"Kee" Points with Jim Kee, Ph.D.

A strong payroll report last Friday allayed concerns regarding a US recession, while globally the expectations seem to be for more policy responses in 2016, particularly on the monetary side (e.g. China, Europe, and Japan). That’s getting to be a pretty tired formula in my opinion. And while it doesn’t tend to send markets soaring like it used to, it does seem to put a floor beneath them. As for the US Presidential election, Pollyvote’s combined forecast continues to favor the Democrats, though there are individual component parts of that forecast, like the econometric models, that favor Republicans. Many of the concerns over Donald Trump, even among members of his own party (as well as the more conservative financial press like the Wall Street Journal) have to do with his rhetoric regarding protectionism (i.e. trade restrictions with other countries). In this Kee Points I’d like to mention a few things that I think are missing from the narrative.


The economic teachings on the subject of trade restrictions are pretty straightforward, stating in general that free and open trade has winners and losers, but that the gains to the winners generally exceed the losses to the losers. That goes back to at least Adam Smith (1700s), who argued that businesses always want to “widen the market (sell to more countries) while narrowing the competition” (allow fewer countries to sell here). The losers here are consumers, who pay higher prices than they otherwise would have, and those losses tend to be multiples of the gains going to the protected businesses.


That’s why free trade is generally considered to be desirable. For example, credible economists like Nobel Laureate Robert Mundell (in his Nobel Lecture) have argued that trade restrictions like the Smoot-Hawley Tariff (passed by Republicans) contributed to the onset and severity of the Great Depression of the 1930s. But the increasingly knowledge-based nature of modern economies, and the current digitalization and instantaneous flow of that knowledge around the world, has created new arguments for protectionism. For example, the reading and interpretation of radiology charts or financial reports can ostensibly be outsourced overseas to the cheapest provider at the push of a button, immediately devastating the domestic firms/industries engaged in those activities. Currently Bernie Sanders and Donald Trump are the most outspoken critics of our free trade agreements.


Here’s what I think: The US holds all of the cards. This shouldn’t be construed as providing logic for a candidate’s position – but just the way I think about it. US trade in goods and services (called the “current account”) is in deficit, meaning we buy more from other countries than they buy from us. Foreign producers really like to have access to US customers! But if I am buying more from the world than I am earning by selling to the world, then I must borrow the difference (called the “capital account”). So the US borrows from the world, and the deal has always been that if other countries will loan us money (buy our debt)  to buy their stuff, that is, the current account deficit is matched by the capital account surplus, then everything is fine. If we threaten to not buy their goods, then they can threaten to not buy our debt (i.e. loan us money). But with an ongoing global “liquidity glut,” in which there is more money around the world looking for debt instruments than there are debt instruments (bidding up their prices and lowering their yields), I’m not sure the world as a whole can avoid buying our debt. With Europe in perpetual debt crisis, and Japan arguably over-levered (debt-to-GDP ratio > 200%), US debt looks like the best game in town. That position only strengthens if our economy grows, which would increase debt quality (just like a company). So to summarize the argument, other countries like China need access to our consumers, but we don’t necessarily need access to their capital (because there is an excess supply of capital in the world). That’s not the whole story, but it’s a story you might be missing by just following the press. And the point is that the US might have more leverage in trade deals today than it has historically had.


And bargaining leverage wouldn’t hurt! Most people are aware, as clients who have done business overseas tell me, that foreign markets tend to be more restrictive and less open in practice than the US. Foreign countries like Japan and China, for example, often engage in trade distortions like subsidizing their exports in ways that are hidden from common view. Merton Miller (also a Nobel Laureate) used to point out that Japan, for example, would restrict what their citizens could invest their savings in, forcing them in effect to invest their savings in government vehicles (e.g. the former “Japan Post”). These vehicles would then give the money to Japanese banks, who in turn handed it out to Japanese exporting businesses on an as-needed basis. In countries like the US, on the other hand, companies have to compete for capital – it flows to its highest valued use. But in Japan companies would (and still do to an extent) get capital as needed. So Japanese businesses could lower their prices below that of international competitors and drive them out of business without having to worry about making a profit. That’s because they got their capital virtually free through the aforementioned process. In financial economics terminology, their Return on Invested Capital (ROI) did not have to exceed what it would normally cost to acquire that capital, because the capital was essentially free. For example, in the US, if you borrow money at 5% to run your business, you need to earn at least a 5% ROI or you won’t be in business for long. But in Japan, you could acquire capital for 0% and have an ROI of just 1% (by having lower prices or perhaps providing more costly service) and still be viable. That’s because your “cost of capital” was being subsidized by the people of Japan (who paid for it with lower returns on their savings). And Miller’s story is true – Japanese companies have had, for over two decades, the lowest return-on-investment in the world. A negative side effect of this is that these companies also have little incentive to improve themselves or jettison wasteful activities or lines of business. So you have a lot of “zombie” businesses and “zombie” banks, in the sense that they will go under as soon as their access to free capital ends. In other words, they aren’t really profitable or viable. That’s where this “zombie” term in the press comes from. This same story plays out with various country-specific nuances all over the world, including in China. So even though a free-trader, if I was a union guy in Ohio, I would want all of this known and brought to the table during trade negotiations.