate during these rallies were assembled with parts made in more than 40 countries or that the profits are booked in a low-tax country, like Ireland or that the executives’ private wealth may be managed out of South Dakota for the most “tax-efficient” structures.  Some have argued that the US current account deficit results from pursuing faster growth than other high-income countries, reflecting the US elite’s preference to run the economy hot — to ensure a growing pie that lessens the fights over its distribution. 

Pettis and Klein do not have anything insightful to say about class and confuse accounting functions for class antagonisms.  While they show great appreciation for historical developments, they singularly fail to appreciate the origins of the current international political economy.  This gets to the heart of my substantive criticism:  How can one offer an interpretation of current events, global imbalances, and trade-wars without mentioning Reagan even once?  

In my telling, Thatcher and Reagan are central to understanding the developments of class antagonisms and trade for the last forty years. I argue that political and ideological forces associated with Reagan and Thatcher emerged as the solution to the crisis of the late 1970s and set the broad course that ended with the Great Financial Crisis.  It represented an offensive that broke the shackles and liberalized capital. The social contract that had allowed men’s wages to keep up with inflation was shattered.  With the state-led defeat of miners in the UK and air traffic controllers in the US, a dramatic blow was dealt to organized labor, the one institution committed to raising wages and living conditions for millions of workers directly and even more indirectly.  

The surplus savings that Pettis and Klein argue are the result of the suppression of demand in Germany and China have deeper roots. The Political Economy of Tomorrow is grounded in the tradition that sees the distribution of power and absorption of the surplus as the central challenge of capitalism.  Market economies have demonstrated an amazing ability to reform and integrate (co-opt) opposition.  Many of the ills that were thought to be necessary for capitalism, like slavery in the southern part of the US,  limited political rights for women, the near-total disregard for the environment (negative externalities), and child-labor, turned out were not so essential after all.  

The most profound challenge of capitalism does not arise from its weaknesses that can be reformed away.  Harnessing our species creative and productive forces, capitalism creates wealth on a scale unimaginable in previous eras.   Its strength is its greatest weakness.  

On one level, the Political Economy of Tomorrow (2017) is a retelling of the King Midas’ myth that school children still learn.  In Greek mythology, sometimes the gods would punish someone by granting their wish.  Midas was the original miser.  He wanted everything he touched to turn to gold.  It was fine at first, but then he hugged his daughter and tried drinking some wine.  He choked on his wealth, and so are we.  

The story I tell begins in the late 19th-century in the US.  My protagonist is a journalist, a banker, a monetary fixer for presidents.  And by a weird quirk of fate, Charles Conant worked at Brown Brothers, a little more than 100 years before I did.  Conant is the “missing link” as it were between Marx and Keynes, between “foreign ideology” and Americanism.  

Conant understood that the repeated economic crises of the last third of the 19th-century resulted from the creation of a national economy post-Civil War that produced a surfeit of goods.  In part, the overproduction of goods stemmed from the changing balance between fixed and variable costs in favor of the former. Market logic dictates under conditions of high fixed costs that production is maintained even at a loss.  The surplus production resulted from a surplus of capital, what Conant called “congestion” and “ruinous competition.”

He proposed a two-prong strategy.  The first was an increase in government expenditure (to be financed through borrowing), including extensive infrastructure efforts, such as improvements in education, proper sanitation, highways, and public buildings. Conant advocated the creation of a social safety net with something like Social Security.  Appreciating that this may not be sufficient to relieve the capital congestion,  Conant advocated a great international infrastructure effort.  Yes, the Belt Road Initiative was Conant’s second prong with American characteristics.  

It was not inevitable and took much fighting, but Conant carried the day, or should we say century? The Open Door Notes (1899-1900), penned by Secretary of State John Hay (who had been Lincoln’s secretary), began codifying Conant’s broad international strategy in the specific application to defending the territorial integrity of China from Japanese and European powers carving it up into spheres of influence.  It took the Great Depression for Conant’s domestic strategy to be adopted and federalized in the New Deal, and WWII and Bretton Woods to successfully institutionalize and globalize the Open Door.  

