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Let's Discuss Giant Sucking Sounds, Mexico, NAFTA, Global Trade, and Gold

Mexico and NAFTA came up in a pair of Tweets by Michael Pettis last week. Let's tune in to the discussion.
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Ross Perot Giant Sucking Sound2

Giant Sucking Sound

In 1992, third-party presidential candidate Ross Perot warned NAFTA would create a ‘Giant Sucking Sound’.

“You implement that NAFTA, the Mexican trade agreement, where they pay people a dollar an hour, have no health care, no retirement, no pollution controls and you’re going to hear a giant sucking sound of jobs being pulled out of this country.”

Perot's message resonated with union voters and he received about 19% of the vote, an amazing total for a third-party candidate. 

Was Ross Perot Correct?

Many, if not most people, believe Ross Perot was proven correct. 

Actually, Perot was wrong. The US started losing manufacturing jobs long before NAFTA was implemented. 

Much of this job loss was due to increasing productivity, the rest was due to China's inclusion into the WTO. 

This subject came up in a pair of Tweets by Michael Pettis whom I consider to be the world's foremost expert on global trade.

Michael Pettis on NAFTA

"As I argued four years ago in an essay for Carnegie, although Mexico runs a large bilateral surplus with the US, its participation in the global economy actually reduces the overall US deficit – unlike that of Germany, China or Japan. For Washington to assume otherwise was based on a pretty thorough misunderstanding of how trade works in the post-Bretton Woods environment, especially bilateral trade," says Pettis.

How US Investments in Mexico Have Increased Investment and Jobs at Home

In a July 2014 article the Peterson Institute for International Economics explains How US Investments in Mexico Have Increased Investment and Jobs at Home

This essay builds on our recent PIIE Policy Brief The US Manufacturing Base: Four Signs of Strength, which presents empirical evidence that increased offshoring by US manufacturing multinational corporations (MNCs)—a phenomenon criticized as contributing to domestic job losses—is actually associated with overall greater investment and increases in jobs at home. This update focuses on the subset of US firms that offshore to Mexico. We find that they, too, use their foreign activities to complement, and not just substitute for, their employment, sales, investment, and exports in the United States, with the net result not a loss but an increase in jobs and investment at home that can be directly linked to investment abroad.

The above article is lengthy and includes many charts. It's difficult to excerpt so I just noted the conclusion. 

Instead, let's dive into the theoretical basis behind the above conclusion.

Mexico’s Positive Impact on the U.S. Trade Balance

Please consider Mexico’s Positive Impact on the U.S. Trade Balance by Michael Pettis April of 2017 on Carnegie (emphasis mine).

In today’s global trading environment, persistent trade surpluses are usually caused by distortions in income distribution that force up savings rates. 

For most of modern history, however, it wasn’t this way. Trade imbalances reflected mainly the relative costs of producing goods. If British textile manufacturers could produce and ship textiles to France at a much lower cost than French producers could manage, for example, England would run a trade surplus in textiles with France, and bankers would finance the trade imbalances. During this time, 90 percent of all international financial transactions in London consisted of trade finance. A country’s trade balance consisted of the sum of all its various bilateral trade imbalances, and net flows of capital were primarily driven by trade finance.

Trade and capital flows today follow a completely different dynamic, but the older model is so intuitively appealing that it implicitly underlies, and confuses, most trade discussions today. Two fundamental differences have transformed trade and should have transformed the way we think about trade. First, the collapse in transportation costs has stretched value chains across sometimes dozens of countries, so that most trade consists of intermediate goods, not finished goods. Second, international finance is no longer trade finance. Capital flows have grown so much that investment flows wholly overwhelm trade flows. A s a result, one country’s trade imbalances with another can easily be the consequence of capital flows created by distortions originating elsewhere.

Mexico is a case in point. Ranked third among major US trading partners, after Canada and China, Mexico’s $525 billion in total trade with the United States in 2016 is a major focus of complaints by the Trump administration. This might at first seem reasonable: Mexican exports to the United States last year exceeded imports by $63 billion, constituting the fourth largest bilateral U.S. trade deficit, after those with China ( $347 billion), Japan ($69 billion), and Germany ( $65 billion).

Mexico, however, is a net importer of capital and runs an overall current account deficit that is the seventh largest in the world, equal in 2015 to 2.8 percent of GDP. This makes it very different from the other three countries. Their large American bilateral trade surpluses are subsumed within even larger overall surpluses with the world. 

