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.


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).

The Problem of Saving

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

[1] Treatise on Money, p. 147.

The Trouble with Exchange Rates

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

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

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

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

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

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

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

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

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

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

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

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

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


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

Thoughts on the Piketty Thesis

As is the case with the vast majority of commentators on this topic, I have not read Thomas Piketty’s book (Capital in the Twenty-First Century). The following is therefore gleaned from other sources, mainly this interview, from which, unless otherwise indicated, the following quotations are taken.

The first thing to say is that, on the face of it, Piketty’s exposition is capitalism-friendly. In fact, his approach would seem to be a capitalist prerequisite, for it requires wealth to be put to work, which is a capitalist imperative. In his own words “my point is not at all to destroy wealth. My point is to increase wealth mobility and to increase access to wealth.” Which sounds like a good thing.

But, for one thing, it would entail the capitalization of resources that otherwise would be kept out of the sphere of what is unkindly referred to as capitalist exploitation. For instance, forestry. Having been an undergraduate forestry student, I recall the discussion in forest economics class with regard to the exigency placed on forests by a property tax. All of a sudden, a landowner must generate a revenue from that forest simply in order to pay the tax, on a piece of land that otherwise might be left undeveloped, hence ecologically undisturbed. This could lead to the application of sustainable multi-use forestry practices, or it could lead to elimination of the forest, depending upon the ecosystem involved. The same thing applies to traditional, less-than-profitable land uses. Followers of the television series Downton Abbey will recall the difficulties put upon the estate by the imposition of a wealth tax, causing Lord Grantham to anguish over having to remove inefficient tenants in order to turn the land to more productive uses.

Furthermore, a wealth tax would penalize saving in favor of consumption. Piketty can argue that consumption is difficult to distinguish from investment: “What’s the consumption or income of Warren Buffett or Bill Gates when they are using their corporate jet? Are they consuming? Are they investing? Nobody knows.” But the fact of the matter is, the imposition of a wealth tax would establish a prima facie incentive to spend income rather than save it, especially given the bias against inheritance Piketty displays (“In order to get a zero capital tax result, you need basically two very strong assumptions. One is that wealth is entirely a life-cycle wealth; you have no inheritance at all. Once you have inheritance, you want to tax it”). The moral will be, “eat, drink, and be merry, for what is not taxed today will be taxed tomorrow, if you try to hold onto it.” In Holland, there already is a wealth tax, on top of the 52% income tax (highest bracket, which begins rather early), the 21% VAT, the gasoline tax that jacks the price of a gallon up over $10, etc. So the money that escapes the fevered clutches of the Belastingdienst the first time around gets hit at the rate of 2.5% a year in perpetuum. The moral: spend it before it gets eaten away. Or at least, invest it for a return in excess of 2.5%, which in this day and age is no mean feat.

Another point is that Piketty’s wealth tax would be tax on “net” wealth, in other words, assets minus liabilities, property owned net of debt. It thus incentivizes indebtedness. “If you own a house worth $500,000, but you have a mortgage of $490,000, then your net wealth is $10,000 so in my system you would owe no tax. Under the current system, you pay as much property tax as someone who inherited his $500,000 home or who paid off his debt a long time ago.” The anti-saving bias is evident here. What is also evident is the built-in incentive to take on debt so as to offset taxable property holdings.

Regarding Piketty’s discussion of inequality: the message is that inequality has been increasing over the past 20-plus years, precisely the period of time in which globalization and international trade have surged forward. While Piketty himself does not argue this point, his findings do prompt the conclusion that globalization and free markets lead to inequality, while protectionism and government intervention are needed to foster income equality. And Piketty’s wealth tax is precisely one form of government intervention.

