The Economic Consequences of the Release (i.e., Brexit)

Much has been written on the recent decision by the UK to leave the European Union. Much of it is emotion-driven. But that is no way to assess such an important turn of events. The actual significance is, in significant degree, economic in nature. This calls for an economic analysis, to which we now turn.

The Organisation for Economic Co-operation and Development’s (OECD) Report published in April 2016, entitled The Economic Consequences of Brexit: A Taxing Decision[1], provides a competent summary of the disadvantages that might follow upon a British departure from the EU. We will use it as a reference for interaction.

Initial objections

The initial objections the Report registers are based on circumstantial evidence.

This holds for “Since EU membership in 1973, UK living standards have risen more than in peers” and “A multipolar world implies that the UK is economically stronger as an EU member, and in turn contributes to the EU strength.” (both on p. 9). Despite the graphs, such arguments, are, at best, suggestive rather than demonstrative. The same holds true for the objection that “Uncertainty has already begun to have a negative impact on the economy” (p. 10).

Exchange rates and the balance of trade

The Report then claims that “Uncertainty about Brexit has led to capital outflows and a weaker exchange rate” (p. 12). For a country running a perennial trade deficit, this is anything but objectionable. The graph below shows the development of the UK’s balance of trade since joining the EU (then the European Economic Community) in 1973.UK balance of trade


This shows a downward trend, and since the late 1990s, a persistent trade deficit. As such, a decline in the pound’s exchange rate will only help matters, by encouraging exports and discouraging imports.

This leads directly to the next objection, which is a weighty one. “Trade would be hit when the UK formally exits the EU.” If this is the case, it would be dire indeed. Let’s examine the substance.

“The EU remains the main trade partner of the UK and the financial sector benefits from direct access to the Single Market, which has strengthened the comparative advantage of the City” (p. 14). Absolutely true. And by way of elucidation: “Exports to EU countries account for about 12% of UK GDP and about 45% of total UK exports, and for imports the EU is even a more important partner.” This was already implied in the trade deficit data we looked at above.

The graphs below shows the breakdown. The first shows, by percentage, the UK’s export destinations, the second shows the UK’s imports by country of origin (source: The Observatory of Economic Complexity []).

UK exports

UK imports

The data is from 2014. As can be seen visually, Europe accounts for the lion’s share of both imports and exports.

The Report includes the following graph on page 15, showing the trade and current account situation between the UK and the EU:

UK current account2

Now then, all of this indicates mutual dependence. Even more than that, though, it indicates that the EU is more dependent upon the UK as a source of income than the other way around, given the fact that the UK runs a trade deficit with the EU. The EU has every reason to maintain existing trade relations with the UK. It would be to the EU’s disadvantage not to do so.

Renegotiating trade deals

The Report goes on to claim that “Negotiating a new trade agreement with the EU is likely to be complex” (p. 16). The various possibilities are laid out in a table, which we reproduce here:

brexit arrangementsThe claim is that negotiations will be complex and that the UK will be on the outside looking in, with the very real possibility of being relegated to “Most Favored Nation” status, in which trade with the EU will be “subject to the EU’s common external tariff.”

For one thing, negotiations need not be complex at all. The website Lawyers for Britain has put together comprehensive, detailed research papers on this issue, of which we gratefully make use. On Brexit and International Trade Treaties, it summarizes the issue both for the UK and for trading partners generally, with the following points (emphasis added to highlight key issues):

  • “Because of the EU customs union and ‘common commercial policy’, the UK is not able to negotiate its own trade agreements with non-member countries — we can only do so as part of the EU. The UK will be able to participate in new trade agreements with non-member countries from the day after exit.  The process of negotiating new trade deals can be started during the 2-year notice period leading up to Brexit, with a view to bringing them into force on or soon after the date of exit.
  • “The EU has existing free trade agreements which currently apply to the UK as an EU member.  Most of these EU agreements are with micro-States or developing countries and only a small number represent significant export markets for the UK.  Both the EU and the member states (including the UK) are parties to these agreements. The UK could simply continue to apply the substantive terms of these agreements on a reciprocal basis after exit unless the counterparty State were actively to object. We can see no rational reason why the counterparty States would object to this course since that would subject their existing export trade into the UK market, which is currently tariff free, to new tariffs. There will be no need for complicated renegotiation of these existing agreements as was misleadingly claimed by pro-Remain propaganda.
  • “The UK was a founder member of EFTA but withdrew when we joined the EEC in 1973.  We could apply to re-join with effect from the day after Brexit. There is no reason why the four current EFTA countries would not welcome us back, given that the UK is one of EFTA’s largest export markets.  EFTA membership would allow us to continue uninterrupted free trade relations with the four EFTA countries, and also to participate in EFTA’s promotion of free trade deals with non-member countries around the world.
  • “The EU is seriously encumbered in trying to negotiate trade agreements by the large number of vociferous protectionist special interests within its borders.  After Brexit, the UK would be able to negotiate new trade deals unencumbered by these special interests much faster than the EU, and with a higher priority for faciliting access to markets for our own export industries including services.
  • “It is completely untrue that you need to be a member of a large bloc like the EU in order to strike trade deals.  The actual record of the EU compared to that (for example) of the EFTA countries demonstrates the direct opposite.
  • “The baseline of our trade relationship with the remaining EU states would be governed by WTO rules which provide for non-discrimination in tariffs, and outlaw discriminatory non-tariff measures. From this baseline, and as the remaining EU’s largest single export market,  we would be in a strong position to negotiate a mutually beneficial deal providing for the continued free flow of goods and services in both directions.  We explain what such a deal would look like in a later post, Brexit – doing a deal with the EU.”

All of this indicates that it will require no herculean effort for the UK to reestablish itself as an independent trading partner, neither vis-à-vis the EU, nor the world at large. After all, the other countries of the world are not members of the EU, and they are surviving. And it bears repeating that for the EU to impose a tariff on UK imports would make no sense at all, because the same kind of tariff would be imposed reciprocally on exports to the UK: all $420 billion of them (from all of Europe, 2014).

