Michael Hudson

Trade Theory Financialized

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This demographic effect of trade deficits was well recognized by economic writers already in the 18th century. But free trade theory expurgated the linkages between trade and population growth, for the same reason that it conflated finance capital extracting debt service with industrial capital employing labor to produce goods and services: Greater realism leads to policy conclusions not favored. So economic theory was over-simplified. The rent and tax structure is taken for granted or simply treated as “exogenous,” being political or “institutional” and as such, excluded from the sphere of “scientific” economics proper. The resulting legacy of Ricardian trade theory focuses on subsistence consumption, not debt-financed housing costs, education, financialized pensions and Social Security, and other FIRE-sector charges.

A scientific body of analysis would demonstrate how financialization adds to the cost of living and doing business. The financial overhead consists not only of debt, but also compulsory saving in the form of wage withholding to pay for future pensions and medical care. In the United States these wage set-asides gained momentum after 1980. And the post-2001 Bubble Economy that inflated prices on credit for housing, commercial real estate and corporate ownership celebrated “debt leveraging” as raising returns on equity. But the effect was to absorb more of the national economic surplus in the form of debt service.

All nations face common global prices for fuels and raw materials, and licensing fees for patents such as information technology and pharmaceuticals. Trade competition reflects financial dynamics, economic rent and tax policy in four main national variables: (1) labor’s cost of living, wages and non-wage benefits (mainly pensions and health care), (2) land rent and debt overhead, (3) the incidence and level of taxation, and (4) the terms on which governments provide infrastructure services such as transportation and communications, Social Security and health care, along with economic subsidies. The impact of financialization and an anti-labor tax shift on the deteriorating U.S. industrial trade balance, for example, is clear from the following rough approximation of typical American employee budgets:

Balance-sheet factors (debts taken on to buy assets rather than current output)

  • Housing (ownership or rental costs) 32 – 40%
  • Debt service (non-mortgage) 15%
  • Private health-care and pension fund contributions ?

Government tax policy structure

  • FICA withholding for Social Security and Medicare: 15%
  • Taxes (income, sales and excise or VAT) 15%

U.S. de-industrialization – and rising motivation to invest in less debt- and rent-ridden economies – reflects the fact that rentier payments and taxes absorb as much as 75% of family budgets. In Germany, housing absorbs only about 20% of family income, half the U.S. rate. So the proportion of German wages available for spending on goods and services (rather than being paid to the financial sector as mortgage interest) is 20 percentage points higher than is the case with U.S. family budgets. This is explained partly by institutional factors and partly by financial practice. Germany has a tradition of rental co-ops, to which many families belong. Membership rents are based on current operating costs. Also, Germany’s construction industry is not monopolized or criminalized as it is in New York and other major U.S. cities.

But the major differences between Germany and U.S. real estate are financial and legal. European homebuyers typically must save 20 or 30 percent of the purchase price to obtain a mortgage, in contrast to America’s practice of 100% mortgages (or even a net cash payment to new home buyers) as the 2002-06 real estate bubble gained momentum. European mortgage markets also have been relatively free of no-documentation “liars’ loans” to NINJA borrowers (“no income, no job, no assets”) backed by crooked real estate appraisals by brokers and appraisers. Wholesale financial fraud has effectively been decriminalized in the United States.

U.S. renters and prospective homebuyers in the 1970s and ‘80s were panicked into buying at extortionate prices as residential real estate in the large cities was sold off to buyers. Co-ops typically were sold with existing mortgages attached to them, with buyers borrowing almost an equivalent volume of new debt. Housing costs soared, prompting speculators to increased their share of the residential housing market to an estimated one-sixth by 2006.

Looser lending terms – lower down payments, slower amortization rates (culminating in no-interest mortgages by 2006), and less regulation to keep income declarations honest – fueled a larger debt pyramid. Real estate or other assets are worth whatever banks will lend against them. And whatever the tax collector relinquishes is “free” to pay the banks to obtain mortgage loans. A lower tax on land rents leaves more to be capitalized into bank loans, and hence inflates the price of housing – while government revenue is balanced by burdening labor and industry with income and sales taxes. The financial sector accordingly aims to shift taxes off its major customers (real estate and monopolies) so as to leave more revenue “free” to be capitalized into bank loans and paid out as debt service. And to subsidize debt leveraging, interest is made tax-deductible.

This has major implications for the how best to adjust to international payments and debt imbalances. Pro-financial “neoliberal” lobbyists urge an anti-labor policy of “internal devaluation,” lowering wages as a means of making economies more competitive to “earn their way out of debt.” But the cost of labor could be reduced just as effectively by a tax policy that shifts the fiscal burden off employment onto property rents and other economic rent.

Failure to deal with bank loans, real estate, stocks and bonds – and the income diverted away from consumption and tangible investment to pay debts – limits monetary and price analysis to relating the money supply and government budget to price and wage levels. Left out of account is the use of credit to fuel asset purchases and speculative gambles. And government deficits may stem from bailouts taking bad bank debts onto the public balance sheet. In 2011, for example, banks used the U.S. Federal Reserve’s $700 billion Quantitative Easing (QE2) mainly for foreign currency arbitrage, not making it available for domestic consumer spending. Also left out of account are the prices at which public or private infrastructure services are supplied.

