Gideon's Blog

In direct contravention of my wife's explicit instructions, herewith I inaugurate my first blog. Long may it prosper.

For some reason, I think I have something to say to you. You think you have something to say to me? Email me at: gideonsblogger -at- yahoo -dot- com

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Tuesday, November 04, 2003
 
Warren Buffett has an article in the latest issue of Fortune decrying America's soaring trade deficit. The same issue has a piece about how the problem in China might not be that growth is overstated in official statistics, but that it is *understated* and the economy is overheating, heading for a crash.

Normally, I wouldn't bother linking to either Fortune nor to a piece by Warran Buffett. But the persistent American trade deficit - and its corollary, the massive Chinese trade surplus - is something I worry about, too, and a topic on which views are wildly divergent. So I thought it was worth exploring a little.

Buffett makes the classic home-economics argument against a trade deficit. He posits two islands, Thirftyville and Squanderville, who each produce one product - food - and each have one asset - land. The Thrifties work really hard, and produce more food than they need. The Squanders barely work at all, and import the extra food they need from Thriftyville. They finance this trade deficit initially by selling Squanderville bonds, and later by selling their only asset - land. In the end, having sold all their land to the Thrifrties, and heavily indebted to them as well, the Squanders are reduced to the condition of tenant farmers working for their Thrifty masters.

Sounds ominous, no? And Buffett duly points out that America, by consuming more than we produce, and financing this consumption by selling debt and assets (equities and real estate), we are heading down the path of the Squanders. His solution is appropriately drastic: a strict limitation on the dollar value of imports to equal the dollar value of exports, with "import credits" created by exports and then tradable for value on the market. The massive distortions this solution would create I leave to readers to imagine.

But there's another way to spin the trade deficit story, and it's the one generally told by the Wall Street Journal and other "what, me worry?" commentators on the subject. Imagine two other islands - not Thriftyville and Squanderville, but Innovativeland and Stodgyville. The Innovators of Innovativeland and the Stodgies of Stodgyville each work hard, albeit the Innovators tend to work longer hours. But the Innovators spend half their day upgrading their land - introducing irrigation, inventing and building tractors and reapers and so forth - while the Stodgies spend their entire day working the land in the traditional way. The Innovators can't grow enough food in their half day of work, so they import food from Stodgyville, and finance the imports by selling bonds and by selling equity shares in their land. The Stodgies shake their heads, and predict doom for the Innovators when they run out of land to sell and can't service their debts. But after several years of running a deficit, the Innovators' productivity has increased so much that they can produce vastly more food on their remaining land in a half-day's work than the Stodgies can produce on their whole island in a full day.

What do the Innovators do now? Well, they could simply out-produce the Stodgies, selling them food so cheaply that they don't see the point of working. They would thereby turn the Stodgies into Squanders, and steadily take control of their island as the Thrifties did in the Buffett scenario. But why bother? With their new technology, they can already produce plenty of food; why do they need tenant farmers? Alternatively, they could become Stodgies, producing enough food for themselves and neither importing nor exporting - except that, with their advanced technology, they can achieve this with much less work. Regardless, it seems pretty clear that the Innovators, not the Stodgies, have come out on top, contrary to the Stodgy predictions.

But why should the Innovators stop here? They could keep on going as before, working as much as possible on innovation so as to perpetually reduce the amount of time they need to spend growing food, and continue importing from the Stodgies to make up any food shortfall caused by the amount of time they spend innovating. But this isn't the most efficient strategy, because the Stodgies, working in the old way, produce food that is relatively expensive (relative to the cost of land). So the most efficient thing for the Innovators to do is to sell their innovations to the Stodgies, thus upgrading the Stodgies' productive capacities and lowering the price of the food they import. The Innovators can now innovate faster, because they can import more food at a cost of less debt (or fewer land-sales) and devote a greater percentage of their day to innovating, making themselves even more productive.

This is pretty much the story that the WSJ and others tell about the US-China (and US-World) trade imbalance. The US is focused on increasing productivity rather than producing enough low-value-added goods to support domestic consumption. So we import both goods and capital - goods to satisfy domestic consumption needs, and capital to invest in productivity-enhancing innovations. We import both from China, and export our latest innovations to them to enhance their productivity, and thereby lower the cost of the relatively low-value-added goods we import from them. We could always stop importing, or refuse to export productivity-enhancing technology, but either would slow our pace of innovation, so how this benefits us in the long run is unclear. So long as our imports of financial capital increase the value of our human and physical capital (because of increased productivity) by more than the rents we have to pay to the owners of that capital, America has come out ahead.

But this isn't the end of the story either, because both my thought experiment and Buffett's assume that the two islands are monolithic entities. They should, rather, be fully articulated societies, with diverse populations in terms of native talents, values and so forth. Every island has some Squanders and some Thrifties, some Stodgies and some Innovators. How does this diversity affect the story above?

Well, among the Innovators, those who actually do the innovating are the ones whose human capital has been upgraded, and who (presumably) own the innovations. If we define savings as the change in value of net assets owned, then the innovators save a great deal, even though Innovatorland imports capital. But those who do *not* innovate are in a very different position. Previously, they might have worked producing food, but the cost of land (measured in terms of food) has gotten so high that there is no way to make a living doing that in Innovatorland. And the steady demand for Innovatorland debt keeps interest rates very low, making debt-financing very attractive even to those who are not innovating enough to shoulder the burden of debt. The non-innovators in Innovatorland increasingly resemble Buffett's Squanders, enticed into debt-financed consumption by the low interest rates and cheap imports made possible by the Innovators in their midst.

