Border-Adjustment Sleight of Hand? Sense and Nonsense on the Border Adjustment Tax

The trickle of articles discussing the proposed Border Adjustment Tax (BAT) has turned into a veritable flood. Not surprisingly, the lion’s share of these articles oppose the idea of border adjustment. It would be tedious to run through them all; suffice it to say that the primary argument is that such a tax would raise the price of consumer goods.

That of course is true. But that would not be such a bad thing. For, what is the point of cheap consumer goods if the purchasing power required to buy those goods has been shipped overseas, in the form of productive labor, otherwise known as jobs?

Is this not the Achilles’ Heel of the current structure of the division of labor? We have divided up the world into rich consumption-oriented regions and poor production-oriented regions, and have allocated production capacity accordingly. The problem with this arrangement is, it has divorced production from consumption: production does not finance consumption, as it should in a healthy economy.

What should happen in such an arrangement is that the low-wage, producer countries should be seeing a steady accretion in purchasing power, reflected both in higher wages and appreciating exchange rates, which would serve to bring trade relations into balance by allowing them to consume more and so import more. The rich consuming countries would constitute the flip side of this: they would produce more and so export more.

That would be a healthy arrangement for international trade. But the current system does not allow for that. It keeps low-wage producer countries at the low-wage end, and obstructs their consumption; conversely it keeps rich consumer countries consuming at the same levels, whether through asset-bubble-financed consumption (which led to the housing crisis of 2007-2008) or simply by lavish wealth redistribution schemes, which in effect redistribute wealth from the future to the present, because they are financed in increasing degree by deficit spending, otherwise known as debt.

So the gap between production and consumption is being bridged by indebtedness. Which is one of the reasons why the world has generated such a massive debt overhang. And no matter how much one hears politicians crow about “the crisis being over” and “the future looks bright,” the debt overhang only gets more overhangy: In 2016 global debt continued its unsustainably onward and upward course.

We owe it to ourselves? Let’s not kid ourselves. Borrowing is not a shuffling of money from one drawer to another, or, as the Dutch say, “broekzak-vestzak” (pants pocket-shirt pocket). No, borrowing is receiving money in exchange for a promise to pay at some future date. In other words, it is not that we owe it to ourselves; rather, we owe it to the future – to future generations, who are on the hook for what we, collectively, borrow in the present.

The idea behind all sound borrowing is that it goes toward investment, not consumption. (Borrowing for consumption can only be permitted if sufficient reliable future income stands over against it – hence, a form of cash flow management.) Borrowing should be done in order to finance future, reliable, income – a return on investment.

Our present global trading system fosters irresponsible borrowing – borrowing for consumption without heed to the capacity to repay. In fact, it is built upon such borrowing. Which explains its unsustainability. Global indebtedness continues to burgeon, as we just pointed out. And fueling this indebtedness is the production/consumption divorce, which is reflected in trade imbalances. These imbalances are simply measures of indebtedness, for all trade deficits are “financed.” Which is another way of saying, paid for by debt rather than by a reciprocal performance.

We have gone over this many times in previous posts. The funny thing is, you won’t hear a word about it in the discussions regarding the BAT. At least, not on the part of its opponents. For them, all that matters is that it raises prices on consumer goods.

As far as popular treatments go, one of the most adept criticisms of BAT was published on April 16 in the Wall Street Journal: “The Border-Adjustment Sleight of Hand,” by Veronique de Rugy and Daniel J. Mitchell.

For starters, de Rugy and Mitchell go after one of the main arguments pushed by the pro-BAT forces, that the tax will cause the dollar’s exchange rate to rise, and so neutralize the effect on imports. Hence, any rise in prices of consumer goods will be wiped out by the rise in the dollar’s exchange rate, which has the effect of lowering prices of imported goods. De Rugy and Mitchell throw cold water on this notion. The data, they say, argue against any such compensating effect taking place, especially in the short term.

I thank the authors for making this argument. Because if the BAT has no effect on trade relations, then – to paraphrase Flannery O’Connor – “to h/*& with it.” What is needed is precisely an arrangement that will do something about trade imbalances, and if the BAT won’t, then let’s get something that will.

