Editors note: Professor Michael Pettis wrote the book called “The Great Rebalancing” and is a core expert on global trade and balances. He is supportive of the Competitive Dollar for Jobs and Prosperity Act recently introduced by senators Baldwin and Hawley.
A bipartisan bill that would create a trade-balancing exchange rate for the dollar also aims to reduce foreign purchases of certain U.S. assets.
[Michael Pettis | August 1, 2019 | Bloomberg]
Senators Tammy Baldwin and Josh Hawley have introduced a bill that would require the Federal Reserve to manage the foreign-exchange value of the U.S. dollar to achieve balance in the U.S. capital account. Whether the bill is passed, it nonetheless marks the beginning of a necessary reappraisal by Washington of the forces driving international trade and American trade imbalances.
The bill would task the Fed with implementing a variable tax on foreign purchases of U.S. dollar assets whenever foreigners direct substantially more capital into the U.S. than Americans direct abroad, something they have been doing for more than four decades. The tax would aim to reduce capital inflows until they broadly match outflows. Because a country’s capital account must always and exactly match its current account, if the American capital account is balanced, then its current account must also balance, and the U.S. trade deficit would effectively disappear.
But if the goal is to reduce trade deficits, wouldn’t tariffs on imported goods be more effective than taxes on imported capital? The answer depends on what drives the imbalances. Had Baldwin, a Democrat from Wisconsin, and Hawley, a Republican from Missouri, proposed their bill in the 19th century — when international capital flows were dominated by trade finance — their proposal wouldn’t have made much sense. Today, however, the world is awash in excess savings and has been for years, even decades. The need to invest these excess savings is what drives global capital flows, which in turn drive trade imbalances. Capital has become the tail that wags the dog of trade.
Consider that even with interest rates at historic lows and with American businesses already hoarding piles of non-productive cash on their balance sheets, the U.S. is still attracting vast amounts of foreign capital. This is clearly not because American businesses need foreign capital to fund productive investment, but because foreigners must direct their excess savings somewhere; not surprisingly, they choose to send them into the deepest, best-governed and friendliest markets they can find, which invariably means the U.S. and, to a lesser extent, markets like the U.K.
Those who still argue that Americans need foreign capital to counter low domestic savings rates are mostly confused about the direction of causality. It is an immutable condition of the balance of payments that if capital inflows do not drive up domestic investment, they must drive down domestic savings. I have explained elsewhere how they do so: by distorting the American economy in ways that either raise unemployment or, more likely, raise fiscal or household debt. The U.S., in other words, does not import foreign capital because its savings rate is low; its savings rate is low because it is forced to absorb imports of foreign capital.
Taxing capital inflows doesn’t just rebalance American trade. If done intelligently, it has at least five other benefits.
First, if it is designed for flexibility, it allows the U.S. current and capital accounts to be broadly balanced over a period of several years. Over shorter periods, trade can be temporarily imbalanced for good reasons, and any good proposal must allow for that flexibility. Second, the tax on inflows should penalize short-term and speculative inflows more than longer-term inflows into productive investment. This would create greater American financial stability.
Third, unlike tariffs, which benefit one set of American producers at the expense of another, a tax on capital inflows benefits nearly all domestic producers, mainly at the expense of the banks. Because large international banks profit from intermediating major capital flows into and out of the U.S. and from borrowing cheap, short-term money and lending it for longer terms at higher rates, they — not producers — would be the losers from a tax on capital inflows.
Fourth, taxing capital inflows doesn’t distort the relative prices of goods and services and disrupt value chains, as tariffs do. And fifth, while such a tax does distort capital inflows, to the extent that international capital is driven not by efficient capital allocation but by short-term investment fads, capital flight, reserve accumulation, debt bubbles and speculation, this distortion can actually enhance the efficiency of capital allocation.
Today’s U.S. trade deficits are driven mainly by capital flow imbalances, and so the most effective way to reduce them is with restrictions on capital inflows. Tariffs are much less efficient and only work by distorting the real economy and rearranging bilateral imbalances. Whether it is ultimately passed, the Baldwin-Hawley bill may be the first attempt by lawmakers to address the persistent U.S. trade deficit by addressing capital imbalances. It is clearly a step in the right direction.