The real policy dilemma
When you follow policy issues and hear someone say were going to talk about the real policy dilemma you probably think in this environment it's going to be something critical about the Federal Reserve chairman selection process. That process has devolved into a name-calling credential-comparing circus largely involving Larry Summers and Janet Yellen. There's very little in the way of substance other than the name-calling that brands Summers is an egotist and Yellen as a policy dove. Could their whole careers really be boiled down to be as simple as that? And while that is something that bothers me it's not my point.
So next, you probably think it's about fiscal policy. Long-term fiscal policy remains a mess current tax collections have stepped up causing the recent budget deficit to shrink more than expected and as a result the President is no longer aiming at any kind of budget reduction. The Republicans are still concerned about the long run budgetary consequences. While I am concerned about fiscal policy and I think the long run is a mess, that's not the issue I'm after either.
I'm after the neglected and not well understood problem of why the economy has not been able to get a real recovery going. And, curiously enough, that's not substantially about either fiscal policy or monetary policy.
What it's about is US- United States' - competitiveness.
I am more than a little concerned that people including some economists are focused on the energy finds in America and think that this will be the basis for an improvement in our manufacturing sector and in our competitiveness. I'm quite concerned that if we are able to develop this energy-find and that if it does help to lower energy costs, that will simply compensate for the higher costs of doing business we have elsewhere. Then, when our energy largess runs off we will find that we haven't addressed the underlying problem at all. And that's the real problem: why we are not competitive.
Developing domestic energy has contributed to some improvement in the US balance of payments. As the economy has grown we have not sucked in as many oil imports as we would have without the improvement in domestic energy production. But our trade deficits remain large. They are large as a percent GDP. We are still looking at better than 30 years since the US has had any kind of a significant surplus on our current account.
How will we ever get back to surplus or balance?
Looking at a nation's welfare, monetary economists look at the terms of trade. The terms of trade refers to the ratio of export to import prices. That ratio reflects the terms under which trade is conducted. The higher are export prices relative to import prices the more export earnings are able to pay for our imports. On the other hand when import prices rise relative to export prices imports become relatively more expensive and are an added burden on the economy's balance of payments.
But that only looks at the price ratios. And what's interesting is that in order for exports to be competitive prices have to be low compared to global competition. So while we might want export prices high because they represent increased purchasing power from the exports we sell, set export prices too high we might not sell anything.
In a nutshell that describes the allure as well as the peril of a too-strong dollar. Over the last 20 to 30 years, as Asian economies have hyper-developed, they have focused more on using exports as way to stimulate domestic economic growth. They have focused more on the potential to increase export sales, and export sector employment because of increased export sector output than they have on trying to get the most for the exports that they sell. This is somewhat less than profit maximizing behavior but you can see the tremendous growth it has fueled in Asia as country after country has tapped into the domestic demand in the United States and in Western Europe. Instead, of having to balance their own economy with supply and demand they have been able to hook their export stream into one of our able-bodied arms and drained off some of our lifeblood like a donor participating in a blood drive at the Red Cross.
Only have more or less watched this happen and let it go. Republicans have watched it. Democrats have watched it. No one has really been too worried about it. American companies, instead of moving out of the industrial North into the right to work states in the South, or, instead of migrating jobs south of the border to Mexico, have picked up factories lock stock and barrel and located them in Asia where wages are even lower. And because these corporations are powerful I think they've had a substantial effect of keeping American politicians quiet.
This is been done in a system that has masqueraded under the mislabel of floating exchange rates buttressing free trade.
Exchange rates in fact have been very controlled by the countries in the pursuit export led growth. Asian countries have stockpiled foreign-exchange reserves which is the price they have had to pay-to keep buying excess dollars-in order to keep their currencies from running up as they sold more to the US than they bought from it. And when exchange rates are determined by governments rather than by markets you do not get a free trade result.
We can see that clearly in the United States where current account deficits, raw deficits, or deficits relative to GDP continue to be huge and surpluses are scarcer than hens' teeth.
This is not a result that emanates from free trade. This is not a result you expect if you have freely fluctuating exchange rates. This is a result you would never expect if you had a gold standard and if the countries that ran persistent current account surpluses were amassing gold reserves that they were taking from you - YOU!. Could you imagine the US allowing China, Korea, Taiwan, and earlier, Japan to have accumulated so much of our gold under a fixed exchange rate system?
Under a fluctuating exchange rate system current account balance is supposed to be restored as a country were running a surplus is supposed to see its currency rise. The country running the deficit is supposed to see its currency fall. This more or less automatic market mechanism has been undercut as export oriented countries have continued to buy the dollars to keep the dollar stronger than it should be so that they can maintain a competitive advantage and continue to pump their export goods into the US market.
