Fixing “global imbalances” in three easy steps
Some problems are hard.
Some problems are not, except when we blind ourselves to pretty obvious solutions. Addressing “global financial imbalances”, or, more specifically, the fact that some countries are running persistent current account deficits that they (correctly) perceive not to be in their interest, falls into the second class of problems. It is flawed ideology, nothing more, that makes this problem seem difficult. If you want something to stop, stop it. Let me break it down for you into three easy steps.
Stop blaming China!
Yes, China’s success at limiting its currency’s real appreciation against the dollar amounts to a combination export subsidy / import tariff, turbocharging China’s tradables sector by making Chinese goods cheap abroad and foreign goods costly to Chinese consumers. The policy has, in some formal sense, robbed Chinese consumers of purchasing power, and shared the loot between Chinese elites and Western consumers.
But it has also been profoundly good development policy. (See Dani Rodrik.) China’s rise has been miraculous, something that the planet as a whole, and Americans in particular, ought to celebrate. Literally hundreds of millions of people have transitioned from poverty to comfortable modernity. China’s abrupt rise most resembles that of the United States, which went from a civil-war-riven backwater to a dominant world power in only eighty years time.
I don’t mean to gloss China’s problems or excuse its sins. China’s rise presents huge environmental challenges, to its own people and to the world. I dislike many aspects of its political system. Economically, I’m pretty sympathetic to Tyler Cowen’s China skepticism, and expect that during the continuing economic crisis, a parade of Brobdingnagian boondoggles will come to be revealed.
Despite all that, in any nondystopian future, China’s gains will be consolidated, not reversed. We should all be rooting for its success. During whatever turbulence lies ahead, we should do everything we can to help.
I agree with many critics that the combination of China’s currency peg and America’s economic dogma has been harmful to the US. But it is an odd sort of petulance to blame China for acting in its national interest because of consequences that US policymakers have always had the power to prevent. The blame for America’s (very serious) predicament rests squarely with a policy establishment that remained willfully blind to obvious problems for years, and that still refuses to consider effective remedies.
Recognize that a nation’s balance of payments is a legitimate object of public policy.
Yes, you can write models in which no agent transacts except when doing so is in her infinite-horizon self-interest, in which case policy that restricts or discourages any trade is Pareto destructive, QED. But those models bear little resemblance to the real world.
In reality, financial flows — trades of promises rather than current goods or services — are subject to unusual uncertainty, and individuals have great difficulty distinguishing advantageous from disadvantageous exchanges. Aggregate financial flows affect both real and financial economies in ways no competent government can afford to ignore. There are reasons why a country might prefer to run a current account surplus or deficit for a while, but that ought to be a considered policy choice. It is rarely sensible for a large, mature, and diverse economy, like that of the United States (or Germany), to run either a deficit or surplus. Persistent trade deficits are a problem for human aggregations of any scale, from family to city to nation-state and beyond. Surpluses are okay at small scales, but become dangerous as they grow. Some groups have reason to oscillate between deficit and surplus, but no sustainable arrangement involves capital flows that never reverse, and whose reversion is not planned for in advance. (This is slightly overstated: a growing economy can sustain persistent small flows indefinitely and maintain a stable net financial position with the rest of the world. For a growing economy, “balance” is a modest range surrounding zero, not a single point. You can also write models — I just did — under which capital flows would never reverse, but the assumptions you need to make are, to say the least, dangerously unreliable.)
I know of very many arguments that try to justify persistent imbalance, especially persistent deficits. After all, the United States has run very large current account deficits, but its net international position has been relatively stable, because foreigners’ return on their US investments has been abysmal compared to Americans’ return on their gross foreign investment. Also, when a country like the United States, whose debts are incurred in its own currency, runs a trade deficit, it exchanges claims on tokens it can produce indefinitely at zero cost for real goods and services. Why shouldn’t it take the deal?
These arguments are both ways of saying that some countries, either intentionally or inadvertently, are willing to offer other countries real subsidies mediated and often hidden by complex financial arrangements. But perpetual subsidy is often harmful to the recipient, even if it is willingly offered by the donor. And usually the subsidy is not explicit, so that the donor retains a claim that it expects (however implausibly) to be payable in future goods and services. Arrangements that rely upon systematically reneging on that promise, by perpetually offering poor real returns on creditors,cannot endure, and are likely to be harmful to the spirit of trust and cooperation upon which trade ultimately depends. All financial claims are mere paper, or “spreadsheet entries”. But our ability to sustain economic arrangements that extend over time and geography depend upon our continually giving meaning to that paper by backing our accounts with sweat and treasure. To the degree that we are unable to do so, to the degree that we issue claims that we find ourselves incapable or unwilling to back, we corrode the scaffolding upon which cooperative prosperity depends.
To be clear, this does not mean that issuers of financial claims should be bound, come what may, to deliver on those claims. Promises, including bad promises, are always joint projects of a promisor and promisee. There may be times and places where the burden of trying to make good on bad paper exceeds the costs, particular and general, of reneging. We are living through those times in very many places, and we are witnessing the consequences — a corrosion of trust, a diminishment of enterprise. The point here is to recognize that promises are fragile but essential. An environment in which promises made are generally kept, in letter and in spirit and without duress, is crucial to organizing the vast collaborations without which we are naked and cold. Persistent net capital flows imply some group of people accepting a flow of current goods and services in exchange for ever more expansive promises to reciprocate at some time in the future. That may occasionally be justifiable, but it is always dangerous, and ought to be subject to very careful scrutiny. When bad promises are made and broken, the consequences are rarely limited to the foolish transactors. The “externalities” can be severe.
