When he signed the finalized NAFTA agreement in September 1993, U.S. President Bill Clinton was backing away from a campaign promise he made months before. He famously explained his decision to do so by arguing that the marriage of finance and technology had wrought major changes in the global economy. “Nothing we do in this great capital,” he added, “can change the fact … that people can move money around in the blink of an eye.” That is why, he argued, the United States had no choice but to accept the disruptions NAFTA might impose.
But while Clinton was right to stress the disruptive impact of frictionless capital flows on the American economy, he drew the wrong conclusion.
It is true that the unfettered flow of capital around the world sharply constrains the ability of individual countries to manage their economies. By transferring production to more pliant jurisdictions, for example, investors can swiftly punish economies for policies that protect or boost workers’ income at the expense of business profits. Contrary to conventional wisdom, however, this is not just about transferring production facilities from high-wage to low-wage countries. It is about transferring production from countries in which wages are high relative to average worker productivity to those in which wages are lower. (Germany, for example, is a high-wage country, but its wage levels are still low compared to the high productivity of its workers.) It is this mismatch between wages and productivity, not lower wages per se, that creates global trade imbalances.
And it is the unfettered flow of capital that abets these imbalances. Countries like Germany and China that have been the most successful in raising exports and running large trade surpluses are able to do so not because they are more efficient, but because of policies that promote manufacturing at the expense of household income. They do this either directly, by putting downward pressure on wages, or indirectly, through currency depreciation, manufacturing subsidies, environmental degradation, weakening social safety nets, and so on. These arrangements effectively transfer income from middle-class households, workers, and farmers—who are most likely to spend their income—and deliver it to large businesses, governments, and the rich—who are most likely to save it. But even as these policies promote manufacturing, they also create the twin problems of excess savings and excess production above what the economy can absorb domestically.
The solution to both problems is to foist them onto trade partners abroad by exporting the excess savings and running the corresponding trade surpluses. If they weren’t able to do that, countries with deficient domestic demand would be forced either to reverse their earlier policies—by raising wages and reducing manufacturing subsidies—or to endure the consequences in the form of rising unemployment.
But there are two problems with this solution. First, the global economy suffers from weaker demand as countries compete in manufacturing by suppressing growth in domestic wages. Second, the countries that receive the excess savings must then run the corresponding deficits. This requires paying for their deficits by transferring ownership of assets—in the form of stocks, bonds, real estate, and factories—to the rich savers of the exporting country, and forcing their economies to adjust to the capital inflows. The way they adjust, if they are advanced economies, always involves either higher unemployment or (much more likely in the case of countries like the United States) a rapid rise in debt.
Those who claim, in other words, that the United States needs foreign financial inflows because of its low savings rate have gotten it backward. It is the foreign financial inflows that necessarily drive down American savings rates, and they do so either through higher unemployment or rising debt.
This is a point that mainstream economists miss. If the United States were a developing country, in which high investment needs were constrained by scarce savings, foreign capital inflows might increase American investment, as they did in the 19th century, which would be a good thing. But in a world characterized by excess global savings and the lowest interest rates in history, and in which American businesses sit on stockpiles of uninvested cash, it is obvious that more foreign savings will not lead to additional investment. In that case, if foreign capital inflows do not cause investment to rise, they must cause savings to decline. This is an iron rule of the balance of payments.
There are several mechanisms by which foreign capital inflows can force down American savings. Foreign capital inflows can cause the value of the dollar to rise, shifting income from net exporters (businesses) to net importers (households), which in turn raises the consumption share of GDP and lowers the savings share. Cheap imports can displace American products sold at home or abroad, resulting in layoffs in the United States. (Unemployed workers have negative savings rates.) Or to forestall this rise in unemployment, fiscal authorities might increase the deficit, or monetary authorities might put into place policies that encourage looser lending standards, in either case forcing up debt levels. (Debt is negative savings.) Finally, foreign purchases of American stocks, bonds, and real estate can cause their prices to surge, making Americans feel richer, which spurs them to borrow more and spend a larger part of their income.
But the United States does not have to accept these consequences passively. It could instead reverse policies that in recent decades have enshrined the unfettered flow of capital.
It’s not that there are no arguments in favor of the free flow of capital. The standard claim by economists is that if investment can flow freely to its most productive use, the global economy advances by transferring resources from less productive users to the more productive. In this idealized world, smart investors constantly search out investment efficiencies around the world in an attempt to profit by improving the productive capacity of infrastructure and manufacturing facilities. This benefits the whole world by raising global productivity, even if it creates conflicts over the distribution of those benefits.
But few international traders and investors believe that this is actually what happens. International capital flows mainly take the form of portfolio flows—short-term flows into stocks and bonds—rather than direct investment in productivity-enhancing projects. Portfolio flows tend to be driven by speculation, investment fads, capital flight, reserve accumulation, index investing, or a dozen other reasons that have nothing to do with allocating capital to its most productive uses. In fact, rather than flow from advanced economies with slow investment growth, low interest rates, and excess capital to rapidly growing emerging economies with high investment needs, as the theory tells us should happen, the vast majority of international capital flows into advanced economies that are already flooded with excess savings and cheap capital.
This means that there is little to justify the fetish for unfettered capital movement. In a world already flooded with excess savings, it doesn’t result in more productive investment; it encourages global savings imbalances by allowing wage suppression in trade surplus countries to be exported abroad; it forces up either unemployment or debt in trade deficit economies; and it weakens the negotiating power of workers and exacerbates income inequality everywhere. The only ones who benefit from unfettered capital flows are international bankers and the very wealthy owners of movable capital.
For the past several decades the unfettered flow of global capital has allowed financial elites to create and profit from savings and production imbalances in one country that force the opposite imbalances elsewhere. Global capital has become the tail that wags the economic dog. It is time for governments, and especially Washington, to take steps either to limit or to stabilize these flows. The are many ways to do so without creating distortions in trade or undermining real direct investment. For example, Washington can impose one-off taxes on foreign currency transactions, or on all capital inflows. It can withhold a portion of interest and dividend payments made abroad (as it did until the early 1980s). It can restrict use of the U.S. dollar internationally, perhaps by replacing it with a synthetic basket of currencies. It can organize with like-minded countries a new international trade and capital flow regime.
The point is that Clinton was wrong: We can and should change the fact that people can move money around in the blink of an eye. Only then can we rebalance trade in a way that is optimal for the global economy. Much of Wall Street, for obvious reasons, will be ferociously opposed to policies that limit the unfettered flow of capital around the world, but the right polices can sharply reduce the economic disruption wreaked on workers, producers, farmers, and the middle class. And as was the case for most of U.S. history, they will force large businesses around the world once again to compete for profits by investing in domestic productivity, rather than by lowering wages.