Weekly Geopolitical Report – Are the Germans Bad? (June 5, 2017)

by Bill O’Grady

At the NATO meetings late last month, the German media reported that President Trump had called the Germans “bad” for running trade surpluses with the U.S.  The president threatened trade restrictions, focusing on German automobiles.  Needless to say, this comment caused a minor international incident.

Although such incidents come and go, it did generate a more serious question…are German policies causing problems for the world?  In this report, we will review the saving identity we introduced in last month’s series on trade and discuss how Germany has built a policy designed to create saving.  We will move the discussion to the Eurozone and show the impact that German policy has had on the single currency.  From there, we will try to address the question posed in the title of this report.  We will conclude, as always, with market ramifications.

The Saving Identity
In the month of May, we published a four-part report on trade that is now combined into a single report.[1]  In that report, we introduced the saving identity.

(M – X) = (I – S) + (G – Tx)[2]

The saving identity states that private sector domestic saving (I – S) plus public sector saving (G – Tx) is equal to foreign saving.  If a country is running a positive domestic savings balance, either by investing less than it saves or by running a fiscal surplus, it will run a trade surplus (X>M).  In public discussion, trade appears to be all about jobs, relative prices, trade barriers, etc.  However, regardless of how nations interfere with trade, the saving identity will always be true.  As we noted in the aforementioned report, tariffs, exchange rate manipulation and administration barriers will, in the final analysis, be explained through the saving identity.

In the process of economic development, nations must build productive capacity through investment.  Both public and private investment are necessary for success.  Public investment in infrastructure, roads, bridges, canals, etc., are critical to supporting private investment.  In capitalist societies, a legal framework to adjudicate contract disputes and support the enforcement of agreements is also necessary and mostly provided by the public sector.  Private investment usually occurs along with public investment.  But, all investment requires funding, which comes from saving.  That saving can come from both domestic and foreign sources.

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[1] See WGR, Reflections on Trade (full), May 2017.

[2] Imports (M), exports (X), investment (I), saving (S), government consumption (G) and taxes (Tx).

Weekly Geopolitical Report – Reflections on Trade: Part IV (May 22, 2017)

by Bill O’Grady

(Due to the Memorial Day holiday, our next report will be published on June 5.)

This is the final report of our four-part series on trade.  This week, our discussion on trade continues with a look at the relationship between trade, employment and inflation.  We will also conclude the series with market ramifications.

What are the tradeoffs of trade?
Trade is part of a broader societal tradeoff between equality and efficiency.[1]  To function, societies need some degree of both.  Nations with a high level of inequality tend to become politically unstable.  At the same time, perfect equality tends to stifle initiative and prevent the building of productive capacity.  Efficiency helps an economy provide goods and services at reasonable costs.  Complete inefficiency makes everyone poor.

Okun’s insight is that societies balance equality and efficiency to maintain order.  What we observe in history is that there doesn’t appear to be a balance point; in other words, this isn’t an optimization problem.  Instead, we see broad periods of oscillation where one goal or the other is waxing or waning.

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[1] Okun, A. (1972). Equality and Efficiency: The Big Tradeoff. Washington, D.C.: Brookings Institute.

Weekly Geopolitical Report – Reflections on Trade: Part III (May 15, 2017)

by Bill O’Grady

This week, we continue our discussion on trade by examining the reserve currency issue.

What is the reserve currency?
When a country runs a trade surplus, it creates excess saving that must be either invested overseas or held as foreign reserves.  If a gold standard is being used, the excess saving/foreign reserves can be held as gold (or other precious metals).  In theory, reserve managers can hold just about any asset as foreign reserves.  However, if the ultimate goal of generating saving is to build the productive capacity of the economy, then the best foreign reserve assets should be safe and easily convertible, with broad acceptability in markets.

Here is an example we often use to describe why the reserve currency is important.  Imagine that a chocolatier in Paraguay wants to purchase a ton of cocoa beans.  He calls a dealer in Côte d’Ivoire for a price; the seller offers $1,800 per ton.  The buyer in Paraguay notes he does not have U.S. dollars but does have Paraguayan guaraní.  The seller does not want the Paraguayan currency because it would limit his purchases to Paraguay because the guaraní isn’t widely accepted.  The seller in Côte d’Ivoire would be able to buy a wider variety of goods (or have wider avenues for investment) from selling cocoa if he receives U.S. dollars instead.

So, how does the chocolatier in Paraguay get dollars?  The most efficient way would be to export chocolate to a U.S. buyer, then use the dollars he receives to buy cocoa beans from Côte d’Ivoire.  Because the reserve currency has widespread acceptance, non-reserve currency nations have an incentive to run trade surpluses with the reserve currency nation to accumulate the reserve currency, which allows them to pay for imports from around the world.

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Weekly Geopolitical Report – Reflections on Trade: Part II (May 8, 2017)

by Bill O’Grady

In this multi-part report, we offer several reflections on trade that we hope can provide some insight into how to use macroeconomics to judge the veracity of certain claims.  In Part I, we laid out the basic macroeconomics of trade.  This week, in Part II, we will discuss the impact of exchange rates and examine the two models of economic development, the “Japan Model”[1] and the “American Model.”[2]

The Japan Model of development calls for policies that drive up household saving.  This is usually done through financial repression and wage suppression.  This model is designed to provide cheap investment funds to build up the productive capacity of the country.

In contrast, the American Model of development relies on foreign investment.  In this arrangement, the trade deficit is an import of foreign saving for investment.

As a review from Part I of our report, the following saving identity means that the private investment/savings balance (I-S) plus the public spending balance (Govt-Taxes) is equal to the trade account, M-X (Imports less Exports).

(M – X) = (I – S) + (G – Tx)

If a nation’s saving equals its investment and it runs a balanced fiscal budget, then it will run a balanced trade account.  It doesn’t matter what the exchange rate is or what trade policy is in place; if the private and public sector balances, there will also be balanced trade.

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[1] We call this the Japan Model because it has been adopted by Asian nations for development.

[2] We call this the American Model because it is how the U.S. acquired saving during its industrial revolution, which began in earnest in 1870.