All in all, it would be in the EU’s best interest to simply maintain existing trade relations, as they are eminently in its interest.

Other near-term effects

Further near-term effects discussed in the Report, such as a putative “reduction in UK trade openness,” “imposition of tighter controls on inward migration,” leading to “a large negative shock to the UK economy, which would spillover to other European countries” (all p. 21), are either mere surmises or could serve to argue the exact opposite.

The argument that a decline in the exchange rate would have deleterious effects on the UK economy is an example of an argument that could just as well be used to argue the opposite. As discussed above, a decline in the exchange rate would bolster UK exports and inhibit imports, which would benefit the UK and disadvantage the EU. In other words, the neo-mercantilist export policy of the EU countries like German and the Netherlands would be brought more in line with equity.

Long-term effect on trade

The Report goes on to discuss possible long-term effects.

The first one discussed is the trade situation. “The UK is the most attractive destination for FDI in the EU, partly owing to access to the EU internal market” (p. 24). Foreign direct investment would be restricted by withdrawal from this internal market. But again, as noted above, access to the single market is unlikely to be restricted, as the EU derives more advantage from it than the UK. Furthermore, the major inhibitor to direct investment is currency risk. But it’s not like the UK is withdrawing from the euro; it is only rearranging its relation with the EU, with the relation between the pound and the euro (a free float) not changing at all.

Effect of reduced immigration

Secondly, “Immigrants, particularly from EU countries, have boosted GDP growth significantly in the UK” (p. 26). Apparently, immigrants are more productive than native-born Britons. This is obviously a contentious statement; whether it proves anything is another question. Then there is this contention: “Immigrants from the EU make a positive contribution to the public finances, despite relying on the UK welfare system, which is also the case of UK migrants elsewhere in the EU” (p. 27). This is another statement difficult to rhyme with realities. Even if immigrants are all net contributors in terms of social welfare revenues and payouts, the jobs they take, leave other labor market participants without jobs and thus, at least in part, adds to the social welfare rolls (unemployment and other forms of social assistance). In addition, “immigrants from new EU countries have comparatively lower wages…” (p. 27), which means they depress wages, which may be beneficial to employers, but not to employees, and additionally reduce consumption.

The claim is made that reduced immigration would lead to reduced skills, and “A loss of skills would reduce technical progress.” That may be true in the short term, but where there is demand for skills, there will be training and education to enable workers to acquire those skills, and there is no inherent reason why native-born Britons could not be trained up. It is in fact a curious prejudice and form of reverse discrimination to believe otherwise.

The upshot

As a result of these putative disadvantages, the claim is made for a “central scenario” in which “UK GDP is more than 5% below the baseline by 2030.” Just the opposite is at least as likely.

Objections in favor of withdrawal can also be made, of course, but the Report neglects to mention those. One is the fact that the UK is the second-largest net contributor to the EU’s budget, after Germany. Another is that the UK bears a major part of the costs of the EU’s common defense. Yet another is the costs of an inherently cumbersome and inefficient, far-off, relatively unaccountable bureaucracy regulating so much of the economic life of the nation.

But the biggest problem with the EU is tangential to this particular debate. It has to do with the single currency, the euro, in which the UK, of course, is not a participant. The euro forms a massive net drag on the world economy, and the debt overhang to which it has contributed, by having encouraged irresponsible, indeed unconscionable, North-South lending, is an toxic inheritance that not only stifles current economic growth, but also forms a burden that future generations will be hard-pressed to alleviate.

That, however, is stuff for another discussion. For now, it is enough to re-emphasize that, in line with the position outlined here (with an assist here), it is nations, not empires, that create wealth. And that should be kept uppermost in everyone’s mind.


  1. Kierzenkowski,R., et al.  (2016), “The Economic Consequences of Brexit: A Taxing Decision”, OECD Economic Policy Papers, No. 16, OECD Publishing, Paris.

The Mystery of Capital in Context

Given the rancorous debate unleashed by the UK electorate’s decision to depart the European Union – in particular, regarding the damage to the UK economy that independence might bring – it seems wise to re-examine the foundations of economic prosperity and its relationship to political and legal factors. I do so by examining Hernando de Soto’s seminal book, The Mystery of Capital, which goes to the heart of the relationship between political framework, legal framework, and economic development.

The “mystery of capital” is the intriguing title of one of the most important books of the new millennium. Written by the Peruvian economist Hernando de Soto, it breaks with the tradition of dealing with capitalism as a system established of, by, and for the rich, by looking at it from the bottom up: from the lowest levels of society. De Soto finds capitalism even at that level, albeit in a stage of dormancy, as it were. His treatise is intended to help us understand that capitalism is nothing esoteric – despite its being a “mystery” – but rather something down to earth, active in the lowest levels of society, and only waiting for a proper legal and political framework to become an equitable system, in the service of all, not just the well-to-do.

De Soto first made a name for himself with his path-breaking work in Peru, which culminated in the best-selling book The Other Path. In order to show an alternative route to a better society, De Soto developed a unique investigative method. At the time – the 1980s – the better society was being promised by radical revolutionary groups. In Peru, such a group was El Sendero Luminoso, the “Shining Path” – the path to the enlightened society, the workers’ paradise. Officially, this was the Communist Party of Peru, and throughout the 1980s it engaged in violent revolution. De Soto proposed El Otro Sendero, the “other path,” which would render the revolution irrelevant by integrating the real-world economies of the poor within an all-embracing economic framework that left no one out.

