‘Is America Living Beyond its Means?’ -- Is That the Right Question?
My co-blogger (& fellow-Briton) Mark Brady, links to a Guardian article on the US _trade_ deficit (below). The author, he says, “raises some serious arguments….certainly ones that have troubled me for some time.”
The points made in the article are commonly & widely stressed by commentators & others on this issue. Let me therefore take this opportunity to bring out some key facts that appear to be scarcely known (going by the resounding silence in comments on the topic). These facts emerge only in answer to the kinds of questions that historians ask, as distinct from the interests of economists, journalists, politicians, etc.
To begin with:- A. The balance of payments figures (quite properly) bring together both private & govt. transactions. But each set of transactions is the outcome of _entirely _different_ -- separate & distinct -- sets of influences. In other words, there are _two_ distinct stories here, which need to be distinguished & told separately, & we’ll see what these are ( see further).
B. The present US trade ‘deficit’ has _not_ been there since time began. The US ran trade _surpluses_ before 1980 & therefore _exported_ capital_ on net. Only after 1980 did it run current account deficits & therefore import capital on net. The real question therefore is: _what circumstances changed, to bring about this changeover?_ The answer will emerge as we proceed.
1. As the Guardian article sees it, Americans have been recklessly borrowing against their assets to buy consumer goods; hence the trade deficit & capital inflow:- ‘Consumers have been using their homes like ATMs - borrowing against rising prices - but this cannot go on forever. The US economy needs quite a prolonged period in which consumer spending grows more slowly than the economy: that is the only way that the trade deficit is going to be reduced.’
The facts:- (a) The _bulk_ of (private) US imports have always been _production_ goods, _not_ consumer goods
(b) the proportion of consumption in imports has been _falling_, i.e., the proportion of _industrial inputs_ has been _rising_
( c) there has been _no_ change in the overall _composition_ of (private) imports for the last fifty years _& more_.
US imports (& exports) are made up of _all_ sorts & types of industrial goods; they run the _entire gamut_ of industrial production. In the classifications, industrial inputs can be identified fairly clearly, but manufactured _consumer_ goods are not always as clear. The _identifiable_ (identifiable) groups of such consumer goods came to somewhat over 23% of _all_ imports in 2004. This proportion has in fact been _falling_: it stood at 31% in 1951-55 & 1965, & at 26% in 1979. Correspondingly, production goods have made up a _rising_ proportion of imports.
Thus when the US had a trade _surplus_ & exported capital on net, it imported a _larger_ proportion of consumer goods. But during the period when the US had a trade deficit & imported capital on net, the proportion of consumer goods in imports declined, i.e., that of production goods rose.
Thus the present US trade deficit/capital inflow _cannot_ be the result of irresponsible, high consumption.
2. Since the bulk of US imports have always consisted of _production_ goods, the net inflow of (private) capital into the US _cannot_ be a case of borrowing to finance consumption. Why then has capital inflow risen so much faster than capital outflow since 1980?
It is crucial here to separate _private_ capital flows from US government borrowing abroad. Changes in private capital flows are a relatively straightforward story. But govt borrowings are a separate & distinct complication of their own, & clearly show up as such in the figures.
On private account, the US has been importing capital on net since 1980. Capital inflows into the US have come overwhelmingly from Western Europe since the late 19th century; this still continues. Thus in 1960, Western Europe supplied 68% of total _direct_ investment into the US; 44 years later, in 2004, it provided 71%. But there have been major changes in _other_ sources of direct foreign investment. Canada provided 28% in 1960, just under 9% in 2004. Correspondingly, the share of Japan & all other investors rose from just under 4% in 1960 to just under 21% in 2004. This change reflects the rise in capital in all these areas.
‘Portfolio’ investment -- in stocks & shares -- has accompanied direct investment. The latter began rising towards the end of the 1980s. Portfolio investments, however, shot up much more rapidly from the beginning of the 1990s, & now constitute the bulk of foreign investment in the US.