But de Rugy and Mitchell go on to argue that the BAT will not do anything to affect trade relations anyway. They do so by pointing to the effect Value-Added Tax (VAT), another kind of border-adjusted tax, has had on trade. In their view, VAT has done nothing to skew trade relations one way or the other.

Here’s the nub of their argument:

The claim is that VATs give foreign companies an advantage. Say a German company exports a product to the U.S. It doesn’t pay the American corporate income tax, and it receives a rebate on its German VAT payments. But an American company exporting to Germany has to pay both—it’s subject to the U.S. corporate income tax and then pays the German VAT on the product when it is sold.

Sounds horribly unfair, right? Don’t be fooled. Like magicians, those making this argument are distracting the unwary, hoping that nobody will notice the trick.

Here’s the real story: What matters from a competitive perspective is whether the playing field is level—and it is. When the German company sells to customers in the U.S., it is subject to the German corporate income tax. The competing American firm selling domestically pays the U.S. corporate income tax. Neither is hit with a VAT. In other words, a level playing field.

What if an American company sells to a customer in Germany? The U.S. government imposes the corporate income tax and the German government imposes a VAT. But guess what? The German competitor selling domestically is hit by the German corporate income tax and the German VAT. That’s another level playing field. This explains why economists, on the right and left, repeatedly have debunked the idea that countries use VATs to boost their exports.

While this argument sounds convincing, it overlooks some essential information. In fact, it focuses on one effect only and totally overlooks another. So it’s not sleight of hand that’s the problem, it’s short-sightedness. Granted, in this example there is a level playing field in America, and an equally level playing field in Germany. But that’s the problem – there are two playing fields. On the American playing field, you have no VAT, but on the German one, you do. The question is not so much whether individual German products are advantaged or disadvantaged vis-à-vis their American counterparts, but whether Germany is shifting its entire playing field to the advantage of producers – both German and American – and disadvantage of consumers – both German and American. And that is what’s happening. Germany, and other countries that employ VAT, have made it more difficult to consume in their countries. Therefore, they end up overproducing, and shipping their excess production to foreign countries, mainly the United States. It is this that leads to the trade imbalances we have been harping on and will continue to harp on.

Here is an overview of US trade imbalances with key trading partners in 2014, taken from the Wikipedia article, “List of the largest trading partners of the United States.” Firstly, notice that the overall US trade balance is in deficit by a $734 billion. That’s an additional $734 billion in debt, rung up in just one year. Add that to the federal deficit and you really do have a twin-deficits problem.

But notice also that all the major bilateral trade deficits are with countries that have a VAT.

Rank Country/District Exports Imports Total Trade Trade Balance
World 1,454,624 2,188,940 3,643,564 -734,316
1  China 115,775 462,813 578,588 -347,038
 European Union[3] 270,325 416,666 686,991 -146,340
4  Japan 63,264 132,202 195,466 -68,938
5  Germany 49,362 114,227 163,589 -64,865
3  Mexico 230,959 294,151 525,110 -63,192
15  Ireland 9,556 45,504 55,060 -35,948
16  Vietnam 10,151 42,109 52,260 -31,958
11  Italy 16,754 45,210 61,964 -28,456
6  South Korea 42,266 69,932 112,198 -27,666
18  Malaysia 11,867 36,687 48,554 -24,820
9  India 21,689 45,998 67,687 -24,309
21  Thailand 10,573 29,493 40,066 -18,920
8  France 30,941 46,765 77,706 -15,824
12   Switzerland 22,701 36,374 59,075 -13,673
10  Taiwan 26,045 39,313 65,358 -13,268
27  Indonesia 6,037 19,203 25,240 -13,166
2  Canada 266,827 278,067 544,894 -11,240

Is that coincidence? We think not. Of course, VAT is not the only factor involved in trade deficits. There is also the infamous currency manipulation, as well as factors such as forced savings. I have gone over these in previous posts, and the reader would do well to apprise him- or herself of them.

