The Financial Age of Free Trade

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On September 22, 1985, government officials from five nations, the United States, France, the United Kingdom, West Germany and Japan, met in the Plaza Hotel in New York City to sign a definitive agreement to work toward U.S. dollar devaluation. Over the next two years central banks used a "massive" $10 billion to force the dollar lower. The primary target of this intervention was Japan, where the weak yen was, according to three other signatories, giving Japanese businesses a competitive advantage (the German mark was also a minor target). In the U.S., the merchandise trade balance, and therefore the balance on the current account, had grown to "nightmare" proportions of about $40 billion quarterly (around 3.5% of GDP).

The devaluation itself was so successful that it led to another historic "accord" in February 1987. The "Louvre Accord", signed at the Louvre in Paris, France, aimed to undo some of the excess of the Plaza Accord. It was feared that if the dollar continued to fall much further it would trigger a rise in U.S. interest rates, derailing the economic expansion that was, at that point, becoming more uneven than the first stages of the recovery from the 1982-83 recession. Other members of the G6 were also wary of the trade implications of an overly weak dollar. The dollar itself stabilized somewhat in the late 1980's, as did the trade and current account balances, as U.S. monetary policymakers pledged and carried out stable, low interest rates.

By the end of the decade, however, the U.S. was in recession again, amidst a (for that period) frightening banking crisis. Interest rates did eventually rise since inflationary pressures had rebuilt (perhaps someone should have thought about the idea that artificially low interest rates = inflation of some type), a very unwelcome event coming less than a decade after the "end" of the Great Inflation. The Federal Reserve, now under Alan Greenspan, responded to the recession by forcing short-term interest rates even lower, to lows not seen since the 1960's. Though the recovery from the 1990-91 recession was the weakest post-war recovery to that point, it was a relatively mild recession and Greenspan's Fed was (and, unfortunately, still is) near-universally lauded.

While the Fed was busy "defeating" the business cycle, the trade balance became lost in the shuffle of the new age of economic "management". For its part, Japan responded to the Plaza Accord with massive monetary stimulus of its own. The Bank of Japan was not willing to simply absorb the dislocation (conventional economics uses the word deflation here, but unless there is a desperate currency shortage rather than an economic shock, I prefer to use the more appropriate term) and responded by adopting a radically "stimulative" position. Of course, the last half of the 1980's for Japan was wrapped into the largest asset bubble/vortex in history (to that point), a situation the country has yet to escape.

Across the Pacific in the U.S., the dollar continued to slide on a trade-weighted basis, but only slightly from its 1987 position. Against the yen, the move was far more dramatic, falling from a high around 160 yen to the dollar in early 1990 to 80 yen to the dollar in 1995. Counterintuitively, over the same period the US merchandise deficit revisited the nightmare $40 billion level. The Japanese were just beginning their "lost decade" (which would turn into two lost decades) while the U.S. was entering the "best" years of the Great "Moderation".

On a trade-weighted basis, the U.S. dollar began to rise after 1995 as a result of an increase in U.S. interest rates, however slight that increase may have been. From 1995 through 2000, the dollar appreciated by about 40%, and still the merchandise trade deficit grew from $40 billion a quarter to $120 billion a quarter. At the same time, the US fiscal deficit turned to a surplus.

Yet if we look at net financial flows, we still see a massive increase in flows into the United States. From 1998 until 2000, the same time as the U.S. fiscal surplus, the net financial flows into the U.S. grew from a quarterly average of $16 billion in 1997 to $140 billion by the end of 2000. According to the Federal Reserve, the bulk of those monetary flows into the U.S. were in the form of private (not government) foreign direct investment in the US and foreign purchases of "securities other than U.S. Treasury securities" (which includes U.S equities). Foreign money from the imbalance of trade was being directed into the growing equity bu.bble.

