Immigration, Migration, and Imbalances

The current fracas with regard to immigration through the southern border of the United States will die down in time, and another issue will replace it in the headlines, in breaking news announcements, in round-table discussions. There will not be a resolution any time soon. But what is important is to understand the underlying issues involved. The context is what we need to get a better idea of how to judge necessarily ephemeral events.

The first thing to understand is that at bottom, the motivation for these people movements is economic. For this reason, we can start our analysis by eliminating the category of refugees seeking asylum. The latter is not a function of economics but of justice and compassion. While this is important, it is dwarfed by the scale of economics-inspired movement.

We also need to distinguish immigration and migration. In the sense I intend, immigration concerns people going to the country of destination with the mindset of assimilating into that country. For example, hitherto when immigrants moved to the United States, they moved with the intention of becoming Americans, of leaving their home countries behind and entering into the civic compact that has defined the United States from its inception. Migration, on the other hand, is no so much concerned with assimilation, but rather with the maintenance of the original culture and religion in the midst of the new environment – the establishment of enclaves within a foreign culture, that while engaged, is not entirely received, and indeed is held at arm’s length. In this sense, migration is a form of colonialism. And indeed, contemporary migrations are looked upon, approvingly or otherwise, as a form of retribution for the centuries of colonial relations the West imposed upon the rest of the world: these foreign peoples are now returning the favor, colonizing, and extracting wealth from, the host nations.

In the current climate, and in this analysis, it is migration with which we are concerned.

Some economic principles to guide the discussion

Migration, then, is an aspect of a global confluence of factors mainly economic in character.

Certain basic economic concepts have to be grasped in order to get a proper view of this phenomenon.

First: the economy, whether viewed locally, nationally, or globally, is a circular flow of the production and consumption of goods and services. This is a reflection of Say’s Law: supply creates its own demand. Say’s Law, which was most effectively employed in the work of Joseph Schumpeter, from whom the phrase “circular flow” comes, helps us understand how economies function.

The circular flow of goods and services concerns is the so-called real economy.

Second: not only is there a circular flow of goods and services, there is also a circular flow of payment, credit and debt, which is generated together with the other circular flow. It is both the result of that flow, and affects that flow. This is the so-called financial economy.

The two impinge on each other and determine each other. They cannot be viewed in isolation but as two parts of the same coin. The trouble with much of modern economics is that it does not do that, but treats them in abstract separation.

These circular flows are firstly local, comprising a local economy. A larger economy is a composite of smaller economies, and so comprises a confluence of circular flows. For this reason the economy, especially in other languages like French, is also called the conjuncture. The broader economy is a conjuncture of smaller economies operating more or less in sync with each other.

The component sub-economies do not move in lockstep. Rather, they develop at varying paces, some experiencing boom periods, others bust periods, others more or less stagnating.

What happens, then, is that factors of production flow towards areas of greater productivity: that is where the jobs are, that is, where capital receives a better return.

Borders and exchange rates

Within a political unit, these flows can occur unhindered. Between political units, they are obstructed by borders. These borders are the product of law. Laws set up obstructions to the crossing of boundaries. Furthermore, currencies, which are the product of law, form hidden barriers. Because they fluctuate, they make it more difficult to judge relative values, such as wages, keeping investors and workers from making the move, especially if the move looks to be from a more valuable to a less valuable currency. But beyond all of this, language and culture form boundaries, so that even in the absence of legal or monetary hindrances, people are hindered from moving because of the difficulty in adapting to foreign conditions.

So how do adjustments occur between economies separated by boundaries? By adjustments in the exchange rate of the countries’ currencies, so that areas with expanding economic activity see their currencies appreciate, while those with relatively contracting activity see their currencies depreciate. This is reflected in the current account, which is the sum of a country’s economic activity as far as production of goods and services is concerned, as it relates to other countries. The current account is in surplus when exports exceed imports, and vice versa. And a current account surplus should result in an appreciating currency.

In a perfect world, this mechanism would proceed unhindered, and the balance between nations would be maintained, with current account surpluses and deficits continually issuing forth into currency shifts that automatically lead to their reversals. Outperforming countries would have more money to buy foreign goods and services, and underperforming countries would have relatively cheaper goods and services to offer. This would result in a reversal of flows, with the more expensive countries importing more (and producing less) and the less expensive countries exporting more (and consuming less). Wages would increase in step with the currency, allowing them to import more. This is not a static condition. Currency exchange rates would continue to shift, balancing flows through the fluctuations and reversals of economic conditions over time.

Short-circuiting the feedback mechanism

But here is where problems arise. Particular interests are favored at any particular time, on both sides of the equation. On the side of the exporting country, there is the interest of the export industry, while on the side of the importing country there is the interest of consumers. Or at least, consumers can be led to believe that it is in their interest to have cheap goods available, although there is a hidden cost to this, which we will discuss shortly.

This is the situation in our current regime of globalism. Cheap-production countries are looking to lock themselves into exchange-rate and regulatory conditions favorable to their continued exports, even though such a regime is unfavorable to their own domestic economies. In those countries, domestic consumers face high prices on imports and production geared to foreign markets; workers see their wages artificially suppressed, rather than automatically rising vis-à-vis foreign competitors, as they would if currency exchange rates moved in step.

The gainers in such a situation are mainly multinational corporations which have relocated to low-wage countries and use their former home markets as dumping grounds for cheaper production. Other gainers are governments in the exporting countries, which book revenues from those corporations and their exports. Controlling elites on both sides of the equation benefit financially and politically.

The result in the importing countries is cheaper imports, but likewise a drain of production capacity, leading to an economy heavy on service-sector jobs.

Is such an economy – one lacking in production capacity – sustainable? It would seem that, given the demands and requirements of modern welfare states and the generation of revenues they require, that such an economy is not sustainable – for ultimately it is production capacity that generates wealth, while services only redistribute pre-existing wealth. Not to mention the utterly redistributionist nature of entitlement and benefit payments, which generate no wealth whatsoever, and in fact entail a form of friction which erodes wealth.

The stubborn expansion of imbalances

In the event, such a regime generates what have come to be known as imbalances. And a lot of effort is expended to counter those imbalances without resolving them. For to resolve them would lead to favored parties – e.g., multinational corporations, exporting countries – losing their lucrative advantages.

One of the important consequences is reflected in money and banking. The regime of fixed or pegged exchange rates is realized by keeping currency exchange from taking place. Normally, cross-border trade is paralleled by currency exchange, which leads to shifts in exchange rates. But to keep those exchange rates stable, currency exchange has to be headed off at the pass, as it were. This is accomplished through what is known as “sterilization.” Central banks act to keep foreign currency earnings from being released into the domestic economy. This holds down purchasing power and so eases pressure on the domestic currency to appreciate against the foreign currency. But this also leads to bloat in the currency of the importing country. Under our current regime, in which the US dollar serves as the reserve currency for international trade – and in which the US, not coincidentally, serves as the “consumer of last resort”—this has led to the buildup of massive amounts of liquidity which circulate aimlessly on financial markets without touching ground in real markets. This leads to bubbles in markets that traditionally serve as havens for excess liquidity, such as real estate markets and stock markets. Such asset “bubbles,” when they burst, lead to massive failures in the banking system, as occurred in 2008–2009.

Migration as a rectification of imbalances

This is one way in which imbalances are generated, and how they, by hook or by crook, get resolved. But capital flows comprise only one of the factors that resolve cross-border imbalances. The other mobile factor of production – labor – will likewise be drawn by the magnetic attraction of richer countries, especially where 1) those economies are lopsided toward service jobs, which cannot be exported and therefore draw low-wage labor to them rather than going to where low-wage labor is, like manufacturing capacity can; and 2) those economies maintain more or less lavish welfare and benefit regimes which ipso facto exert an attraction on citizens of less prosperous countries.

Therefore, in a world of fixed or pegged exchange rates – or especially, in the case of the European Union, a single currency – imbalances are rectified globally in the same way they are internally within a domestic economy. For the effect of the current globalist regime is to turn the entire world economy into a single domestic economy.

It would seem that this is a driving force behind current policy decisions being taken by Western nations, both in North America and in Europe. In the United States, border control lapsed and the government introduced a range of measures to accommodate inward migration, rather than making an attempt to stifle it. This is a tacit acknowledgement that a regime of floating exchange rates, the counterpart of nations able exert to effective sovereignty, has been set aside for all practical purposes, and that the great dream of cosmopolitan liberals everywhere is at hand: a global regime of universal jurisdiction, of a police rather than a military force, of a global welfare state in which ostensibly universal human rights move from the category of “ostensible” to “actual,” and the entire globe is harnessed to a redistributionist regime in which equal rights for all becomes a reality, regardless of cost.

