Comment Rescue: Advantage and the breakdown in Bretton-Woods

This is a long comment by Ramblin’ Rod, that really belongs on the frontpage. JamesK and anyone else who wants to give a sustained reply to this can reply here instead of adding to the comment thread in the original post.

by Ramblin’ Rod

Here’s my  big post on trade, as promised. I’m a huge fan of both trade and free markets. Sure would like to see me some. While I agree in principle with the libertarian ideal of no tariffs, quotas, etc., I’d also like to see them pay some attention to the huge subsidies we currently lavish on foreign imports. It’s all about money and the Federal Reserve. To understand where I’m coming from, let me develop the argument:

Ricardian Comparative Advantage is basically a theory of barter. English cloth for Portuguese wine. Each country’s comparative advantage lay in a combination of natural advantages such as climate and developed expertise in the respective industries. These advantages are really differential advantages in productivity. TMK, it didn’t address the question of absolute advantages in such things as wage levels. And, as noted above, it didn’t really address the issue of trade conducted through the medium of money.

Smith, on the other hand, explicitly addressed the latter issue and the concerns of mercantilists who worried about all the money going overseas due to trade deficits. It’s important to note that Smith was a strict metallist about money. To him, money was gold and gold was money, full stop. So in a sense, Smith’s theories were also about barter with gold serving as the universal trade commodity. It’s often claimed that Smith definitively proved that trade deficits didn’t matter. That’s not really the case. Actually, Smith’s thesis was that trade surpluses and deficits were self-correcting and therefore no governmental intervention was necessary. The mechanism was fairly simple. If country A was running a trade surplus with country B then money (gold) would pile up in country A and become relatively scarce in country B. This would cause the general price level to rise in country A and fall in country B, which would then make exports from B to A more attractive until a new balance was achieved. A second part to his argument was that trade is never really just bilateral and so it’s silly to worry about trade balance with any particular country since gold can and would be repatriated by more circuitous routes.

Of the two arguments, the second is the most sound. Just as you’re not going to lie awake nights worrying that the grocery store that you’re constantly spending money in rarely if ever buys anything from you, there’s no reason to worry about the balance of trade with any particular country (i.e., China). However, there’s a big problem with this first argument. Perhaps he didn’t understand the dynamics or just chose to ignore them* but, to put it succinctly, deflation sucks. Big time. As a corrective mechanism it’s fairly brutal, causing an economy to plunge into punishing bouts of recession and depression. When money is becoming more valuable and prices are falling, consumers are incentivized to hoard cash in the hopes that the price of whatever they may want to buy will be cheaper next week, next month, or next year. Consumer demand drops, production falls off, unemployment rises, even fewer people have money to spend, and it just all goes into a death spiral. Eventually, prices bottom out and the economy recovers, but in the meantime a lot of people suffer.

Recognizing that this dynamic was less than ideal, yet desiring the gains from international trade, the major industrial economies of the world entered into a post-WWII agreement, largely devised by Keynes, called the Bretton-Woods accords. It established a system of fixed exchange rates relative to the dollar which, in turn, was pegged to gold at a value of $35/ounce. This also established the IMF which served as a mechanism for smoothing out imbalances in trade and currency flows. I’d be lying if I said I totally understood exactly how this all worked. But the result was that from the signing of BW, until it’s eventual repudiation by Nixon in 1973, the U.S. maintained an overall trade balance, with only little temporary blips of surplus and deficit.

Was it a good plan? In the sense of doing what it was designed to do, yes. During that time we experienced no major deflationary recessions, certainly nothing like what we’ve seen since then. But my sense of it is that it was unsustainable long-term, and many (most? all?) economists believe it was responsible for restraining growth. Personally, I think it’s a case of right diagnosis, wrong cure. And that wrong cure was motivated by a continuing belief in “sound”, metallic-based, currencies, a belief that almost no reputable, mainstream, economist currently holds.

Since the collapse of B-W in 1973 at the unilateral hand of Nixon (dubbed the Nixon Shock), the U.S. has run a perpetual and growing trade deficit. That’s also the exact point, that I term the Great Divergence**, where a number of important indicators suddenly shifted. Wages, which had previously closely tracked productivity growth, stagnated. The overall CPI, which had for the entire post-war period ran at a pretty consistent 2.3% rate of inflation, suddenly shifted permanently to 4.3%. This is also the point at which the CPI for professional services–medical, legal, educational, financial, etc.–diverged sharply from the overall CPI. I’ve posted the graphs before and they’re stunning. Just this really sharp knee-bend from one constant rate to a different subsequent constant rate. Inequality, as expressed by the GINI coefficient, which had been steadily declining over the twentieth century started to sharply rise in the ’80s. The correlation with the Nixon shock isn’t as clear, but given all the other indicators I find it hard to believe that it isn’t a lagging indicator from the same root cause.

So what’s the mechanism that ties all this together? Well, it’s interesting to note that the latter half of the ’70s were characterized by an economic phenomenon that had the econ professors scratching their heads. Stagflation. A period of relatively high inflation and high unemployment, despite high interest rates (typical mortgage rates were in the low teens). These aren’t supposed to go together. It wasn’t until Volker took over the Fed under Reagan, clamping down on the system with high Fed funds rates and triggering the ’82 recession that inflation was brought under control. I’m not entirely sure what all the Fed was doing in that period (since the Fed’s operations are notoriously opaque) and subsequent that’s different from earlier eras, but the result has been relatively modest base interest rates combined with a strong dollar policy.

This strong dollar policy is precisely the stealth subsidy to imports that I referred to way, way, way up above (sorta gave up on me getting back to that, huh?). Have we had stronger growth? Maybe. That’s not clear. But we sure have had bubbles, huh? My own pet theory here is that the Fed is managing money basically the same way it always used to without really taking advantage of the fact that our currency is now fiat. But that failure isn’t accidental, since the Fed is owned by banks and our financial sector (Wall Street) has done very well under this new regime, thank-you very much.

So what would real free trade look like under a fiat currency regime assuming the goals of B-W still operated (i.e., avoiding punishing deflationary recessions)? Simply allow dollars to flow overseas and make up the difference through deficit spending without calling it that. Just spend whatever extra you need from printed dollars to keep the domestic money supply stable (with a modest inflation bias) and don’t figure it as debt that has to be repaid. Because it doesn’t need to be.

The result of such a policy would be dollar devaluation overseas which would make imports more expensive and exports more competitive, realizing the mechanism outlined by Smith oh so many years ago, while avoiding the harsh medicine of domestic deflation. You couldn’t do something like that with gold-backed currency but there’s no reason not to do it with fiat money.

* Smith was pretty plugged into the moneyed elite of his day. Deflation is great for creditors like banks, so it’s easy to understand if he had a blind spot for that.

** Various writers use this term to describe the divergence between productivity and wage growth and others use it to describe the subsequent rise in inequality that became evident in the ’80s moving forward.