Saturday, 1 June 2019

The (real) way to solve the (real) US trade deficit problem

Last year, I wrote a piece (here) opining that Trump had a point in objecting to the US's large and persistent trade deficit - even if he may have arrived at that conclusion through a different intellectual route than I. I continue to hold that view. However, what I do not support is the means by which Trump is seeking to address the problem, which are both unlikely to solve the problem, and also quite likely to create significant costs in the process - albeit that the US economy could well still end up a net beneficiary of the policies.*

Trump's recent announcement of intended tariffs against Mexico (starting at 5%, and potentially escalating to 25%), with implementation contingent on whether Mexico cooperates to stem the tide of illegal immigration at the border, is particularly problematic. Trade policy should be based on sound economic logic, and not become an impetuously-wielded political weapon used to boss other countries around, or be implemented in ways that are capricious, unpredictable, and abrupt.

In the era of free trade, hundreds of billions of dollars have been invested in complex international supply-chains, which cannot be undone easily or quickly, or without imposing significant economic costs (stranded investments and duplicated supply chains/investment). Furthermore, the ability of tariffs to materially change on a presidential whim makes long-range corporate investment planning nigh on impossible. Major capital investments are expensive and multi-year projects that often require decade-long payback periods, and the uncertainty created by such policy capriciousness is sure to slow down the pace of investment, and weaken the global economy.

However, these remarks notwithstanding, I stand by the my view that there is a problem - something that remains far from a widely-subscribed view. Indeed, the consensus view is that the status quo prior to Trump's interventions was already optimal, and consequently that any and all trade interventions will be a lose-lose for everyone, including the US. In my view, the actual truth is that there is in fact a significant problem, and provided appropriate policy remedies are implemented, addressing the US trade deficit would likely not only significantly benefit the US economy (although harm large trade surplus nations), but in the long term, likely benefit the global economy as well. The problem, instead, is simply the means by which Trump is attempting to address the problem. The fact that the issue is also not a simple win-win (free trade) or lose-lose (anything else), but rather win-lose (in the medium term), is also a fundamental reason why a negotiated solution between the US and China has proven elusive, despite widespread expectations to the contrary held as recently as early May (even luminaries such as Charlie Munger got this completely wrong).

As argued in my original article, the problem is the unthinking extrapolation of the undeniable benefits of balanced free trade, to trade that becomes significantly unbalanced. I agree with the conventional view about the benefits of exploiting comparative advantage, and the improved economic efficiency that can result therefrom. This sort of trade is a genuine win-win. However, this is the sort of trade where I sell you $100 of goods A, and you sell me $100 of goods B. This is not the situation where you sell me $100 of goods B, and I don't sell you anything in exchange, but instead borrow $100 from you (or, less commonly, sell you $100 of my assets) to finance their acquisition. This is the realm of unbalanced trade, which results in large financial imbalances, and these imbalances can have many highly undesirable long term consequences.

Foremost amongst these negative consequences is the fact that if a country runs a large and persistent trade/current account deficit (excepting small developing countries with large net FDI inflows), it must accumulate significant indebtedness in the process (and/or sell significant domestic assets to foreigners, or some combination therein; in practice, the majority of the imbalance is expressed via the debt channel).

One of the consequences of the former is a significant increase in domestic liquidity in the deficit nation, which ultimately has the effect of driving down domestic interest rates in order to stimulate sufficient domestic borrowing, which is necessary to ensure that liquidity is borrowed and spent. The banking system intermediates this process, and is a significant beneficiary (until a credit crisis eventually occurs), as banking-asset-to-GDP rise, and lending spreads and asset quality remain healthy. The outcome is usually an inflated banking sector; inflated levels of household (and other) debt; and housing and other asset bubbles. And when these bubbles burst, it can be extremely painful/economically damaging.

This is the dynamic that caused not only the GFC (preceded by a huge run-up in the US current account deficit, to in excess of 6% of GDP, alongside China's swelling trade surplus), but also the 'conundrum' that puzzled Bernanke in the pre-GFC years, where a strong economy and rapidly rising debt levels were being accompanied by downward pressure on long term interest rates. He didn't understand it because like many economists, he got the direction of causality wrong. Falling rates were driving higher borrowing (and rising house prices), rather than interest rates being the outcome of higher credit demand - the latter of which would have resulted in rising interest rates. The push factor was excess liquidity; rising debt levels were the outcome. For similar reasons, the widely-subscribed view that low interest rates (QE aside) are purely the function of central bank behaviour is also fundamentally wrong - if that were the case, excessively low rates would have resulted in inflation, not disinflation/deflation.