What De Soto and his colleagues at the Institute for Liberty and Democracy had discovered was that, at the poorest and most basic levels of society, a vibrant economy was already in existence. It functioned in spite of, rather than because of, the formal institutional and legal structures provided by the state. For in Third-World countries such as Peru, there was not one economy but two: the formal economy, the economy of the wealthy and middle class, connected with the rest of the world; and the informal economy, the economy of the poor, the “off the books” economy, comprising the residual and peripheral denizens who happened to make up the vast majority of the nation. Essentially, the legal and political institutions functioned within and for the benefit of the formal economy, while the informal economy ran on its own, ignored and neglected by the powers that be, kept by the phalanx of rules and regulations from ever graduating from the shadows into the sunlight of the economy proper.

De Soto’s book highlighted this situation and the potential that it held, if it could be harnessed, both for the benefit of the poor and for the nation as a whole. Mainly, the regime of bloated regulation and official corruption needed to be exchanged for the rule of law, specifically the institutions of property and contract. If this would occur, the chains would come off of the poor and they could become full-fledged participants in a functional rather than dysfunctional social order.

De Soto’s second book, The Mystery of Capital, is the culmination of the work done in the wake of, and building on the foundations laid in, The Other Path. It is the product of the transfer of the method pioneered in Peru into many other Third World countries facing similar problems. De Soto took his show on the road, making the Institute for Liberty and Democracy into a globally active entity.

Unlike The Other Path, however, The Mystery of Capital is more than an exposition of the findings of investigative field work. In fact, it transcends the empirical method altogether: it sets forth a philosophical outworking that is both result and foundation of those empirical findings.

In making this leap from practice to theory, De Soto had penned a most important book on the subject. He was enabled to do this precisely because of the empirical basis: the book went beyond economic theory to the real world in which economic practice is embedded, a world that economic theory studiously ignores; it takes into account the real-world framework within which economies function.

The recognition of the two-tiered economy led De Soto to perceive the crucial importance of the legal system. For in his findings, it was the legal system that made the difference between the two economies. This led him to explore virtually virgin territory: the relationship between the legal system and the economy has been largely ignored, except for certain specialty (and rather idiosyncratic) disciplines such as institutional economics, “new” institutional economics, and law and economics. While these latter disciplines have not been entirely fruitless, they have not helped to rework economic theory the way that De Soto had done in his book.

De Soto’s reworking of economic theory starts from a rather crucial distinction that is well known to legal philosophers, the distinction between possession and property. This is a staple of the Western legal tradition (both civil and common). Essentially, the difference between possession and property is physical versus mental – possession is physical holding, while property is an entitlement that stays in force regardless of whether the owner is in physical possession or not. And this distinction depends on a functioning legal order that enforces its arrangements. With possession, enforcement is essentially left to the possessor; with property, it is maintained by a separate entity charged with law enforcement, and hence is not dependent upon the physical strength of the owner in order to enforce possession.

With property arrangements, then, the relations of people and things are elevated to a higher plane than arrangements of pure possession. And they provide for higher-order exploitation of resources than simple possession does. For one thing, property rights can be split up and farmed out any number of ways. For another, property allows for encumbrance in credit contracts, whereby the property item serves as collateral. Without changing its physical status, the encumbered asset engenders a new set of economic advantages. The owner can borrow money against it; and, as Steuart showed back in the 18th century and Schumpeter in the 20th, this is essentially the way in which, in the modern world, money comes into being. At least, in a banking- as opposed to a coinage- or scrip-based system. Credit and debt are the source of money issue. As any bank balance sheet will show you, all money issued has as its counterpart an encumbered economic asset.

In his book, De Soto never explicitly refers to the legal doctrine of possession vis-à-vis property, but despite that, it underlies his entire exposition. He argues that it is the legal system that enables possessions to become property, thus assets, and assets to become capital – resources capable of generating new productivity and income. “Like electrical energy, capital will not be generated if the single key facility that produces and fixes it is not in place. Just as a lake needs a hydroelectric plant to produce usable energy, assets need a formal property system to produce significant surplus value. Without formal property to extract their economic potential and convert it into a form that can be easily transported and controlled, the assets of developing and former communist countries are like water in a lake high in the Andes – an untapped stock of potential energy.”[1]

De Soto’s argument is crucially important – as far as it goes. But it runs into problems when he goes further and highlights a single aspect of the legal system, to which he attributes excessive importance. This in turn causes him to lose sight of other aspects, and indeed, the bigger picture.

De Soto emphasizes the role of record-keeping as the determining factor in creating a cognitive layer overlaying the physical layer of tangible things. Records, titles, data storage and retrieval, allow the things that otherwise exist in isolation to be integrated together into a collective mind map, by which they become a synergistic whole that is greater than the sum of the parts. For De Soto, this is the crucial element of a system of property rights, which enables it to generate productive economic assets – capital.

But this is to overplay his hand. It is not so much record-keeping within a framework of law, but the framework of law itself that is the important thing. The key is the establishment of common law: a law that is valid across the board across the entire territory, which holds for everyone and which establishes at its core, property rights and freedom of contract, uniformly and equally enforced. Historically, this kind of common law was established early on in England, where the king’s writ came to run everywhere. Which is why England became the common-law country par excellence.[2]

Such an establishment of common law, in turn, depends upon the consolidation of sovereignty.

Sovereignty is the power by which the rule of law is established. It is the prerequisite of a functioning legal order. Sovereignty is the power to establish and confirm shared, social value. It does this through legislation and adjudication, establishing laws as standards by which the social order is ruled – the rule of law. These, then, are values, which are universally valid and binding.[3]

But there is more to the establishment of value than this. Valuation has, of course, an economic dimension as well as a juridical one. But does the legal system generate economic value? Yes it does, through the utilization of property and contract. And here we have the intangible, mental, symbolic dimension of the economy that De Soto intuits, but does not quite elucidate, given his focus on record-keeping. Property and contract generate value by the process of credit and debt. When property is harnessed as collateral in a credit contract, it is valued; and this valuation is expressed in the issuance of a monetary equivalent. A deposit is established at the bank, in the equivalent of the loan. Borrowing a metaphor from the days of minting coinage, Steuart called this the “melting down” of property into “symbolical” money. Hence, the regime of property and contract participate in the process of valuation in a very critical way. And out of this valuation comes capitalization – capital.