The fact of the matter is, the BAT – or something like it – is direly needed to offset these ongoing trade deficits. Of course, there will be a price to pay, in the form of higher prices for consumer goods. That is why representatives of industries ranging from retail sales to the Koch Brothers to “big oil” oppose it. But higher prices for consumer goods will of  necessity reduce consumption vis-à-vis production and help bring that relationship more in line with trading partners, thus helping rebalance trade. Granted, it would be better if those other countries would eliminate their border-adjusted tax regimes, but that is not in the offing. Something has to be done, and this is better than nothing.

 

A Monetary Solution to Trade Imbalances? Gilder and the Gold Standard

The wait continues regarding the tax reform proposal to come out of the White House and be taken up by Congress. Despite the headlines dominated by more peripheral matters, tax reform is shaping up to be one of the cruxes to the success of the new administration. It is not simply a matter of reducing tax rates, or eliminating loopholes, or otherwise rendering the tax code more transparent and equitable, as important as those things might be. It turns out that tax reform is also crucial to combat the out-of-kilter trade arrangements that not only are strangling the US economy but also are perpetuating inequitable and exploitative terms of trade, at both ends of the trade relation, for both developed and developing countries.

How is tax reform relevant to this question? By virtue of one of the key proposals now being discussed: the border adjustment tax. We discussed this, and its importance in terms of trade relations, in a previous post.  As of this writing, the prospect of its being incorporated into the tax reform proposal taken up by Congress is up in the air. One report even speaks of it being on “life support.” If it, or something like it, does not come along, something else, most likely more draconian, will probably take its place. Something more like traditional protectionism.

But there are other proposals being floated likewise intended to counteract the cockeyed trade regime with which the world is now saddled. Conservative icon George Gilder has one for us that merits consideration. Gilder’s focus of late has been money, as evidenced by his 2016 book The Scandal of Money: Why Wall Street Recovers but the Economy Never Does. The burden of the argument is that floating exchange rates are the bane of the modern economy; our economic issues can only be rectified by a return to the gold standard. Floating exchange rates, in this version, are the product of government-controlled money, and as the Friedrich Hayek-authored epigraph has it, “The source and root of all monetary evil [is] the government monopoly on the issue and control of money.”

In his book, one of the claims Gilder makes is that the accusation against China as being a currency manipulator, is specious. Quoting John Mauldin, Gilder asserts that “Trump and all those who prattle on about Chinese currency manipulation have the economic comprehension of a parakeet” (p. 40). But Gilder, at least on this score, has had a change of heart. Writing in The Federalist, Gilder confesses “I was wrong.” Trump’s economic comprehension, apparently, does exceed that of a parakeet. In fact, he is on to something – though he does not quite know what. “World trade is no longer expanding for a reason, and Trump has put his finger on it. That reason is a combination of crazy quilt trade pacts, disguising wild and wooly monetary manipulation.”

So Gilder puts his finger on what Trump already put his finger, refining what he implies is a wooly argument. It is not the “crazy quilt trade pacts” that are the problem, so much as the “wild and wooly monetary manipulation” that they ostensibly conceal. Gilder’s vision is of a world in which speculators in the currency trade generate deranged exchange rates, wild swings that make a mockery of economic fundamentals. “Currency trading is a speculative orgy that fails to correspond at all with relative productivities of workers, or comparative advantages between countries, or purchasing power parities between different markets.”

For example, US workers have lost their jobs – because the Japanese yen went from 80 to the dollar to 300 to the dollar and back, and because the euro has fluctuated 20% vis-a-vis the dollar: “A worker who lost a job because of the global economy might as well have been hit by lightning. No rhyme or reason explained it. What we call a crisis of trade is really a scandal of money.” NAFTA was a big mistake, not because of the specifics of the deal, but because it led to Mexican peso devaluation: “No entrepreneurial creativity or worker efficiency or technological virtuosity could dent the overwhelming impact of the drastic relentless change in the unit of account. It emitted—as Ross Perot put it—a ‘giant sucking sound’ symbolizing a major reorganization of North American manufacturing. Yet the entire costly and tempestuous change was mostly an effect of monetary speculation.”

