The Hallmarks of Mercantilism
When I first heard about this tweet on television earlier this week I laughed. Within the character limitations of the twitterverse President Trump not only accused China of being a currency manipulator, he also pressured the Federal Reserve to lower interest rates in order to weaken the dollar which is -oh! – currency manipulation.
Let’s face it. The President appears to show a very shallow understanding of economics and foreign trade and their impact on US foreign policy. In his tweets and campaign rally comments he presents a world view that is a zero-sum game. He rejects the possibility of a win/win scenario. He says he wants “fair” trade but what he seems to mean is that he wants the trade deficit to be a big fat zero.
Unfortunately, economic reality trips him up. Much of the trade deficit he is so upset about is due to the large and persistent budget deficits of the federal government. The chart below using data from the US Census Bureau shows the US trade deficit from 1960 until 2018. The second chart below that ,using data from the White House website, shows the budget deficit also from 1960 until 2018. You can see that the two charts track each other closely. The trade deficit was a minor problem until the 1970’s when it started to grow larger. This was also when the US budget deficits grew larger. As budget deficits grew, so did trade deficits.
This is not a coincidence. As we buy imported goods, we must ship dollars overseas. Most countries cannot pay for a lot of imports with their domestic currency. Foreigners don’t want to hold them and so sell the unwanted currencies and, as we all know, when supply exceeds demand the price goes down. As their currency devalues, imported goods and services become more expensive blunting demand until the supply of that currency in the market is reduced as purchases decline and trade flows adjust to a new equilibrium.
But the United States is different. Our currency is the world’s reserve currency, so foreigners don’t mind holding dollars. Instead they hold onto the dollars we give them and invest that money in US assets, such as the Treasury bonds needed to fund our deficits. There are other factors that affect this equation such as the Eurodollar market where foreigners keep their dollars overseas and put them in foreign banks that lend this money out in the form of dollar denominated loans. But, generally, this formula holds true.
For this reason, it is very unlikely that President Trump will be able to get the trade deficit down anywhere near to zero. In fact, since he came into office the trade deficit has increased despite all his efforts. And it is unlikely to improve very much as long as he continues excessive government spending which is expected to create a trillion dollar deficit in the next fiscal year.
Despite this grim reality and also despite the opposition of most of his closest advisors (according to a Wall Street Journal article), President Trump is doubling down on the looming trade war with China, slapping tariffs on an additional $300 million in Chinese exports. China has retaliated by devaluing its currency to keep its exports competitive (the move which triggered the early morning twitter outburst).
All the uncertainty created by fears of a trade war with China is undoing the beneficial effects of the Trump tax cuts and his deregulation of President’s Obama’s overly stringent grip on business. For businessmen it has been a case of trading the devil you know for one that you don’t. No one knows how this will turn out.
As a nationalist populist, President Trump has fallen into the same error as all the progressive populists clambering the crowded stage to be the next populist-in-chief. He focuses on outcomes and not the causes of the outcomes. And he is now reaping the unintended consequences of ignoring those causes.
I’ve seen this all before. When I first started working in Latin America, the whole continent was under the sway of what we called import substitution economic systems. These economic systems featured high tariff and non-tariff barriers to promote domestic industries and safeguard domestic employment, especially in manufacturing. Exactly the system President Trump seems to favor for the United States. These countries also featured crony capitalism, rampant corruption, shoddy domestic products and extensive smuggling. They also featured excessively strong currencies protected by the high tariff barriers, capital flight and foreign borrowing to make up for the missing domestic capital.
Only Chile under Pinochet was making any economic reforms thanks to the help of the “Chicago Boys,” a group of economists trained at the University of Chicago under the tutelage of Milton Friedman. But the house of cards that was the import substitution countries was about to fall. Reviewing the credit files of my employer in Mexico, the credit officers assured me that our clients were sound and that the dollar denominated loans we had lent were safe. They pointed out that while the exchange rate for the Mexican peso was at about 20 to the dollar, they had done sensitivity analyses of exchange rates all the way to 75-to-1 and our clients could still repay our loans. During my visits to Mexico in 1982, the peso went to 45, then 70 and by the end of the year to 150-to-1. Our clients were all broke.
As fears of devaluation ran through the city, capital flight reached massive proportions. President Jose Lopez Portillo vowed to defend the peso “like a dog” and said he would publish a list of the “saca dolares,” the people taking their money out of Mexico. The list was never published because it likely included many of his friends and relations. When the president of Mexico went to a local restaurant, all the patrons started barking.
Mexico collapsed in 1982 and created a cascade of failed economies across the continent and the world. The 1980’s are known as the Lost Decade in Latin America because of the economic hardship most countries endured.
Import substitution is a mercantilist economic system that goes hand-in-hand with populist authoritarianism. During the Lost Decade (la Decada Perdida) dictatorships in Argentina and Brazil fell as economic conditions provoked civil unrest that even the authoritarian boot of dictatorship could not contain. Somehow, the Partido Revolucionario Institucional (PRI) In Mexico managed to hang on until 2000.
State capitalism is a form of mercantilism practiced in China and which is credited for spurring the rapid growth of that country from a poverty-stricken basket case to a formidable world power. But much of that growth has been behind high tariff barriers, with heavily subsidized state-owned companies run by party hacks or military officers and funded by loans from state-owned banks. Bitcoin was very popular in China as a means for capital flight until the government cracked down on the cryptocurrency.
Is this the model that President Trump wants for the United States? Although the United States had a mercantilist economic policy soon after it was founded (as did all the other countries in the world at that time) it was the free market policies that the United States developed that have made it the prosperous nation it now is. And the American people are still relatively free. But that might change if the populists of the left or right have their way.