Now then, the context of this valuation and process issuing forth ultimately in that mysterious entity, capital, is a common legal order, the product of a consolidated and viable locus of sovereignty. Sovereignty, then, enables this whole process of capitalization to take place. What is the locus of sovereignty? Following the German Calvinist statesman and political philosopher, Johannes Althusius, we can answer unambiguously, the nation.[4]

The Industrial Revolution, the “take-off,” as W.W. Rostow put it, did not come about in a vacuum. It came about in nations in which sovereignty had been consolidated; and those nations in which sovereignty had not been consolidated, did not experience it. Nationhood and sovereignty go together. Like a lens out of focus, sovereignty is weak where it does not shine through the prism of nationhood. And, where sovereignty is weak, there also a domestic economy does not materialize; as a result, conditions are rife for an exploitative, colonial or neo-colonial framework. Wallerstein’s center-periphery framework then looms large. None of that is necessary for economic growth: in fact, it only benefits particular interests, at the expense of broad-based, populace-elevating economic growth.

So then, it is sovereignty refracted through nation-states that has enabled the genesis of the capital which De Soto seeks to demystify. Summarizing this state of affairs, I wrote: “Through the institutions of property and contract, credit and debt, the asset base in man (human capital) and through man (tangible and intangible property) becomes capitalized, generating a money supply which, when properly maintained, is the faithful representation of that asset base, no more and no less. The nations of the world have no need of a Wizard of Oz to grant them prosperity. It is in their hands to do so, if they would only recognize it.”[5] That is the mystery of capital explained. In its fullness, only nations can bring it off. Neither inchoate peoples, nor empires, ever have, or ever will.

[1] Hernando De Soto, The Mystery of Capital: Why Capitalism Triumphs in the West and Fails Everywhere Else (New York: Basic Books, 2000), p. 48.

[2] For more on this point see my book Common Law & Natural Rights (Aalten: WordBridge, 2009), pp. 68ff.

[3] For more on this point see my book Common-Law Conservatism: An Exercise in Paradigm-Shifting (Aalten: WordBridge, 2007), ch. 1.

[4] For more on this point see this previous post.

[5] Follow the Money, p. 190.

Maggie’s Revenge

The British vote on June 23rd, 2016, to leave the European Union, is one of those events that will long be remembered. Yet there was another event involving Britain on the one hand and the European Union (then Community) on the other, that likewise came as a shock, and which likewise lives on in the memory, at least for those who, at the time, were political aware. I refer to Margaret Thatcher’s resignation of the prime ministry, exactly 25 years and seven months earlier, on November 23rd, 1990. Personally, I remember exactly where I was and what I was doing when I heard that bit of news over the radio.

Thatcher’s resignation resulted from her opposition to European union. She paid the price by being cashiered by her own party, not by the electorate. I wrote an article in 1991, discussing this event, its significance, and what I considered to be its historical relevance. In terms of the latter, the article was flawed in its diagnosis, but not in its recognition of that relevance. And today, I think that Margaret Thatcher is looking down with a sense of grim satisfaction.

To honor this event, I excerpt from that article, published in 1991.

It came so suddenly as to leave the world in a state of shock. Margaret Thatcher, the “Iron Lady,” the fighter who would rather die than quit, did just that: she voluntarily resigned her position as Prime Minister of the United Kingdom. She did so as she reflected on what “a funny old world” it should be that a party leader never defeated in a general election, still commanding a majority of her own party, who had led that party to three successive election victories, who had spearheaded a thoroughgoing reformation of public policy whose very name was synonymous with that reformation, should be forced by her own party to resign her post. Truly these were rather funny goings-on.

To top it all, it was not any strictly domestic issue but “European unity” that brought all this about. To many, she was the champion of a by-gone era of national sovereignty and “Little England,” “the prim and condescending leader of a has-been empire bent on turning back the tide of history, a latter day King Canute who actually believed the sea would heed her.”(1) So it was portrayed: Thatcher versus Europe, isolation versus community, proud independence versus peaceful cooperation. And it turned out to be an Achilles’ heel which her opposition lost no time in exploiting as soon as opportunity presented itself.

Her enemies’ strategy worked. But to characterize Margaret Thatcher’s position with respect to the European Community (E.C.) in these terms is, at the very least, open to question. She regarded herself the most pro-European of them all; nevertheless her approach to and her concept of unity differed – fundamentally – from theirs.

Perhaps the key element of difference lay in the goal of monetary union. Thatcher remained to the end staunchly opposed to the formation of a pan-E.C. single currency administered by an independent central bank. Most others see such an arrangement as the indispensable core of a truly common market. Across Europe as a whole, the goal of monetary union commands broad support. Certainly it was this issue more than any other which isolated her from her peer heads of state and made her vulnerable to attack at home.

Such issues have not heretofore been the stuff of dramatic controversy, at least if one follows standard historical accounts. Most historically-conscious folks have a vague recollection, for example, that the establishment of a central bank in the United States was a very hot issue from time to time and was finally brought to pass with the Federal Reserve in 1913 (which isn’t really a true central bank but rather a “federally organized” group of regional banks). But they remain supremely indifferent to the subject and would much rather look into the accounts of politics or war or class struggles, or perhaps “social” histories of “everyday life” in such and such a period. The history of banking and monetary policy is definitely a subject for the specialist. And thus supremely boring.

Yet as contemporary events should insinuate, a long look needs to be taken especially at the history of monetary union. Upon further inquiry that history proves to be decisively important to understanding our present and certainly what Margaret Thatcher would consider our predicament. One has consequently to go back to its roots and see how and why it has become so fundamental – as it truly has – to modern society….

