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Richmans' Trade and Taxes Blog
American Economic Leaders keep giving Advice to China
Howard Richman, 12/5/2010
With China growing about 10% per year and the United States growing at about 2% per year, I'm really getting tired of U.S. economic policy makers telling the Chinese government how to run its economy. They think that if China's leaders would just hear their cogent arguments, China would change course.
Take, for example, Treasury Secretary Timothy Geithner. In his written testimony at his January 2009 Senate confirmation hearing, he wrote:
More generally, the best approach to ensure that countries do not engage in manipulating their currencies is to demonstrate that the disadvantages of doing so outweigh the benefits. If confirmed, I look forward to a constructive dialogue with our trading partners around the world in which Treasury makes the fact-based case that market exchange rates are a central ingredient to healthy and sustained growth.
Or take Federal Reserve Chairman Ben Bernanke’s advice to China in his November 17 2010 speech. He said:
Third, countries that maintain undervalued currencies may themselves face important costs at the national level, including a reduced ability to use independent monetary policies to stabilize their economies and the risks associated with excessive or volatile capital inflows.... Perhaps most important, the ultimate purpose of economic growth is to deliver higher living standards at home; thus, eventually, the benefits of shifting productive resources to satisfying domestic needs must outweigh the development benefits of continued reliance on export-led growth.
This statement is incorrect in two ways. First China is not practicing "export-led" growth. It is practicing "mercantilism." If it were practicing export-led growth, its trade would be balanced, but currently it is running trade surpluses of about 5% of its GDP each year. Second, China is not hurting its long-term standard-of-living by practicing mercantilism, it is hurting ours.
At some point, Geithner and Bernanke and the rest of our arrogant policy makers are going to have to take the time to learn about mercantilism. And they have no excuse now that the key mathematical analysis of modern mercantilism is online, Heng-Fu Zou's 1997 Dynamic Analysis of the Viner Model of Mercantilism, originally published in the Journal of International Money and Finance. Zou is Senior Economist at The World Bank with appointments at both China’s Shenzhen and Wuhan Universities. China’s current policies may be based upon that paper.
Modern mercantilism is based upon the twin goals of mercantilism as explained by University of Chicago economist Jacob Viner: (1) maximizing a country's power through accumulation of foreign assets while (2) maximizing long-term consumption by delaying present consumption in favor of future consumption.
In order to accomplish these ends it places tariffs (and other barriers) upon foreign products while at the same time buying foreign assets (mainly interest-bearing bonds today; gold in the past). In other words, mercantilist governments maximize their power and their people's future consumption through the combination of import barriers and foreign loans.
Zou demonstrated mathematically that Viner’s goals are compatible. First, he found that the more that the mercantilist country was willing to sacrifice present consumption by accumulating foreign assets, the more power the mercantilist government would gain and the more consumption the mercantilist people would have in the long-run. This was the first of the propositions that he demonstrated:
Proposition 1: The stronger the mercantilist sentiment, the larger the long-run consumption and asset accumulation....
The reason for this proposition is quite clear. As a nation highly values its wealth and power in the world, it saves more and consumes less in the short run in order to run a current account surplus and accumulate more foreign assets. More foreign asset holdings means more interest income, which in turn leads to more consumption in the long run. Proposition 1 is a very strong argument for mercantilism if a nation intends to maximize its citizens’ long-run consumption.
Zou also found that the more successfully a mercantilist government applied tariff barriers to foreign consumer products, the more it would gain in wealth and power and its people would gain in long-run consumption. This was the second of the propositions that he demonstrated:
Proposition 2: A permanent increase in the tariff rate raises the total long-run consumption and asset accumulation....
Proposition 2 provides support for the mercantilist protection policy, namely the ‘fear of goods’ (Hecksher, 1955), if attainment of a higher long-run consumption is the national objective. Both proposition 1 and proposition 2 indicate the long-run harmony between wealth and power. Indeed from the mercantilist perspective, ‘there is a long-run harmony between these two ends, although in particular circumstances it may be necessary for a time to make economics sacrifices in the interest of … ‘long-run prosperity’ (Viner, 1991, p. 136). Following an increase in the tariff, short-run consumption will be cut because people invest more in foreign asset. But in the long-run, the increased foreign asset accumulation gives rise to more consumption and more power for the nation.
Zou did not address the effect of mercantilism upon its victims. In fact, he assumed for the purposes of mathematical tractability that the mercantilist country was a small economy with little effect upon its victims. But the effects upon its victims can be predicted as exactly in the opposite direction as the effects upon the mercantilist country. In the short-run the victim countries gain consumption, while in the long-run the victim countries lose both power and consumption.