Failure to take account of debt service and government spending on anything except current employment affecting consumer prices makes trade theory unrealistic. But financial interests endorse this narrow-mindedness to promote anti-labor austerity and high interest rates, and to exclude an understanding of how financialization burdens economies with banking and financial charges while lobbying for fiscal austerity.

To secure its privileges and tax favoritism, the financial sector opposes government power to tax or regulate. Fighting under the banner of “free markets,” it is now fighting to centralize economic planning power in Wall Street, the City of London and other financial centers. What is remarkable is that under ostensibly democratic politics, an “independent” central bank has been carved out – independent from elected officials, not from the commercial banks whose interests it represents. Many voters believe that a financial bubble enriches the economy rather than turning the surplus into a flow of interest and banking fees.

The 2011 crisis over whether the European Central Banks can create money to bail out French and German banks holding Greek government debt, but not to spur “real” economic recovery

The Eurozone’s stricture against central banks lending to governments has been attributed largely to Germany’s hyperinflation trauma in the early 1920s. The myth is the old MV=PT tunnel vision claiming that the problem was caused by the Reichsbank using the printing press to finance Germany’s budget deficit. Today’s constitution accordingly prevents the central bank from creating credit to lend to government. This is what psychologists call an implanted memory, a false image suggested in this case by anti-government ideologues.

Every hyperinflation in history has been caused by international payments deficits. For the industrial nations these deficits almost always involve foreign military spending. War spending also is responsible for most growth in public debt (as government budgets tended until quite recently to be approximately in balance during peacetime). Paying these debts abroad involves the capital transfers that Ricardo argued could not cause serious structural problems, on the myth that such transfers are self-financing!

But in the 1920s the Allies imposed an unpayably high reparations burden on Germany – largely to obtain the foreign exchange to pay the Inter-Ally arms debts that the U.S. Government insisted on collecting, rather than forgiving these debts as allies traditionally had done among themselves upon achieving victory.1 The Reichsbank created German marks to throw onto the international currency markets to obtain the foreign exchange to pay reparations. France also monetized francs to obtain the dollars to pay the American Government. A monetary theory that looks only for links between the money supply and current production and consumption will fail to understand this situation. The tragic results are clear from reviewing the narrow-minded arguments of Jacques Rueff and Bertil Ohlin with Keynes and Harold Moulton in the 1920s over the roots of international instability in the way that World War I was settled financially.

The moral is that in addition to the (1) international and (2) financial-rentier dimensions, (3) the government sector plays a key role the economic system. This dimension is missing from models that limit their scope to private sector transactions, and indeed, to “current” production and consumption spending without reference to the purchase of assets on credit. The European Central Bank’s operating philosophy fails to distinguish between creating money to spend on employment, production and consumption in the “real” economy (affecting consumer prices, commodity prices and wages) as compared to creating credit (or simply Treasury debt) to give to banks to buy or lend against assets in the hope that this will bolster prices for real estate, stocks and bonds. The latter policy inflates asset prices but deflates current spending.

The $13 trillion increase in U.S. Treasury debt in the post-2008 financial meltdown was not spent in product markets or employment in the “real” economy. It was balance-sheet help. Likewise for the ECB in 2011, pressure arose by October to violate the German constitution and the Lisbon agreements to buy Greek debt – the bonds that French, German and Belgian banks held, along with other debts of the PIIGS (Portugal, Ireland, Italy, Greece and Spain). European financial stability came to rest on the ability of Greece and other debtor states to pay their debts, or to rescue banks holding these debts. This new money and debt creation has little interface with the “real” production-and-consumption economy, except to burden taxpayers.

This Eurozone financial crisis of summer and autumn 2011 shows the importance of distinguishing between two applications of central bank money and debt creation. The first is to spur spending deficits “Keynesian-style” by spending on employment, goods and services. The second is simply to increase balance-sheet debt without necessarily spending on current output. This policy was to give banks government bonds to add to their reserves – to buy bonds and make loans or, as was promised in the United States, to write down mortgage loans so as to pull property owners out of negative equity in order to start re-inflating real estate prices.

The Eurozone has fallen into an intellectual trap in which banks have come to believe their own anti-government propaganda. Associating budget deficits only with wage and price inflation excludes consideration of government spending to bail out banks or provide credit to re-inflate asset prices (as well as creating infrastructure to hold down the cost of living and doing business). Opposing public social spending, German and other European banks threw out the baby with the bathwater by blocking central banks from doing what the Bank of England, the U.S. Federal Reserve and other central banks were created to do: finance public deficits. This obliges governments to borrow from banks, insurance companies and other financial institutions. The resulting debt overhead leads to debt deflation that slows the economy and its tax yield, producing a fiscal crisis that in due course becomes a financial crisis.

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