Mrs. Thatcher … faced opposition on two major points – domestically, the poll tax issue, and in external affairs, her position concerning the European Community. The poll tax weakened her position with respect to the electorate, enabling her opposition in the Conservative Party to gain ground on her. But in the final analysis the poll tax is not what felled her.

The timing of events leading to her fall is conclusive here. At the annual party conference in early October [1990], the Conservatives showed themselves lackluster, despondent, without much enthusiasm for the upcoming elections which they feared they might lose. More than anything else, it was the Europe issue that divided them. Many in the party were leaning toward a strong pro-Europe stance; Sir Geoffrey Howe, for instance, argued for full acceptance of monetary union, and Michael Heseltine preached pro-union to a well-attended side meeting. On the other side were the anti-union forces worried that Mrs. Thatcher, who had been showing herself conspicuously indeterminate in the last months, would be “led gently to monetary union, like some doddery old lady, with Mr Major and Mr Douglas Hurd… at either elbow.”(2)

Thatcher herself was then “ambushed” at the E.C. summit in Rome at the end of October. Italy’s prime minister Giulio Andreotti presented a proposal with definite dates for achieving monetary union, something which caught Mrs. Thatcher by surprise. This seems to have woken her from her lethargy. Back home she gave a rousing speech in the House of Commons against monetary union and giving over national sovereignty to Brussels. Her old followers were delighted. Others wondered how long she would last.

It was this speech and her renewed hard line which led to the resignation of Sir Geoffrey Howe from her cabinet. And it was his resignation speech which solidified the opposition against Mrs. Thatcher, prompting Michael Heseltine to run against her in the party election. Howe vociferated against her “anti-Europe” position, arguing that it jeopardized the future of the nation and its role in a united Europe. And then of course Heseltine gained enough votes on the first ballot to force a second one, after which Thatcher resigned.

It was, then, undoubtedly the Europe issue which brought Thatcher’s downfall. That much is clear. In the final analysis, however, not even the politicians were ultimately the cause. The powers-that-be want monetary union, and if anyone stands in their way, they will simply remove him, or her, to get it. The politicians know this and act accordingly if they know what is good for them. The people do not know any better than to accept this goal because it is proffered to them by every available media source from which they derive their opinions.

1. Newsweek, Dec. 3, 1990, p. 22.
2. The Economist, Oct. 31, 1990, p. 43.

The Problem of Saving

When Schumpeter writes, “Now to the question: what is a savings account?”,[1] he is not being facetious. There is more to savings than meets the eye. Of course, the bare fact of saving is simple enough to understand. Rather than spend all of our earnings, we take some and put it to one side. What could be more straightforward?

Actually, the problem is not so much understanding what savings, or a savings account, is, but what kind of effect it has. And that is anything but straightforward.

Essentially, what is accomplished with the act of saving is the removal of circulating medium from the cycle which is what an economy is.

An economy is a cycle or a circular flow: this is one of the first lessons of basic economics, encapsulated in the principle originally put forward by Jean-Baptiste Say, “supply creates its own demand.” All this means is that, at the end of the day, the producers are the consumer and the consumers, the producers. It is the same people producing who do the consuming, and vice versa.

At least, this is the basic picture, before things get complicated with things like foreign trade and fiscal policy. And things like savings. For what savings does is remove some of the circulating medium by which this economic cycle does its cycling. There are two aspects to the cycle: the circulation of goods and service, and the accompanying circulating medium by which the goods and services are accounted. When a shortfall of the circulating medium crops up, the result is deflation. And so, saving on the face of it has a deflating effect on wages and prices. And a deflationary environment is noxious to economic growth.

As a result, we have what economists have dubbed the “paradox of thrift” whereby saving, normally thought of as an act of economic virtue, or at least efficiency, actually depresses economic activity. The details as to how this occurs differ depending on the analyst, but the upshot is that saving, far from being the benign, even constructive act that it may well be on the personal level, actually has, or can have, a negative effect on the economy at large.

So which is it? Do we really have a paradox here along the lines of moral man, immoral society? Is personal saving something good for the individual or the household or other economic entity, but bad for the economy at large?

To figure this out, we have to take a look at what actually happens in the act of saving. First, of course, there is the proverbial mattress, or, especially in the days of coinage, the chest. In such a case, we have the circulating medium definitively removed from the economy for however much time the saver desires. (Or for much longer than that, as witness contemporary discoveries of hoards of coins from e.g. Roman times.) We can call this form of saving “hoarding.” It is peripheral to the main discussion.

What happens in the modern world is something different. When we save, our first resort is not the mattress but the bank. And when we do this, our money earns interest. What is interest? Let’s just say that is another of those phenomena that economists have a hard time figuring out. Perhaps we can address that subject in a future article. For now, we mention it in passing with the caveat that in the contemporary zero-interest-rate environment, it is not the incentive for saving that it normally might be.

So we put our money in banks. What happens then? Does it just sit there, like in the mattress? Not in the modern system. Instead, it enters into a second market, which runs independently of the market for goods and services with which we are already acquainted. We speak of the financial market. Banks (and non-bank financial institutions) are the gatekeepers of this market. We include a graphic taken from the accompanying course to indicate the structure of this second market.

Figure 3:  Two Markets, Two Monetary Circulations
Figure 1:  Two Markets, Two Monetary Circulations

Savings, then, go into this market, where they are “put to use” to earn income for the bank or other financial entity. The differential between what these latter entities earn and the interest they pay out is their profit.

What happens on this market? There are several submarkets which determine this. The bond market is where corporate and government borrowers go to get ahold of some of these savings. The stock market is where corporate interests go to sell stock in their companies – the money that goes here is not savings in the strict sense, as is money lodged with banks, but it does fall under the same category of earnings set aside to earn a separate income and to be available for future use, so we include it in our discussion.