In the meantime, what this regime of more-or-less fixed exchange rates and open borders spells is mass migration. For able-bodied labor will move if it can move, and given the technical transportational possibilities that increasingly have become available to low-wage populations everywhere, this movement will only accelerate. This is even more the case where populations are stuck not only in low-wage situations but in crime-ridden or even war-ridden, dysfunctional countries. Muslim populations in particular seem to be caught inordinately in such situations. Not surprisingly, Muslim populations are on the move.

The problem with this solution

But this points up the profound danger involved in these movements, and the misgivings they give rise to among “receiving” populations. For we are not dealing here with interchangeable parts; we are dealing with human beings, with cultures, mores, religions, in addition to whatever wealth or lack of it, health or lack of it, they may already have. Add to this the migration-orientation as opposed to immigration-orientation of these peoples, and the problem becomes all too apparent.

With migration, nationhood itself becomes problematic; instead of these groups being encouraged to assimilate, they become treated as victims of nationalistic jingoism, and encouraged to become integral parts of the grievance coalition. Patriotism really does come to be seen as the last refuge of the scoundrel, at least for the idealist. Cosmopolitanism becomes de rigueur.

But that cosmopolitanism is only a façade covering over deep divisions. For example, to what degree is Islam compatible with liberal democracy? If Muslims ever were to become a majority, would they maintain Western liberal institutions, or would they impose the institutions peculiar to Islamic countries, such as Sharia law? These are questions that not only are interesting academic exercises, but which practice will answer unequivocally, sooner or later, and of which real people will feel the effects.

Another such question: to what degree can countries like the United States sustain influxes of low-wage labor for service jobs that already are under pressure from unemployed or underemployed citizens? How can revenues be generated to counter the massive amount of pressure being put on the health, education, and welfare systems these countries have built up over the years, especially given their aging populations? Is it not a form of collective suicide to allow these migrations to take place in the hope that the gravy train will continue to flow? For looked at purely in terms of economics, these flows look to be unsustainable.

The end game?

Perhaps that is what our contemporary global elites are after. The very destabilization of nations, the undermining of national sovereignty, only plays into the hands of those desiring to establish a global regime to replace, or at least gain dominance over, sovereign nations. Nationhood itself is at stake. Politicians seem to have placed the dream of universal jurisdiction and the realization of every human being’s inalienable rights to food, accommodation, livelihood, education, health care, and the rest of it, above the exigencies of national survival. Apparently, they will pick up the pieces left in the aftermath of conclusive national failure.

Indeed, this would seem to be end game of national leaders favoring and preferring foreign interests to those of their own nations (e.g., Barack Obama, Angela Merkel). They seem to be auditioning for leadership in the regime which is yet to come, a regime to supplement or even replace our current framework of internationalist institutions such as the United Nations. Will it ever come to that? Yet another of those questions that practice will answer. But it is looking increasingly likely.

But there is an alternative. The venerable tradition of national sovereignty, of laws and currencies which are the expression of that sovereignty, of national populations that determine their own destinies rather than having them determined by unaccountable elites at transnational levels – the infrastructure for this is still there. And the top priority to this end, quite simply, is floating exchange rates and maintenance of the institutions protective of national sovereignty. This is not rocket science. It is a simple choice. Nationhood, or globalism?

Trumponomics and the Strong Dollar

Since the November election results, markets have been gaining – so much so that the big Wall Street trading firms booked eye-popping earnings in the fourth quarter. “Citigroup’s $3.7 billion trading haul was its best fourth-quarter showing since the financial crisis. J.P. Morgan Chase & Co., which reported its results last week, had its best fourth-quarter for trading ever,” reports the Wall Street Journal. The reason? According to this same article, the prospect of rising interest rates and “confidence that President-Elect Donald Trump’s policies will spur the economy.”

In particular, the prospect of reduced corporate taxation has markets in an upbeat mood. The expectation is that billions of dollars held overseas will start finding their way back into the country, taking advantage of the improved investment climate.

Such an influx of money from abroad, whether it’s being repatriated or it constitutes a fresh inflow from foreign investors, has the effect of increasing demand for dollars. This boosts the dollar’s exchange rate.

Supposedly, this is good news. The vast majority of commentators in general view a strengthening currency, and in particular a strong dollar, as a boon. An unsigned editorial in the Wall Street Journal argues that a strong dollar policy historically has gone together with a strong economy, as was the case with Reagan and Clinton, while a weak dollar policy has accompanied a weak economy, as with Nixon, Carter, George W. Bush, and Obama.

Although this particular editorial makes many dubious assertions, the main thrust of it is the claim that Mr. Trump’s recent statements emphasizing the undesirability of a strong dollar is simply another bit of evidence that he shoots from the hip, says things without thinking, and really doesn’t understand that a strong economy of necessity fuels dollar appreciation. Like other presidents, he should leave pronunciations about the dollar’s exchange rate to his Treasury secretary.

The point that the editorial makes, that a strong economy leads to a strong dollar, is not the point it is trying to make, that a strong dollar leads to a strong economy. The latter is precisely what must be demonstrated rather than asserted. And it leads us to re-evaluate whether or not Mr. Trump is shooting from the hip in a wild and unthinking fashion. For it forgets a cornerstone of Trumponomics, as articulated on the stump ad nauseum throughout the campaign, which is that there can be no economic restoration without a rectification of global trade imbalances, of which the US trade deficit is the most glaring manifestation.

It is easy for the Wall Street Journal to say that, during the Reagan years, “[while] extended dollar strength did hurt some U.S. companies against foreign competition, and the U.S. ran a large trade deficit…. The boom continued, and except for a shallow recession in the early 1990s the economy sustained a strong dollar and strong growth for many more years.” Yes, GDP figures superficially may have been strong, but under the surface, as we have outlined in previous articles,[1] the entire manufacturing base was being packed up and shipped overseas. For thanks to the strong dollar policy, the US not only ran a large trade deficit, it kept running a large trade deficit, and continues to do so to this day. This ongoing, year-in-year-out trade deficit is the telltale sign that we are living beyond our means, paying for our consumption not by equivalent production, but by debt.

This, not strong economic growth, is the legacy of the strong dollar policy. Is it pursued out of hubris, out of blindness, or simply at the behest of our friends, the Transnational Capitalist Class? Be that as it may, it is the background to Mr. Trump’s statement regarding the undesirability of a strong dollar. Trump knows that the dollar rally may signal strong economic growth in the short term, but in the long term it will keep the necessary rebalancing of the global economy from taking place, and in that all the efforts at relocating jobs and rebuilding manufacturing capacity will have gone for naught.


[1] For background on debt-financed consumption and the accompanying deterioration of production capacity, see these previous blog entries.

Trumponomics and the Great Rebalancing

Donald Trump’s election victory on November 8th is now a fact. Reactions to it have not been lacking, of course. On the economic front, they have ranged from the cautiously optimistic to predictions of utter doom. For their part, the financial markets went from downturn to upturn in short order (as chronicled here by Jerry Bowyer). But the financial markets, disconnected as they are from the real economy, are not very good arbiters of broader economic trends. What is important is the concrete policy decisions the Trump administration is going to make with regard to trade.

This is not to diminish the importance of other measures, such as tax policy. These will play an important albeit subordinate role in the kind of economic performance the country and the world will experience in the coming years. But the key issue – and significantly, one of the key issues addressed in Trump’s campaign – is trade. In terms of economic importance, nothing else comes close. To paraphrase Alfred North Whitehead, contemporary economic policy consists of a series of footnotes to trade policy.

For those who have been following this blog, such a statement should come as no surprise. Allow me to reiterate the main points:

  1. The global economy is so structured as to be systemically imbalanced. Certain countries run persistent, sizeable trade deficits; certain others run the mirror image of persistent, sizeable surpluses.
  2. Far from being innocuous, these imbalances are unsustainable, and leave a trail of carnage in their wake. They are unsustainable because they are financed, not by Palley’s “virtuous circle of growth” characterized by the circular flow of production and consumption, but by indebtedness. The trail of carnage is the hollowed-out production capacity in rich countries combined with sweatshop production in low-wage countries.
  3. The benefits of this system accrue to transnational elites: first, transnational corporations which profit from “buying low and selling high” within this made-to-order framework, then the politicians, media entities, and academics who serve to justify the framework, mainly by deflecting attention from its true nature and toward the ersatz quest for “justice” as embodied in identity politics, which locks subjugated populations permanently into this exploitative framework.

