The 'Closed' World Economy and the Global Imbalance Myth
"There will not be a ‘surplus' of capital until the most backward country is as well equipped technologically as the most advanced." ~ Henry Hazlitt, Economics In One Lesson, p. 188.
As the world economy recovers from the financial crisis of 2008, myriad post-mortems have sprung up from individuals seeking to explain its causes. One of the most popular is the old notion that "global imbalances" drove faulty investment in the countries that imported a great deal of capital earlier in the decade.
In a recent piece for the New York Times, columnist David Brooks observed that our "economic crisis was caused by a complex web of factors, including global imbalances caused by the rise of China." In a speech at the University of Exeter, Bank of England Governor Mervyn King stated his belief that "If countries do not work together to reduce the ‘too high to last' imbalances, a crisis of one sort or another in financial markets is only too likely." Last fall, at a San Francisco Fed conference in Santa Barbara, Fed Chairman Ben Bernanke warned that governments must "avoid ever-increasing and unsustainable imbalances in trade and capital flows."
All three subscribe to the belief that national economies can overflow with an excess of capital. The supposition is that poor investment decisions in a country like the US result essentially from too much money chasing too few quality investment opportunities.
Similarly, if countries practice strategies to boost exports and curb imports, they'll return capital to their trading partners, with overinvestment once again the result. Unless countries get together to "correct" these trade and capital imbalances, overinvestment in the countries which import excess capital will supposedly drive yet another investment-led collapse.
Countries don't trade, but people do. It's a basic misconception in all this theorizing that countries trade and invest. Instead, it is individuals who do both. The very notion of "too much capital" is a logical impossibility owing to the certainty that humans have unlimited wants that entrepreneurs constantly seek to meet through the use of what is always limited capital.
Put simply, the world's economy is the only closed system, and since the world economy is merely the sum total of individual economic effort worldwide, there's no such thing as a global imbalance. Net borrowing, too, is zero for the world as a whole.
In a typical financial publication today, the discussion of trade almost always centers on exchange between countries. The variations are diverse, but we often read of "Japan" exporting the goods it produces to the "United States," and the "United States" exporting its wares to "Canada." And if Japan exports more to the US than the US exports to Japan, it is said that the two countries aren't in balance.
This description is a misnomer. As singular economic entities all, each one of us can only demand after producing first, at which point it should be said that trade between two countries is nothing more than the exchange of myriad goods between consenting individuals. A "country" is a political entity with economically arbitrary boundaries.
Conventional economists often speak of trade "imbalances" between countries, but broken down to the individual, imbalances dissolve. Consider the average person who goes to work each day. This individual usually runs numerous small trade deficits that are paid for by one large trade surplus. Specifically, the typical working adult has trade deficits with his landlord, dry cleaner, restaurants frequented and a local car dealer, but to fund those supposed deficits, this same individual carries a trade surplus with his employer. Looked at from the perspective of the individual, trade balances because demand always matches production.
Of course it's often said through a foggy macroeconomic lens that certain countries pursue "export strategies" whereby their imports don't match what they export. China is frequently fingered as the main miscreant here given the high rates of saving among its citizens. Happily, this supposed imbalance is also easy to explain, precisely because there's no imbalance to speak of. Savings - unless stashed under a mattress - are a form of demand even if the Chinese themselves aren't spending at all.
It's an economic tautology that no act of saving ever detracts from demand. Savers merely shift their consumption to other individuals, or better yet, their savings are lent to businesses eager to grow. As evidenced by exports with a Chinese origin, its citizens are by definition importing goods of equal value; that or lending excess funds to others with near-term designs on imports.
Imbalances within the United States? To develop a better sense of why economic imbalances cannot be, it's useful to look within the United States. Among the fifty different states in the union, what capital imbalances are there to speak of?
None in the way that economists might assume. Indeed, what's so fascinating about the very discussion of supposed global imbalances is that if real, they would logically show up among regions within each country. The way it works stateside offers insights into an economic concept that is overdone, misunderstood, or both.
It's a rare economist who will decry capital or trade imbalances between Arkansas or Tennessee, or California and Arizona. In the US we don't so much have imbalances of capital as we have talent imbalances and innovation imbalances that attract or repel capital.
It is through financial flows in the US that poor stewards of capital are starved of it, while good managers receive it in abundance. And far from "imbalances" that create economic crises, capital flows within the US are an essential agent of growth by virtue of the fact that best economic practices are rewarded.
In that sense, the rise of Ford Motor Company served as a capital magnet back in the early part of the 20th century as Ford's success led to copycats in and around Detroit that similarly were able to attract financing. Back then, talent and capital often found its way to the industrial Midwest.
In the 1970s, oil's spike amid the dollar's decline wreaked havoc on the Big Three auto makers in Michigan, after which a great deal of talent and capital was redirected to states like Texas and Louisiana where oil was plentiful. The '80s and '90s witnessed the rise of software and technology firms such that California's Silicon Valley, Boston's Route 128 and Austin, TX were the recipients of human and financial inflows.
Far from an economic retardant, the change in investor preferences merely spoke to market forces, once again reorienting capital to its highest use. In the future, depending on wherever talent and innovation in the U.S. are most prevalent, capital will continue to follow.