“For future use” – this already indicates that the so-called paradox of thrift need not be so paradoxical. The writers on the problem of saving often seem to talk as if the money put into saving will never come back. In fact, the whole point of saving is to put earnings aside for “a rainy day,” or for the later purchase of big-ticket items, or for retirement – at any rate, not to eliminate it but to return it to circulation at some future time. And in a developed economy, over time the money put aside as savings will be counterbalanced by money previously set aside as savings and now returning to circulation. In addition, this money may have been supplemented by earnings on the financial market, which means that more money will be returning to circulation than left it. So on the face of it, this shouldn’t be a problem.

But there is a problem, and it is this. In normal situations this flow of funds back and forth between the ordinary and the financial markets is not problematic. But in the contemporary situation, it is.

One reason is because the ordinary market is being hit from various directions, making it unproductive and therefore unattractive. Firstly there are what Jane Jacobs (see this post for more on her) called “transactions of decline,” in which government removes money from productive activities, precisely because they are productive, and redistributes it to non-productive activities, precisely because they are unproductive. This can have a Keynesian motivation, whereby Say’s Law is turned on its head: demand then creates its own supply, and all government has to do is distribute money around to consumers (breaking the link between production and consumption) to generate productivity. According to Keynesians, this should in and of itself bring about prosperity, but as Jacobs points out, it only undermines productive activity and the human capital that underlies that productive activity, and so becomes a self-generating downward spiral.

Other things government engages in that undermine productivity are excessive taxation and regulation. All of this makes the ordinary market an unproductive affair, in which risks exceed rewards. The upshot is that savers put their money, not in ordinary investment, but in the financial market, which essentially is a zero-sum game, but in which at least the prospect of a decent return beckons.

And so more funds flow into the financial market than flow out, creating a dearth of liquidity in the ordinary market, which manifests itself in low interest rates combined with difficulty in borrowing (despite those low interest rates).

The flip side of the dearth of liquidity in the ordinary market is a glut of liquidity in the financial market. As funds pile into the market, returns there diminish and the quest for “alpha” (market-beating returns) becomes a frenzy. This is what happened during the 2000s in the run-up to the credit crisis. With the excess liquidity in the financial market, funds were available for lending that never would have been lent in a normal risk/reward analysis, often under political duress. An example is the subprime lending that took place. Michael Lewis (see this post for more on him) wrote about this in two of his most important books, The Big Short and Boomerang (the latter in particular gives a dramatic picture of the workings of the liquidity glut).

This was exacerbated by the trillions of dollars kept in the financial market by exporting countries like Japan and China (see this post this post for more on this), in their attempts to hold down the values of their domestic currencies. That in itself added substantially to the glut. But the very fact that what these countries were doing– looked at globally – was further undermining productivity by destroying productive capacity in rich countries while misdirecting investment in their own countries, only meant that another nail was being driven in the coffin of the ordinary market. Such “global value chains,” when established and maintained through currency manipulation and other fiscal and monetary policies designed to create unfair advantage for exporters at everyone else’s expense, only make the ordinary market even less attractive, which is another reason for the flight to financial markets, and even to inert investments like gold and other luxury items such as works of art.

A lot of work has to be done to restore ordinary markets to decent functionality. One of these is a return to an emphasis on the national economy as opposed to the lopsided emphasis on global-value-chain globalism such as obtains today. And within the national economy, a return to emphasizing the production side of the economy. Consumption does not magically engender productive activity; in particular, deficit spending to fund consumption is as pernicious a fiscal policy as can be devised. Various forms of capital are needed for that, various forms of infrastructure, from legal to educational (virtue versus entitlement) to religious. All of this is fodder for new discussions, so we’ll leave it at that for now.

This topic and more are dealt with more fully in the accompanying course.

[1] Treatise on Money, p. 147.

The Trouble with Exchange Rates

Do floating exchange rates work? By which we mean, do floating exchange rates bring countries, national economies, into equilibrium? Equilibrium here means that trade between countries is in balance. Thus, exports and imports of goods and services, although in constant fluctuation as economies progress along divergent paths, balance each other over time.

With this we do not refer to the total global trade balance. By definition, this will always sum to zero. The problem of imbalances crops up when certain countries run persistent surpluses and/or deficits. Because then, precisely by virtue of the zero-sum condition, other countries will have to run the reverse, a persistent mirror image, whether surplus or deficit. And the question then is, how is this possible in an age of floating exchange rates? In terms of theory, at least, floating exchange rates should compensate for such imbalances. If a country is running a trade surplus, the currency should appreciate, and vice versa if it is running a deficit, and this should result in the trade surplus or deficit being eliminated. But we have countries that run persistent surpluses or deficits. So what is going on?

The current regime of floating exchange rates has been in place ever since President Nixon eliminated the link between the dollar and gold back in 1971. Prior to that, we had the Bretton Woods system, in which the dollar was linked to gold, and was established as the reserve currency for the world’s monetary systems. Since then, the dollar has still officially played the role of the world’s reserve currency, but no longer like it used to. Back in the day, it was the means by which countries could maintain their currencies at the agreed-upon fixed rate: they needed to hold a certain level of reserves to maintain that exchange rate of their currency. Nowadays, of course, not being obligated to maintain a particular exchange rate, the need to maintain dollar reserves falls away. Or so one would think.

The fact is, even in an age of floating exchange rates, the “float” can be undermined and even negated, precisely by making use of dollar reserves. Two questions: how does this work? And, why would a country want to do this?

The first question, as to how it works: by resorting to techniques that were originally developed during the days of the gold standard (in order to short-circuit it) and have since been fine-tuned.

Essentially, since the dollar is the currency in which international trade takes place, a currency’s exchange rate with the dollar can be depressed by keeping dollar earnings from being exchanged into that currency. This is done by “sterilization,” the process of diverting dollar earnings from being converted into the domestic currency and repatriated into the domestic economy. This keeps the domestic economy from being “inflated” – from feeling the effects of prosperity, and, crucially, from importing more, which would force up the exchange rate. Therefore, export prospects remain undiminished, but at the expense of household consumption. The export machine is maintained at the expense of domestic prosperity. This is referred to as “forced savings,” which is really forced underconsumption.