Hence, the global trade imbalances which have precipitated the mass transfer of production and capacity and thus jobs have been caused by floating exchange rates. The solution, as one might surmise from such a diagnosis, is to eliminate them. “So long as central banks possess the power to change currency values virtually at will, free trade cannot be either fair or efficient.”

Let us take note at this point, that we have added a person of interest to the list of currency malefactors. To the currency traders, the “10 international banks that do 77 percent of the exchanges,” Gilder has added central bankers. But this does not yet exhaust Gilder’s list. Where are the politicians? Here they are: “With money controlled by politicians in the guise of central bankers, it cannot serve as an objective measuring stick of commerce.” So central bankers are really politicians – essentially giving us three categories of malefactors. Which is why Gilder endorses Hayek’s assertion that it is government-run money that we are dealing with.

Gilder’s solution: “We Need A New Bretton Woods Agreement. ” Let’s take a look at that. Bretton Woods was the post-World War II monetary arrangement whereby the dollar, tethered to gold, served as the reserve currency for the countries of the world’s various domestic currencies. We will be exploring the concept of a reserve currency more fully in a future blog post (for now, these posts will suffice). The idea of a reserve currency is to function as “real” money in the banking system, so that monetary issue is limited to some multiple of reserve currency holdings. In other words, in the Bretton Woods framework, domestic currency issues were restricted by the amount of dollars held by the banking system, mainly the central bank. The amount of dollars, in turn, was restricted by the requirement of gold redeemability, with the price of gold fixed at $35 per ounce.

This would eliminate both inflation and deflation: “The best way to obviate both inflation and deflation is a global agreement to tie currencies to gold in the spirit of Bretton Woods.”

For all the respect I have for Mr. Gilder’s work – and it is a lot: his Wealth and Poverty made a permanent impression on my thinking, back when I was a wet-behind-the-ears Peace Corps volunteer – I think he claims too much here. The problem is that he posits precisely what he needs to demonstrate: that a commodity money standard, such as the gold standard, brings with it price stability. Certainly, tying domestic currencies to gold would eliminate their fluctuations vis-à-vis one another, but that is not the same thing as saying that prices would cease fluctuating. Quite the contrary.

During its heyday in the 19th century, the gold standard operated in terms of the so-called “automatic mechanism,” with gold flows settling imbalances between trading regions. Not between countries per se, but regions – because in the framework of the gold standard, borders vanish and the participating countries become locked into a single economic unit. At least, theoretically; practice was different, as we shall see.

So then, where countries tied their currencies to gold, and gold flows were allowed to occur without hindrance, and where corresponding trade flows of goods, services, labor, likewise were allowed to occur without hindrance, there you had the properly functioning automatic mechanism. And within this mechanism, gold flows are triggered by interest rates. Where interest rates are high, there gold flows. What leads to shifts in interest rates? Economic performance. Interest rates are raised where economic performance is lagging, and reduced were economic performance is buoyant.

What was the result of such actions? It has everything to do with the reserve function of gold in this system. The money supply is tied to gold; the more gold held by banks, the more money could be issued (a healthy multiple was considered to be two to three times the amount of gold reserves). Gold inflows allowed for monetary expansion, hence increased lending and thus increased investment and expenditure, while gold outflows reduced the money supply, tightened lending conditions, and throttled economic growth. In this way, economic regions were kept in balance: where growth was occurring it would automatically be restrained, and where contraction was occurring, the economy would automatically be stimulated.

Trade imbalances could not arise under such a system, but there was a price to pay: inflation and deflation. Where the money supply was allowed to expand, there you had inflation; and where the money supply was forced to contract, there you had deflation. Inflation and deflation was built into the gold standard with its automatic mechanism. Mr. Gilder’s assertion that a gold standard eliminates price fluctuations is totally mistaken. A gold standard functions precisely by triggering inflation and deflation.

There is more. The broader economy, in this system, is tied to the amount of gold held in reserve. In other words, economic growth, population growth, and attendant phenomena depended upon the vagaries of gold mining production as to whether they could even occur or not.