These effects are quite apparent in the United States of the 12 years. During the house price bubble from 1998-2006, the United States got more consumption than normal by accepting the mercantilist loans from mercantilist governments. (When a mercantilist government buys another country's financial assets, it is giving that country a loan.) These loans financed first and second mortgages on homes.
Now the United States is trying to maximize current consumption by using loans from China and the other mercantilist governments to finance huge budget deficits. We get more consumption in the present, but become debt ridden at the same time. Eventually the loans have to be paid back in some form or another and so we will get less future consumption. In the meantime the United States government continuously loses power on the world stage.
Back to Bernanke
Bernanke's November 19 speech contained a paragraph what can be either read as a warning to China or as more arrogant advice. If it it is a warning, he is telling China that the United States will not continue to permit mercantilist predations. If it is arrogant advice, Bernanke is telling China that if they prevent American economic growth, they will be hurting themselves. Bernanke said:
First, as I have described, currency undervaluation inhibits necessary macroeconomic adjustments and creates challenges for policymakers in both advanced and emerging market economies. Globally, both growth and trade are unbalanced, as reflected in the two-speed recovery and in persistent current account surpluses and deficits. Neither situation is sustainable. Because a strong expansion in the emerging market economies will ultimately depend on a recovery in the more advanced economies, this pattern of two-speed growth might very well be resolved in favor of slow growth for everyone if the recovery in the advanced economies falls short. Likewise, large and persistent imbalances in current accounts represent a growing financial and economic risk.
If the above paragraph is a warning, then Bernanke is telling China that he will advocate unilateral policies to balance trade if China does not move in that direction. The scaled tariff could be his best option. Its rate goes up when our trade deficit with a mercantilist goes up, down when our trade deficit goes down, and disappears when our trade deficit with that country disappears, it would force China and the other mercantilists to buy our products so that they could export to us.
If the above paragraph is economic advice, then Bernanke has failed to understand mercantilism. Power is one of the twin goals of mercantilism. The Chinese government would like nothing better than to bury us. The eventual result of continuing U.S. inaction in the face of mercantilism is predictable, China will eventually replace the United States as the dominant power on the world stage. Given the nature of the two governments, this means that totalitarianism will replace democracy as the world's dominant political philosophy, all because our economic leaders wouldn't take the time to learn about mercantilism.
Comment by Frank Restly, 12/6/2010:
Reducing deficits is politically difficult as evidenced by the failure of President Obama's commission to reach a consensus. But is the problem the deficit or the debt? The deficit is the difference between what the federal government takes in tax revenues and what the federal government spends. The debt is means by which this difference is financed. My belief is that the problem is the debt. Reducing the debt is fairly simple, straightforward, and benificial to the long term health of the U. S. economy.
First, the federal government has an income stream (tax revenue) and has expenditures. Whenever the government's expenditures exceed its income stream, the federal government must finance the difference. It does this by borrowing money much like a company when it builds a new building or when an individual purchases a house. The interest rate on the debt of the federal government is the policy tool that the federal reserve uses to control inflation. Why you may ask - because unlike individuals, the federal government is always a going concern, meaning the federal government never goes bankrupt. If interest rates on government debt were 10%, the federal government would not go bankrupt, 20% the federal government would not go bankrupt, pick an interest rate and the federal government would still not go bankrupt.
Obviously the interest rate that the government pays on its debt has an effect on the interest rate that the private sector (people and companies) pays on its debt. With government bonds being rated AAA, lower grades of debt tend to have higher interest rates because of the possibility of default. That being said, one must remember that in a number of cases (mortgages, corporate bonds, student loans), the borrower can deduct the interest payments from his / her taxable income and thus realize an after tax cost of credit that is lower than the nominal rate that the individual is paying.
So why is large amounts of government debt a problem? In 1978 Representative Augustus Hawkins and Senator Hubert Humphrey coauthored the Full Employment and Balanced Growth Act. The four goals of that act were 1. Growth in production, 2. Price stability, and 3. Balance of trade and 4. Balanced budget. Full employment is mandated by the 1946 Employment Act.