In effect, the American Century was the evolving rules of engagement for global competition among the largest countries and created new public goods for lesser developed and poorer countries.  Bretton Woods was not particularly liberal in the modern understanding.   Interest rates were capped, exchange rates were fixed, and capital mobility was limited.  It ultimately proved too rigid for a world in which Europe and Japan had been rebuilt after WWII.  Pressures were clear in the foreign exchange market, culminating with the severing of the dollar-gold link. Many high-income countries experienced stagflation–strong price pressures and weak growth–something that economists thought impossible.  

Reagan-Thatcher’s liberal solution turned Conant on his head.  Rather than aggravate the surplus capital problem, the US (and other Anglo-American economies) would absorb the world’s surplus savings and become the custodian and managers of it.  This would often entail recycling funds by reinvesting them in the equities, bonds, or factories of the very same country that had sent its surplus savings to the US. It would entail de-regulating capital on a scale never seen or conceived of previously.  On trade, the short-comings of the General Agreement on Trade and Tariffs were clear as Reagan enacted “voluntary export restrictions” and “orderly market agreements” to check the rising protectionism that responded to the growing trade deficit.  The seeds were planted for GATT’s successor, the World Trade Organization.  

Domestically, the capital offensive rolled back some earlier concessions to labor,  including, in particular, the decoupling wages from inflation and productivity gains.  It was the beginning of a new secular increase in wealth and income disparity, not just in the United States, even if its experience was among the extremes.  Over the past forty years, disparities of wealth and income have grown throughout high-income countries.  

The internal and external elements of Reaganism fueled the modern financialization of capitalism.  To draw the world’s surplus savings, there had to be someplace to put them. At the same time, the risks of retirement were shifted from businesses (defined benefits) to employees (defined contributions), which required an “equity culture.”   This was part of the equitization and securitization process that created the financial superstructure, which, in turn,  absorbed domestic and international savings.   It also served to deflect savings from redundant investment in plant and equipment, which drove the rate of profit down.  Surplus savings were driven from real to paper assets.  

The financialization was also understood to help moderate the business cycle, for which the downturn in the early 1980s was the most severe for many countries since the Great Depression.  If the price of money (interest rates and exchange rates) could be more flexible, they would absorb shocks and mitigate the strains on the real economy and employment.   However, the Great Financial Crisis demonstrated that the capital markets’ pressures could themselves create a feedback loop and disrupt the major economies.  It slowed trade and cross-border capital flows and weakened emerging market economies indirectly.    

Moreover, the disparity of wealth and income that resulted from the financialization helped facilitate and frame the political discourse and the political action that pushed back against it.  It is as if the Reagan-Thatcher solution to the surplus capital problem,  offered when Conant’s solution failed,  was wrecked on the shoals of Karl Polanyi’s Great Transformation, which saw a counter-movement after large liberalization campaign and Hyman Minsky’s financial instability hypothesis (extended period of financial stability can lead to instability through speculation and leverage).

Rather than depict America as a victim of the suppressed demand in China and Germany, as Klein and Pettis insist, I see the US as a key driver of events.  The Open Door Notes made the US the revisionist nation at the start of the 20th century after its state and railroad bonds were the crisis-prone emerging markets of the second half of the 19th century.  Within a half of a century of Conant’s essay and assistance in putting the Philippines and Nicaragua on the silver standard,  America rode astride the world.  The American Challenge ( Jean-Jacques Servan-Schreiber, 1967), a best-seller in the US and Europe, was decrying the colonization of Europe by American companies, buying and building production facilities and distribution chains.   The American ruling class managed to re-make the world, not once but twice: at Bretton Woods and, then, with its demise, the Reagan-Thatcher era, throughout which the dollar has remained preeminent.  