Of course, over the next decade, the age of real estate, all these imbalances grew far worse. From 2002 through 2005, the merchandise trade deficit for the U.S. doubled from about $100 billion per quarter to $200 billion per quarter. The financial inflow imbalance, which had fallen during the dot-com bust to a quarterly average of about $90 billion in 2002, regenerated all the way back to a $145 billion average quarterly rate by 2005. This time, however, foreign funds were flowing into U.S. government debt (largely from foreign official, i.e., government, sector) and "U.S. liabilities reported by U.S. banks and securities brokers " (largely from the foreign private sector). On the official side, the flow of money into U.S. government securities was not generic U.S. treasuries, it was, by and large, into agency debt, including GSE bonds backed by pools of mortgages.

Over the course of the decade of the 2000's, the U.S. dollar devalued in almost every currency cross except China. Yet the merchandise trade imbalance grew with nearly every major trade partner. It is little surprise that the imbalances with China grew (the current account deficit with China averaged about $20 billion annually from 1999 through 2001, but reached an astounding $412.3 billion in 2008), but the pace and the scale are mind-boggling. The trade deficit with Japan grew to $200 billion in 2007 despite a slight appreciation in the yen. Even Germany, which had a $32 billion trade deficit with the U.S. in 1999, saw that deficit reverse to a massive $200+ billion trade surplus (trade deficit from the US perspective) in 2007 and 2008 despite an appreciation in the euro of more than two-thirds!

There are a few interpretations to make out of all this, but none more than the fact that the simple world of the Plaza & Louvre Accords appears to have been lost into the age of monetarism. It is no longer the case that simple devaluation leads to the alleviation of a negative trade imbalance. Something more is going on here, as the marginal trade picture appears to be a function of something other than currency crosses, especially since we have a direct connection between imbalanced trade dollars and the asset bubbles.

Going back to the impetus for the Plaza Accord, the US trade deficit with Japan, US companies were agitating for devaluation because of the currency advantage that Japanese companies were afforded within the US marketplace (this was the era of the "Made In America" campaign). The inference being that the currency imbalance and "unfair" pricing advantage to foreign companies would lead to jobs being shipped overseas if US consumers shifted their preference to imported goods. But that is exactly what happened over the course of the next twenty-five years, aided in no small part by the trend toward "free trade" (NAFTA and other treaties).

Those mid-1980's warnings were largely correct in that wage growth, especially during the 2000's, was far weaker than previous decades, yet it was not the large multi-national businesses that suffered for it. Corporate profits, at least in the accounting sense, have experienced exceptional growth during the period in question. In fact, the free trade period, leading to these massive trade imbalances, was a prime factor in creating the financial productivity within their business systems, fostering the appearance of low consumer inflation throughout the developed world. The shifting of production resources outside the US has proven to be very beneficial to the bottom lines of US-based business. The benefit to consumers, at least according to this narrative, has been low inflation in nearly every consumer segment (the WalMart model) driven by that labor cost productivity.

However, it is not as simple as that. It cannot follow that the system of economic distribution within the United States can flourish during a period where businesses generate massive profits but invest them nearly universally, at the margins, elsewhere. The unquestioned economic paradigm since the early days of economics had always relied on business investment as a means to organic growth and productivity. That is, business profits being invested locally was a significant part of the ability of an economic system to flourish and grow over the long run. If businesses suddenly stopped investing corporate profits in the local economy, economic growth should suffer proportionally from that breakdown in monetary circulation. Now, as these massive trade imbalances demonstrate all too well, that paradigm has been overturned. Something else is squaring this new economic circle.

At least that circle was squared up until 2007. I think it is pretty clear to anyone paying even remote attention to the global economic system over these past twenty-five years what has been the marginal economic "filler". More and more the shortfall in productive capacity has been made up by debt created from nothing. In mid-1985, US households owed about $2.2 trillion in credit market debt (mostly mortgages and consumer credit). By mid-2008, they owed $13.8 trillion, a 550% increase. On a compounded basis, that is about 8.4% a year. In reality, the acceleration in debt usage by households matches almost exactly the acceleration in the merchandise trade deficit, really taking off in the 1998-2001 and 2003-2007 periods, suggesting more than a casual or random linkage.