Economists have largely been blasé about this effect. Many have argued that were getting real goods and the exporters are getting only pieces of paper. True. But these pieces of paper represent payments that we owe to them while our exports are nowhere close to earning the revenue we need to pay them back.
No one seems focused on this problem. No one seems to be aware that it even exists. However, I'm very concerned that it is what's at the bottom of the growing inequality in America. And that's a big problem because the President is talking about how he is trying to fashion policy initiatives to solve the problem and one of the things that he wants to do is to draw targets on the back of rich people. Does that even make sense?
I international trade there is a very elegant two-factor model called the Heckscher-Olin model that describes comparative advantage and other conditions tha arise when nations trade. Trading nations use two inputs, call them labor and capital, to create their output. One of the implications of this theory is that you'll get something called factor price equalization even if only one of the factors of production is mobile. Not both of them, just one of them.
Factor price equalization is just what it sounds like. It means that the factor prices referring to the return to capital and the return to labor will be equalized between the trading nations under conditions of free trade even if only one of the factors of production is mobile. And we have seen how much capital has been able to flow to Asia – most recently to China – making it quite clear that capital is internationally mobile.
It's not much of a stretch to argue that what has happened is since Nixon opened China and since China has developed and capital has poured in is that the process of factor price equalization has been set in motion. And with wages in China so low is it surprising that wages in the United States have not been rising? or tha real wages have been eroding? Or that unemployment is high and stubborn? Is it surprising that the return to less skilled labor has been held in check? Is it surprising that more skilled laborers, that entrepreneurs, that people with business talent, have been relatively better paid in a world where the pool of unskilled labor has expanded so sharply and skilled labor is relatively scarce?
I think the President has sunk his teeth into an issue that isn't what it seems.
Blaming rich people a.k.a. successful people for being successful is not really the issue here. I don't mean to protect those whose compensation packages have gone to the moon. But the main point here is that there has been a real wedge driven between skilled and unskilled labor by international trade and it has to do with trade rules that do not conform with the principles of free trade and with an exchange rate system that in no way supports what academic models of free trade really address or suppose.
And because corporate America has largely learned to benefit under this system and can earn its profits either here or there, it has been effective in keeping both political parties from attacking this model. It hasn't just been the fear of attacking China that has kept politicians at bay it has been corporate America. But this model is destructive and it's doing destructive things to America and no amount of education, or, investment, or jaw boning about the rich taking advantage of the poor, is going to solve the problem. Because the problem is emanating from an economic system that is in place and that continues to pump out the same results year after year.
It's not going to stop because you elect a Democrat President. It's not going to stop because you elect a Republican President. And its not going to stop unless you elect someone who sees the problem and vows to fix it. And right now that person doesn't exist.
The closest we have (had), actually is Mitt Romney who saw trade as a big problem. And although people are fond of making fun of Mr. Romney and have his indecision about whether he's a conservative or moderate his position on this issue seems to be the most enlightened one among any recent political candidate. His unearthing of the 42% figure is one of the most astonishing things in American politics that has ever been uncovered and promptly swept under the rug.
Romney discovered and made it known that fully 42% of our population that filed income tax returns was paid so poorly that it did not pay any federal income tax. Democrats came to their defense, arguing that the people pay property taxes and sales taxes and FICA and other taxes. But at the end of the day so does everyone else. Republicans backtracked on the issue a little bit because the point seemed somewhat mean-spirited to go after people on some of the welfare programs who clearly were needy.
But both of those reactions miss the point. The point of the 42% figure is the 42% figure! I don't glorify it; I don't disparage it. I simply look at it. What it says to me is that every politician of every color, of any partisanship that has held any office in America recently has been part of an abject failure to the American economy and people. When the economy turns out jobs that are so bad that so many people can't afford to pay federal taxes that's a travesty. It's a failure of everyone who's been in office. It's a failure of the Democrat model. It's a failure the Republican model. It's a failure of our system of democracy.
There is no one in American politics today that is committed to fix this problem. The President's idea is to tax the rich. Does it make sense to tax the 58% that already are paying all the taxes to have them funnel more money to the 42% who are paying no taxes? I mean they are wealthier but does this really make sense? When more people show up to the party do you cut the pizza slices in half or do you order more pizza?
The President wants to cut pizza slices in half. I want to grow the size of the pie.
To do that we have to improve the competitiveness of America. And that is certainly going to step on the toes of some of the people who are currently successful under the way the economy currently is running.