The American strategy broke from the traditional export-oriented approaches.  For historical reasons, including an over-valued dollar and protectionist barriers, American businesses serve foreign demand primarily by building locally and selling locally. The sales of majority-owned affiliates of US multinational companies have been outstripping US exports for more than half a century. A significant minority of imports are from foreign branches and affiliates of US companies.  

The current account and the net international investment position are one type of metric for score-keeping, but it is not the only one.  Here is one:  America’s household net worth rose 8% in Q3 20 year-over-year to a new record-high of $123.5 trillion, even in the face of the pandemic and an increase in debt.  Not only doesn’t the current account position say anything about the class struggle, but it doesn’t say much about the country’s wealth.  Of course, household wealth also does not say anything about its distribution, which is a function of political forces in Washington and the US, not Beijing and China.  

It seemed to me that the old organizing principle (what I call “cash registers” in Political Economy of Tomorrow) has ended before a new one arises.  The US does not enjoy the unipolar moment it had at Bretton Woods or the dominance it did in the last days of the Soviet Empire. Yet, it is incumbent on it with the world’s largest economy, which continues to dominate the “commanding heights” of the global economy, to shape the new order.  

In the absence of visionary US leadership, economic nationalism will fill the vacuum, as it did after WWI.  Klein and Pettis offer a rationale for the modern-day isolationist, i.e., unilateralists. The macroeconomic imbalance is outside America’s control now, and the international agencies it sponsored do not protect its interests. The serial financial crisis in the US has not been the result of deregulation, which itself seems to be pro-cyclical, the equity culture, or the opaqueness of securitization but the result of Germany and China gaming the system at the expense of their workers.  It is not misplaced priorities that led to the US importing 90% of its penicillin from China, contributing to the overall trade deficit in medicine and medical devices and most of its rare earths, but was a consequence of China’s export thrust while suppressing domestic demand.  

By attributing the source of America’s angst to a foreign country, the Klein/Pettis thesis offers America a self-serving explanation that distracts from the current challenges and the need for a long-term grand strategy. Pointing to a foreign enemy is a time-tested way to suppress domestic class conflict and foster the kind of conformity that is the enemy of innovation.  If the US is going to remain competitive, it needs to strengthen its workforce’s skills, upgrade its infrastructure, and update its power grid.  It needs to maintain strong, transparent, and accessible capital markets. While there is a surplus of world savings to draw on, the most important deficit may be social trust, which is eroded by the acid of the extreme disparities of income, wealth, and opportunity, coupled with the rigidities of class mobility.  As we have seen clearly with the pandemic, poverty itself is a comorbidity.  

Despite the title, Pettis and Klein are not interested in class wars, and their analysis of trade wars is a diatribe against surplus countries. The political program that emanates feeds the rising economic nationalism of the day and weakens the commitment to the multilateral institutions, even among parts of the elite that previously were more internationalist. 

Separately, Pettis has proposed taxing capital imports into the US.  Few economic measures come to mind that would be as disastrous.  It could very well spark a sharp downturn, producing higher levels of unemployment, economic stress, and interest rates.  The dollar’s role would diminish by abandonment more than encroachment.  Some have suggested that foreign investors already face a levy in the form of a potential exit tax should the dollar decline, orchestrated or otherwise, that would reduce the value of US debt (when measured in foreign currencies).  

Political Economy of Tomorrow does not see America as a victim or having become poorer because Germany and China run large current account surpluses. What shapes the distribution of productivity gains in the US has more to do with the relative domestic power of capital and labor, and the responsiveness of government than class relations in Germany and China. An American’s life choices and opportunities have very little to do with the party boss on the factory floor outside of Shanghai.  

Like Pettis and Klein, toward the end of my book, I quote Keynes:  “Thus for the first time since his creation man [sic] will be faced with his real, his permanent problem–how to use his freedom from pressing economic cares, how to occupy the leisure, which science and compound interest will have won for him, to leave wisely and agreeable and well.”