Michael Hudson

Trade Theory Financialized

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Paper delivered at the Boeckler Foundation meetings, Berlin


Ricardian trade theory was based on the cost of labor at a time when grain and other consumer goods accounted for most subsistence spending. But today’s budgets are dominated by payments to the finance, insurance and real estate (FIRE) sector, and to newly privatized monopolies. This has made FIRE the determining factor in trade competitiveness.

The major elements in U.S. family budgets are housing (with prices bid up on credit), debt service and health insurance – and wage withholding for financializing Social Security and Medicare. Industrial firms also have been financialized, using debt leverage to increase their return on equity. The effect is for interest to increase as a proportion of cash flow (earnings before interest, taxes, depreciation and amortization). Corporate raiders pay their high-interest bondholders, while financial managers also are using this ebitda for stock buy-backs to increase share prices (and hence the value of their stock options).

Shifting taxes off property onto employment and retail sales spurs the financialization of family and business budgets as tax cuts on property are capitalized into higher bank loans. Payments to government agencies for taxes and pre-saving for Social Security and Medicare absorb another 30% of family budgets.

  • Housing (ownership or rental costs) 32 – 40%
  • Debt service (non-mortgage) 15%
  • FICA withholding for Social Security and Medicare 15%
  • Taxes (income, sales and excise or VAT) 15%

These transfer payments to the FIRE sector and government agencies have transformed international cost structures, absorbing roughly 75% of U.S. family budgets. This helps explain the deteriorating U.S. industrial trade balance as the economy has become financialized.

Trade and Payments Theory in a Financialized Economy

If trade theory is to be based on how economies work and relate to each other, it should focus on the financial overhead, capital movements and tax policies that are the key to today’s prices payments and exchange rates. Mortgage debt taken on to buy homes (with prices bid up on credit) and to obtain an education, and wage set-asides for pension funds, Social Security and Medicare, all raise the cost of living and doing business – and hence, make economies less competitive. So do debt-leveraged corporate buyouts.

Most trade and exchange rate models have neglected these financial, rental and fiscal charges ever since David Ricardo analyzed costs as if economies operated on barter. He claimed that debt service and military spending could not create economic problems, insisting that they were automatically self-financing. This approach excluded recognition of how debt service adds to the cost of living and doing business, and depresses exchange rates. Capital transfers supposedly set in motion re-stabilizing “corrections” enabling debts or payments outflows to be paid without disrupting price and income structures.

What is remarkable is that debtor interests have accepted this “don’t worry about debt” logic about “automatic stabilizers” for nearly two centuries. Forecasts promising that austerity will revive growth and that debt leveraging helps economies get richer faster rarely are innocent. They even get the direction of change wrong. When such theorizing is pursued generation after generation, the explanation is that special interests must be benefiting from its tunnel vision.

When it comes to minimizing the role of debt and credit, the financial sector’s motivation is to distract attention from the problems caused by debts growing beyond the ability to be paid, disrupting economies and add to the cost of living and doing business. This turns economics into a public relations lobbying effort for financial deregulation.

One cannot discuss the roles of finance and government without the concept of economic rent, because rent seeking is the largest category of bank lending – and also of tax favoritism. Today’s academic mainstream rejects the classical idea of unearned income, defined as that which has no counterpart in socially necessary costs of production. But economic historians will recognize the concept of a free lunch as the centuries-long description of rentiers – bankers and landlords in the private sector. It is to this class that Keynes referred to when he spoke of “euthanasia of the rentier” as the wave of social reform to avert future depressions.

Post-classical economics claims that there is no such thing as a free lunch – as if everyone earns and hence deserves whatever income and wealth they obtain, regardless of how they get it. This conflates transfer payments (including outright fraud and looting) with productive effort. All rentier income appears to be payment for providing economically helpful services, equal in value to the income paid to the financial, insurance and real estate (FIRE) sector. This is the concept that underlies the national income and product accounts (NIPA).

The classical doctrine now swept under the academic rug began in the 13th century with the Schoolmen discussing Just Price, mainly to distinguish between fair and extortionate banking charges. The idea of unearned income came in time to be applied to land rent. The classical analysis of economic rent – whether in finance, insurance or real estate, or even monopoly pricing – finds no room in today’s curriculum. The concept is muddied by turning the tables to depict government officials as “rent-seeking” bureaucrats increasing public spending and regulation in ways that increase their own power, exclusively in unproductive ways that add to the economy’s “deadweight” cost of doing business. Nothing about predatory FIRE-sector rentiers in this view!

Excluding debt service from trade theory – and from domestic price and income theory

The financial sector historically has sought to make itself invisible. After all, what is not seen will not be criticized – or taxed. To paraphrase Charles Baudelaire’s quip that the devil wins at the point where the public comes to believe that he doesn’t exist, the financial sector’s lobbying effort wins at the point where people believe that running into debt contributes to economic growth rather than burdens it, and that they will end up richer by acting as bank customers. Debt leveraging is depicted as the easiest and even the surest way to accumulate wealth – going into debt to buy assets whose prices are being inflated on credit, or to spend in the hope of paying out of rising and more easily earned future income.