It's quite clear that one of the big problems would be swept aside if countries could be forced not to stop running persistent current account surpluses. When the dollar is the reserve currency and countries target their exports on the US market and target their bilateral exchange rate in order to effect their trade objectives the dollar winds up being higher than it should. The US current account deficit is bigger than it should be. And it stays there persistently. Capital flows continue coming to the US as foreigners purchase dollar assets in order to peg their currencies low and keep the dollar strong. The advantage is that the dollar has stronger purchasing power than it should. So people with jobs are able to purchase goods from abroad cheaply. But because the dollar is strong there are not as many jobs and there are more people who go looking for them and are unsatisfied.
That's exactly where we are today. Many economists do not see the exchange rate as the root of this evil. But I do. And, there such an elegant logical case to explain and justify it in the realm of conventionally known economic theory. I just don't see how you can dismiss it except to say that people don't want to deal with it. US corporations don't want to change it. US politicians do not want the confrontation. And, in fact, it is much more lucrative for traditional Democrats and Republicans to point the finger and blame at the other guy for the problem.
International cooperation and reform is always hard to come by. One of the fundamental asymmetries in international trade is that it's always the deficit country that's forced to adjust not the surplus country. And as long as the dollar is the reserve unit other countries will peg against the dollar and the US will not be able to peg against them. So countries that choose a weaker exchange rate will be able to attain it. But that doesn't mean that the resulting US current account deficits won't become threatening or damaging either to the US or to the world economy.
We can see from the last G 20 meeting that there is no taste to handle any of these problems having to do with trade warfare or formulating a better international currency system with any sorts of rules or obligations.
To the extent that the US is adjusting and containing its deficit, as it is one of the deficit countries, it's because of the high debt that is crimping consumption. US consumers simply can't spend money the way they used to. It's because of the lack of competitiveness has led to a high rate of unemployment. And now with financial institutions somewhat beleaguered, they are lending money much less readily so that debt-fueled spending cannot be sustained by the consumer. The development of a domestic energy resource has allowed relatively more the US energy demands to be met by domestic output. But all of that is essentially a passive a reactive adjustment rather than the kind of proactive pro-growth sustainable adjustment that the US economy needs.
In fact the debt problems in the US and in Western Europe finally are affecting China, causing it to change its export-ed growth model because it can't export the way it used to. China has been forced to develop its own domestic demand which means it's going to have to actually pay its workers which means it will have to undercut its own competitiveness in order to fuel its growth. There may be some limited opportunity for China to try to keep wages low in export industries and raise them elsewhere but that's only a partial solution since China cannot continue to export as it used to. Europe simply can't continue to absorb goods at that pace either. China has some of its own debt worries to face too, as it tries to achieve a more balanced and sustainable basis for growth.
But it should be clear as I describe this situation, that what has happened is that these pronounced systemic imbalances have caused countries to do things that have stopped what I would regard as the madness of their past policies.
This is not an enlightened approach to a problem that's been discovered. This is a problem that has been dealt with because of systemic repercussions through an unregulated blow back.
This is exactly what the late economist Herb Stein used to refer to when he used to say don't worry if the situation is unsustainable because, if its unsustainable, it won't be sustained! But of course the repercussions of not dealing with problems that we can see are festering and that can't be sustained is that they will remedy themselves in a way that might be even more painful. And that should be a lesson for our politicians except they are too busy fighting one another and setting the other one up as the straw horse that you should fight against – or vote against.
Within the European Monetary Union Germany has been accused of using the same tactics.... of having essentially a fixed exchange rate system and of running inflation rates that are so low that its competitiveness improved compared to everyone else in the system so that Germany came to dominate the European Monetary Union as its most competitive economy and did so largely by restricting the rise of the compensation to labor. German labor acquiesced to this largely because Germans were willing to forgo improvements in their standards of living in order to get assurances that inflation would be kept under control having developed an extraordinary distaste for hyperinflation during the interwar period.
But whatever the reason or whatever the tactic, allowing countries to pursue export led growth is a bad idea. Allowing countries to accumulate ever larger foreign-exchange reserves so that they can peg their currencies to achieve trade objectives is also a bad idea. And at some point it's an idea that will have to be put to an end.
Because of the last financial crisis and the problems that it's created with world banking system problems and the repercussions for policymakers everyone is distracted looking at the minutia of how to recalibrate international banking laws to make the banking sector say for the economy. In Europe there's a focus on debt and how to reduce debt and how to keep the European Monetary Union together. In the US there is is hand wringing about the policies of the central bank, about fiscal policy, about too big to fail and other aspects of bank regulation, and about class warfare... but mostly it's about Democrat-Republican issues. They keep us so busy we can never look at the real problem.
The real problem is how can we make America more competitive? The real problem isn't how can we blame the rich and pry more money out of their pocket. The real question isn't, are the people poor because they deserve it? It's hard to argue that 42% of the population deserves it- isn't it? Clearly there something systemic that's wrong and our policymakers are pointing their finger's in the wrong direction.
Will anybody figure it out?
Before it's too late?