But of course, the 19th century was also the age of the social question, the silver question, the labor question, the suffrage question. All of these questions were tied to the gold standard with the restriction it inherently placed upon economic growth. The labor movement arose in response to that restriction, as did expansion of suffrage: for politicians realized that much hay was to be made by appealing to that ever-expanding voting bloc of disgruntled workers subjected to the whims of gold flows and gold reserves.

In response to incessant social and political agitation, there came the institution of central banking, the goal of which was to mediate between these social forces, on the one hand, and the dictates of the automatic mechanism, on the other. Increasingly, the pound sterling was considered to function as a substitute for gold, enabling money supplies to expand accordingly. But like the post-WW2 dollar standard, this made the world dependent upon sterling, and countries like Germany chafed under that dependency. The sterling standard gave the UK an “exorbitant privilege,” as they say, and provoked rivalry with Germany that ultimately led to the First World War.

Things got even worse in the aftermath, as war reparations along with the devastations of war led to the ascendancy of the US, which, in accordance with the dictates of the day, received in payment mountains of gold. But despite copious amounts of lip service, the automatic mechanism was not allowed to reassert itself. Instead, it was during the 1920s that the entire ideology of “price stability” and “full employment” began to be developed and implemented by central bankers, and the key to this was to keep all that gold from entering the financial system, provoking an unsustainable boom, or, even worse, allowing it to flow back to the countries from whence it came, as those countries tried to export their way to prosperity. The US, of course, had always practiced protectionism and now continued to do so, essentially consigning countries like Germany to relative penury and sowing the seeds for the Second World War.

What needs to be realized is that any system of currency which short-circuits the feedback mechanism (Jane Jacobs’ term) of currencies vis-à-vis one another, like the gold standard did, only substitutes another feedback mechanism. If one does not wish for fluctuating exchange rates, one should welcome the inflation-deflation whipsaw, because that is the alternative means for rectifying imbalances. And where such a whipsaw mechanism is politically unfeasible, as in any developed democracy it will be unfeasible, then the alternative is stagnation, as imbalances are allowed to build up on bank balance sheets in the form of unredeemed debt.

These are our alternatives. There are no others. The dream of a return to the gold standard should be laid to rest. Besides, the likelihood that such apparitions from the grave will be given new life is probably zero. Let’s spend our time talking about feasible alternatives.


More on the gold standard can be found in these posts and in these excerpts from my book Follow the Money: The Money Trail Through History. More on floating exchange rates can be found in these posts.

The Border Adjustment Tax The Way Forward, or Regrettable Sidetrack?

The persistent trade deficit being run by the US, which is the major manifestation of the lopsided global trading system, has to be dealt with to ward off economic disaster. The reason for this is outlined specifically in this previous post, and generally in these posts. It is a sad but revealing commentary that it has taken this long to get someone in charge who at least acknowledges the problem and promises to rectify it. The question now is, how to go about it?

In another previous post, I argued that the best way to do so would be not to impose tariffs and a protectionist regime (for more on tariffs, see these posts as well). Of course, if President Trump follows through on his threats against certain supposed recalcitrants and does so, he would only be acting in quintessentially American fashion, for during the course of the first hundred-plus years of the Republic, such tariffs were the chief source of revenue for the US government.

Such tariffs are also a blunt instrument that have significant economic disadvantages. Beyond that, they do not contribute to any kind of smooth transition toward a better framework for global trade, which is what is ultimately needed. As I argued in “Trumponomics and the Great Rebalancing” (singling out China), “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.”

The goal, then, is not to create more economic distress, but less. This is a tall order in a global economy erected upon, and addicted to, the divorce of production from consumption. We need to restore the balance between production and consumption, and so enable the financing of consumption out of production, and not out of indebtedness. But how?

The “Great Rebalancing” will have to be achieved, first, by identifying the factors that lead to imbalances, and secondly, implementing policies that constructively deal with those factors.

Michael Pettis, an author to whom I have often referred, provides us with a competent summary of the structural factors which have deranged trade relations.[1] These factors go far beyond measures like currency manipulation and tariffs, which obviously have a direct impact on trade. Policy measures with an indirect impact are as great a problem, for they function precisely as a tariff or a devalued currency would.