Here are links to:
Here is our trade balance (actually current account balance which includes overseas investment returns, goodwill, and a few other minor items):
Here is our budget deficit
Here is the employment picture
And here is the consumer price index (price level)
One other chart that I am going to provide is a comparison between inflation and the unemployment rate:
In 1995 inflation as measured by the consumer price index was about 2.5% and the unemployment rate was about 6%. Now the inflation rate is about 1.75% and the unemployment rate is 10%. This is what bad monetary and fiscal policy looks like (the same as it looked in the 1970's). Note also, that changes made by President Clinton's Boskin commission pushed the measured inflation rate down by about 1.5% by most estimates.
The following data is from the bureau of labor statistics and the St. Louis federal reserve. From the year 2000 to present, U. S. employment for manufacturing durable goods has shrank from 10.8 million to 7.1 million, and nondurable goods manufacturing employment has shrank from 6.4 million to 4.5 million. Total employment in the production of goods has shrank from 24.6 million to 17.9 million. This represents a net loss of 6.7 million jobs. This is not a cyclical phenomenon. This is a structural change brought about by a government that has ignored principles set forth by its own members over 30 years ago.
A return to these principles begins with number 3 price stability. The federal reserve maintains price stability by keeping interest rates on short term government debt above the rate of inflation. See here for a comparison of rates vs inflation: (http://research.stlouisfed.org/fred2/graph/?chart_type=line&s[id]=CPIAUCSL&s[transformation]=pc1). But they can only do so much. The rest of the bond market must cooperate as well. Back in 2003 Mr. Greenspan commented on the bond conundrum. The federal reserve was being overly accomodative in pushing short term interest rates down to below 2%. They were expecting a bond market revolt on the long end of the market that never materialized. Part of the reason that bond market revolt never materialized was because of our trade imbalance and part of it was deliberate efforts by the U. S. Treasury department at the time to shorten the average duration of its outstanding debt. Interest rates on government debt cannot be used to lower deficits AND keep prices stable at the same time. If the federal government tries to use interest rates on its own debt to lower deficits then unemployment becomes the inflation control (which is where we are today). The way to avoid this problem is to a. sell less debt and b. force the U. S. treasury to always sell its debt with a positive real interest rate.
Obviously this change could lift market rates on government debt. A rise in rates on government debt could in turn lift market interest rates on private sector debt as well. If the rates on private sector debt go too high then unemployment will not fall and could instead rise. This brings me to item number 1 – full employment. To achieve full employment, the private sector after tax cost of debt service must be low. The federal government currently offers several tax breaks that allow individuals and companies to subtract interest payments from taxable income. These include mortgage interest deductions, corporate interest payment deductions, and others. I believe that the federal government must begin selling forward year tax receipts (FYTRs) to augment these deductions.
What is a forward year tax receipt?
Currently a corporation in the United States has three means of financing itself:
1. Current year income from sales
2. Borrow (issue bonds or tap a line of credit)
3. Issuing stock
The federal government only has two means of finance:
1. Current year income from tax receipts
2. Borrow (issue bonds or bills)
The third means of finance should be for the U. S. Treasury to accept payment in advance for taxes due some time in the future at a discounted rate. For instance, suppose the U. S. Treasury offered a 10% annualized discount for taxes paid 30 years in advance. This would mean that $1,000 paid in taxes today would cover about $17,450.00 of tax liability due 30 years from now. The U. S. Treasury would issue a forward year tax receipt (FYTR) in return for taxes paid in advance. That FYTR would be returned to the Treasury to cover $17,450.00 in tax liability 30 years from now. You may ask how this is different from 30 year bonds offering 10% interest. Here are the ways:
1. The U. S. Treasury guarantees that the 10% annualized interest on a 30 year bond will be paid back to the holder of the bond in dollars at the end of the 30 years. The U. S. Treasury does not guarantee that the 10% annualized appreciation on a 30 year FYTR will be recovered by the holder of the FYTR. That is completely up to the earning potential and future tax liability of the holder.
2. Unlike U. S. Treasury bills and bonds which are held around the world by foreign governments, retirement funds, etc., FYTR's would only be bought and held by individuals and / or corporations that have a potential tax liability in the United States.
Obviously the 30 year 10% FYTR is an arbitrary example. Like Treasury bond issuance, there should be a variety of maturities with rates of appreciation that decrease for shorter maturity.
This brings me to items number 4, balance of budget and trade. While not word for word, what I am about to tell you is inspired by what the economist Abba Lerner had to say about government finance. Financing federal government expenditures should not be thought of in the same terms as personal finance. Meaning, barring a foreign invasion or a civil war, federal governments with monetary authorities don’t go bankrupt or broke. However, debt levels can matter depending on who is holding the debt.