The keys to this squared circle were the U.S. dollar and the asset bubbles. As more and more trade dollars were stranded overseas, they had to return to the U.S. in some form that allowed an artificial channel of monetary flow to form and maintain itself. As I said above, in the late 1990's a good proportion of trade dollars were recycled back to the US by foreign private investors into US equities. That trade money helped push the prices of US equities higher, expanding on the "wealth effect" which enticed households and consumers to spend at levels further and further above earned income (earned income that was being held back by production moving overseas). The savings rate declined noticeably as a result. Based solely on earned income, US consumers would never have been able to afford the same amount of imported goods.

After the dot-com bubble collapsed, another avenue for squaring the imbalanced circle was opened in real estate. Since the Chinese were operating essentially a fixed currency peg, that peg required trade dollars to be recycled back to the US in "official" form through the Chinese central bank as "official" reserves, thus favoring US government debt, including GSE's. From the foreign private sector, money flowed into the shadow banking system, showing up as private "bank" liabilities, often in the form of repos with the mortgage securities of off-balance sheet structures as collateral. As long as marginal trade money came back to the U.S. within the asset bubble channel, these trade and financial imbalances could maintain their destructive course, growing far greater than they would have otherwise.

Free trade, as it is supposed to exist, does not look like this. Free trade should follow comparative advantages, leading to bi-lateral trade mechanisms that create real productivity for both parties. Trade as it has developed in the age of monetarism is unilateral, whereby marginal trade is returned in the form of some financial instrument rather than a reciprocal good. Not only is that not free trade, it is fundamentally impoverishing to both trade parties. In a truly bilateral arrangement, the US would purchase goods from a foreign counterparty that would then return those funds by purchasing US goods. This arrangement benefits both parties in that productivity and productive capacity has been enhanced on both sides - this part is well known and often is mistakenly used as the justification for these blind free trade arrangements. Less well known is the impact on true wealth in each jurisdiction. Both parties in the true bilateral arrangement see an increase in productive wealth as goods are produced on both sides, likely in a sustainable and productive fashion. This was the stated goal of the Plaza Accord, to at least set the stage for a more balanced approach for productive trade with Japan (that was ultimately impossible because of the Japanese structural inhibitions toward importing foreign goods).

In our current set of arrangements, we see unilateral arrangement after unilateral arrangement. As the numbers above bear out, there is true wealth creation only on one side of the trade. In reality, foreign counterparties saw growing true, productive wealth while the US has seen growing financial "wealth". The US has piled up trillions in paper while trade partners pile up productive capacity.

The destructive nature of this arrangement has become clearer in the past four years, especially that this unilateral schematic is destructive for both sides. For the U.S., we are left with a shortage of productive capacity, especially when compared to the massive growth in the amount of claims on that productive capacity (debt in all forms). On the other side, we see the vulnerability of producer countries as they realize just how much of their productive capacity, and therefore domestic levels of production, were based solely on the squaring of that monetary circle. In other words, the Chinese economy, for example, is just as vulnerable to US consumer deleveraging since so much marginal production in China was predicated on US consumers spending so far above earned income. So China is just as captured by the Fed's ability to create artificial asset inflation channels to supplement weakened earned income as the US is.

Philosophically, if a true bilateral regime had been in place all these twenty-five years, the levels of true productive income on both sides of the trade schematics should have been far more proportional. Trade with China would have helped put Chinese to work, while reciprocal trade with the US would have helped put Americans to work. The growth in that type of arrangement would not be as susceptible to financial reversal, offering a more stable platform for long-term global economic health.

Of course, the main problem in the way of this bilateral arrangement was and is the disparity of incomes for labor in both places (we also see this within the Eurozone, as the German-PIIGS disparity plays out in that crisis, where Germany grew in productive capacity and PIIGS grew in financial debt). That is highly suggestive of currency terms that are far out of "equilibrium" (as much as that word applies here), raising questions about whether there should be so many currency interventions, and what should ultimately control the terms of global exchange.