But as the dust settles from 2008, most fortunes have been made by bankers and brokers, largely at the expense of their clients (and as it turns out, taxpayers as well). The banking system’s product is debt, in a dynamic that ends with many debtors falling into negative equity and forfeiting their property to foreclosing creditors. That is the legacy of the real estate bubble and debt-financed corporate takeovers. And internationally, debt-ridden economies are subject to pressure from inter-governmental institutions such as the IMF and European Central Bank to impose fiscal austerity on their labor force, cut back public spending and even sell off public enterprises.

This explains why the non-financial “barter” approach to trade and exchange rate theory pioneered by Ricardo, writing as Britain’s leading bank spokesman, denies that foreign payments or credit cannot cause economic problems. Bankers are depicted merely as oiling the wheels of commerce, providing the “neutral” means of pricing goods and services (pretty much ignoring asset prices), not intruding into the circular flow between production and consumption by extracting debt service and lobbying for rentier privileges.

The public relations problem that Ricardo faced was that debt service in 1815 absorbed three-quarters of the British government’s budget. Especially problematic was foreign debt taken on to finance military spending and subsidies to Britain’s allies in its many centuries of wars against France. The Seven Years War (1756-63) and Napoleonic Wars (1787-1815) sharply increased the national debt and, as Adam Smith illustrated in Book V of The Wealth of Nations, new excise taxes to pay for each new borrowing. Confronted with popular criticism of the proliferation of excise taxes to pay interest to bondholders, the political task of bankers was to deny the problems caused by loading down economies with debt.

Most money and credit, wages and national income are spent on the FIRE sector

The textbook formula MV = PT means money (M) times the velocity of turnover (V) = the market price (P) of the economy’s transactions (T). However, the “transactions” in question are limited to current production and consumption, and “price” refers only to consumer prices or those of other commodities – or wages. Yet by far most credit is spent on assets, not goods and services. Every day a sum larger than an entire year’s GDP passes through the New York Clearing House and the Chicago Mercantile Exchange for asset purchases and sales. So more than 99 percent of spending in the United States and other financialized economies is for real estate, mortgages and packaged bank loans, and for stocks and bonds. By limiting the scope of analysis to commodity prices and wages, mainstream monetarist theory leaves these credit transactions and their debt service out of account.

International payments are dominated by capital flows for direct investment, bonds and stocks, bank loans and speculation. To the extent trade remains based on the cost of labor and doing business, rising payments to the FIRE sector also dominate. This is a far cry from the early 19th century when prices reflected mainly the price of food and other basic consumer goods. Each country’s debt overhead, housing prices, tax rates, public subsidies and fiscal systems determine product prices. And foreign lending and debt service, military spending and financial speculation are an inherent part of the global system affecting exchange rates. But despite John Stuart Mill’s analysis of how “capital transfers” affect exchange rates, popular discussion still calculates purchasing-power parity rates for MacDonald’s hamburgers and other consumer goods, as if this were a measure of international equilibrium.

Some 70 to 75 percent of typical U.S. wage-earner budgets are paid to the FIRE sector and to government. So economic analysis is trivialized if it only takes into account direct production costs reducible to labor, not taxes or “economic rent” as an element of price with no counterpart in technologically necessary production costs – land rent, monopoly rent (including bank credit-creating privileges), interest charges and kindred transfer payments to rentiers.

This has far-reaching implications for how best to achieve trade competiveness. Neoliberals tell Latvia, Greece and other countries to impose economic austerity by monetary and income deflation to cut wage levels (“internal devaluation”). But this leaves financial and tax structures in place. Policy discussion is limited to fiscal austerity and currency depreciation – but not a shift of the incidence of taxation to real estate, finance or monopolies, or less regressive taxation on employment and consumption, not to speak of debt write-downs. What is lacking in this approach is a view of the economy as a system. Wage levels and interest rates are singled out as the only variables to “solve” the debt and balance-of-payments problems. So we are dealing with a purposeful narrow-mindedness.

Latvia has flat taxes on employment that add up to 59 percent of the wage. Cutting this tax by 40 percentage points – down to about 20 percent of the wage – would double labor’s take-home pay (from about 40 to 80 percent of the wage). The government would make up the loss by raising the land tax to absorb the groundrent, and also the economic rent now being collected by the buyers of the formerly public infrastructure. But this rental income is the preferred object of bank lending – turning rent into interest payments, mainly to branches of Scandinavian banks. Yet there has been little discussion of shifting taxes onto land and monopolies, leaving less economic rent to capitalize into interest payments, thereby holding down housing prices.

Latvia’s public-sector wages were cut by 30 percent during 2009-10 as the GDP plunged by over 20 percent. But cutting wages also cut employment taxes, so take-home wages fell only by 12 percent – as unemployment spread, turning Latvia into a neoliberal disaster story. Its regressive tax policy has made the nation’s industrial labor so uncompetitive that young adults have emigrated to find work, causing Latvia’s population to plunge by 10 percent (from 2.2 million to 1.9 million since the last census).

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