Supply-Side University Summer School Economics Lesson #11
Memo To: Website Students
From: Jude Wanniski
Re: The World Trade Deficit
Economist Paul Krugman of MIT is on our list of the ten most dangerous people in the world because he writes and speaks with such arrogant intelligence that important liberal media such as The New York Times and Microsoft’s Slate magazine give him a ready platform for his views. The danger lies in his undistilled hostility to risk-taking, which makes him one of those on the cutting edge of the Dark Side of the Force. Because he knows the mechanics of commerce better than most academics, he is a formidable foe when he engages in hand-to-hand combat. Part of our assignment today is to read his July 17 Slate column, “The East is in the Red,” in which he explains, with no flaws we can find, why the U.S. trade deficit with China is no big deal. There are a few points we would add, but when Krugman takes on Alan Tonelson of the U.S. Business and Industrial Council Educational Foundation, he mops the floor with him. Tonelson’s August 17 reply should be carefully read, as well as Krugman’s reply to Tonelson. It is important that when the Forces of Optimism take on the Forces of Pessimism, they at least can agree on the size and shape of the playing field.
1. We are in agreement with Krugman that a country’s statistical trade deficit or surplus is of trivial importance in the global scheme. In arguing that if New York City were somehow separated into a new sovereign nation, the U.S. merchandise trade deficit would disappear as a statistic is no doubt correct. The city imports practically everything it eats, wears, shelters, and it exports almost nothing of a similar kind. It earns its keep by providing intellectual services, most particularly by earning fees by financing trade in the rest of the world, or in medicine, education, communications and entertainment. Trucks and trains come into the city full and they leave empty. The balance of trade may be in deficit, but the balance of payments on “current account,” which includes all these intangibles, is in balance, or maybe in surplus.
2. This is not a matter of accounting. It is a matter of arithmetic. New York City has to earn the money it uses to buy the stuff on those trucks. Krugman draws a parallel with China and Hong Kong, noting that if you consider them together, the mainland is running a surplus with the world and Hong Kong is running a deficit almost as big. That’s because Hong Kong, like NYC, exports intangibles that are not counted in the trade deficit.
3. Krugman could have strengthened his argument on the point he makes about New York perhaps earning a surplus on current account. If, as he argues correctly, there must be arithmetical balance, no ifs, ands or buts, how does New York run a surplus? Of course, the answer is that it would hold that surplus in monetary reserves issued by the rest of the world. In other words, it buys $100 worth of goods in exchange for $110 worth of fees, and buys US bonds with the extra $10. So too with China. In addition to paying for some of its imports to the world by fees earned by Hong Kong, China has had a residual which it has been using to buy US bonds. The People’s Bank of China now has $126 billion in monetary reserves, which pay interest, and which permit it to withstand speculative raids on its currency and on the Hong Kong dollar. That is, the Chinese currency is tied to the dollar and so is the HK dollar, which means the three are tied together. When Hong Kong became part of sovereign China on July 1, it added its $70 billion of monetary reserves to Beijing’s. If China and Hong Kong continue together to sell more than they buy in goods and services from the rest of the world, they will only add to the almost $200 billion in U.S. bills and bonds it holds in reserve. Once Beijing is satisfied with the size of its warchest, it can devote more of its export earnings to imports of goods and services -- including trips by its citizens to New York City to see a Broadway show. The Federal Reserve reports that foreign governments own $650 billion of U.S. government securities as monetary reserves.
4. A separate point that Krugman does not make in his Slate piece, which should be borne in mind, is that it is so much easier to collect information on imports than it is on exports, that each country has a bias toward errors which shows more imports than exports, a trade deficit. When the International Monetary Fund adds up all the deficits and surpluses of the world in exports and imports of goods and services, it should show the total in balance. This is because the world cannot have a trade deficit with itself. Yet the IMF additions indicate that the world is now running a deficit with itself of $143 billion. Over the ten years covered in its survey, the world has run a trade deficit of more than $1 trillion with itself.
5. For hypothetical purposes, suppose there were a world government, only one country. It could not have a trade deficit or payments deficit on current account. It would be similar to the domestic commerce of the United States, in which 50 states do well enough without any statistics being kept by anyone on which state is running a deficit and which a surplus. They come together in balance, as they must. The errors in keeping track of those citizens who are moving about from one state to another with their claims on goods and services would make the exercise worthless, and of course there is no attempt to keep such records. For most of the history of the world, no statistics were compiled by governments on trade accounts or current accounts.