Going back to the Plaza Accord, the failure of the devaluation that occurred to stem the tide of imports should have led to quite severe economic retrenchment in the US. Instead, the monetary interventions, especially with the economic engineering in the early 1990's, allowed the trade imbalances to grow far out of proportion because artificial, asset and debt-driven growth replaced the lost productive growth of business investment in domestic production. The growth of those imbalances, and ultimately the short-run and intermediate efficacy of monetary management, was all predicated on acceptance of the dollar at terms that were out of alignment with longer-term trade "parities". Or, to oversimplify at the margins, foreign trade partners made goods while the US made dollars. It all worked as long as those foreign trade partners accepted those newly made dollars pari passu, relatively speaking.

The size of the trade/financial imbalances and the length of time over which they were derived constitutes a trap from which neither side can easily escape. For its part, the U.S. would like to debase the dollar right out in the open (rather than hiding it in asset inflation), but is stung by the reversal of the marginal "productivity" that the domestic economy has been riding these past twenty-five years. While this would not conform to the accepted definition of inflation (deriving from employment growth), it would show up as such. Remember that it has been the "productivity" gains from outsourcing production overseas that has largely kept consumer prices in check during the Great "Moderation", reversing that through open dollar devaluation would mean cost increases throughout the economy, wherever imported goods are used (if prices at WalMart suddenly and quietly rose, or if the size and quantity of standardized goods quietly and suddenly shrank). We have already seen this to some degree, but certainly not to a scale that would eliminate the trade imbalance and the size of financial interventions.

Given that the merchandise trade imbalance is headed back toward $200 billion per quarter, the level of this new inflation is largely a function of dollar devaluation. Without the squared circle of consumer debt channeling new money into the hands of households and consumers, there is no way to sustain this inflationary spiral. There is no concurrent asset inflation channel (though central banks are delirious trying to restart one), meaning there is no ability to grow alternatives to earned income. The global economy is caught in a valuation limbo, where producer states cannot consume all that they produce, and consumer states can no longer consume that surplus without that enlargement of circulating financial resources. It is the worst of all worlds. The only solution is a schematic where production capacity is much less one-sided, but that means significant and disruptive revaluation throughout every trade channel and most certainly within the financial economy.

These unilateral arrangements grew solely through monetary means, and monetary policymakers are aiming to keep them largely in place to avoid that disruptive revaluation. Left to their own devices, imbalances in productive trade would have meant economic retrenchment decades ago, leading to slower growth and likely some hard choices about how to create a productive economic system on both ends. The Great "Moderation" certainly would have been far less great, especially since so much of it was financed by unreciprocated trade dollars, but, in light of today's circumstances, that would have been a welcome development. All of these imbalances would have been far more manageable, and the financial domination through asset bubbles that continue to threaten the global economic system would likely never have appeared.

What happened at the Plaza Hotel in 1985 was really a continuation of the system as it has evolved since 1971. The Federal Reserve and the U.S. government, for its part through administrations of both parties, have been trying to have their cake and eat it too. The Fed willingly accepts the low consumer inflation that "free trade" conveys, but is unwilling to accept the low-grade economic growth that such unilateral trade brings with it. Therefore it has "overcome" the outsourcing of production by enlarging the financial economy, circulating dollars within and without the United States backed by a minimal relative increase in the domestic productive capacity (but a lot of financial innovation).

Free trade throughout the 1990's and 2000's was the embodiment of the proverbial free lunch. Except there is no free lunch, not even when you control the printing press and the keys to unfettered fractional credit production. For all that has happened since 1985, and all that was intended to happen, imported goods rule the marginal economy to a degree never imagined back then, no matter where the dollar has traded during the interim. While large businesses have changed their tune about the devalued dollar, the public on both sides have little to show for it. The Fed may have masked these imbalances, but in doing so it, along with the collusion of central banks the world over, impoverished both ends of these free trade regimes. International trade is supposed to be internationally beneficial, but as long as the financial economy is required to maintain the unbalanced equation, the only real benefits seem to go first and foremost to the financial economy, while the real trade parties are left with nothing but illusions and artificial foundations. The PIIGS, Germany and Europe may only be the first concrete examples of where these types of intentional structural imbalances all eventually lead.


Jeffrey Snider is the Chief Investment Strategist of Alhambra Investment Partners, a registered investment advisor. 

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