So why have _private_ flows of capital _into_ the US risen faster than private outflows?
Firstly: In 2004 investors came from far more areas than, e.g., 44 years earlier. In 1960, Canada & 8 European countries supplied 96% of all foreign direct investment in the US; Japanese investment was lumped in with ‘all others’. In 2004, investment from _14_European countries, Japan, & Canada, provided 91% of the total. (Another 8% or so came from entirely new sources that had developed only in the 1980s: Hong Kong, Singapore, Taiwan, Australia, Israel, & several tax havens in the Caribbean.) Thus as savings & investment expanded _especially in (more regions of) Western Europe_, these higher savings _continued_ to flow into the US, as they had done since the late 19th century.
Secondly: American savings ratios have been declining very much faster than in Western Europe since 1988. Thus more & more investment opportunities in the US are available to European savers.
A crucial point: Although the US household savings ratio has been falling, industrial inputs _continue_ to form the bulk of US imports; indeed, their proportion has been rising (above.) This reinforces the point that European savings have simply _replaced_ US savings, in utilising investment openings in the US.
3. Now to the loose cannon on deck: the US govt. Capital imports on _official_ account (US govt borrowings abroad) appear in the figures in specific years, as _additional_, mostly very large, capital inflows. Such borrowings started rising in the early 1980s. Thereafter, they rose nearly 2 ½ times faster than _private_ capital inflows. In the five years 1980-85, some 17.3 % of total capital inflows consisted of US govt borrowings, on average. In the three years 2002-04, they were 34.4% of total capital inflows, on average. Thus the US govt’s share of total capital imports has just about doubled over the last 24 years or so. And, beyond argument, this is _the_ exemplar of borrowing capital to finance current spending.
Two issues now, that are regularly conjoined with the issues above. As we shall see, these two are in the nature of red herrings.
4. Imports from China are routinely seen as sinister & baleful. As the Guardian article puts it: ‘The US has struck a Faustian bargain with its trading partners, particularly China….. Meanwhile, China creates millions of jobs and builds modern factories that are transforming it into an industrial superpower…..[The US] deficit has enabled the Chinese to build up their industrial strength at a rapid rate….’
Again, the facts:- (a) In 2004, China supplied somewhat over 13 % of all US imports of goods. In other words, just under _87%_ of such imports came from _all other countries_. But obviously the world does _not_ stand still: the sources of US imports have changed over the years.
In 1965 the _DCs_ including Japan, jointly provided the US with 65% of her imports of goods. This figure fell to 46% in 2004. Correspondingly, the share of East & Southeast Asia (South Korea, Hong Kong, Taiwan, the Philippines, Vietnam, Indonesia, Singapore, Malaysia, Thailand) rose from just over 6% to 12 %. We’ve just seen the Chinese share; that of all the remaining countries stayed at around 29%.
(b) Over the last 35 to 50 years, industrial production increased sharply in East & Southeast Asia. Hence exports _ to the world_ also climbed (& so also to the US.)
From the early 1950s onwards, Hong Kong, South Korea &Taiwan were already producing light industrial goods, including consumer goods & then electronic products, for _world markets_. The Southeast Asian territories, on the other hand, started by producing raw materials for the world’s industries in the late 19th century. Then, from the later 1970s onwards, they _added_ the same range of industrial & electronic products as the East Asian territories. Most of the industrial investment was local, but initially Japanese & then Korean & Taiwanese, investments were significant. China was last -- forced by circumstances to join in the early 1980s. China forged ahead with investments from Hong Kong & especially Taiwan, & also from the ‘overseas Chinese’ in SE Asia.
(So the US deficit has nothing whatsoever to do with industrial investments in these areas. And in China, US investments came late, & are only a minor part of the whole.)
(c ) The regions of East & SE Asia export _to the world_ & _therefore also_ to the US. In 2005, only about 21.4 % of China’s exports went to the US; over 78 % went to other countries. Similarly, 15.2% of South Korea’s exports went to the US; just under 85% went to other countries.
