Tariffs, saving, and investment

I haven’t written much about tariffs, because so many other economists are doing such a great job. Tariffs are easy: The right answer is unilateral free trade. Tariffs are hard: The rest is explaining why 100 objections are wrong. I’ll get there.

One aspect is less clear than the others: the whole business about saving, investment, “reserve currency” and so forth. Most economists reacted in horror at CEA chair Stephen Miran’s essay claiming that US reserve currency status — that we can print money, send it abroad and other countries work hard and send us stuff in return — is a burden for the US. Actually there is a kernel of logic here, and a great danger, though tariffs will do absolutely nothing to rectify the situation at least without huge economic cost.

Start with Greece, a good source of cautionary fables. In 2001, Greece joined the euro. By doing so, it foreswore inflation and devaluation should it borrow too much and not be able to repay. European financial markets (especially banks) responded by offering very low interest rates. Greece could have used the money for productive investment. Instead, it largely went on a consumption boom. Porsches went south, paper promises went north. When the lenders figured out what had happened, they refused to roll over loans (all crises are crises of short term debt), and the famous Greek crisis erupted. (For more details, see Crisis Cycle with Luis Garicano and Klaus Masuch.)

Something similar has happened to the US, on a grander scale and with nobody standing in the wings to bail us out. That’s the danger.

For various reasons, many countries around the world including China wanted to save. For various reasons, additional domestic investment did not seem like a good idea. Chinese savers did not want even more Chinese factories. One of many reasons for this saving (more later, but it helps to make the story) is that China is aging and has little safety net, so its middle age workers want to put money aside, to withdraw when they get old. So, those savers chose to invest in the US. China already does a huge amount of domestic investment, including a suspicious number of bridges to nowhere and empty apartments. Maybe they just ran out of opportunities.

Now, apply three bedrock principles of economics:

1) The capital and current account must add up. If the US imports more than it exports, it has to give foreigners something valuable in return. Even China doesn’t send us stuff for free. We give dollars, treasury securities, or stocks and bonds in return. And if other countries like China want to accumulate US securities, they must send us more goods and services then we send them, to get dollars they can use to buy securities.

2) Money is a veil. Understand the underlying movement of goods and services. To understand economics, look beyond money and watch the underlying flow of real stuff. To invest in the US, other countries must put things on boats and send it here (or sell us services). One Chinese person can buy a stock from another Chinese person, but China as a whole cannot accumulate US assets without putting goods on boats (proverbially).

From the US side, we are investing more than we are saving. China, in effect, wants to send us factories. But China doesn’t make portable factories. It’s great at making consumer goods. So China sends us consumer goods so that we can build our own factories without lowering consumption.

3) The overall trade (goods and services) deficit equals the difference between savings and investment plus the government deficit [(M-X) = (I-S) + (G-T)]

Put these ideas together. What happens if other countries decide they want to save more, and invest in the US? They buy US assets, which sends up the real exchange rate.

Another bedrock principle: 4) Separate real from nominal. There is an immense amount of confusion over “currency manipulation” and other phantasms. Even if we used the same currency, or the foreign currency were pegged to the dollar, the foreigner’s demand for US securities would drive up the prices of those securities, and the underlying factories and houses they represent. We would see higher prices in the US than abroad and thus a higher real exchange rate. Instead we see a higher value of the dollar, which generates the same real effect — things are worth more in the US.

Now, higher prices in the US induce people in the US to buy more cheaper foreign goods. Presto, the trade deficit opens up.

We know that trade and capital accounts add up, but this story tells us how an increase in foreign demand to save in the US rather than at home will push up the dollar, and cause the trade deficit, which is in effect how foreigners send us factories which they would rather build here than in their own countries.

That’s not the whole story of course. China and other countries opened up, started to make things first cheaply and then well, at lower cost than the US. Again, lower cost abroad is a higher real exchange rate. People import. Now it’s the egg moving the chicken. We have to give them something in order to import, so we give them US assets.

The second is the more common story. In economics, it’s always possible that supply or demand move, and usually both. But surely part of the story stems from the savings vs. investment story. (Both stories are elaborated by various nefarious reasons why foreigners, especially China, want to save or how they produce so cheaply. We’ll get there. But for the basic story of how trade deficits and capital surpluses open up, that doesn’t matter.)

Now comes the Greek trouble, the hubris, the pride before the fall. The US reacted to the offer by other countries to borrow from them (sell them assets) at very low interest rates, not by building factories, but going on a consumption binge. Just as Greece had done. Most of that is due to the actions of the federal government. The total trade deficit is about $1 trillion. The US budget deficit is about $1.3 trillion. All of that extra saving is going to the federal government. And the federal government is not building a trillion dollars a year of productive investment with the money. The federal government is, by and large, sending checks to its citizens to support current consumption. The federal government saw an amazing opportunity to borrow cheaply, sometimes even at negative real rates of interest. Borrow it did, and sent checks to happy voters.