Great profits are being made within this arrangement, the flip side of the great losses (the ever-burgeoning global debt burden) the tab for which will be picked up by future generations (hello Millenials!). It stands to reason that anyone threatening to upset this particular apple cart will incur the ire of the entire range of vested interests, popularly known as “The Establishment” and more scientifically as the Transnational Capitalist Class.

The gravy train must keep flowing, and the uneasiness bordering on panic bordering on hysteria evidencing itself in much of the post-election news reporting has its roots precisely in the realization that (to use yet another of these analogies) the punch bowl is about to be taken away.

Now then, if these trade deficits are as important as I am claiming they are, what can be done about them? Obviously, this will be easier said than done: not only will there be the implacable resistance of special interests, there will be the entire set of problems that is involved in what has come to be known as “The Great Rebalancing.” For what is required is that entire national economies be reordered to restore the “virtuous circle of growth” and break some seriously settled habits.

On the export side, there are two major forms of imbalance that need to be addressed: the Asian Tiger model and the German model. Let’s take these one at a time.

The Asian Tiger model was pioneered by Japan and took flight during the 1970s upon the breakup of the Bretton Woods arrangement. Ultimately it is based on the artificial suppression of the currency’s exchange rate in order to ensure export sales. The export industry in combination with government controls the economy. They structure the economy in order to benefit the export industry at the expense of domestic industry and trade. In particular, the banking system is subjugated and forced to perform certain functions, such as paying below-market interest rates on both savings (thus penalizing households) and loans (thus benefiting business).

One result of this model is that it keeps money earned from exports (which earnings are denominated in dollars) from re-entering the ordinary market (a process called sterilization), as this would cause the currency to appreciate. Rather than being repatriated to the producers, much of those dollar earnings are kept in dollars, held by the country’s central bank, and invested in US government debt (Treasury bills and bonds). In this manner, earnings are taken out of the ordinary market and kept on the financial markets, leading to asset bubbles. This money can return to the ordinary market and so fund consumption, but not by the original earners spending it (which would reinstate the virtuous circle); rather, it is borrowers, who are given access to this liquidity, and in this manner are allowed to fund consumption in an unsustainable manner. This was one of the factors behind the boom-bust of the first decade of the 21st century.

The German model differs from the Asian Tiger model because it does not depend on obtaining competitive advantage via manipulation of exchange rates or by sterilizing foreign earnings. Rather, it achieves this through fiscal policy, mainly through measures to suppress consumption. Wages are held down in the interest of competitiveness, and consumption is discouraged by means of a consumption tax (VAT). The result is the same: the producers, whether they produce for domestic or foreign consumption, are kept from spending their own earnings. These earnings are simply foregone. This benefits the export sector by improving terms of trade, but it does not benefit the country, because those foregone earnings could have gone to generate and sustain the domestic economy, thus reducing the country’s dependence upon the vicissitudes of export markets.

What these methods have in common is the suppression of consumption. It is perhaps no coincidence that the countries engaging in these practices have long traditions of frugality and asceticism. This is not the place to enter into a discussion regarding the relation of religion and morality to economic growth, although I do reserve the right to do so at some point in the future. I only raise the point to indicate something that cannot be mere coincidence. And indeed, the countries on the other end of the trade relation – the net consumers – have gotten a name for being spendthrift and lazy, incapable of competing. The reality, as we hope to explore another time, is more complicated.

So, in order to achieve this “great rebalancing,” essentially two things have to happen – countries need to reorient their fiscal and monetary policies to, in the case of the producing countries, promote domestic consumption, and in the case of consuming countries, promote domestic production. In the latter case, a reworking of venerable “import replacement” policies is in order. A focus on the domestic economy is required which will restore the virtuous circle of growth and break the cycle of unsustainable debt financing.

What kind of policies would the Trump administration need to pursue in order to further this proposed state of affairs?

First of all, one thing needs to be made clear. All the saber rattling on the part of countries in Europe and Asia with regard to a trade war, such as China’s threat to buy Airbus aircraft rather than Boeing aircraft, are nothing more than that. As with the dire warnings surrounding Brexit earlier, the countries doing the threatening are, in point of fact, in no position at all to threaten. They are running trade surpluses with the US or the UK, as the case may be, which means that they selling more to those countries than they are buying from them. This means that they need those countries’ markets, and if they cannot sell to them, they will be left with surplus production and nowhere to offload it. Hence, these countries know as well as anyone that saber rattling is useless at best and counterproductive at worst.

What about US threats of (to cut to the chase) a 45% tariff on imported goods from China? This would be the least desirable method of achieving some sort of rebalancing. Leaving aside the corruption involved in business lobbying for protected status (as noted in 1931 – another period of protectionist agitation – by James Harvey Rogers), such a tariff would dislocate whole industries and so undermine economic growth in the short to medium term. In the longer term, a tariff might lead to a functioning economy in the US, as domestic industry restored itself to some level of its former glory, but it would damage China severely, without providing any mitigating mechanism to enable it to begin producing for the domestic economy on a sustainable basis.

There are far better and more mutually agreeable ways to engage the great rebalancing than punitive tariffs. Firstly, and Mr. Trump is absolutely right on this, currency manipulation has to be stopped. While China may not be engaging in this at the moment, it most certainly was for a long period in the late 1990s and up until the crash of 2008, leading to its mountain of dollar reserves. In this regard, Trump is closing the gate after the horse has bolted, at least respecting China, but the entire system of sterilization and amassing of dollar reserves has to be put an end to.

Then there are the domestic policies that structurally suppress consumption. These have to be reversed. In the case of China, household consumption in 2010 declined to an “astonishing” (Michael Pettis’s word) 34% of GDP, astonishing in view of the fact that for most countries this figure is at 60-70%. Behind this low level of domestic consumption are policies promoting forced savings and what Michael Pettis refers to as “financial repression,” wherein banks operate to transfer savings from households to business and government at below-market rates. The German method utilizing wage restraint and consumption tax must also be reversed.

The Trump administration must insist on these common-sense changes in domestic policies on the part of its trade partners, because they are not mere matters of domestic concern: they affect trading partners as well. Pettis shows this in ch. 6 of his book The Great Rebalancing. Using the case of Germany vis-à-vis Spain, he outlines how domestic policies in Germany affect Spain’s economic prospects, and how both countries need to make coordinated adjustments to ensure a transition to a balanced economy. The same has to be done on a global scale.

On the domestic front, changes to the tax regime regarding business, bringing it more in line with other countries’ corporate tax rates, will be of some help, as will various initiatives to reconstruct and bring jobs back to the inner cities, and the various infrastructure projects. But these will be of little use if the main issue, international trade and its discontents, is not addressed comprehensively and thoroughly. Otherwise, the opportunity presented when the US electorate dodged the bullet of a Clinton presidency, which would have sealed the deal for the transnational corporate class, will have proved to be only a bump in the road to Elysium.

What This Election is Really All About

The Economics of the 2016 Election Cycle

The current election cycle in the United States is like none other in recent memory. At least in terms of vitriol, it is no contest. But beyond the partisan slams back and forth lies a deeper fundamental reality which really lies at the heart of the contest.

In fact, despite surface appearances, this is not a typical Democrat versus Republican, left-wing versus right-wing, liberal versus conservative, election. It goes far deeper than that.

My own wish is that partisans on both sides would suspend judgement for a moment, follow me through a rather involved analysis of the economics underlying the current political situation, and think through the implications. In advance, the author thanks you for your attention.


Vantage points are everything. We have a good one provided us by the Keynesian economist, Thomas Palley. Palley’s leftist credentials are impeccable, as might be expected from a former Assistant Director of Public Policy for the AFL-CIO. As such, the following exposition can make the claim, at any rate, to being something other than a mere partisan discussion. The hope is that we get beyond the left-right divide as it has manifested itself in the current political landscape, to the underlying realities that transcend that divide as currently manifested.

Back in 2009, Palley wrote a significant article[1] outlining the real underlying causes of the financial meltdown and credit crisis of 2008. In the course of explaining that catastrophic course of events, Palley ends up providing a succinct summation of the condition of the world economy generally, that retains its applicability to this day.