Gradually impose nondiscriminatory capital controls to regulate ones own balance of payments
Fundamentally, there are two ways a country can regulate its international balance. It can target the “current account” or the “capital account”. Managing one takes care of the other as a matter of course. The current account is dominated by the trade balance — the gap, if any between the value of a nation’s imports and exports. The capital account is equal and opposite: if a nation has imported more than it has exported, it has “paid for” the difference with promises. To accept a promise in exchange for present value is to supply capital. Simplifying a bit, a nation receives capital to the degree that it accepts imports in excess of exports, and offers financial claims to cover the difference. A current account deficit implies a capital account surplus, which sounds nice but is nothing more than a windfall of promises yet to keep.
Traditional protectionism — trade restrictions like tariffs and duties — target the current account. They alter the price of foreign goods and services relative to domestic goods and services, usually making foreign goods more expensive in order to encourage domestic consumption. However, these policies have a deservedly bad reputation. Attaching duties to imported goods and services implies that choices have to be made about how large the duties should be, and to which goods and services they should attach. That discretion generally proves very attractive to politicians, who may reward political supporters with protection of specific industries, skewing consumer choices far beyond the small home bias that might be necessary to manage the balance of payments. In theory, countries might adapt small, perfectly uniform tariffs. But in practice, this never happens, both because the political temptation to pick winners is impossible to overcome, and definitional questions of what ought and ought not be viewed as imports become fraught. (If I buy advertising on a foreign website, is a duty owed?)
A much better approach is “capital account protectionism”. Rather than getting into the messy business of interfering with the trade in goods and services, manage capital flows directly. The simplest way to do this is to tax (or subsidize) the purchase of domestic financial assets other than zero-interest cash by nonresidents. There need be no interference in Ricardian free trade, the exchange of present goods and services. But the cross-border trade in promises would be taxed and regulated.
I can already hear the cacophony of objections, and many of them are valid. Yes, clever people would quickly find ways to circumvent a financial asset tax, especially if implemented unilaterally by a single government. (Mutual enforcement would be preferable, but not essential.) Off-balance-sheet arrangements, clever swaps, would have to be controlled (but we have a lot of good reasons to want to do that). Transactions that multinationals now consider “internal” would become more costly and subject to scrutiny (but again, there are lots of reasons to think that supervising “internal” but international corporate flows might be a good idea, given how often these flows are tax motivated). A good regulatory regime combines tactical flexibility with clear goals to which regulators will be held accountable, creating incentives for regulatory innovation to counter circumvention. Those who think capital controls are always futile and doomed to failure are simply wrong. Sometimes they fail, and sometimes they work very well. That capital controls inevitably “leak” is besides the point. Evading controls entails costs and risks that discourage flows at the margin. The point is never to stop flows, but to modulate them. Capital controls that are intended to maintain balanced accounts are more likely to succeed than controls intended to sustain or enlarge imbalances. Also, in a world where disruptive financial flows are increasingly due to the official sector, capital controls are less likely to be actively evaded. A private speculator might hide capital flows in overpayments for current goods (and bear a huge risk of whether her partner will honor her legally unenforceable claim). A foreign government would hesitate to play such games for fear of provoking conflict with the government whose laws it would be flouting.
Speaking personally, I don’t “like” the idea of capital controls any more than I like trade protectionism. I enjoy the freedom to think globally and invest wherever I choose. But the experience of the developing world for half a century and of the developed world over the last decade ought to have convinced all but the most ideological observers that balance of payment matters; that we cannot expect balance to naturally emerge in global markets; and that relying only on self-correction means tolerating massive-scale waste of real resources while flows persist, then indiscriminate destruction and human misery when flows reverse, or when the poor quality of earlier investment decisions becomes revealed. Our choices are to simply accept these costs as the price of freedom, to use the tools of trade protection, or to add a layer of regulation to the financial economy. In a world of bad alternatives, normalizing capital controls is by far the least awful. Capital controls aren’t perfect, but they are much more resistant to corrupt micromanagement than trade controls.
The process of going from liberal to more managed capital flows won’t be easy, but it needn’t be that hard either. First and foremost, it can be done without sparking trade wars. If a country imposes capital controls to manage its own balance of payments, it needn’t discriminate against any particular foreign power. China (its government or private investors) could continue to buy US Treasuries on precisely the same terms as European investors. The market would determine which flows (of both goods and capital, they are inextricably linked) would continue and which would be blunted based on demand and comparative advantage. In public relations and in fact, managing ones balance of payments wouldn’t be “about” or any particular trade partner, but simply a matter of national prudence. In order to minimize disruption to other economies, a nation could announce a several year timetable over which it would gradually increase controls as necessary to bring its accounts into balance. Rather than the heated rhetoric of trade protection (which usually involves somebody accusing somebody else of cheating or dumping or poisoning), capital account protectors can focus on the hazards of their own financial position, and adopt an apologetic rather than accusatory tone to help trade partners to save face as they find ways to accommodate the adjustment.