The basic goal of these policies is underconsumption. In order to promote exports, a country imposes policies upon its population causing production to exceed consumption. It thus imposes a form of forced saving. Macroeconomic accounting tells us that production (Gross Domestic Product) = consumption + saving – investment; as such, an increase in saving is accompanied by a reduction in consumption, assuming investment stays the same. The non-consumed production is thus left over, to be exported. As Pettis explains, “Anything that reduces consumption … without changing total production or total investment, must cause an increase in exports relative to imports” (The Great Rebalancing, section entitled “Trade Intervention Affects the Savings Rate”).

One of the policies that makes this happen is “financial repression.” This is basically the Japanese model, and has been followed by other Asian Tiger economies, particularly China. In this policy variant, the banking and financial system is essentially controlled by the government, which dictates interest rates and allocates loans according to its own criteria. The upshot is that lenders (consumers) are paid below-market interest while borrowers (business) are charged below-market interest. For all intents and purposes, this is a subsidy to business, a wealth transfer from consumers. It is also a restriction on consumption in favor of production, and so a generator of structural net exports.

How to deal with this? It helps to realize that these countries by now have come to realize the shortcomings of this model. After all, it is one of the reasons the Japanese economy has tanked since 1990. But weaning a country away from it is another matter, as so many vested interests are involved in maintaining it.

Another – and for this article, very important – method is the Value-Added Tax (VAT). VAT is a consumption tax and as such provides for a structural surplus of production over consumption. And given the high levels at which such a tax is often levied (e.g., 21% in the Netherlands) it constitutes a severe form of consumer repression. Consumers thus bear the brunt of a policy that favors exports over domestic consumption.

VAT includes yet another element making it even more favorable to exporting countries. This is called border adjustment. In this arrangement, VAT is “adjusted” depending upon whether goods are exported or imported: goods that are exported are exempted from domestic VAT, while goods that are imported are assessed VAT.

VAT thus acts as both an export subsidy and an import barrier. Therefore, it has a double effect on trade relations: the fact that it suppresses consumption acts, as we have seen, as an export stimulant; and the effective boost it gives to exports through border adjustment likewise acts as an export stimulant.

For these reasons, countries that make use of VAT enjoy a great advantage as far as terms of trade are concerned. And countries that don’t are left holding the bag, as it were, for that advantage held by exporting countries is the mirror image of the disadvantage at which non-VAT countries are placed.

It comes as no surprise that this setup, putting non-VAT countries[2] generally and the US in particular at such a disadvantage, receives such severe criticism. Progressive political commentator Thom Hartmann puts it like this: “Germany is not alone in this [border-adjusted VAT]. Japan, South Korea, China, Taiwan, and most European nations do the same thing. The only developed country without a VAT tax to use as an effective tariff is the USA – we’ve become the international village idiots. Nothing protects our workers or manufacturers, which is just fine with the big transnational corporations making billions exporting our jobs.”

The obvious thing to do would be to implement a similar border-adjusted consumption tax in the US. The problem with this is that it would introduce the same sort of onerous tax arrangement that countries in, e.g., Europe labor under. A 21% tax on most goods and services, such is holds in the Netherlands, forms a real drag on household spending, and disproportionately affects lower income classes (which means that, in the parlance, consumption taxes are regressive).

An interesting side note: what sparked the Dutch Revolt against Spain in the 16th century was not religious intolerance or political domination – it was the imposition of a 10% sales tax, Alva’s Tenth Penny tax. An unkind interpretation would be that the Dutch might suffer their consciences to be oppressed, but not their pocketbooks! Nowadays, however, the tables have been turned: freedom of conscience is protected while pocketbooks are rifled.

The long-term goal would be gradually to reduce or eliminate VAT in favor of other tax regimes that are not so oppressive both to economies abroad and to lower income classes domestically. But what to do in the meantime? How can the US in particular achieve some sort of harmonization within this ubiquitous tax framework?