As Palley has it, the standard explanations of market failure do not go nearly far enough, which is a significant admission by a left-leaning economist. For the usual explanation of economic problems provided by economists of this persuasion puts the blame precisely on market failure. This time is different. “Most commentary has … focused on market failure in the housing and credit markets. But what if the house price bubble developed because the economy needed a bubble to ensure continued growth? In that case the real cause of the crisis would be the economy’s underlying macroeconomic structure” (p. 1).

In other words, the housing bubble was not an unfortunate unforeseen occurrence: it was fostered by deliberate, albeit blind, policy. How and why such a situation would actively be pursued, is the burden of Palley’s article.

The roots of the said macroeconomic arrangement actually go back decades. Palley traces them to the onset of the Reagan administration of 1980. “Before 1980, economic policy was designed to achieve full employment, and the economy was characterized by a system in which wages grew with productivity. This configuration created a virtuous circle of growth …. After 1980, with the advent of the new growth model, the commitment to full employment was abandoned as inflationary, with the result that the link between productivity growth and wages was severed. In place of wage growth as the engine of demand growth, the new model substituted borrowing and asset price inflation” (p. 2).

We must register a quibble with the timing of events here. 1980 did not happen in a vacuum. The hyperinflation of the 1970s is what discredited these Keynesian policies and the Reagan policy responses were the fairly obvious policy response. Anyone who lived through that period knows just how helpless everyone felt at the inability to tame the inflation dragon. In that regard, the Reagan response was inevitable and welcomed.

What really precipitated the new macroeconomic arrangement was the abandonment of the previous such arrangement, the post-war Bretton Woods currency and trade setup. This occurred not in 1980, but in 1971, with President Nixon’s abandonment of the dollar-gold link. What this meant was a switch from fixed to floating exchange rates, which together with the advent of OPEC and skyrocketing oil prices, deranged a hitherto relatively stable situation currency and trade situation.

A graph provided in another of Palley’s articles[2] suggests the same correlation:

Productivity and real average hourly wage and compensation of US non-supervisory workers, 1947-2009. Source: EPI analysis of Bureau of Economic Analysis and Bureau of Labor Statistics data.
Productivity and real average hourly wage and compensation of US non-supervisory workers, 1947-2009. Source: EPI analysis of Bureau of Economic Analysis and Bureau of Labor Statistics data.

As can be seen in the accompanying figure, the divergence between productivity and compensation/wages begins in the early 1970s, corresponding with the breakup of Bretton Woods. So, it was the early 1970s and not 1980 that saw the change in fortunes of which we are speaking.

The new arrangement was characterized by a new priority: globalization. The preference for globalization expressed itself in a new attitude toward trade deficits. “Under the earlier economic model, policymakers viewed trade deficits as cause for concern because they represented a leakage of aggregate demand that undermined the virtuous circle of growth. However, under the post-1980 model, trade deficits came to be viewed as semi-virtuous because they helped to control inflation and because they reflected the choices of consumers and business in the marketplace” (p. 5).

This is a crucially important statement. It provides the kernel of what has been happening over the last 40 years. “The virtuous circle of growth” is Palley’s way of formulating what we in our own model (as described in the accompanying course) refer to as the circular flow of the economy. In essence, all economies are local, then regional, then national, and only then international. A “virtuous circle of growth” is what we understand as the domestic economy. But arrangements can be made that discombobulate this order. What we then have is the domestic economy subordinated to supranational interests. In essence, it is a form of colonialism. And that is what Palley is referring to when he speaks of a “leakage of aggregate demand.” The circular flow is disrupted; supply and demand are disconnected from each other in the domestic economy, diverted toward an international economy characterized by trade deficits and surpluses, the ineluctable by-products of these “leakages.”

This arrangement is papered over by appeals to free-market principles. Hence the epithet “neoliberalism.” These trade deficits do indeed help to control inflation, but at a steep price. And they may reflect “the choices of consumers and business in the marketplace,” but without consumers and business realizing that there is a flip side to these cheap imports, and that is the loss of employment and productive capacity.

For what do these trade deficits actually represent? For one thing, the systematic suppression of wages on both sides of the trade equation. “American workers are increasingly competing with lower-paid foreign workers.” This is obvious and well-known. What is less well-known is what is going on with these foreign workers: “That pressure is further increased by the fact that foreign workers are themselves under pressure owing to the so-called Washington Consensus development policy, sponsored by the International Monetary Fund (IMF) and the World Bank, which forces them into the same neoliberal box as American workers.” They are both being disadvantaged; they are being played against each other. For the loss of purchasing power on the part of American workers is not compensated for by increased demand from abroad, for foreign workers likewise are deprived of purchasing power, despite the fact that they are on the receiving end of the job-offshoring program. “Neoliberal policies not only undermine demand in advanced countries, they fail to compensate for this by creating adequate demand in developing countries” (p. 7; emphasis added).

This is the double bind in which workers find themselves, both in developed and developing countries.

In developed countries this arrangement has hit the manufacturing sector particularly hard. The idea has been spread abroad that in the US the decline of the manufacturing sector is the result of inevitable trends, in particular, increased productivity. But this does not explain the loss of jobs: “A smooth long run declining employment share brought about investment and innovation that creates a more efficient manufacturing sector is a fundamentally different proposition from decline caused by adoption of a policy paradigm that dismantles the manufacturing sector by encouraging off-shoring and undermining competitiveness” (p. 4). It is the latter, not the former, that explains the loss of manufacturing jobs. That is to say, the new macroeconomic arrangement with its leakage of production to low-wage countries is the real reason.

Accompanying the loss of manufacturing jobs has been a steady divergence in income share. “Between 1979 and 2006, the income share of the bottom 40 percent of U.S. households decreased significantly, while the income share of the top 20 percent increased dramatically. Moreover, a disproportionate part of that increase went to the 5 percent of families at the very top of income distribution rankings” (p. 6). Palley also points to increased labor market flexibility and the abandonment of full employment as a policy objective as factors behind widening income inequality, but the obvious driver of the process is the pressure on the job market brought on by the offshoring of jobs.

All of this has displaced what Palley terms the “stable virtuous circle growth model based on full employment and wages tied to productivity growth” (p. 9). What has taken its place? The new arrangement “based on rising indebtedness and asset price inflation.” These two, not productive activity, generate the income to fund consumption.

In the new arrangement, production takes place in developing countries, while consumption takes place in developed countries. Production has been divorced from consumption. This is the reality behind the ever-present trade imbalances characterizing the modern global economy.

In the old model, in line with Say’s Law, production funds consumption and consumption, production. This is the circular flow of the domestic economy, Palley’s “virtuous circle growth model.” The new model divorces production from consumption. Production no longer pays for consumption: the producers in developing countries have their wages suppressed, and so cannot provide increased demand, while the consumers in developed countries are not producing and selling enough to pay for their consumption. The shortfall is paid for by taking on debt: in terms of economic jargon, this is known as “financing the trade deficit.”

This in turn leads to asset bubbles. “Since 1980, each U.S. business cycle has seen successively higher debt/income ratios at end of expansions, and the economy has become increasingly dependent on asset price inflation to spur the growth of aggregate demand” (p. 9). Various asset markets have done duty to generate this asset inflation and thus artificial prosperity, yielding the dot.com bubble, stock market bubbles, and housing market bubbles. These bubbles are self-feeding phenomena: increases in asset prices spur borrowing based on those asset prices, which in turn encourages further spending leading to further increases in asset prices. But they also provide income to sustain standards of living that essentially are beyond the means of the underlying wealth-producing capacity of the economy.

Palley speaks in particular of the “the systemic role of house price inflation in driving economic expansions.” He points out that “Over the last 20 years, the economy has tended to expand when house price inflation has exceeded CPI (consumer price index) inflation.” This is true for the Reagan expansion, the Clinton expansion, and the Bush-Cheney expansion, and so is “indicative of the significance of asset price inflation in driving demand under the neo-liberal model” (p. 10), which has truly been a bipartisan affair.

Of course, “The problem with the model is that it is unsustainable.” It requires continued excessive borrowing and continued reductions in savings rates, which can only be sustained by ever-expanding asset inflation, which eventually must come to an end.

This dynamic lay behind the credit crisis of 2008, only this time things were different. Mainly, the degree of indebtedness, the breadth of participation in it – as might be expected from a bubble generated by the broader housing market – far exceeded previous instances and precipitated the enormous blow to the real economy, not to mention the carnage wrought to the financial economy.


Behind this macroeconomic structure lay the disruption of the production-consumption linkage of the domestic economy. It was this that made necessary the generation of artificial prosperity to maintain a standard of living, a level of consumption, without any connection to the level of production.