And what about the Stodgies? Well, innovative types among the Stodgies have to compete with the Innovators for capital. There is presumably some reason why the Stodgies are stodgy; either they have less of a talent pool or their political and economic system discourages innovation. In either case, an Innovator among the Stodgies will have a hard time competing with the Innovators of Innovatorland. So he'll do one of two things. Either he'll become a conduit for the transmission of innovations from Innovatorland. Or he'll try to move to Innovatorland to maximize the value of his own talents. The Stodgies, then, see a steady export of their most productive citizens.

And it's not just the innovative types who want to move. Thrifties, too, if they live among Stodgies, will be strongly inclined to move to Innovatorland. Why? Living among the Stodgies, where prices for goods are high relative to wages, and looking across the water at life in Innovatorland, where wages are high relative to the price of goods, the opportunities for a Thrifty among the Innovators would seem obvious. (Why is there this differential in wages? Because the price of goods will be set quickly on a world market, as goods are sold globally, while labor is less mobile. Labor migration to Innovatorland will, over time, drive down wages there, and the resulting relative scarcity of labor in Stodgyville will keep wages higher there than they would otherwise be, albeit both effects may be swamped by other factors in practice.)

So the population of Innovatorland gets more economically stratified by relative productivity, the less-productive portion of the population gets progressively more indebted even as the society as a whole gets richer and more powerful. These disparities, moreover, result in an increasing swell of migration of Stodgyville's most valuable citizens - its Innovators and its Thrifties - to Innovatorland.

Doesn't that sound like the relationship between America and China? (Or between America and the world, if you prefer.) America's greater productivity, and our focus on productivity as an economy and a society, is the major driver of the trade deficit, because it creates an enormous demand for capital. Our productivity growth is financed by foreigners who share in the benefits of our productivity (by purchasing our innovations and by earning rents on their share of our capital stock or our debt). But the benefits of that growth are not evenly distributed in our society, and they result not only in differential economic results domestically but significant migrations of population.

Is there anything that can be done about this situation? Well, everything has a cost. As Buffett has noted, we could end the trade deficit - and, consequently, our imports of capital - by fiat. But the cost (in addition to the enormous friction added to commerce) would be a capital crunch that would reduce our productivity growth, but also increase wage rates in the short term (as businesses substituted labor for more expensive capital). Long-term, our society would be poorer, even if short-term there was some redistribution from Innovators to the rest of society. The same effects would be observed with any redistribution scheme; some would have more transaction costs or friction than others, but all would reduce the long-term growth potential of the economy. Ditto with restricting immigration; this would surely raise wages temporarily among America's less-skilled workers, but it result in reduced productivity for the economy as a whole and reduce our domestic capital stock (since we'd no longer be importing Thrifties). Mind you, immigration reform that focused on reducing rent-seeking immigrants (those who come to consume services, not to work and save), or reforms that focused on the negative externalities associated with immigration (e.g. the cost of acculturation, the inevitable arrival of less-productive immigrants under family unification, etc.) are another story.

What are strategies that would *increase* the growth potential of the economy and help redress these imbalances that Buffett worries about? Well, I can think of three.

First, we can eliminate aspects of our tax and regulatory regime that discourage saving and reward consumption. Buffett's story is true to the extent that our society is composed of Squanders, and the WSJ is true to the extent that our society is composed of Innovators. If our society were perfectly balanced between Thrifties and Innovators, we'd produce enough capital internally to fund our productivity growth. So whatever we can do to promote thrift among our less-innovative classes is a Good Thing. For example: we could remove the many incentives to consume rather than save. They are legion. They start with obvious things like multiple-taxation of income, extend to less-obvious things like tax deductions for mortgage debt and liberal bankruptcy laws, and (I would argue) extend very much to entitlements: Social Security, which strongly discourages personal saving, and Medicare/Medicaid, which encourages the elderly to spend down their assets rather than saving them for the event of illness or to pass them on to the next generation. Personally, I have long been an advocate of a universal and unlimited savings deduction; we'd continue to tax income, even at highly progressive rates, but all net savings and investment would be fully deductible. This would strongly encourage savings and discourage personal consumption. A much less expensive (in terms of transaction costs) but more regressive way of achieving the same result would be to simply replace the income tax with a national sales tax or value-added tax. We're probably not going to eliminate the trade deficit this way; our appetite for capital is quite prodigious. But we'd eliminate it to the degree that it is unproductive financing of personal consumption, rather than productive financing of capital investment.

Second, we can do whatever we can to upgrade the productivity of other countries. In relative terms, this would make America's competition fiercer, which could be construed as a negative. But in absolute terms, it would increase the value of the world's human capital. So long as America's productivity doesn't fall behind other countries', we should have nothing to fear from other countries' productivity increases, and, indeed, we would benefit from a more balanced world that would result if other economies experienced high productivity growth as well, not to mention that we would benefit from the more rapid pace of global innovation. Even if we come out ahead because of our trade deficit, that doesn't mean the current imbalance is optimal, only that it may be the optimal result of structural imbalances in the productivity of different economies. How we raise other countries' productivity is a tough problem, however, and beyond the scope of this piece.

Third, we can focus our domestic public spending on public goods that are used by the citizenry at large. This is really a response to the economic stratification that is the inevitable result of a productivity-oriented economy rather than to the trade deficit. Even if our population were entirely composed of Innovators and Thrifties, we'd still see massive economic stratification. The proper - American - response is not to try to make all outcomes the same (which would result in a catastrophic drop in productivity) but to focus on social equality and the public goods that make social equality possible: public parks and civic spaces, a high-quality education system, and so forth. Some of these things aren't government goods at all; religion, for example, can be a binder of classes, although sectarian America tends to religiously segregate by class as well. This isn't an easy one either, but to the extent that the government can foster a common culture, something that binds different classes together, that's very much a good thing in a dynamic economy where disproportionate rewards flow to the most productive.