(So there is nothing sinister happening here. Just ordinary, common-or-garden economic development & therefore _diversity_ in exports -- to _the world_, which includes the US.)
5. In common with numerous other commentators & economists, the Guardian article holds that the US can run a trade deficit because the US dollar is a ‘reserve currency’: ‘The US is living beyond its means, hoping that nobody cashes the cheques it has been merrily writing as the current account has gone deeper into the red. That's the advantage of being a reserve currency…’ It quotes a former AFL-CIO economist: “US consumers get lots of cheap goods in return for which they give over paper IOUs that cost less to print.” And finally the article underlines that, because of the US trade deficit, ‘[China] also accumulates billions of dollars in financial claims against the US’.
Now the facts:- World currencies have _floated_ (floated) since 1973. Floating exchange rates mean the world has _not_ had or needed a ‘reserve currency’ for some 33 years or so.
World currency markets operate 24 hours a day, a little over 5 days a week, from Sydney’s opening time to San Francisco’s closing time. Internet banking is possible 24/7. There are extensive futures markets in currencies. No central bank or treasury officials could now maintain price controls over foreign exchange rates. The last such major attempt crashed spectacularly in 1973. The SE Asian attempt also failed dramatically in 1997.
_Some _ central banks, notably those of Japan, South Korea, Taiwan, & now China, have very large _holdings_ of US dollars. Japanese holdings are the outcome of repeated attempts to prevent the yen from rising. Chinese holdings have the same basis -- attempts to keep the yuan down. Thus their respective central banks have deprived Japanese & Chinese workers of cheaper imports: these workers have been robbed of deserved rises in their real wages.
When the foreign exchange rate of the US dollar falls, the dollar holdings above correspondingly lose some of their value. (Conversely when the US dollar rises.) Since 2002, it has been reported, the central banks of South Korea & Taiwan have been diversifying into other currencies & the Bank of China has been selling US dollars on net.
And finally, we return to where we began: it is only through ‘historical’ knowledge that we can know what is happening ‘now’. The ‘present’ is a continuation of the ‘past’. Historians see this, but _not_ economists, of course -- they are ‘scientists’. As for journalists & others: the ‘past’ stops dead six months or a year ago; the ‘present’ then drops from the sky, full-grown…
Sudha Shenoy - 10/9/2006
Just _very_ quickly: I want to emphasise I was _quoting_ from the Guardian article. (This is indicated in the blog entry.) The words _quoted_ are that writer's opinion, which I used as a discussion point.
Andrew D. Todd - 10/9/2006
In the first place, the United States cannot, in the nature of things, get into debt to China, as the term is ordinarily understood.
Money is not a commodity. That is simply a fiction of economists playing at being hard scientists when they are only theologians. Money consists, for the most part of "instruments," pieces of paper reading "promise to pay" or whatever. There is very little actual cash, that is gold and silver coins or bullion, in use. These pieces of paper have serial numbers, and are carried on ledgers in various financial institutions. It is not technically very difficult to freeze or repudiate such instruments, and to do it in a precise enough way that it affects only the desired target. If China should offer American T-bills to a French banker, the first thing that banker will do is to call up Washington, and find out whether or not the United States Treasury is willing to put the things in his name or not. One well-placed rumor that the Chinese Central Bank is forging American paper would probably be enough to render the Chinese Central Bank's holdings nontransferable without explicit American consent. Short of military action, an international creditor has no recourse, save to refuse to engage in further trading. Within a country, one's ultimate resort is to apply to the courts for a sheriff's seizure, a garnishment, or the equivalent. However, there is no generally accepted international agency with the power to compel payment. A country can decide which of its trading partners it wishes to stiff, and which it does not wish to stiff. The fact of the country having repudiated a large portion of its external debt means that its balance-of-payment problems are eased, and it is therefore less likely to repudiate other debts. Under the circumstances, it would take a very strong measure of solidarity between creditors for a finely controlled asset freeze to injure the freezing country's general credit.