This macroeconomic structure was supported by trade policy. Palley points to the establishment of the North American Free Trade Agreement (NAFTA), the establishment of the “strong dollar” policy after the East Asian financial crisis of 1997, and permanent normal trade relations (PNTR) with China in 2000, as the “most critical elements” of the global economic arrangement. These were “implemented by the Clinton administration under the guidance of Treasury secretaries [sic] Robert Rubin and Lawrence Summers.” The measures “cemented the model of globalization that had been lobbied for by corporations and their Washington think-tank allies” (pp. 12-13).

The upshot was a global economic arrangement featuring a “triple hemorrhage:” leakage of spending on imports, leakage of jobs overseas, and leakage of investment overseas.

We gained a new economic arrangement in which trade deficits became the rule and the world became the production zone for US corporations, which could turn around and sell this production to compatriot consumers. “At the bidding of corporate interests, the United States joined itself at the hip to the global economy, opening its borders to an inflow of goods and exposing its manufacturing base. This was done without safeguards to address the problems of exchange rate misalignment and systemic trade deficits, or the mercantilist policies of trading partners” (p. 14).

This created a “widening hole” in the economy “undermining domestic production, employment, and investment.”

NAFTA in particular ushered in a new era of exchange-rate policy. “Before, exchange rates mattered for trade and the exchange of goods. Now, they mattered for the location of production” (p. 15). This worked to the advantage, of course, of multinational corporations, enabling them to pursue the policy of producing in low-wage markets and selling the production in developed markets. This in turn led to a strong dollar policy, likewise pushed by multinationals. “This reversed their commercial interest,” as US corporations previously favored a weak dollar, for obvious reasons.

The collapse of the peso in 1994 was a direct result of this new policy. In the new arrangement, the cheap peso was a boon to US corporations producing in Mexico and exporting to the US. “The effects of NAFTA and the peso devaluation were immediately felt in the U.S. manufacturing sector in the form of job loss; diversion of investment; firms using the threat of relocation to repress wages; and an explosion in the goods trade deficit with Mexico …. Whereas prior to the implementation of the NAFTA agreement the United States was running a goods trade surplus with Mexico, immediately afterward the balance turned massively negative and kept growing more negative up to 2007.”

The strong dollar policy was further implemented during the series of financial crises in the late 1990s, starting in East Asia. “In response to these crises, Treasury Secretaries Rubin and Summers adopted the same policy that was used to deal with the 1994 peso crisis, thereby creating a new global system that replicated the pattern of economic integration established with Mexico” (p. 16). The strong dollar increased the purchasing power of the US consumers: “critical because the U.S. consumer was now the lynchpin of the global economy, becoming the buyer of first and last resort.”

One result of this policy was that “manufacturing job growth was negative over the entirety of the Clinton expansion, a first in U.S. business cycle history” (p. 18). Positive business cycle conditions obscured the underlying trends; to add insult to injury, “the Clinton administration dismissed concerns about the long-term dangers of manufacturing job loss. Instead, the official interpretation was that the U.S. economy was experiencing—in the words of senior Clinton economic policy advisers Alan Blinder and Janet Yellen—a ‘fabulous decade’ significantly driven by policy.” Janet Yellen is, of course, the current Chair of the Federal Reserve Board.

The final step in this process was taken when China was granted the status of PNTR and then admitted to the World Trade Organization. “Once again the results were predictable and similar to the pattern established by NAFTA—though the scale was far larger.”

Hence, all the pieces were put in place during the 1980s and 1990s, but they did not come to full fruition until the crisis of 2008. “From that standpoint, the Bush-Cheney administration is not responsible for the financial crisis. Its economic policies … represented a continuation of the policy paradigm already in place. The financial crisis therefore represents the exhaustion of that paradigm rather than being the result of specific policy failures on the part of the Bush-Cheney administration” (p. 21).


Given the above, it is obvious that the credit crisis of 2008 was not the result of the usual suspects, deregulation of financial institutions and banks pushing excessive lending for no other reason but greed. The excessive lending was built into the structure; the entire world economy depended on it, for only through this asset-inflation-induced debt could US consumption, the driving force of economic growth in developing countries, be paid for.

So what is needed is paradigm change. And in this context, Palley, writing in 2009, makes a prophetic statement.

The case for paradigm change has yet to be taken up politically. Those who built the neoliberal system remain in charge of economic policy. Among mainstream economists who have justified the neoliberal system, there has been some change in thinking when it comes to regulation, but there has been no change in thinking regarding the prevailing economic paradigm. This is starkly illustrated in the debate in the United States over globalization, where the evidence of failure is compelling. Yet, any suggestion that the United States should reshape its model of global economic engagement is brushed aside as “protectionism. [sic]”, which avoids the real issue and shuts down debate (p. 25).

“Shuts down debate,” indeed. In the intervening period between 2009 and 2016, the topics of trade deficits, currency arrangements, and multilateral trade deals, have consistently been dismissed as matters of concern, denigrated as unworthy of debate; while proponents of such a re-evaluation have been routinely dismissed as cranks undeserving of serious attention.

As it happens, two candidates for the office of President have put this issue on the table, despite the bile they have received for it: Bernie Sanders and Donald Trump. The concerns of both have been dismissed out of hand by regnant opinion-makers. This should not come as a surprise. After all, “The neoliberal growth model has benefitted the wealthy, while the model of global economic engagement has benefitted large multinational corporations. That gives these powerful political interests, with their money and well-funded captive think tanks, an incentive to block change” (p. 26). Furthermore, “Judging by its top economics personnel, the Obama administration has decided to maintain the system rather than change it,” and subsequent history confirms this. In fact, at the time of writing, President Obama is promoting the latest iteration of this neoliberal arrangement, in the form of the Trans-Pacific Partnership (TPP).

It is not only the Obama administration that continues to push this arrangement. The entire Washington establishment, both Democrat and Republican, is fully behind the continuation of this unsustainable model. Given this intransigence, what is the logical next step? Palley points to it, and subsequent history has only confirmed it: “stagnation is the logical next stage of the existing paradigm” (p. 27). Ever-burgeoning debt that only gets rolled over and never repaid, leads, as the example of Japan teaches, only to economic stagnation, the so-called zombie economy.

Where does Hillary Clinton stand on this issue? Recent statements indicate softening in the direction of Sanders’ position, including announced opposition to TPP. Besides the pronounced skepticism with which such proclamations have been greeted by the left wing of the Democratic Party, there is the little matter of track record. After all, it was during her husband’s administration that all the pieces of the neoliberal program were implemented, and on that, she was with him all the way. Nothing in her subsequent record either as Senator for New York, or as Secretary of State, would indicate otherwise. Quite obviously, her current registered opposition to TPP was driven by Sanders, Trump, and poll numbers.

But beyond this is her place within the framework of what has become the Clinton global network. This network is anchored by a range of institutions: the Clinton Foundation, the Clinton Family Foundation, and the Clinton Global Initiative, among others. The Clinton Foundation was established in 1997 with the purpose to “strengthen the capacity of people throughout the world to meet the challenges of global interdependence.” The Clinton Global Initiative is part of this entity, although between 2009 and 2013 it was hived off, presumably in connection with Clinton’s stint as Secretary of State, to avoid the appearance of conflict.

Articles such as this one from the Washington Post, providing The Inside Story of How the Clintons Built a $2 Billion Global Empire, yield a glimpse into the global reach the Clintons enjoy within the current neoliberal framework. In fact, one might paraphrase Palley’s characterization of the US by saying that indeed the Clintons are joined at the hip with the neoliberal framework. We might go so far as to say that Hillary Clinton is the poster child of this framework, which doubtless is part of reason she enjoys such favorable press despite the fact that she carries so much baggage, of the kind that would have eliminated just about any other candidate.

And so it can be argued that the globalist corporate elite, which props up, and benefits from, the neoliberal arrangement, is promoting the Democrats’ progressive agenda, using it, exploiting it, the better to ensure that this pernicious arrangement remains cemented in place. Hillary Clinton is certainly progressive on social issues. The question is, is she progressive on economics? Let the record speak for itself.

Notes
  1. Thomas I. Palley, “America’s Exhausted Paradigm: Macroeconomic Causes of the Financial Crisis and Great Recession,” IPE Working Papers 02/2009, Berlin School of Economics and Law, Institute for International Political Economy (IPE). Available at https://goo.gl/gRkfD7.
  2. “Making Finance Serve the Real Economy,” in Thomas I. Palley and Gustav A. Horn (eds.), Restoring Shared Prosperity: A Policy Agenda From Leading Keynesian Economists (CreateSpace Independent Publishing Platform, 2013), p. 74. Available at http://goo.gl/1uJZv6.

