Humpty Dumpty and Global Financial Imbalances

This article was received from Project Syndicate, an international not-for-profit association of newspapers dedicated to hosting a global debate on the key issues shaping our world.

WASHINGTON, DC: There is an old saying that goes, “If you have only a hammer, everything looks like a nail.” Nowhere is this clearer than in discussions of the United States’ trade deficit and global financial imbalances, given economists’ tendency to reduce most economic problems to questions of savings. Unfortunately, this focus on savings distorts understanding and distracts from the real challenge of creating mass consumption markets in developing countries.

Within national income accounts, trade deficits represent the excess of a country’s consumption over production. From an accountant’s perspective, that makes it logical to label trade deficits as negative savings.

Most economists go a step further, asserting that the US deficit is caused by a savings shortage. But, since one country’s trade deficit is another’s surplus, US Federal Reserve Chairman Ben Bernanke has argued for turning the conventional logic on its head: rather than resulting from a savings shortage, the US trade deficit is the result of a global savings glut – especially in China.

Both stories are flawed. How does a savings glut translate into exports, given that households do not export? Likewise, if the US is consuming too much, why has it been closing manufacturing capacity, and why is there so much labour market softness?

Both the savings shortage and savings glut hypotheses confuse accounting outcomes with causes. Trade deficits reflect transactions between producers and buyers, and those transactions are the result of incentives and price signals. US consumers buy imports rather than American-made goods because imports are cheaper. This price advantage is often due to exchange rates in places like China and Japan, whose currencies are undervalued by between 25% and 40%, which often offsets US efficiency advantages.

Undervalued exchange rates are only one of the policies that countries use to boost exports and restrain imports, so that they run trade surpluses, while their trading partners (including the US) run deficits. Policies aimed at ensuring export-led growth also include export subsidies and barriers to imports.

In the modern era of globalization, export-led growth is supplemented by policies to attract foreign direct investment (FDI), a combination that has been particularly successful in China. Such FDI policies include investment subsidies, tax abatements, and exemptions from domestic regulation and laws.

These policies encourage corporations to shift output to developing countries, which gain modern production capacity. This increases developing countries exports and reduces their import demand (or increases it at a lower rate than export growth). Meanwhile, corporations reduce home country manufacturing capacity and investment, which reduces home country exports while increasing imports. Once again, China provides clear evidence of these patterns, with almost 60% of Chinese exports being produced by foreign corporations.

This story is fundamentally different from the savings shortage and savings glut hypotheses, and it leads to dramatically different policies. Developing countries need to grow, but nowadays it is easier to acquire capacity and grow through FDI than it is to develop domestic mass consumption markets. Consequently, rather than facing a savings glut, the global economy faces a problem of demand failure in developing countries.

The challenge is to get corporations to invest in developing countries, but for purposes of producing for local consumers. That requires expanding markets in developing countries, which means tackling income inequality and getting income into the right hands – an enormous organizational challenge that is off the radar because economists focus exclusively on savings and supply-side issues.

Labour standards, minimum wages, and unions are part of the solution, as they were in countries that developed successfully. Unions have historically been especially important since they engage in decentralized wage bargaining that tie wages to firms’ productivity. Consequently, wages are market sustainable.

Government spending can also help, but its role is limited. Countries that substitute government spending for market spending either generate inflationary budget deficits, or end up with excessively high tax rates that destroy incentives. But no solution is possible until we abandon the savings shortage and savings glut hypotheses and connect today’s global financial imbalances with global production patterns and inadequate demand in developing countries.

Tortuous claims that saving is merely the flip side of consumption and investment spending are the economic equivalent of Humpty Dumpty’s argument in Through the Looking Glass : “When I use a word, it means just what I choose it to mean.”