Suppose China refuses to trade with the United States: what are they going to do with all their cheap t-shirts, then? The Europeans are already buying as many t-shirts as they are likely to want. The United States supplies China with some raw materials, and especially foodstuffs, and gets back clothing, housewares, machinery, etc. These last are collectively durable goods. You break off the trade for a month or two, and Americans get incrementally scruffier, whereas Chinese get hungrier. The Arabs have no cornlands-- they cannot replace the food deficit. Most of the world's sizable agricultural nations are so badly organized that they cannot generate food exports-- most of Africa and Latin America, and the former Soviet Union, for example. Hungry people become violent, and they tend to attack someone close at hand. Unless the Chinese government is completely mad, it will do what it has to do in order to ensure continued supplies of wheat from Montana, Idaho, and the Dakotas.
A second point is that the Chinese are not, economically speaking, ten feet tall. Here is one American businessman's account of outsourcing something to China:
It is quite clear that China is not Japan, nor is it South Korea either. A lot of the things China manufactures tend to be "delocalized," that is, bits and pieces get moved around the world, with different operations being done in different countries. Looking at an object with a "Made in China" label may give you a somewhat exaggerated idea of China's industrial capability, especially in electronics. Over the moderately long-term, say ten years, China may not do so well, because greater automation diminishes the importance of unskilled cheap labor, China's strong suit. When a factory passes a certain threshold of automation, its insurance rates, and especially, its government subsidy, become more important than its wage bill. For example, if the United States Air Force wants to purchase microprocessors which have never been in Chinese control, and cannot possible have implanted sabotage devices, and which are of the latest type, that will result in a proliferation of surplus chip foundries inside the United States. Since the cost of operating a chip foundry once built is negligible, that will mean that in trying to sell to Americans, the Chinese will in effect be competing against military surplus goods. What seems to be developing in the computer and electronics industry is a system of price wars subsidized by two or more governments. China may well be able to produce a lot of electronics in absolute terms, but that does not necessarily work out to being able to trade them for foodstuffs.
Similarly, over the next ten years or so, the costs of goods which can be automatically manufactured are going to come down quite a lot, compared to things which cannot be automated. For example, there are few if any operations in manufacturing either a computer or an automobile which cannot be performed by robots. The limiting factor on automation is usually American workers who fear losing their jobs. Once the job has gone off to China, that is no longer a consideration, and the ground is potentially cleared for extremely automated factories in the United States, again, probably operating under government (military) subsidy. I have been reading The American Machinist's blogsite a lot recently, and I gather that large numbers of machinists are getting their hands on "5-axis" numerically controlled machine tools, which can manufacture almost any metal part.
What I think this will translate to, among other things, is a radically increased ability to go energy-independent upon very slight provocation. The cost, and time requirement, of switchover will decrease by annual increments until it will become something which can happen in retaliation for an insult, something on the order of Teddy Roosevelt's "This government wants Perdicaris alive or Raisuli dead."
What it comes down to is that our economic relationships with the third world do not represent the most advanced aspects of out economy, and they are likely to become less important with time and technological progress.
Mark Brady - 10/8/2006
Sudha, you have written a very interesting and informative article, and I am grateful for the time you must have spent drafting it. I'm sure our readers will concur.
Below are some observations, questions, and clarifications that are prompted by your thoughtful post.
1. I linked to the Guardian article because it was a convenient peg on which to hang my brief comments. Such widely-respected commentators as Sir Samuel Brittan and Martin Wolf, both of whom have established credentials as economists outside of journalism, have repeatedly articulated serious and well-informed concerns about the prospects for the U.S. economy vis a vis the rest of the world. Larry Elliott of the Guardian is not in their league. However, I can link to anything on the Guardian website whereas the contents of the Financial Times are behind subscription.