For the parts of the country away from which investment migrates, reduced investment flows serve as a market signal to individuals in depressed locales to either relocate, change their business strategies, or demand that local and state governments moderate tax and regulatory policies that are pushing away what economist Reuven Brenner refers to as the "vital few." In that sense, capital outflow can be seen as an economic positive for a region that is hurt by it.
If not states, what about country imbalances? To answer this question, a basic thought experiment is in order. What if Mexico and Canada became our 51st and 52nd states? If they did join the union, it's a fair bet that soon enough the worry over jobs lost to our southern neighbor would ease. And as Canadian oil interests are the largest provider of "foreign oil" to US refiners, it seems that the misbegotten fear over job losses and oil imports would disappear.
In sum, few policy makers express concern about the trade balance between Texas and Tennessee. But what doesn't matter within our borders suddenly becomes a pressing issue when foreign countries are introduced to the mix.
Since economic forces do not recognize political borders, it becomes apparent that capital and trade flows between countries have no different economic significance than those between our fifty states. The rest is politics. Domestically and internationally, capital flows result merely from the fact that people are more productive in some places than in others.
Of course, inter-country capital flows have long been with us, and those financial flows have helped formerly undeveloped countries achieve first-world status. As economists David Backus and Thomas Cooley recently observed in the Wall Street Journal, "England financed canals in this country and railroads in Australia and India."
In more modern times Backus and Cooley note that the US, Australia, Spain and the UK have been importers of capital, while "Germany, Japan, China and Switzerland have been significant exporters of capital." Rather than a driver of economic destabilization, these capital flows simply represent an acknowledgement on the part of profit-oriented investors that within certain countries the combination of ideas, talent and property laws are more welcoming to investment than others.
Is there any such thing as too much capital? Addressing a question similar to the one above, the great economist Henry Hazlitt once responded that "It is incredible that such a view could prevail even among the ignorant." Hazlitt understood well an earlier made point that with human wants unlimited and forever unmet, there will never be enough capital to fix all that needs fixing.
Economics at its core is about entrepreneurs easing our myriad needs. Until we reach a point at which everyone is sated, and every productivity-enhancing innovation has reached all sources of production, there will always be a need for new capital. Indeed, while the word "capital" conjures up "money" in the minds of most, the word capital is really about access to mechanical and human inputs in order to utilize them both in more productive ways.
Free capital is what enabled Ford to produce cars that replaced the horse-drawn carriage, allowed the ATM to replace the traditional bank teller, and turned tortoise-like land-line Internet access into a high-speed service that increasingly serves as our source of communication, news and television. To assume that there might ever be a time of too much capital is to suggest that someday society will be so intellectually bankrupt that ideas will disappear altogether. A more absurd notion would be hard to imagine. Despite the notions of some of the world's best known writers and economists, an overflow of capital due to global imbalances could not have been the driver of the 2008 financial crisis.
If not global imbalances, then what? If the world economy was not undone by "global imbalances," what was the trouble? One answer is that it suffered currency fluctuations driven most notably by a weak, unstable dollar. Indeed, as past Wainwright publications have made plain, when the dollar declines in value, this is frequently a worldwide event as central banks mimic US Treasury policy to varying degrees under the mistaken belief that their exported goods will otherwise become too pricey.
Looking back, the dollar began its long descent versus gold in 2002. As David Ranson and Penny Russell observed in 2007 in the Wall Street Journal, the dollar's eight-year decline against nearly every major foreign currency "obscured the fact that the world economy" had "embarked on another classic ‘run' on paper currencies." And with hard assets like housing frequently the nominal beneficiaries of currency weakness, capital around the world flowed into assets traditionally least vulnerable to that same weakness.
Austrian School economist Ludwig Von Mises noted in The Theory of Money and Credit that "monetary depreciation falsifies capital accounting." Looked at in light of what happened this decade, Austrian mal-investment drove all manner of investment mistakes that obscured the true health of bank balance sheets ahead of looming economic weakness driven by a migration of capital to hard, unproductive assets.
In that certain sense, the "global imbalances" referenced by leading economic lights were nothing of the sort. Instead, it should be said that inflation is always and everywhere an economic retardant. Declining currencies of all shapes and sizes from 2002-2008, at least for a time, camouflaged how poorly capital was being deployed.
Conclusion. The modern approach to economics has largely been one in which national economies have been viewed as living and breathing entities unto themselves. This view places politics above economics. National economies are, in fact, collections of economic actors pursuing individual self-interest.
As a result of this misconception, a great deal of commentary has sprung up concerning country trade and capital flows on the false suggestion that countries trade and invest with each other. To the contrary, it is individuals who invest and trade with other individuals across national borders.
Our trade flows by definition balance because, as self-interested producers, we can only buy insofar as we sell first. Consumption and production are merely two sides of the same coin. In light of that truth, trade can't fail to balance precisely because, individuals cannot, on average, either over or under-consume.
In the context of a closed economy of individual producers, the very notion of global investment imbalances collapses under its own illogic. Indeed, since no individual can ever prosper or innovate too much, it's plainly impossible that one city, state or country can ever be the recipient of too much investment. Instead, the value of investment is only limited by our singular power to invent.
The financial crisis of not long ago was decidedly not a function of mythical global imbalances. Instead, the money prices of investments around the world were distorted by currency fluctuations that ensured the kind of investment mistakes that invariably lead to economic downturns.