Thankfully, a VAT does not look to be in the offing. But another proposed tax reform might achieve a similar goal. I refer to the so-called Border Adjustment Tax (BAT) put forward by the House GOP as part of a wide-ranging tax reform plan. Reportedly it is under consideration by the Trump administration in conjunction with Congressional Republicans, although Pres. Trump has referred to it as “too complicated,” going on to say, “Anytime I hear border adjustment, I don’t love it. Because usually it means we’re going to get adjusted into a bad deal. That’s what happens.”

The proposed BAT is a bit complicated, but is also widely misunderstood. The border-adjustment part makes it comparable to VAT, but rather than being a tax on goods and services, it is a tax on business income – corporate earnings. That in itself puts this tax into another category. The tricky part is the border adjustment facility being added to it.

The BAT would eliminate the deduction companies currently enjoy when they import goods, including intermediate goods – goods that are used in the manufacture of other goods – but especially consumer goods purchased for resale. That would take away part of the advantage companies have had by importing cheap foreign manufactures. It would also take away some of the advantage retailers like Wal-Mart have had in terms of price competitiveness, which is why Wal-Mart opposes the measure.

In this way the BAT would act as an import barrier, in the same way that VAT does. By the same token, the BAT would exempt from taxation earnings from goods sold abroad. And that would act as a stimulus to exports, for if business earnings from exports are exempt from taxation, that would lower the price of exported goods, making them more competitive on the world market.

There is concern that this new regime would run afoul of current World Trade Organization (WTO) regulations. The WTO makes a distinction between indirect (consumption) tax and direct (income) tax. According to its rules, indirect taxes may be border adjusted, but direct taxes may not be. Thus, by virtue of this agreement, the US with its tax code has been disadvantaged against most of the rest of the world, another example of the “bad deals” Donald Trump says the US has been making.

But in effect the BAT works as a consumption tax. The House GOP’s proposal (as explained in the Better Way Tax Policy Proposal) argues as much: this “cash-flow tax approach for businesses… reflects a consumption-based tax.” And because it does, “for the first time ever, the United States will be able to counter the border adjustments that our trading partners apply in their VATs.” Harvard economist Martin Feldstein likewise argues that this objection is a red herring. “So what are they going to say, you can’t have a VAT?”

A bigger concern is that the BAT will lead to a stronger dollar, which in turn would have a negative impact on the trade balance, negating the advantage provided to exports. The argument is that stronger demand for US exports will increase demand for dollars to purchase those exports, while weaker US demand for imports will shrink the number of dollars being brought onto foreign exchange markets, likewise increasing the price of dollars there.

I don’t believe this argument has much merit, because it only looks at one element of what would be a complex interaction of causes and effects. As we explored above, a key mechanism behind trade balances is domestic policy that reduces consumption while holding production and investment steady. In this case, the leftover production has to be sold abroad, automatically producing a trade surplus (or reduction in a trade deficit). This is the effect VAT has had on global trade for all these years. Therefore, if such an effect were predominating, then all the countries gaining a trade advantage by implementing border-adjusted VAT would subsequently have lost that advantage as their currencies appreciated. But this has not been the case. Quite the contrary: their trade surpluses have been unremitting.

The truth is, if the US likewise introduces a tax which acts like a consumption tax and thus reduces consumption vis-à-vis production, it would similarly affect the trade balance by offsetting the advantage other countries have had in promoting underconsumption. The net effect will be to reduce trade imbalances; exchange rates will have to find a new equilibrium, hopefully without the manipulations in which central banks love to engage. The following step would be to repair the divorce of production from consumption by gradually removing such underconsumption-oriented policies. Equal underconsumption is offsetting, but no underconsumption is the ultimate goal. If, along with this, central banks show restraint, and countries likewise scale back their various systems of financial repression, the global trading order just might plod along toward the rebalancing it so desperately needs.


[1] In The Great Rebalancing: Trade, Conflict, and the Perilous Road Ahead for the World Economy (Princeton and Oxford: Princeton University Press, 2013).

[2] Go here for a list of countries that implement VAT (160 countries), or that do not (41 countries).

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.

Confessions of a Free Trade Advocate

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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.