2. There's no denying that Americans have been borrowing against the rising equity in their homes to finance home improvements and other consumer goods. This has surely added somewhat to imports and thus to the size of the trade deficit. It's not incompatible with the story you tell about how producer goods are the larger and growing share of imported merchandise. Think fungibility. After all, if the U.S. economy gears up to satisfy the growing demand for consumer goods, the demand for producer goods will be increasingly met by imports. I therefore suggest that your statement that "Thus the present US trade deficit/capital inflow _cannot_ be the result of irresponsible, high consumption" does not hold. Moreover, it is not true to assert that "Since the bulk of US imports have always consisted of _production_ goods, the net inflow of (private) capital into the US _cannot_ be a case of borrowing to finance consumption."
3. You describe how the U.S. government borrows far more from abroad than it once did and how these borrowings grew in the early 1980s and again in the first years of this century. Note that this would not have happened if American investors had lent more to the federal government and invested less in the private sector. In that case, foreign investors would have lent more to the private sector and bought fewer Treasury Bills and government bonds. That did not happen because foreign governments, mainly East Asian and oil-exporting states, sought to accumulate dollar-denominated securities and now hold trillions of dollars worth of such assets. The implication is that THE DISPOSITION OF THESE ASSETS WILL BE DECIDED NOT BY MILLIONS OF PRIVATE INVESTORS BUT FOR THE MOST PART BY A FEW FOREIGN STATES. That's the point. (It should be noted that the returns are generally lower than those that American citizens earn on their foreign assets and this has helped increase the net property income that Americans receive from abroad.)
4. Imports from China are no different from imports from Germany or Japan. And I certainly don't see imports from China or any place else as "sinister and baleful." I am an unapologetic advocate of unilateral free trade—for the U.S., the UK, and every other state. And, I might add, I am totally opposed to all attempts by the U.S., the EU, and every other polity to cajole their trading partners into reducing barriers to trade.
5. You assert that "World currencies have _floated_ (floated) since 1973." I'm sure you would agree that currencies have been largely subject to managed or dirty floats. You then state that "Floating exchange rates mean the world has _not_ had or needed a 'reserve currency' for some 33 years or so." Although "reserve currency" may be a misleading term to use in the context of a world of somewhat floating exchange rates, the fact is that the U.S. dollar, along with the Euro and yen, is used to settle transactions throughout the world, not least in the markets for oil and illegal narcotics, and is also held in the foreign currency reserves of most states, most notably the People's Republic of China. The more that people and states use the U.S. dollar for transactions and a store of value outside of the U.S., the greater is the demand for U.S. dollars abroad, and the larger is the U.S. current account deficit and/or U.S. investment abroad.
6. You state that "No central bank or treasury officials could now maintain price controls over foreign exchange rates. The last such major attempt crashed spectacularly in 1973. The SE Asian attempt also failed dramatically in 1997." What exactly do you have in mind? Surely if a state has sufficient reserves or is prepared to accumulate sufficient reserves, it can maintain an exchange rate above or below the rate that would arise in a free market? Indeed, you acknowledge this point when you state that "_Some_ central banks, notably those of Japan, South Korea, Taiwan, & now China, have very large _holdings_ of US dollars. Japanese holdings are the outcome of repeated attempts to prevent the yen from rising. Chinese holdings have the same basis -- attempts to keep the yuan down. Thus their respective central banks have deprived Japanese & Chinese workers of cheaper imports: these workers have been robbed of deserved rises in their real wages."
7. You conclude by stating that "And finally, we return to where we began: it is only through 'historical' knowledge that we can know what is happening 'now'. The 'present' is a continuation of the 'past'. Historians see this, but _not_ economists, of course -- they are 'scientists'. As for journalists & others: the 'past' stops dead six months or a year ago; the 'present' then drops from the sky, full-grown…" I agree with you about the importance of history. I do think, however, you are being rather unfair about some of the more informed economists and commentators. Sir Samuel Brittan and Martin Wolf are extremely cognisant of the insights of economic history and its cousin, historical economics.
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