Problems often arise in countries whose debts are denominated in foreign currencies, but the U. S. does not suffer this problem. Instead the problem the U. S. suffers from is that because of its trade imbalance, much of its government debt is owned by other countries. Countries such as China are pursuing mercantilist trade policies and recycling their trade surplus into U. S. government debt. This makes it difficult for market yields on government debt to rise to contain inflation. This is what Dr. Alan Greenspan called the bond conundrum and Dr. Ben Bernanke called the global savings glut. What this really means is that the United States spends too much and saves too little while trade surplus countries save too much and spend too little.
The normal way to rectify this situation is for the country with the trade surplus to allow its currency to appreciate. But this method is completely at the leisure of the country with the trade surplus. Another way to rectify this situation is for the country with the trade deficit to lower its private cost of capital by selling FYTR’s to the private sector, making that country more cost competitive in the global markets. This also reduces the supply of government bonds that the country with the trade surplus can buy forcing them to buy something else.
Achieving goal number 2 – growth in production then becomes easily achieved by adopting these methods.
The federal government is too often portrayed and thought of as a personal entity like “big brother” or “Uncle Sam”. The federal government should instead be thought of as a business. The federal government is a business that takes in revenue in the form of tax receipts, spends money on purposes identified by its elected representatives, and finances the difference between what it collects and what it spends with debt. The federal government, unlike any other business, does not have a profit motive. Meaning that to achieve full employment and low inflation in the United States, the liabilities that the federal government sells to the public must have a high real rate of return whether those liabilities are bonds or FYTR’s. These public sector liabilities become private sector assets. The federal government must begin selling FYTR’s to limit the amount of bonds it must sell and to lower the private sector after tax cost of debt.
Response to this comment by Howard Richman, 12/6/2010:
Frank, thank you for your thoughtful comments, but I disagree. First, the cost of capital in the United States is near zero at present -- our problem is not expensive capital, it is lack of investment opportunities. Second, cutting back on the available government bonds would not deny to China a supply of American assets they can buy. They could still buy corporate bonds, stocks, land, our gold, almost any asset and their mercantilism would still work. Mercantilism produces imbalanced trade. You fight it through balanced trade.
Comment by The_Observer, 12/6/2010:
Politicians in the USA have failed and continually fail to understand why the USA doesn't export or sell more to China. The USA is hardly likely to be able to export t-shirts, rubber slipper or even rubber tyres to China. China wants to import commodities, capital intensive goods and technologies that will help develop her economy. This is why countries like Australia, Brazil, Germany, Japan, etc have a healthy export trade with China. The USA on the other hand has export restrictions on dual-use goods that China would like to import and politicians that kick up a stink every time that China wants to invest in US companies whether it be an oil company, Unocal or a washing machine company such as Maytag.
Response to this comment by Howard Richman, 12/6/2010:
Thank you for your post, but I disagree. China has lots of barriers to American products ranging from tariffs on our raisins, motorcycles, minining machinery, textiles, automobiles and trucks, and continuing to include freely permiting piracy of our DVDs and CDs while delaying legal selling of the same products. They would gradually balance trade with us if they were forced to do so by the scaled tariff.
Response to this comment by The_Observer, 12/7/2010:
Thank you for your reply. I agree that piracy is an issue in China but it was the same for all developing countries at their development stage including the USA. China recognizes that that is a problem not just for foreign companies but also for her own industries and health and safety reasons as well and is attending to the problem. As for your other point I do believe that Caterpillar does good business in China and that GM currently makes most of its profit in China and that Ford is going to set up factories there. I don't believe that the Chinese singularly restrict imports from the USA. The USA is after all China's biggest customer but high-value, high profit capital and technological goods are imported from France, Germany and Japan. You have to ask why that is the case especially when those countries currencies have appreciated so much against the USD. Then there are the choices countries make. The USA currently spends USD 710 billion per annum on the military budget. China has just announced that she'll be investing USD $300 billion per year on seven strategic industries for the next 5 years. See:
Response to this comment by Jesse Richman, 12/7/2010:
Your comment about GM, Ford, etc., is flawed. Certainly GM sells a lot of cars in China, but those cars are amost entirely cars that are made in China. Very few cars are exported by GM to China.
Comment by Ben Gee, 12/6/2010:
No body practise mercantilism better than Europeans and Americans. When they encounter resistance, gunboats and soldiers were send. China is doing what the west had done for 200 years without sending in gunboats nor soldiers.
Response to this comment by Howard Richman, 12/6/2010:
The age of mercantilism in the west was the 16th to 18th centuries.