Capital continues to drive imbalances in the post-crisis world economy. Capital has been fleeing China, for example, since 2012, at first mainly in reaction to the anti-corruption campaign, but later these outflows were exacerbated by worries about the slowing economy. China ran huge trade surpluses even before then, when it was the Chinese central bank that exported capital as it accumulated one of history’s largest hoards of central bank reserves in its efforts to keep down the value of the renminbi

In today’s environment of weak global demand, there has been little appetite among any major economies for the excess production and savings of these major surplus nations, but the absence of capital controls has made the United States the default adjustment for global capital imbalances. 

Because of its deep financial markets and lack of discrimination between domestic capital and foreign capital, the U.S. economy automatically absorbs nearly half of the world’s net capital exports. As a corollary, the United States must also automatically absorb nearly half of global trade imbalances, usually adjusting to the capital inflows by way of a stronger dollar, rising debt (driven by lower real interest rates), and higher unemployment, all of which inexorably force down the U.S. savings rate.

Predicting the exact form of adjustment is impossible, but it is an ironclad requirement that a change in the capital account must be matched by an equal adjustment in trade.

This is why American concerns about the adverse impact of trade on employment are misplaced when it comes to Mexico. Unlike surplus countries, Mexico doesn’t suffer from domestic demand deficiencies that require trade surpluses and the export of excess savings. As a net importer of capital and with its large current account deficit, Mexico helps absorb excess global savings and production that might otherwise force even larger U.S. trade deficits.

The second way Mexico helps absorb global imbalances is through its own growth prospects. NAFTA creates incentives for Mexican producers to expand manufacturing and export goods to the United States, but the success of Mexican exports creates the need for investment or raises domestic income and consumption, so ultimately this success automatically increases Mexican imports of goods from the rest of the world. Some of these goods are imported directly from the United States. The rest are imported from elsewhere, although in many cases they include American-produced intermediate stages, but even when they don’t, they still reduce the overall U.S. trade deficit because of the aforementioned role the United States plays in resolving global capital imbalances. 

As the seventh largest absorber of excess global capital in the world, Mexico and its trade helps reduce the U.S. trade deficit by moderating global imbalances. It absorbs excess savings from other countries, along with the excess production of consumer or investment goods.

The global trading system clearly needs fixing, but punishing Mexican exporters does nothing to address the fundamental problem of excess savings in certain countries. These excess savings abroad are the root cause of American deficits.

Manufacturing Employees vs Output Index 

Manufacturing Employees vs Output Index + NAFTA 2021-Q1

The decline in manufacturing employment was not due to NAFTA. Heck there was even a brief bounce when it happened.

Several things happened, the first being a massive leap in productivity. Then on December 11, 2001 China entered the WTO. 

Many blame China but the key enabler of China was an event that occurred much earlier.

Absence of Capital Controls 

The "absence of capital controls has made the United States the default adjustment for global capital imbalances," says Pettis. 

Bingo! 

That is the critical sentence and it's very easy to miss.

Guess the root cause. 

Gold, the Ultimate Capital Control! 

Many problems today including deficit spending, trade deficits, and income inequality have their roots in 1971.

Prior to 1971, trade deficits were financed by an outflow of gold. If countries had deficit spending, gold flowed out. 

Here's a historical background of the problems we see today.

Vietnam War and the Dollar Exodus Beginning

The dollar exodus had its beginnings way back in February 1965 when President Charles de Gaulle announced his intention to exchange its U.S. dollar reserves for gold at the official exchange rate of $35 per ounce.

Lyndon Baines Johnson was president. The War in Vietnam and Johnson's "War on Poverty" accelerated the US deficit and inflation.

On a campaign that promised to restore law and order to the nation's cities and provide new leadership in the Vietnam War, Richard Nixon won the election in 1968.

Arthur Burns was Fed chair.

In 1971 President Nixon appointed the then Democrat John Connally as Treasury Secretary. That's when things started rolling.

Our Currency But Your Problem

Shortly after taking the Treasury post, Connally famously told a group of European finance ministers worried about the export of American inflation that the "dollar is our currency, but your problem."

By 1971, US money supply had increased by 10%. In May 1971, West Germany left the Bretton Woods system, unwilling to revalue the Deutsche Mark. Switzerland also started redeeming dollars for gold.

On August 5, 1971, the United States Congress released a report recommending devaluation of the dollar to protect the dollar against "foreign price-gougers".

On August 9, 1971, as the dollar dropped in value against European currencies, Switzerland left the Bretton Woods system.

On August 15, 1971 Nixon directed Connally to suspend, with certain exceptions, the convertibility of the dollar into gold or other reserve assets, ordering the gold window to be closed such that foreign governments could no longer exchange their dollars for gold. 