Piketty argues that income and wealth inequality have been increasing (although his findings are disputed), and blames it on the “huge cut in marginal tax rates.” From the interview: “Matthew Yglesias: How do we know that high executive compensation comes out of the pockets of other wage earners? Thomas Piketty: Well, because the labor share including CEO compensation did not increase. It actually declined. Maybe it would have declined even more without the rise in CEO compensation, but that’s hard to believe. I think the rise of very large CEO compensation came at the expense of the workers.”

This does seem to be the case, but as a matter of fact, I would have been shocked if the effect of the globalization of the post-Bretton Woods period had not led to greater inequality. But that doesn’t entail a critique of globalization per se, nor excessively low marginal tax rates, but the way in which the international trading system has been manipulated. Let me explain.

Ever since Bretton Woods, we have had a system of ostensibly floating exchange rates. Ostensibly — because exporting countries have been resorting to various hooks and crooks to maintain their exchange rates at artificially low levels, thus to manipulate and subvert that float. The dollar being the reserve currency of choice, and the US being the export market of choice (referred to tongue-in-cheek as “the consumer of last resort”), the manipulation is conducted against the dollar, keeping the exporting country’s exchange rate low vis-à-vis the dollar, allowing the exporting country to sell its production to America at ongoing low-wage-maintaining levels. The result is that production capacity shifts towards the low-wage countries, because the exchange rate is not allowed to adjust upward like it should. So the low-wage countries remain low-wage. Meanwhile, production capacity shifts away from the US, leaving only service-economy jobs there, which likewise generally command lower wages than manufacturing jobs. So in both the exporting countries and the consuming countries, the tendency is to depress working-class wages. On the other hand, the profits from the exchange continue to flow, into the hands of exporting country elites and multinational corporation managements, along with (of course) investors in those enterprises. This works to expand the income gap and thus income inequality. No surprise, really.

So the solution to this problem is not to abolish globalization per se, nor to increase marginal tax rates. Rather, it is to get the countries involved to stop manipulating the global system in favor of various special interests and elites, be they domestic or foreign. After all, the working class in the exporting countries suffers just as much from this situation as does the working class in the importing countries. Both are having their wages depressed.

Again, from the interview: “Matthew Yglesias: I thought one of the most interesting graphics in the book is the one where you show the price-to-book ratio in Germany is quite a bit lower than in the other countries. Is there an important lesson the rest of the world can learn there? Thomas Piketty: Yeah. Actually, to me this was quite striking. Previously I didn’t take seriously this idea that there were different ways of organizing capitalism and the property of capitalistic firms. I think the lesson from this graph is that the market value of a corporation and its social value can be two different things. Of course you don’t want the market value to be zero, but the example of the German corporation shows that even though their market value is not huge, in the end they produce some of the best cars in the world. They export a lot, and they are very successful. I think getting workers involved on the board of German corporations maybe reduces the market value for shareholders, but in the end, it forces workers and unions to be a lot more responsible for the future of the company.” I don’t want to speculate as to the reasons why German companies have relatively low valuations, but I will point out that Germany is at the exporters’ end of the export-import imbalance, only this time the import partners are southern Europe. How did the southern European countries run up so much debt? Mainly by paying for imports from, in the main, Germany. Germany’s model parallels Japan’s and China’s, only it functions mainly within the European sphere, with the help of the euro. In essence, Germany’s currency is structurally undervalued, while Spain’s, Italy’s, Greece’s, is overvalued. That’s how Germany can display such favorable economic data. But as Michael Pettis has shown, Germany’s workers are structurally underpaid because of it. The surplus goes to Euro elites.

There is much more to this story than merely the level of marginal tax rates. As long as the causes of inequality are misconstrued, the solutions on offer will always have be more akin to political footballs than actual fixes. Piketty claims that his “point is not to increase taxation of wealth. It’s actually to reduce taxation of wealth for most people, but to increase it for those who already have a lot of wealth.” Which of course appeals to most of us, because most of us don’t have “a lot of wealth.” But this “fix,” like many others past, present, and future, will get nowhere unless based upon a proper evaluation of the causes of the problem it purports to address.