Politics & Policy

Rebalancing the Economy

The U.S. needs domestic reform, not foreign scapegoats.

America’s economy is not performing for its people. As the recovery drags on at a snail’s pace and unemployment remains stubbornly high, the public has grown increasingly impatient for answers and for solutions. In recent months, the Obama administration and much of America’s political class has found an easy target for this frustration: foreigners. The U.S. trade deficit is running over $500 billion annually, or about 4 percent of GDP, while other large economies like China and Germany run equivalently massive surpluses. In the language of political opportunism, that roughly translates to “other countries are stealing American jobs.”

Any policy that could lower the trade deficit, reducing imports and increasing exports, presents a siren’s call for America’s politicians. A proverbial free lunch, it creates American jobs at no one’s expense except foreigners’ (who, crucially, don’t have a vote in the next election). President Obama’s embrace of this formula could hardly be made clearer than it was in the title of his op-ed in the New York Times last Friday: “Exporting our Way to Stability.”

Though the president rightly argues that America needs to rebuild its prosperity on a foundation of innovation and production rather than on debt-fueled consumption, he puts the cart before the horse in his solution. Exports can and must be a key component of the U.S. economic recovery, but the unfavorable trade balance the country finds itself in cannot be reversed simply by forcing American goods into foreign markets with economic saber-rattling or diplomatic sweet-talking.

The true root causes of the world’s economic imbalances, and their remedies, lie in the domestic arena. The United States needs to lead the world’s governments in agreeing to meaningful and reciprocal internal economic reforms if there is to be any hope of progress on this crucial issue.

However, the prospects for thoughtful negotiation and compromise are not promising. World leaders failed to reach any meaningful agreement at this week’s G20 summit, issuing a hollow communiqué that has little power to halt the the growing embrace of protectionist rhetoric and policy by governments around the world. Advocating outright protectionism has become somewhat of a faux pas among Washington’s elite in the age of globalization, so the preferred strategy adopted by most American politicians has been to launch a public relations campaign accusing other nations — and China above all — of protectionism and demanding that they do more to open their markets to American exports.

In today’s putative trade wars, the primary instruments of protectionist policy available to governments are three: First are state subsidies for export industries, which put public dollars to work employing export workers and making their products cheaper. Second are tariffs and quotas, textbook policies which directly restrict imports and make them more expensive. And third, currency devaluation simultaneously makes imports more expensive and exports less expensive.

And it is this last type of policy instrument — currency devaluation — that has become the favored protectionist tool of governments around the globe and is now the primary focal point for the world’s rising economic tensions. In recent months Japan, South Korea, Thailand, Taiwan, Brazil, Indonesia, Malaysia, Israel, and Switzerland — among other nations — have all taken steps to either actively devalue or defensively halt the appreciation of their currencies. Most notably, of course, China continues to keep its currency artificially low (generally assumed to be about 20 percent less than true value). Present in the Chinese currency clamor is not just a call for a rise in the yuan, but also a growing openness to, if not explicit advocacy of, a general fall in the dollar. Yet this comes at a time when the dollar is hitting historic lows against currencies across the board — from the yen to the real to the rupee. Since June alone, it has lost more than 10 percent against the world’s other major currencies.

The dollar devaluation implicitly called for by so many policy-shapers has, to a great extent, already been achieved by America’s monetary authority. Why is it, after all, that so many other countries — especially among developing economies — are trying so desperately to halt the huge and growing pressures on their currencies to appreciate? As they have made clear in ever-louder complaints and condemnations in recent weeks, it is the constant flow of dollars streaming into their markets from a U.S. economy running the loosest monetary policy in its history. Having started a fight over an undervalued yuan, the United States seems only to have succeeded in undermining the legitimacy of its own domestic economic policies. It is now under assault from much of the world for printing too many dollars and stands accused of trying to devalue its way out of recession.

With condemnations and warnings about the dollar’s integrity being issued by the top officials in the German, Chinese, Brazilian, and Japanese finance ministries just days before the G20 summit, chances were never high that President Obama would convince these principal trading partners to alter their currency policies. But the bigger problem is that currency is not even the real root cause of global trade imbalances to begin with. Even if the Chinese enthusiastically agreed to America’s wildest demands tomorrow, playing with those exchange rates alone would not restore balance to the world economy.

The trade patterns of the 1980s offer a useful parallel for today. In 1985 the dollar was overvalued and the United States was running huge trade deficits. To deal with these imbalances, the world’s leading economies adopted the Plaza Accord — a multilateral agreement on currency reforms that is often touted today as a model for the kind of international pact that could solve the current crisis. The accord was extremely effective in devaluing the dollar: Both the yen and the deutschmark rose nearly 40 percent against the greenback in the five years following its adoption. But while the U.S. trade deficit with Western Europe fell from roughly $30 billion to zero and then evolved into surplus by 1990, the deficit with Japan actually grew for two years following Plaza and by 1990 was only a fraction smaller than it was in 1985.