It is no coincidence that the countries that have sustained the largest and most persistent current account deficits correlate very strongly with the countries that have experienced housing bubbles, significant increases in indebtedness, and which have oversized banking systems (whether measured by profits-to-GDP or market cap-to-GDP). Examples include Australia, NZ, Canada, and pre-GFC US, UK, and Southern/peripheral Europe.

Post-crisis, reflation of debt and housing bubbles has also begun to recommence in some of these current account deficit countries, but to the extent such reflation is not possible/does not recur, the only alternative outcome is near-zero/negative interest rates and a significant increases in government debt (the government is the 'borrower of last resort'). The supply-push of the excess liquidity influx emanating from current account deficits has no other outlet. These outcomes - trade/current account deficits; recurring asset bubbles; incessantly rising debt levels (private and then government); and credit crises followed by interest rates trending towards zero - are all intimately connected, but these connections are very poorly understood. It is the fundamental cause of much misguided ideology about the desirability of unfettered free trade even in the presence of very large trade imbalances.

That's the problem, but what is the solution? How does one address these undesirable imbalances, without significantly impairing economic efficiency, economic freedom, and the benefits that derive from the exploitation of comparative advantage? The answer, I believe, resides in an exceptional but much-under-appreciated 2003 Fortune article penned by none other than Warren Buffet, who also recognised the danger of the US's rising trade deficit, and proposed an elegant solution. A link to the full article can be found below.

I think the idea is brilliant. What Buffett proposes is essentially a cap-and-trade policy akin to those that have been proposed/implemented to limit carbon emissions. In short, it would require that every importer purchase a tradeable 'import certificate' of equivalent notional value to the value of the goods sought to be imported, which could be purchased from exporters, who would be allocated marketable import certificates of equivalent notional value to the value of the exports they ship.

This scheme would automatically balance the trade account (because every dollar of imports would have to be matched by a dollar of exports), and would also do so in a manner that avoided all the damaging economic consequences of tariff-based approaches. It would not, for instance, distort markets in any way, which is an inevitable outcome if differential tariffs are applied to different classes of goods/services and/or to certain geographic regions. The scheme is also guaranteed to deliver the desired outcome - a balanced trade account.

One of the problems with Trump's China-focused tariff policy, for instance, is that it could simply result in a relocation of low-end US-bound export manufacturing production from China to other economies such as Vietnam. The trade deficit with China might decline, but it might increase with respect to other nations. In addition, Trump's tariff-based approach could simply cause the USD to appreciate and the Yuan (for e.g.) to depreciate, to an extent which largely offsets the impact of the tariffs on competitiveness, resulting in limited change in the overall trade deficit. A cap-and-trade import certificate policy would prevent that from occurring. In short, befitting of Buffett's brilliance, his solution is both elegant and economically efficient - indeed, optimally so in my opinion.

The other important aspect would be to have a long phase-in period, as well as (ideally) bipartisan political support, so as to remove the risk of economic actors believing the policy will not survive the next electoral cycle. If the preexisting status quo was that the US was (say) exporting only US$0.50 for every $1.00 of imports, the policy could be phased in over ~10 years by requiring importers to purchase only US$0.50 of import certificates for every $1.00 of imports in year one (while exporters would be issued US$1.00 for every $1.00 of exports), increasing to US$0.55 for every $1.00 in year two, and US$0.60 in year three, and so forth. This way, industries and supply chains would have sufficient time to adapt themselves to changing price signals (which would proceed no faster than the typical impact of fluctuating foreign exchange rates at present), and companies would also have a high level of forward visibility on their future relative cost structures, facilitating efficient decision making/long term planning. The level of economic disruption would therefore be relatively minimal.

One of the final complexities that needs to be considered (not addressed by Buffett) is that capital flows are also a fundamental part of the globalised world in which we live, and there are productive as well as unproductive capital flows, and we ought not deter/inhibit the former. A prime example of productive capital flows are those associated with net FDI into developing economies. If all countries undertake balanced trade and end up with balanced current accounts, capital accounts will also necessarily have to be in balance, which could inhibit the free flow of capital into places where it could be put to more productive uses.

I don't have a strong view on the best way to resolve this issue, but there should be multiple potential solutions that - accompanied by balanced trade - should result in outcomes vastly superior to the current system. The shortcomings of the current system are as obvious as they are significant. What ought to be happening is that rich, developed countries ought to be net savers and net investors into developing countries, given that the latter have much higher development needs, a smaller accumulated pool of domestic savings (and less developed capital markets), and many more productivity-enhancing ways in which capital can be deployed than mature economies.

However, what has actually been happening with the US, and many other developing economies, is the exact opposite. The US, Australia, Canada, NZ, and the UK, for instance, have all been large current account deficit countries, and these deficits have been financed (nay, driven) not just by other mature economies such as the EU and Japan, but also developing countries such as China, South Korea, Taiwan and Thailand (and in years past, Japan during its period of rapid industrialisation during 1950-1990).