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 [http://atlas.media.mit.edu]).

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 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.

National Economy?

At first glance the notion of a national economy would seem to be self-evident. After all, the lion’s share of economic data comes in the form of “national accounts,” which treat the nation as a self-contained economic entity, like a business. And the talk, when it comes to the economy, is always of how the nation is doing, or how other nations or countries are doing. Likewise, history revolves around the nations and their economic progress, as with the US and its “manifest destiny.”

But the idea of a national economy does not extend to the level of theoretical category. Economic theory does not take it into consideration. It comes into play because of political, not economic, considerations. The fact of the matter is, because politics is concentrated at the national level, so also is fiscal and monetary policy. And this factual state of affairs determines the subject matter. It is at the national level that both fiscal and monetary policy takes place; it is the level at which results from these policies are expected.

Economic theory, however, is not discussed in terms of the nation but in terms of abstractions: the “market,” “business,” “consumers,” etc. This is, or at least it used to be, referred to as “microeconomics.” Then we have “macroeconomics,” which is essentially the economic role of the state with its aforementioned fiscal and monetary policies; in this way we smuggle the nation in through the back door, as it were.

But the nation never functions as a subject of economic theory in its own right. Economic practice, of course, cannot avoid it – the sovereign democratic state is the way things are, it delimits the subject matter at the “macro” level.

The unexamined presupposition in all of this is, what is the locus of the economy? It is actually a question of the utmost importance, because only in this way can we come to grips with crucially important notions – and realities that, like it or not, we have to deal with – like the “global” economy.

One person who, thankfully, did not leave this presupposition unexamined is Jane Jacobs. In her book Cities and the Wealth of Nations,[1] she puts the notion of a national economy, which she takes to be the reigning doctrine, squarely in the cross-hairs. In her view, such an economy is an artificial imposition: the real economy is city-oriented. Cities, not nations, form the watersheds of an economy. Which is to say, cities are the focus of integrated, mixed economies, involving all major sectors from agriculture to industry to finance. Within the city and its supply regions, a stable and integral economy is maintained.[2]

Therefore exporting and importing takes place between cities, not nations. By extension, cities perform the vital economic function of import-replacing: the replacement of imported goods with goods of their own making. In Jacobs’ model, it is this import-replacing function that is the basic motor of economic growth.[3]

Jacobs adds to this import/export functionality the logical corollary: currencies. Currencies function as feedback mechanisms: they provide economies with information with respect to their productivity vis-a-vis other economies. A rise in an economy’s currency indicates that it is more productive than other economies the currencies of which are falling in relative terms, while a fall indicates the reverse condition.

So then Jacobs draws the obvious conclusion. Since cities are the basic units of import and export, currencies, in order to best perform their function, should be geared to the city economy itself; their rise and fall would thus trigger the appropriate response in the city economy, because this currency fluctuation acts as both tariff barrier and export subsidy (a falling currency acts as an export subsidy, a rising currency as a tariff barrier). Cities should maintain their own currencies.[4]

This also indicates a problem with this entity known as the national economy. A larger political unit such as a nation-state, when it imposes a common currency on a multiplicity of cities, short-circuits this feedback function of currencies. It favors the economies of some cities at the expense of others. Since cities not only import and export to foreign nations but also to sister cities in the same nation,[5] the automatic feedback information provided by the currency does nothing to allow cities within the range of the currency to adjust their economies to each other. They receive none of the feedback information that a city-based currency would provide them. Therefore, the cities whose economic position is favored by the national currency continue to grow, while the others stagnate.[6]

Clearly Jacobs is no friend of the nation-state. “Virtually all national governments, it seems fair to say, and most citizens would sooner decline and decay unified, true to the sacrifices by which their unity was won, than prosper and develop in division.”[7] And she takes classical economics, especially as exemplified in Adam Smith’s tellingly titled Inquiry into the Nature and Causes of the Wealth of Nations, to task for this. Smith “accepted without comment the mercantilist tautology that nations are the salient entities for understanding the structure of economic life. As far as one can tell from his writings, he gave that point no thought but took it so much for granted that he used it as his point of departure.”[8] Smith’s unthinking assumption of this assumption was subsequently passed from generation to generation without any further thought on the matter. “Ever since, that same notion has continued to be taken for granted. How strange; surely no other body of scholars or scientists in the modern world has remained as credulous as economists, for so long a time, about the merit of their subject matter’s most formative and venerable assumption.”[9]

So Jacobs agrees with us that the locus of the economy is an unexamined proposition. Nevertheless, her thesis that the nation was the focal point of classical economic theory is debatable. In fact, it is contradicted by an early proponent of “The National System of Political Economy,” Friedrich List.[10] List certainly does not figure as an unthinking follower of Adam Smith. His description of Smith’s school is telling: he calls it “the Cosmopolitical System.” By which he means that, pace Jacobs, it is the antithesis of a “national system” of economics.

In line with the influential vision of “Perpetual Peace” put forward in the late 18th century by the celebrated Abbé St. Pierre, this “cosmopolitical system” of economics presupposes harmony and peace between the nations. In such a situation, nations per se have no interests; the human race is joined together as one; and for this reason, “for the most part the measures of governments for the promotion of public prosperity are useless; and that to raise a State from the lowest degree of barbarism to the highest state of opulence, three things only are necessary, moderate taxation, a good administration of justice, and peace.[11] Free trade is then the norm, and indeed, can only truly be implemented under the auspices of such a universal peace. But, argues List, this is to confuse a hypothetical goal toward which the nations should work, with a standing condition already attained.

The [classical] School has admitted as realized[,] a state of things to come. It presupposes the existence of universal association and perpetual peace, and from it infers the great benefits of free trade. It confounds thus the effect and the cause. A perpetual peace exists among provinces and states already associated; it is from that association that their commercial union is derived : they owe to perpetual peace in the place they occupy, the benefits which it has procured them. History proves that political union always precedes commercial union. It does not furnish an instance where the latter has had the precedence. In the actual state of the world, free trade would bring forth, instead of a community of nations, the universal subjection of nations to the supremacy of the greater powers in manufactures, commerce, and navigation. [12]

While Smith and the other proponents of the classical school did recognize the existence of nations and national interests, List correctly assesses the basic orientation of the system. Much of this was inchoate; Lists’s strictures served to stir up debate, generate criticism, and give rise to critical schools of economic theory, such as the so-called Historical School.

This is evident not only in the advocacy of free trade generally as panacea for all economic ills, but also, importantly, in the advocacy of free trade in the area of currency. As we explored in this earlier post, leaving currency to the free market is a key element in a cosmopolitan system that deemphasizes nations as economic actors and subjugates sovereignty, in order to establish a “center-periphery” system of exploitation. And Adam Smith’s classical system established commodity money as a cornerstone of its economic order. As such, in its essentials List’s construct holds true.

List is correct to point out that mercantilism, the target of the classical school’s vituperation, took the nation to be the focus of economics. The system of commodity money, established to overcome mercantilism, is thus a product of the cosmopolitan system. Indeed, the latter found its justification in the fact that it overcame mercantilism, with its supposed framework of conflict of interests and the struggle between nations.

The system of commodity money came to be embodied in the gold standard. As I have argued elsewhere (Follow the Money, ch. 14: “The Great Transformation”), that system ended up in the shipwreck of two world wars and a great depression. As such, it is forever a thing of the past.

Since then, we have had national currencies; and since 1971, ostensibly free-floating national currencies. Jacobs’ polemic against the current system of national currencies has this to say for it, that it understands the role of currencies as feedback mechanisms. Furthermore, the understanding of economies as things that are city-oriented and city-generated. Where Jacobs goes astray is in her exclusive focus on currencies as the only way imbalances are rectified.

As I outline in the accompanying course, economic regions within national boundaries, which thus share the same currency, adapt to each other and resolve imbalances between each other by changes in wages and prices. These changes trigger flows between the economic regions, which are called factor flows: flows of mobile factors of production. Two such factors are labor and capital. They flow back and forth between economic regions, depending on such things as wage levels, price levels, and interest rates.

In the cosmopolitan system, these flows take place not only within countries but between countries. The world is then viewed as a unified, universal jurisdiction of provinces, with the free flow of mobile factors of production settling up regional imbalances.