U.S. exports to Japan were largely in primary goods — commodities and agricultural products —  whereas Japanese exports were mostly in electronics, consumer manufactures, and vehicles. In other words, they were in different industrial sectors. Only in high-tech products was there much direct competition. With Europe however, trade in both directions consisted to a greater extent of similar products:  manufactures, vehicles, commodities, and industrial products. When the dollar fell, the U.S. producers gained ground against the Europeans, with whom they were already in close competition. The exchange rate had a much smaller impact against the Japanese, where there was less direct competition.

The parallel with Japan is more relevant to the U.S. situation today. For most of the 20th century, world trade was dominated by flows between rich countries exchanging similar products and services, a phenomenon termed intra-industry trade (think cars made in Detroit versus cars made in Bavaria). Efficiency gains were brought about more by economies of scale and inter-firm competition across countries than by differential sector specialization within countries. But the age of the globalization has reinvigorated trade as classical theory prescribes it — between countries of very different factor-endowments, with each focused on its area of comparative advantage. Today, that largely means high-wage, skilled-labor goods and services from the West, and low-wage, labor-intensive products from the East: in other words, inter-industry trade.

The power of exchange-rate fluctuations is heavily influenced by whether trade flows are predominantly intra- or inter-industry. In the late 1980s, Japan’s intra-industry trade index was roughly half that of Europe’s big economies like Germany and the United Kingdom. And today, China’s trade with the U.S. is heavily weighted toward inter-industry categories.

Most Americans sense this intuitively. Chinese exports are not in sectors where there is close competition with American firms. They are in low-wage manufactured products such as toys, clothing, and consumer electronics, which U.S. companies long ago gave up producing. A 20 percent rise in the yuan will not move these kinds of jobs back to America when an average migrant worker in China earns one-twentieth the wages of his American counterpart.

Global supply chains today are far more interconnected, with individual products being built in pieces and assembled across dozens of countries. So a one-off currency appreciation in China is even less likely to have an effect on the U.S. trade deficit than it was in 1980s Japan. A rise in the yuan would lower the input costs of foreign goods going into Chinese production, offsetting the price disadvantage against the dollar. And if that offsetting is not substantial, it might merely shift more elements of production to other low-wage economies in Asia.

We have already seen how little effect exchange rates have had on the trade deficit in this decade. Between 2005 and 2008, the yuan appreciated roughly 20 percent, yet China’s trade surplus with the United States actually widened by 33 percent over the same period. And again since June, the pattern has replayed, with the yuan rising roughly 2.4 percent but the trade gap hitting an all-time monthly high of $28 billion in August.

Exchange rates are the easiest — and hence the most tempting — policy instrument to use when attempting to manipulate current-account imbalances. But the roots of the problem are structural and lie much deeper than currency values alone can reach. Last month’s meeting of G20 finance ministers offered some hope on this front when it produced a tentative framework agreed to — at least in principle — by both China and the United States. The breakthrough came about because of a change in language proposed by Secretary Geithner that shifted the focus of the talks from the exchange-rate mechanism to trade surpluses and deficits themselves. But setting numerical targets for surpluses and deficits, as the Obama administration proposes, will be meaningless unless world governments agree on how to achieve them. It is largely for this reason that so many members of the G20 refused to endorse the U.S. position at this week’s summit.

There are an array of domestic economic factors and policies beyond exchange rates that hamper the even flow of world trade, from non-tariff entry barriers to overbearing service-sector regulation to the subsidizing effects of state-owned banks. But it is arguably the most important root factor that is being addressed with the least degree of seriousness by American politicians: savings. Countries with unsustainably low savings rates — including the United States — finance excessive, deficit-building import consumption by selling debt to foreigners with high savings rates — such as the Chinese — who pay for it with excessive, surplus-building export production. Regardless of whatever agreement can be reached on currency valuations and other trade policies, it is this debt-savings disparity above all that must be reversed if there is to be any hope of restoring balance to the global economy. For the United States, China, and the world’s other leading trade powers, this process requires internal economic reform, not external quick fixes.

China’s savings rate is astronomical, running at over 50 percent of GDP. It is by far the highest in the world. That massive thrift has allowed the Chinese government to buy $2.5 trillion in foreign reserves, of which nearly $1 trillion are U.S. Treasuries. The Chinese government could try to allay American debt worries by curtailing these purchases in the future. But, one way or the other, all that savings eventually has to go somewhere. The only real solution for the Chinese is to save less and consume more. With last month’s announcement of its next five-year plan, the Communist party declared the shifting of national income away from savings toward consumption to be a national priority, and it set a plan to recalibrate public and private spending in a number of sectors to accomplish that goal. It is a credible proclamation coming from a government that still retains considerable direct control over the economy.