6. In simple terms, imagine half the world has bread and half the world has wine. To get the surplus bread to where there is a bread deficit, in exchange for wine where there is a wine surplus, requires finance. A financial intermediary buys up all the surplus bread and all the surplus wine, carts the goods to the markets of the other, sells the surpluses, and pockets a fee facilitating the exchange. The process does not change when it becomes more complex, with a great many goods and services being exchanged for others, across national boundaries as well as within them. The people who make the bread and those who make the wine and the financial intermediaries all look over the deals they have made and make sure the deals will be profitable to them, one and all. Government recordings of these transactions have no utility except for tax and tariff purposes.
7. In a single gold standard world, in which the sovereign maintained the unit of account in terms of a paper/gold currency, there would be no logical reason for political subdivisions to hold bonds as a hedge against devaluation of the paper. In the same way, if we were to move toward a world in which the dollar was again defined in terms of gold, with the rest of the world becoming comfortable that we would not devalue or float, other governments would be able to shed their dollar monetary reserves as interest rates declined. They would not need warchests of dollar reserves, to fend off speculative attacks that result from currencies being out of line with the dollar or gold, because there would be only one fixed standard.
8. They did not do so to any great degree prior to 1967, when President Lyndon Johnson closed the London gold pool, fearful of losing more of our gold reserves. Foreign central banks could liquidate their holdings as they felt more secure in a new gold-based monetary system, which would be accompanied by a worldwide decline of interest rates. But wouldn’t this be bad for the United States, to have foreign governments unloading Treasury bills and bonds? No, because the reason they would be unloading them is because the world economy would be a less risky place to do business. The costs of hedging, the equivalent of insurance costs, would drop sharply. This would mean higher profit margins everywhere, the expansion of business everywhere, the employment of more people everywhere, the exchange of more goods and services everywhere. There can be no doubt about this, once the issue is examined thoroughly, because it simply is not possible for the U.S. economy to suffer because the world economy has become more efficient in the formation of capital -- because the U.S. has reduced the volatility of the world’s key currency to near zero.
I recommend you print out the Krugman column and his exchange with Tonelson, for your hardcopy notebook. This is an area which takes a great deal of thought in order to come close to understanding. It’s important to remember that just because a simple model is applied to the entire world doesn’t mean it becomes so complex as to be meaningless. Most of what is taught in macro economics in the world today assumes that human behavior changes as more humans are added to the equations. This is why their theories that work perfectly in computer models do not work in practice. It is also instructive to note that as much as we disagree with Professor Krugman on the issue of risk-taking, we find common ground with him in those mechanical areas of the economy which do not involve behavior.
There is one area we have discussed here that I am still not clear on myself. There is roughly a trillion dollars of U.S. government debt in the hands of foreign central banks and as currency in the hands of the rest-of-the world’s population -- $650 billion of the former, $400 billion of the latter. We don’t know how much of this accounts for the $1 trillion of errors in the world’s current account deficit with itself, or if it is related directly at all. The $1 trillion of U.S. debt held by foreigners is, after all, different than the assets and liabilities that show up between the U.S. and the rest of the world in private transactions. It strikes me that to the degree a dollar of U.S. debt is treated not as an investment, but as a commodity -- the equivalent of gold that would pay interest, it may explain some or almost all of the discrepancies in the IMF statistics. This is a hypothesis that has emerged in the process of preparing this lesson. We will kick it around sometime later in the fall semester. By the way, those of you who are not registered should do so. Only registered students will be getting material we will not post on open website. Here is an example of what you might be getting, a memo I sent Fed Chairman Alan Greenspan Thursday, relating to the turmoil in the financial markets of SE Asia. Have a nice Labor Day holiday!
August 28, 1997
Memo To: Alan Greenspan
From: Jude Wanniski
Re: SE Asia
Remember you told Senate Banking that if we were on a gold standard, Mexico would not have happened? If we were on gold, the turbulence in SE Asia would not be happening. Poor Thailand imposes capital controls after Krugman comes through warning about “hot money” and the Tequila effect. Then the Thais follow you up the hill to $383 gold and down the hill to $320, and the deflation wipes out so much business that a financial crisis emerges. So the IMF comes in with a bag of money, on condition that the government raise taxes again -- which reduces the demand for the baht, and encourages speculation of another devaluation, ad nauseum. How many times have you seen this before? After Labor Day, you should have a talk with the President. (Note the strength of our bond market today, betting the Fed will not raise rates in the face of the unprecedented turmoil in SE Asia!)