The problem with this system is, of course, that it does not take nations into account as inescapable realities with inescapable, differentiated, often conflicting characteristics. Nations have different cultures, languages, religions, mores, values, levels of material development, and certainly different approaches to and attitudes towards getting and spending. This leads to evident differentials in things like rates of economic growth.

There is more. Nations have an unsettling penchant: inner drive to establish sovereignty. This was one of the great insights of the German Calvinist statesman and political philosopher Johannes Althusius (1563-1638). At the time, the doctrine of sovereignty was for the first time being fully developed in its modern form as the power that cannot be gainsaid, the power that stands above all other human institutions and authorities and “speaks the law” to them in a final manner. The Frenchman Jean Bodin (1530-1596), coincidentally one of the forerunners of the theory of commodity money, was also the developer of this new theory of sovereignty, which he located squarely in the ruler, whether king or national assembly of whatever sort.

Althusius accepted Bodin’s doctrine of sovereignty but turned it on its head, as it were. It was not the ruler, but the nation as a whole which was the bearer and locus of sovereignty. The ruler was simply the administrator thereof, who exercised its power in the name of and in trust to the true sovereign, the people or nation.

I have attributed the rights of sovereignty, as they are called, not to the supreme magistrate, but to the commonwealth or universal association. Many jurists and political scientists assign them as proper only to the prince and supreme magistrate to the extent that if these rights are granted and communicated to the people or commonwealth, they thereby perish and are no more. A few others and I hold to the contrary, namely, that they are proper to the symbiotic body of the universal association to such an extent that they give it spirit, soul, and heart. And this body, as I have said, perishes if they are taken away from it. I recognize the prince as the administrator, overseer, and governor of these rights of sovereignty. But the owner and usufructuary of sovereignty is none other than the total people associated in one symbiotic body from many smaller associations. These rights of sovereignty are so proper to this association, in my judgment, that even if it wishes to renounce them, to transfer them to another, and to alienate them, it would by no means be able to do so, any more than a man is able to give the life he enjoys to another. For these rights of sovereignty constitute and conserve the universal association.[13]

This key consideration is something that Jacobs and economists in general overlook. Sovereignty is a legal and political doctrine that fixes economic reality in a determinate and conclusive manner. It transcends economics while also acting as a basic datum that real-world economics must take into consideration. And it is nations that exercise sovereignty. As such, it is nations that establish and maintain a common law, the determiner of economic reality: hence, common-law economics. Currency, for one thing, is a function of this common law. No nations, no sovereignty; and no sovereignty, no common law. As this piece is already long enough, I will spare the reader any further elucidations. But this on-site article can serve to fill the gap.


[1] Jane Jacobs, Cities and the Wealth of Nations: Principles of Economic Life (New York: Random House, 1984).

[2] Ibid., ch. 2.

[3] “Whenever a city replaces imports with its own production, other settlements, mostly other cities, lose sales accordingly. However, these other settlements – either the same ones which have lost export sales or different ones – gain an equivalent value of new export work. This is because an import-replacing city does not, upon replacing former imports, import less than it otherwise would, but shifts to other purchases in lieu of what it no longer needs from outside. Economic life as a whole has expanded to the extent that the import-replacing city has everything it formerly had, plus its complement of new and different imports. Indeed, as far as I can see, city import-replacing is in this way at the root of all economic expansion.” Ibid., p. 42.

[4] Ibid., ch. 11.

[5] Ibid., p. 43.

[6] Ibid., ch. 11.

[7] ch. 13; the quotes are from pp. 212, 215-16.

[8] Ibid., p. 30.

[9] Ibid., p. 31.

[10] As elaborated in his book The National System of Political Economy,  first published in German in 1841. The English translation was first published in 1856.

[11] National System of Political Economy (1856 ed.), p. 191.

[12] Ibid., p. 200.

[13] Frederick S. Carney (trans. and ed.), The Politics of Johannes Althusius (London: Eyre & Spottiswoode, 1965), p. 10. Emphasis added.

Weighing the Gold Standard

Seeing as how the gold standard is a “money method”[1] by which all exchange value is made dependent upon the weight of a certain substance, viz., gold, it would seem appropriate to “weigh it up” to determine whether or not, “weighed in the balance,” it is “found wanting.”

Indeed, weight measurement was the standard of value during the period when the gold standard held sway, and that standard was gold by weight: the dollar was set at 23.22 grains of pure gold (a grain being 1/7000 of a pound), the pound sterling at 113 grains, the German mark at 6.146 grains, the French franc at 4.98 grains, etc. In this manner, all the currency systems of the countries that adhered to gold standard were bound together by gold. Gold served as the currencies of the world’s reserve currency. This is likewise the origin of the modern system of reserve currencies, but we reserve that discussion for another opportunity (I discuss reserve banking in more detail here).

The gold standard is considered to be, well, the gold standard of money methods. Its great attraction lies in the discipline it lays on governments to conduct a strict and balanced fiscal policy. It does this because it ostensibly takes monetary policy out of the hands of the state. I say “ostensibly,” because the reality is a bit more complicated than that, as we shall see. Nevertheless, the gold standard system came also to be known as the “automatic mechanism” precisely because it functioned without government interference, indeed without any interference at all, guided by a veritable invisible hand. Again, this was not entirely the reality, but not entirely a departure from reality, either.

So the gold standard took currency management away from the state. Prior to it, the state did manage the currency. And that state-run currency system had its roots far back in history.

To be precise: with the advent of coinage in ancient Lydia (western Anatolia) around 700 B.C., the state became the manager of the monetary system.[2] Prior to this there were systems of commodity money – the Old Testament, for instance, speaks of silver as currency (a shekel being a weight measure of silver), and both silver and barley were used as commodity money in ancient Mesopotamia. These were not state-run but purely market affairs. Coinage was introduced, not as a form of commodity money, but precisely to counteract commodity money, which at that time was intimately tied up with the institution of debt slavery. It was introduced to insulate the domestic economy from foreign hegemony. It thus likewise accompanied the rise of the Western concept of freedom in the Greek city-states: coinage was one of the means which enabled the Greeks to wrestle their freedom from the Eastern (Persian) hegemonic empires.

Rome carried on the Greek tradition of coinage and introduced it throughout its empire (“Shew me a penny. Whose image and superscription hath it? They answered and said, Caesar’s. And he said unto them, Render therefore unto Caesar the things which be Caesar’s, and unto God the things which be God’s” (Luke 20: 24-25).) In so doing, it established for posterity the tradition of state management of the money supply. All of the Western European kingdoms took over this Roman institution and applied it as they waxed into independent sovereign states. But this system had its drawbacks. It required precious metals, mainly silver but also, secondarily, gold, to function. And during the entire period of medieval and early modern times, these metals were in short supply. The money supplies of these countries were subject to the vagaries of that supply – mines exhausted here, mines discovered there, new techniques opening new areas up for mining, the demand for silver from the East, in particular India and China – all of these factors played a role in the relative abundance or scarcity of the raw material needed to make the circulation go.

Add to this the practice of competitive devaluations conducted between currency regions, and one can understand the preoccupation for the provision of a supply of metallic currency; a preoccupation which later ages looked upon disparagingly. They even had a name for it: “mercantilism.” But this was no idle preoccupation, for the entire economic circulation depended on the existence of a metallic coinage; nothing else enjoyed the common consent and confidence necessary for a circulating medium.

Coinage was thus a state-run affair, and when the gold standard came around to supplant it, it actually supplanted the regime of coinage entirely. Where the gold standard became established, there coinage dried up. Gold coins never enjoyed the circulation the great silver pieces did, such as the Spanish pieces of eight, which in fact formed the bulk of colonial America’s circulation. No, the system of the gold standard was based on an entirely different “money method”: that of credit and banking.

This may come as a shock to those advocating a return to the gold standard. The common image is that of a rock-solid metallic currency that cannot be manipulated. But the reality of the gold standard was that, under its regime, credit exploded. This was not a bad thing; in fact, it was the way the Industrial Revolution was financed, and without it, that revolution probably would not have materialized. Still, the gold standard engendered a massive increase in banking and credit-derived bank money.

In this system, gold did not circulate in the sense of changing hands. Rather, it was locked up in bank vaults and served as the basis for the structure of credit. It was thus the reserve that every bank needed in order to issue credit. Theoretically, for every dollar of credit the bank issued, it could back in gold. Practice was different: reserve ratios were maintained depending on the likelihood of “cash,” i.e., specie, withdrawals. A ratio of 1/3 was common, at least initially. But with the practice of reserve banking, by which banks deposited their gold holdings with other “reserve” banks, the basis shrank.