But just as crucially, the United States needs to focus on increasing its savings rate. China could not keep its rate so high if America’s savings rate were not so low. And if America’s rate does stay low while China reverses course and ceases to collect our debt, there are, by the laws of national accounting, only two possibilities: Either some other foreign source must buy U.S. debt, or the gap left behind will not be filled and U.S. investment will fall toward zero. The latter would consign the United States to severe and indefinite long-term economic stagnation. The only acceptable solution is to increase the U.S. savings rate, reduce consumption, and increase production.

In his official statement at last month’s IMF meeting of finance ministers, Secretary Geithner claimed that “We have taken steps to raise national savings . . . and we will bring down our fiscal deficit to a sustainable level as the recovery strengthens.” He proved this promise worryingly hollow, however, by not even pretending to address how the administration would fulfill it. The move recalls President Obama’s empty call in his State of the Union address to double U.S. exports within five years. You cannot just will these things to happen. There is a structural reason the United States has gone so far into deficit, and it must be addressed.

After falling steadily for nearly 30 years and reaching a low of just over 1 percent in 2007, the private savings rate jumped back in the wake of the financial crisis and is currently over 6 percent as consumers deleverage their housing debts and corporations build up their balance sheets. But this development has been more than counterbalanced by the increase in government debt, bringing the overall national savings rate back down and taking it into negative territory for the first time since 1952.

Government spending skyrocketed in the recession with the explicit goal of cushioning the economic blow of lower consumption. But at some point, the United States will have to increase overall savings, reduce public as well as private consumption, and bear some economic pain as the economy shifts its foundations. There simply isn’t an easy way out. Relying on yet more debt-fueled consumption to strengthen the economy will only set the country on a course to repeat the disastrous mistakes of the last decades. Pursuing illusory quick fixes like yuan appreciation will prolong the problem and quite possibly make it worse.

National savings could be boosted by swiftly cutting the government deficit, but even if that were politically palatable, it could do more harm than good if it is done too rapidly and sends the economy into deeper recession or a deflationary spiral. It would be better to pursue fiscal reform that brings the deficit down gradually, and to focus above all on enacting a host of microeconomic reforms that would incentivize private savings and keep that rate high and rising even after the economy recovers and consumers have paid down the mountains of debt they accumulated in the 2000s.

This might be easier to accomplish than is commonly assumed. It has become fashionable to blame America’s low private savings rate on the moral failings and profligacy of American consumers. Yet Americans didn’t simply become degenerate gamblers over the last three decades — they were in large part responding rationally to real incentives laid down by one of the most anti-savings tax codes in the Western world. Americans do not need a moral reawakening to raise their savings — they need comprehensive tax reform.

The federal government collects a higher portion of its revenue from individual income taxes (nearly 50 percent) than almost any other advanced economy. The tax rate on corporate income is the second highest in the world. Is it any wonder that Americans continue to shun investment and guzzle oil — the single greatest component of the U.S. trade deficit — when federal gasoline taxes run at about 8 percent and the capital-gains tax — a tax on the returns from savings — runs at 15 percent, and is set to rise to 20 percent next year?

The government could reduce the negative incentives in place against savings by redirecting some of the tax burden toward consumption. This would have the reciprocal benefit of disincentivizing consumption (of both domestic goods and, crucially, imports). Implementing a valued-added tax or national sales tax, not as a supplement but as a substitute for income taxes, could go a long way to achieving this aim. Many European nations are far ahead of the United States in this regard, employing VAT taxes to fill postfinancial crisis budget gaps, rather than using income taxes. The government could set positive incentives for savings as well by establishing a category of tax-free savings accounts for retirement and health care. Offering tax breaks for the reinvestment of company profits and consolidating tax write-offs for capital depreciation could achieve a similar result for corporations.

All of these policies would face an array of political roadblocks. But our politicians cannot dither forever. At some point, the rhetoric about nefarious exchange rates will be recognized for the distraction that it is, and the real roots of America’s huge deficits will have to be addressed. President Obama would do well to get serious about making these hard choices, and to do so sooner rather than later. For a president who so consistently touts the importance of America’s “moral authority” as its most important foreign-policy tool and argues so passionately for the power of international dialogue, Obama’s conduct on this issue so far have been puzzling. If there is one area of international relations where those beliefs are most true, where unilateral action is most certain to fail and cooperation has the greatest ability to achieve an absolute and measurable positive outcome for all nations, this is surely it. It would behoove the administration to heed its own philosophy, lead by example on internal economic reform and seek compromise on international trade with the zeal it seems so ready to afford in the rest of its foreign policy.

Daniel Krauthammer is a writer in Los Angeles. He holds a master’s degree in financial economics from Oxford University.


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