There are other ways to accomplish the same goal. One is to impose a consumption tax. What this does is reduce spending without reducing production. There is then a surplus of production over consumption, and the surplus production is exported. The exchange rate depreciates, not by any active central-bank intervention, but because demand for the domestic currency declines on foreign exchanges – despite the fact that the country is running a trade surplus. Tariffs work in a similar manner. “Tariffs and consumption taxes always … increase net exports by reducing the real value of disposable household income [vis-à-vis importable goods] and so, presumably, by reducing household consumption.”[1]

Another way is through what Michael Pettis refers to as financial repression. Pettis in fact writes that “financial repression matters to trade even more than undervalued currencies.” Financial repression occurs when countries control the banking system and treat it like a department of state. In that case, the central bank sets interest rates that banks are required to follow, and these interest rates are set at a below-market level. Since households and consumers have no other place to put their money, they are required to accept this below-market interest income. This constitutes a subsidy forcibly paid by households to borrowers – companies. Business borrows at below-market prices, while consumers have interest income taken from them. The result is reduced consumption, and the same effect as discussed above with the consumption tax.

The question then is, why would a country want to do this? After all, we have been conditioned to think that an appreciating currency is a strong currency and a strong currency is a desirable thing to have. The fact of the matter is, for an exporting country which has built its prosperity on maintaining a trade surplus, a weak currency is a must.

This strategy is a staple of the Asian Tiger model of economic development. Starting with Japan, the Asian Tiger economies have pursued policies by which trade surpluses could be maintained. The following graphs give an indication of the success these policies have had in helping these countries’ export industries:

South Korea Balance of Trade Taiwan Balance of Trade Japan Balance of Trade China Balance of Trade Singapore Balance of Trade

Similar things can be said about Germany. This country likewise resorts to consumption-repressing policies, although nothing so drastic as the financial repression characteristic of countries like China. And as far as currency manipulation is concerned, Germany is part of the European Monetary Union and so shares a common currency, the euro, with the other member countries, and so cannot engage in currency manipulation. But Germany runs consistent current account surpluses with other member countries of the EMU. How? By virtue of the fact that its exchange rate was locked in at an artificially low level while those other countries were locked in at an artificially high level, and by voluntarily constraining wage growth (via agreement between labor unions, businesses, and government). The result can be seen in this post I wrote a couple of years back.

All in all, pretty much the same thing can be said of floating exchange rates as has been said of humility, Biblical welfare, conservatism, capitalism, even love: it works every time it’s tried. The problem is, it isn’t tried, even in this age of ostensibly floating national currencies. But there are signs that the problem is being recognized, as witness the spate of books dealing with currency wars. Even politicians are getting into the act: Donald Trump pledges to confront China’s currency manipulation. How this will play out going forward is anyone’s guess. But it will most likely continue to remain a bone of contention and true obstacle to realizing a more prosperous and equitable global order.


  1. Michael Pettis, The Great Rebalancing: Trade, Conflict, and the Perilous Road Ahead for the World Economy(Princeton: Princeton University Press, 2014) , p. 30. Pettis is professor of finance and economics at Peking University.

Confessions of a Free Trade Advocate

Ever since I can remember I have been a proponent of free trade. It seemed the logical thing: why should the government restrict economic activity which in itself is legal and aboveboard? And when I began exploring economic theory, lo and behold, free trade was at the forefront of most every exposition. It was the natural, the logical position to hold, and arguments against it seemed forced and, in fact, unfair, as if a basic principle of justice was being violated.

My instincts received even more validation from historical, moral theology. Francisco Vitoria, the Spanish theologian who was the first to flesh out a recognizably modern theory of the international community and law of nations, made freedom of trade one of the pillars of such a world order. As I wrote in 1991, “Freedom of trade Vitoria also includes among these rights of natural communication. This is quite noteworthy: remember, these rights belong to the ‘primary’ law of nations and as such may never be denied! National governments may infringe the right of neither their own nor of foreign private citizens and subjects to freely engage in trade, so long as trade and business may be carried on without prejudicing the health and safety of the community.” Free trade seemed to be a categorical imperative.

I continued along these lines in a book I published in 1999 entitled A Common Law. There I articulated a twofold tradition in Western constitutional theory and practice, the common-law tradition and the civil-law tradition. Of these two, the common-law tradition espoused limited sovereignty and the primacy of private law over public law, while the civil-law tradition embraced absolute sovereignty and the subordination of private to public law. As an extension of this, I included freedom of trade versus restriction of trade as a dividing line between the two traditions. With regard to the unification of Germany’s disparate states in the 19th century, I wrote that “The roots of German unification lay firmly in the civil-law tradition. Customs union lay the basis for further political union: free trade was established within the customs union, tariff barriers between it and the rest of the world…. In the civil-law tradition, trade can only be securely established within an area controlled by the sovereign; the domestic economy is the only stable economy. In the common-law tradition, trade binds societies under law, a law which also binds sovereigns and commits them to enforce it. In the civil-law tradition, law is the servant of the sovereign; in the common-law tradition, the sovereign is the servant of law” (pp. 125-126). Here again, I made free trade a categorical imperative and one of the core elements of a “constitution of liberty.”

As a final example, I wrote this in 1992: “Today the world is faced with the choice between two kinds of democracy. One, liberal democracy, is the descendant of the theocratic jus gentium, upholding freedom of trade, open borders, restricted national sovereignty, and the primacy of the private sector, considering that human society at the level of private association basically furthers the harmony of interests of its members, and that coercive authority is necessary only to ensure that violations in this harmony are punished. The other, social democracy, is the descendant of divine right absolutism, championing economic nationalism, closed borders, absolute national sovereignty (unless that sovereignty can be transferred to a supranational body), and the primacy of the public sector to rectify the inherent conflict of interests which exists in human society.”