So it was under the regime of the gold standard that we obtained an ever more “elastic” money supply. This was reflected in the explosion of credit. Macleod used the following example (from England) to show how the money supply there had changed under the gold standard.[3] He used the finances of the Slater house as representative of commerce in general. For year 1856, this is how its income statement looked:

macleod1

As Macleod noted, “Gold did not enter into their operations to even so much as 2 per cent. And this may furnish a clue by which we may obtain a rough estimate of the amount of Credit.” If this is representative, then credit amounted to 50 times the amount of gold. “This Credit produces exactly the same effects, and affects Prices exactly as so much Gold: and it is through the excessive creation of this kind of Property that all Commercial Crises are brought about.” It is a warning similar to the one Walter Bagehot made in his classic work Lombard Street: the entire edifice of credit was being erected on an ever slimmer basis.

Macleod avers that this lay at the heart of the commercial crises that repeatedly afflicted the economies under the gold standard. But it was the working of the gold standard during the times when it functioned automatically, the way it was supposed to work, that engendered the misery and resentment that led to the rise of the labor movement, political agitation, and the ultimate demise of the system.

This came about because of how the system affected wages and prices, enterprise, and employment. The automatic mechanism functioned through gold flows, and gold flows determined the money supply. Where gold flowed into the economy, the money supply could expand; where it flowed out of the economy, the money supply was forced to contract.

These flows occurred not only within countries but between them, given the international character of the gold standard. When economies, including national economies, ran trade surpluses or deficits, gold flowed to the surplus country, expanding its money supply and fomenting economic activity. By the same token, gold flowed out of the deficit country, restricting the money supply and depressing economic activity. The result was deflation in wages and prices.

So the gold standard worked by allowing inflationary and deflationary swings to redress trade imbalances. This resolved the underlying imbalance, but at what price? Severe bouts of unemployment, and consumption- (and thus production-) killing deflation. Schumpeter, perhaps the most thoughtful and nuanced defender of the gold standard, argued that deflation was not necessarily a bad thing, when all prices and wages moved in sync. Theoretically this might be true, but in practice, deflation has always been traumatic.

In fact, the only benefactors under a regime of regular deflation are creditors. This dynamic gave rise to the so-called social question and the various labor movements, socialism, and communism which characterized the later 19th century’s political landscape. The political unrest behind these movements found increasing recognition in the expansion of the suffrage, which brought the labor movement into the midst of the political arena, and put the interest of the workers on a line with those of the creditors. As a result, a new political calculus came to hold sway – called “stabilization” – consisting in the pursuit of price and wage stability. From this point on, governments pursued policies that could provide this kind of stability.

What then of the gold standard’s automatic mechanism? After all, it was based on the inflation/deflation model of rebalancing, and this new political agenda worked at obvious cross purposes to such rebalancing. The answer is, it was paid lip service as an ideal but was increasingly undermined in practice, first at the edges, later at its heart.

The first concessions to the new agenda were social programs and labor legislation. While they may have alleviated the working class’s lot, they did nothing to solve the underlying problem – the trade imbalance – and in fact hindered its resolution by devoting resources to perpetuating the status quo. Old-school conservatives recognized in this the first signs of state encroachment on the private sector, and they were right.

Along with this came central bank intervention. At first this was small-scale; but after World War I, it became de rigueur. Central banks came to master the art of “open-market operations” to control interest rates and, hopefully, changes in the money supply. But what really broke things open was the policy known as sterilization. By this policy, the automatic mechanism was entirely short-circuited. Sterilization entailed the removal of gold from circulation in the real economy to keep it from affecting prices and wages. This was done in the name of stabilization, but it effectively kept the gold standard from performing its rebalancing function. The countries from which gold flowed remained in a constrained economic situation, while the countries to which gold flowed were kept from expanding. Instead, that money went into the financial market. This precipitated the great bull run on the stock market in the late 1920s which ended in the Great Crash. After this, the gold standard system fell apart: some countries continued to adhere to it, allowing it to constrain their money supplies, while other countries went off of it and saw their money supplies expand and some degree of prosperity return. In addition, this period saw the advent of massive social programs administered by government, which required some degree of government influence on monetary policy in order to gain adequate financing. This dependence by government upon monetary policy, and the popularity this enjoyed among the electorate, sealed the fate of the gold standard.

What are the lessons to be learned from this history?

  1. The gold standard in its historic form as “automatic mechanism” will never be introduced as long as the electorate is democratic, i.e., as long as universal suffrage is the rule;
  2. The gold standard is not a coinage-based but a bank- and credit-based system;
  3. If it is a hard-money, coinage-based system that people are after, then a silver rather than a gold standard would be more feasible. For centuries, silver formed the backbone of the currency system, and for good reason: it is available in sufficient quantities to form an everyday circulation. When the gold standard was introduced, it displaced coinage, which brought great hardship on common people, who suffered from the lack of a circulating medium fitted to their needs.

 


 

[1] The term is Joseph Schumpeter’s: see his Treatise on Money (here and here).

[2] For the historical background to the following discussion, see my book Follow the Money. For more on this entire discussion, one may also consult the accompanying introductory course in economics, which goes into more detail.

[3] The following is taken from Henry Dunning Macleod, The Elements of Economics (New York: D. Appleton and Co., 1881), vol. I, pp. 324-325.

Is There a PIIG in Germany’s Parlor?

“It is a truth universally acknowledged that a single country in possession of a current account surplus must be in need of an export market.” With apologies to Jane Austen, of course: the sentiment thus expressed actually is anything but universally acknowledged. In fact, it flies in the face of received wisdom. We are accustomed to thinking of countries running current account surpluses as generating these surpluses by dint of superior industry, frugality, in short, superior economic character.

Take Germany. It has been running current account surpluses ranging from 2% to 7½% of GDP since 2001. The popular view is that such surpluses result from thrift or productivity. Let’s assume that’s the case. Given floating exchange rates, the current account surplus should result in an appreciating exchange rate, so that the surplus would result in more expensive exports and cheaper imports. This would then bring the current account back into equilibrium with trading partners; trade “imbalances” would automatically adjust.

But that hasn’t happened with Germany. The current account surpluses have been persistent, and persistently high. That absence of an equilibrating effect is due to the fact that the German currency does not float. Rather, it is linked to the other currencies of the European Monetary System who share a common currency, the euro.

Once upon a time there was a mechanism to bring about equilibrium, even between countries that shared a common currency. This was the “automatic mechanism,” the gold standard of the late 19th century. That mechanism (as I explain in my book Follow the Money) brought about an equilibrium through gold flows. In the country experiencing a current account surplus, gold would flow inward; and in the country experiencing a deficit, gold would flow outward. Thanks to the banking system, this in turn led to expansion in the surplus country, contraction in the deficit country. The boom country, experiencing a rise in prices, would thus import more and export less, while the depressed country, where prices were falling, would begin exporting over importing. And so the two economies would come back into some sort of equilibrium.

Nowadays, of course, there is no gold-standard automatic mechanism: there are no gold flows to do the equilibrating. So Germany’s current account remains in surplus, and its trading partners, chiefly the countries of southern Europe which likewise share the euro, remain in deficit. These countries are collectively known as the PIIGS, an acronym for Portugal, Ireland, Italy, Greece, and Spain. (Of course, Ireland is not in Southern Europe, but functionally it belongs in this group.)

The deficits being run by the PIIGS form the reverse image to Germany’s surpluses, as the following graphs indicate. Each graph shows Germany’s current account balance (surplus or deficit as percentage of GDP) together with each of the PIIGS (source: tradingeconomics.com):

new-1

new-2new-3new-4new-5Take another look at those graphs: prior to 2001 and the introduction of the euro, it was Germany that was running current account deficits! The PIIGS, for their part, ran surpluses or modest deficits. The change came about with the introduction of the euro. The euro was set at exchange rates that favored Germany’s economy and disfavored those of the PIIGS. Essentially, Germany was set too low while the PIIGS were set too high.

So then, thrift or economic virtue might explain Germany’s initial current account surplus, but it is the euro that has kept the system from coming into equilibrium, thus perpetuating those surpluses. The euro also has essentially bankrupted the PIIGS, who paid for their deficits by going into massive debt.

Persistent current account surpluses are not a sign of thrift but of dysfunctional exchange rates, not allowed to perform their equilibrating function. That, of course, is nothing new. But it needs to be recognized.