The Chinese are not, it turns out, financing their retirement from the profits of a new generation of factories. They are hoping to finance their retirement from the US federal government’s willingness to tax its citizens in excess of spending, some day in the far future, in order to reverse the whole process and put stuff back on boats to send to China.

The hard reality of debt is you have to pay it back someday. Or default, which causes lots of trouble. The hard reality of trade deficits/capital surpluses is that foreigners also expect to be paid back — for Americans to work hard to put stuff on boats in return for getting our own paper back. This is what mercantilists desire. Be careful what you wish for, you just might get it. Or we default/inflate away the debt, which will have its own catastrophic implications. If I were China though, I would be very worried about whether I’m actually going to get paid.

This is the germ of truth in the mercantilist folly. When you run trade deficits it is like borrowing, and grandma told you wisely that borrowing too much is a dangerous thing. You don’t want to amass a mound of Scrooge McDuck gold just to swim in it, but it is useful to be able to buy things from other countries — to run future trade deficits. Trade deficits today means you will have to live mercantilist nirvana in the future — work hard, put things on boats and get paper in return.

The foreigners in the US don’t know or really care where the resources to pay them back come from. A promise to fund Chinese retirements with US taxes is just as good to them as a promise to fund them from profitable factories. Until, suddenly, they start to wonder just whether we will be willing and able to pay them back. As French and German banks started to wonder just how Greece would repay them.

In sum, spurred on by the federal government (in many ways), the US borrowed a huge amount from foreigners at very low rates, and went on a consumption binge. Sooner or later we have to pay it back, or we go though the wrenching adjustment of a debt crisis.

Sources of savings/consumption.

Where did the foreign savings/investment differential come from? Where did ours come from? Lots of stories swirl around these issues. Nefarious actions by foreigners ring in the Neo-mercantilist agenda.

Now it doesn’t really matter. Whether foreign savings come from a different culture, from different demographics, or from foreign policies, the result is the same for the US. But let us dig anyway.

The new mercantilists accuse China of all sorts of policies that lower consumption and raise savings. Some of that is true. Some is not quite what you think. China, for example, doesn’t have much of a welfare state, so people save more for retirement. China distorts financial markets a lot, offering terrible interest rates and then directing banks investment. That’s actually an incentive to save less however. The Chinese government grabs a lot of foreign exchange and buys US treasurys directly.

But claiming this all on China doesn’t add up. Lots of other countries save too, and run trade deficits. Incentives for saving doesn’t explain the other half of the coin, why Chinese savings doesn’t end up in Chinese investment. And it denies the agency of the US. We have all sorts of contrary policies against saving, against investment, and for consumption. Huge budget deficits, absorbing our and foreigners savings, are sent as checks to people likely to consume. We subsidize home mortgages. We tax savings and rates of return pretty heavily, including corporate taxes, taxes on interest, dividends and capital gains. Food stamps and agricultural subsidies encourage consumption. Our Keynesian policy establishment spent twenty years pushing extra consumption, via fiscal “stimulus,” fears of “secular stagnation,” and under multiple banners that government debt never has to be repaid. (To be fair, many expansion advocates including Larry Summers and Olivier Blanchard advocated borrowing for investment, not consumption.) Investment faces the contemporary US distinguishing characteristic, massive cost bloat. Whatever its wisdom, compare California’s high speed train to nowhere to the huge network in China. $4 billion per mile subways. Endless lawsuits, cost-exploding contracting requirements, decades to get permits, and more bedevil any attempt to invest here.

Yes, the US is still a great place to invest. We still have tech, we still have the economy most open to innovation. We’re still growing in ways Europe, UK, and Japan are not. We won’t commit energy suicide. And our investment has in fact kept pace. It just did not absorb all of US savings and the inflow from abroad.

So yes, the savings/investment nexus behind part of our trade deficit / capital surplus is at least partly driven by government policies — and as much our pro-consumption policies as China’s pro-saving policies.

Tariffs

Tariffs are not likely to fix any of this. If we cut off all net trade, as the current tariffs seem to aim to do, this process will have to come to an end.

But how? The US will no longer be able to finance $1.3 trillion budget deficits from foreigners, and will have to do it from domestic savings. Or, it will have to cut $1.3 trillion of spending, or raise $1.3 trillion of durable tax revenue. Interest rates will spike, and that’s the point. Higher interest rates encourage domestic saving, and discourage budget deficits and corporate investment, to bring investment plus government spending back in line with savings. But the spike in interest rates require to do this would be huge. And the trade shock will cause a sharp recession, or worse, putting even more stress on the budget. A debt crisis is likely along the way as the US finds it impossible to roll over debt. (I’ve been this guy for a long time

so I’m wary of forecasting debt crisis, but sooner or later it has to come on present course.)

Cure the disease, not the symptoms. Reform taxes to tax consumption, not saving and investment. Stop funneling borrowed money to consumption. Cure the nightmarish cost, regulatory, and permitting bloat making investment so difficult, especially public investment.

(Warning, this post is likely to be updated, as I foresee active commentary.)

Update: I should have cited and pointed to Joseph Sternberg’s WSJ article on these issues, which had a lot of influence here.)