So my free trade bona fides are fairly impeccable. But what I didn’t realize through all these expositions was something I only later began to uncover. It is a principle that already was elucidated by Friedrich List, one of the first post-classical economists to critique the doctrine of freedom of trade. The principle is this: trade between individuals and private entities is not the same as trade between nations, because it is nations that establish the framework within which trade can even take place. In the words of Karl Polanyi, markets are embedded. And this is of crucial importance. Nations establish currencies, laws, markets; they embody cultures and mores that impinge directly on economic performance; they embrace religions that, as Max Weber among others has shown, likewise are of crucial importance to economic activity. The public interest and the common-wealth are real factors that transcend private economy. They condition all economic activity and they cannot be abstracted away as if irrelevant to economics. This is the besetting sin of the free-trade theories of classical and neo-classical economics.

“How!” questions List. “The wisdom of private economy is then the wisdom of public economy! Is it in the nature of an individual to be preoccupied with the business and the wants of the future, as it is in the nature of a nation and of a government?” Leaving everything to individual action could not possibly ensure that collective interests will be taken care of. “Consider only the building of an American city; each man left to himself would think only of his own wants, or, at the utmost, of those of his immediate descendants; the mass of individuals as united in society are not unmindful of the interests and advantages even of the remotest coming generations; the living generation, with that view, submits calmly to privations and sacrifices which no sensible man could expect from individuals in reference to the interests of the present, or from any other motives than those of patriotism or national considerations” (National System of Political Economy, trans. G.A. Matile, Philadelphia: J.B. Lippincott & Co., 1856, pp. 245-246).

The absence of an understanding of the role of nations, and the focus on individuals, led classical economics to consider the entire world as one great commonwealth, with no distinctions of nationality and sovereignty. This is what led it astray. Its basic principles are valid within the framework of the nation, in their own sphere; but they run aground when trade between nations is considered. “In representing free competition of producers as the surest means for developing the prosperity of mankind,” List writes on p. 261, “the School is perfectly right, considering the point of view from which it regards the subject. In the hypothesis of universal association, every restriction upon honest trade between different countries would seem unreasonable and injurious. But as long as some nations will persist in regarding their special interests as of greater value to them than the collective interests of humanity, it must be folly to speak of unrestricted competition between individuals of different nations.” List here speaks only of national interests, but elsewhere he discusses the whole range of relevant criteria by which nations are distinguished. And so, “The arguments of the School in favor of such competition are then applicable only to the relations between inhabitants of the same country. A great nation must consequently endeavor to form a complete whole, which may maintain relations with other similar unities within the limits which its particular interest as a society may prescribe.” The social, public interests which obtain between nations are divergent; they differ from private interests and cannot be treated equally with them. “Now these social interests are known to differ immensely from the private interests of all the individuals of a nation, if each individual be taken separately and not as a member of the national association, if, as with Smith and Say, individuals are regarded merely as producers and consumers, and not as citizens of a nation” (p. 261).

So what does List propose as an alternative? Protectionism. This is his great failing. Because of this, his book has been neglected by those who realize the shortcomings of that doctrine, among whom I include myself. As I knew and still know, protectionism has its own set of problems.

Recall that “the School,” as List refers to the classical school of Adam Smith and Jean-Baptiste Say, advocated a commodity-money regime, which in effect harnessed the nations to a single currency. Because of this, if a nation wished to effectuate some sort of insulation of the domestic economy, it could only resort to protectionism as a fall-back.

The United States pursued a protectionist policy throughout the 19th and into the 20th century. The problems to which this led were given powerful expression at the crackup of the commodity-money regime in 1931, by James Harvey Rogers. Rogers placed a good deal of the blame for the bleak situation on the regime of tariffs obstructing trade.

The prominent part played by our high protective tariff in the present disastrous situation is beyond serious question. Aside from the political corruption which it has engendered in our national politics throughout more than a hundred years of our history, and aside, too, from the glaring domestic injustices which, since its inception, it has created and maintained; on it can now be laid the blame for a very important part in the extraordinary maldistribution of the money metal, in the recent drastic and rapid decline of prices, and therefore in the world-wide depression (America Weighs Her Gold, New Haven: Yale University Press, 1931, p. 193).

Of course this would have to be the case. Tariff walls short-circuit the functioning of a commodity-money regime. The attempt to eliminate trade imbalances through what effectively is a single currency run up against the shoals of that irreducible datum, the national economy. Domestic interests, in particular labor interests, simply will not pay the inflation/deflation whipsaw price to be paid to keep that system running. And so came the inevitable resort to trade barriers, and the eventual collapse of the system.

It is unfortunate that List’s exposition is known only for its advocacy of protectionism. Underneath that veneer lies a trenchant critique of the “cosmopolitan” system which is what unrestricted free trade embodies, which is valid now, as it was then. A common-law understanding of economics, which is what underlies List’s work, recognizes that nationhood and national sovereignty entail a framework of laws and institutions that delimit all economic activity and set up “natural” trade barriers that schemes like free trade and commodity money cannot overcome. A truly “natural” economic framework understands that currency is a function of sovereignty, and that floating exchange rates will provide the balancing mechanism that nations need to conduct trade relations with each other.

So how do we save freedom of trade? Not by eliminating nations, national sovereignty, national boundaries, and the like, but by embracing them within a framework that recognizes rather than undermines national sovereignty. Free-floating currencies are one crucial aspect of such a regime; after all, this is nothing else than free trade in currencies. Another is the adoption of domestic fiscal and monetary policies that do not promote the advantage of one nation over another. This is what happens when, for example, countries like Germany and China inflict forced-savings regimes on their own citizenry, punishing consumption and promoting production. What then in fact happens is that other countries are forced to take on board their excess production, as Michael Pettis has demonstrated in his book The Great Rebalancing. It is here that international efforts need to be conducted, not in imposing transnational regimes that undermine and displace national sovereignty altogether, and make a farce of even the pretense of democratic rule.