The one subject, which became a headline issue last year, and even divides experts is trade. It will become increasingly important in 2018 as the US develops her trade policy, particularly with respect to China, and as the UK negotiates her Brexit terms with the EU.
Ignorance dominates this subject. Surely, people say, industry should be protected from unfair trade practices, such as goods manufactured in foreign sweat-shops, or unfair dumping of commodities, such as steel. If President Trump can protect American business from unfair competition, it would be good for the American economy. Then there's the business of currency rates. Doesn't a lower currency help restore the trade balance, by making exports cheap, and imports expensive? And surely, Britain leaving the EU risks trade tariffs being set up against British business. This means sterling must fall against the euro to rebalance trade.
These are all misconceptions, disproved by verifiable history. Why was it that before the euro, German export surpluses persisted, despite a rising mark, and why is it that after joining a weaker euro, her surpluses have not increased significantly further? And why did Japan, like Germany, also have a strong currency from the 1960s onwards and a persistent trade surplus? Why did Britain in the post-war years have a continual trade deficit despite a falling currency? And why was it that American trade protectionism intensified the depression in the 1930s?
The answers to these questions are relevant today to the development of both US trade policy and post-Brexit trade policy. It is no coincidence that trade imbalances have only become a significant feature since fiat currencies replaced the sound money disciplines of gold.
The purpose of this article is, to tell the truth about trade, by addressing the relationship between trade imbalances and exchange rates, and to expose the harm caused by the imposition of tariffs.
Why trade imbalances cannot persist with sound money
The most common mistake made by neo-Keynesians and the broader commentariat is that a trade deficit can be fixed through a lower exchange rate. This flies in the face of all empirical evidence, yet the myth persists. The error is in ignoring the consequences of monetary expansion in an economy of relatively fixed productive capacity. But first, in the interests of understanding why monetary expansion leads to trade deficits, we must establish money's role in an economy.
Money is the temporary bridge between production and consumption in all economies which are based on the division of labor. What we mean by this is all economic actors, including businesses, employed and self-employed people, produce something with their specialist skills or labor, so that they can buy all the other things they need and want. The unemployed, who do not take part in production, are subsidized by others, either by their families or by the state, so their missing production is always covered by the surplus production of someone else.
All economic actors make the default assumption that money is basically sound for the purpose of their transactions, even if it's a state-issued currency. This is despite the common knowledge that in the long run, its purchasing power changes. It is a precondition for a currency's validity to facilitate the conversion of production into consumption and as the basis for keeping accounts.
Consumption is either immediate, the buying of day-to-day items, or deferred. Deferred consumption is another way of describing savings and the retention of cash liquidity, whose roles are described later in this article. All of us, as individuals, run personal trade surpluses or deficits between our productive output and our spending, the difference being made up by changes in our cash balances, and our overall levels of savings. When we consider groups of people, whether they be the population of a town, city, region or even a country, what holds for us as individuals is also true in the broader aggregated sense.
This was obvious to classical economists, particularly when gold was money, and currency and bank balances were, for the purpose of economic theory, fully backed by gold. Different communities and countries, being a mass of individual actors, would always settle their trade with other communities and countries with sound money, the gold or fully-backed substitutes that they would have to hand.
Variations in trade balances tended to be relatively minor, and could never constitute a trend because no one could spend beyond their means for long, and people always needed to retain a cushion of liquidity and savings. What happened at the macro level reflected the micro, because both were, and still are, governed by the same basic rules.
Admittedly, communities using sound money, including those defined by national boundaries, can have different standards of living, savings habits, and monetary requirements. This does not directly affect the overall trade balance between them, because of payment constraints. But the effect on the split between deferred consumption and current consumption must also be addressed.
Other than the holding of cash liquidity, deferred consumption is the allocation of profits and income to savings, which through banks and financial markets are made available to producers who use them to finance the factors of production. And when a business acquires its productive capacity, be the components sourced locally or from outside its community or country, with sound money it has to pay for them, just like anyone else buying goods and services.
A community or country that increases its direct consumption by reducing its allocation to savings will restrict its own productive capacity. By constraining capital available for production and diverting savings into extra consumer spending, imports relative to exports are bound to rise. This is why differentials in savings rates between trading partners can lead to significant trade imbalances if allowed to persist, which is currently the cause of China's surplus with the US.
Between sound-money economies, there is in practice a strict limit to the diversion of savings into direct consumption. When capital becomes scarce, interest rates adjust until a new balance is found. If savings levels in one country relative to another change, in a purely market-based, sound-money economy these must be restricted to relatively minor short-term fluctuations and can never be a continuing trend, because of the limiting factors. Therefore, a persistent trade imbalance cannot arise.