Something is clearly very wrong with the way capital flows are working at present, and to a large extent, this is a reflection of the said developing countries pursuing trade-surplus-driven economic development, via the mechanism of managing their currencies at undervalued levels (often via explicit currency pegs at undervalued levels), or deliberate excess Fx reserve accumulation (only developing countries with current account deficits should actively seek to increase Fx reserves - see below).

The GFC and its aftermath highlighted the fundamental limits to this approach, as the other side of the coin is the necessity of rich current account deficit countries going deeper and deeper into debt to finance rising imports, but eventually the private sector in these countries ends up borrowing more than it can afford to pay back. At this point, a credit/banking crisis ensues, following which - with the private sector's ability to absorb more debt exhausted and banks chastened - interest rates go to zero and government deficits/debt levels significantly rise - seemingly without end.

In addition, current-account-deficit emerging markets (not to be confused with current account surplus emerging markets) have also suffered in the past from a world of unfettered unbalanced global trade, and the associated large amount of global liquidity it necessarily creates that gushes around the world looking for a temporary home. These dynamics were the root cause of multiple crises in the 1980s and 1990s (such as the Asian Financial Crisis). Capital rushed into such economies during boom times (indeed they were also a fundamental contributor to the boom itself, in a reflexive/self-reinforcing fashion), driving up domestic asset values, economic activity and debt levels, leading to overvalued currencies (as current account deficits expanded to levels that could accommodate large capital inflows). When those capital flows reversed, currency crises ensued, as large current account deficits had to swing into large surpluses to accommodate equivalent capital outflows, driving domestic interest rates to the stratosphere, and crashing domestic economies and asset prices.

EM central banks have since learnt their lesson, and about the importance of sufficient FX reserve accumulation (during capital inflow periods) in order to finance necessary reserve depletion during capital outflow periods, and also about the importance of carefully managing the level of unhedged domestic Fx-based borrowing. The lessons have also extended to development agencies such as the IMF and World Bank, who prior to the recurrent EM crises of the 1980-1990s, recommended complete deregulation of capital flows and trade, and only later realised that this approach was ideologically flawed and was contributing to recurrent crises. These hard-won lessons have significantly reduced the magnitude and severity of EM crises in the new millennium, but successfully managing the destabilising impact of excessive levels of 'hot money' capital flows remains a major challenge for developing economies, and there are no easy or perfect solutions.

However, what can be said with assurance is that if more balanced global trade occurs, the quantity of unproductive and volatile cross boarder net capital flows will be significantly reduced, and in the process, so will these undesirable consequences/challenges. In this vastly more benign environment, there should be ways in which to accommodate more minor capital flow imbalances (predominately net FDI flows) without unreasonably thwarting capital mobility and economic rights (i.e. without the need to implement capital controls).

Unfortunately, my confidence that any of the above will become widely understood, let alone acted on, is exactly zero. Indeed, even Warren Buffett's policy prescription of 2003 was roundly ignored (and as a result, the deficit continued to deteriorate during 2003-07 and eventually led to the GFC). Current economic ideologies are simply too strongly entrenched, and very few people recognise that there is even a problem, let alone there being any incipient move towards a productive consensus on how to best address the issue. Instead, all the negative consequences emanating from unbalanced trade will continue to simply be laid at the feet of bankers, politicians, and central banks (the latter - though far from blameless - generally cop more blame in the investment world than they deserve), and/or are erroneously ascribed to uncontrollable forces of nature that no one can hope to mitigate.

On the positive side (as an investor), the current system will continue to promote sequences of booms and busts, and broadbased confusion about what is happening and why, and hence heightened volatility. This will continue to provide well-heeled investors with a clearer understanding of the actual cause-and-effect dynamics driving outcomes in the real world, and who possess the discipline and fortitude to take advantage of market volatility, with ample opportunities to buy low and sell high. For value investors, the more economic and market volatility there is, and the more pervasive and numerous misunderstandings about how the world works are, the better (even if that is a negative for society).


*Since the commencement of Trump's 'trade war' in early 2018, the US economy has continued to vastly outperform expectations (growing by 3.3% in 1Q19 in spite of broadbased pessimism and expectations for a recession by late 2018), while trade surplus nations such as China and Germany/the EU have sharply slowed. Import substitution has likely played a role (US domestic steel production has risen sharply since early 2018, for instance), as well as a likely pick-up in domestic investment to repatriate certain manufacturing/supply-chain functions back to the US to preserve cost-competitive market access (and/or forestalling the prior rate of net exodus in certain industries).