The American public believed the government was rescuing them from price gougers and from a foreign-caused exchange crisis. Politically, Nixon's actions were a great success. The Dow rose 33 points the next day, its biggest daily gain ever at that point, and a New York Times editorial read, "We unhesitatingly applaud the boldness with which the President has moved."

So Much for Temporary

The move was not temporary. There have not been any restraints on deficit spending since.

Wars became easy to finance. Deficits? No problem.

Global Consumers of Last Resort

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The US is stuck with the reserve currency because we have the largest, most open capital markets in the world, the world's largest bond market, and a far better business climate than the EU, China, or Japan.

To ensure the US remains the curse holder, the EU and Japan have negative rates, China does not float the Yuan but props up corrupt SOEs, and Germany punishes the rest of the EU.

Everyone wants to export to the US, and they do.

The result is a currency war with everyone hoping to devalue their currencies against the dollar.

Total Credit Market Debt Owed

Total Credit Market Debt Owed 2021-Q1

In the quarter ending July 1971, TCMDO was $1.75 trillion. For the quarter ending March 2021, TCMDO was $84.56 trillion. 

US Debt Clock

US Debt Clock 2021-09-10

Not counting unfunded liabilities, US National Debt is $28.745 trillion and rising quickly as per the US Debt Clock. Click on the link for an amusing view that refreshes constantly.

What About Savings?

My one major disagreement with Pettis regards excess savings. Pettis says "These excess savings abroad are the root cause of American deficits."

I strongly disagree with Pettis on the cause.

The root cause of these imbalances and debt buildups is lack of an enforcement mechanism, not excess savings.

Importantly, it's not even possible to have excess savings. Can one be too prepared for the future? That's impossible, isn't it?

Savings Glut Theory

Former Fed Chair Ben Bernanke said the world was suffering from a "savings glut". 

Yeah right, with total credit market debt of $84.56 trillion.

I am quite sure Pettis would redefine "glut" as an "imbalance" as opposed to an "excess". 

Importantly, note the word "abroad" in his sentence "These excess savings abroad are the root cause of American deficits."

I still do not accept that theory although it is certain we have enormous imbalances.  

I will return to imbalances in a moment but first let's discuss a key problem with measuring savings.

Confusing Money Printing With Savings

Central banks and economists repeatedly conflate money with savings. 

In the classic sense, savings equals production minus consumption.

If the US government spends $1 trillion on a bridge and it collapses, there is a trillion dollars still sloshing around but where is the bridge? 

The answer is the bridge was consumed, but savings supposedly went up by a trillion.

Better yet, take the trillions wasted in Afghanistan. Savings? Where are they? 

If the government paid people not to work (and didn't we just do this thrice?) what was produced? The answer of course is nothing. 

Yet, the "savings rate" soared following government handouts of free money.

But if savings = production - consumption and production was zero, what do we have? How about "negative savings"?  

A negative savings rate means consumption. 

Meanwhile, the alleged "savings" build up in the pockets of the politically connected, the already wealthy, and the bankers allegedly doing God's work. The public debt is in the hands of everyone else. 

We need to really rehash this "excess savings" idea from a classical definition standpoint because the classical definition, not money created out of thin air is the correct definition of saving.

Confusing Cause With Result

I certainly grant the notion of huge imbalances. The entire global economy is imbalanced beyond belief.

But savings imbalances are a "result" not a "cause" of anything. The "cause" is lack of an enforcement mechanism that was automatic under a gold standard.  

Maybe there is a "pool of real savings" but that pool is dramatically overstated by malinvestment and debt.

The pool is not necessarily overseas. 

Lack of An Enforcement Mechanism

In the wake of Nixon killing gold redeemability debt soared. Money was wasted. Imbalances grow every year. 

No one seemingly has to pay for mistakes, not governments nor warmongers but the imbalances keep rising. 

There is no incentive on governments to reinstate the gold standard because politicians like to spend and pass the debt to future generations. The US national debt remains (to the tune of $28 trillion) but the real savings is largely consumed. What isn't consumed goes in the pockets of the already wealthy.

China finances US debt but a lot of that went up in smoke in corrupt and bankrupt State Owned Enterprises. 

That's part of the easily seen imbalances.

And the Fed's (central banks in general) response to this convoluted mess is their attempt to force more inflation and still more money and credit into a system literally choking on it. 

This money sloshing around, created out of thin air is constantly confused with "saving". 

What About Money?

There are many disputes as to how to measure it. I discuss money in What is the Best Measure of Monetary Inflation?

In a fiat world where money is created at will, it's easy to confuse money with real savings, the production of goods. 

Money was nearly always a placeholder out of necessity (e.g. grains spoil, produce rots), but money is now diluted almost beyond recognition as the level of debt shows.

This was a long but important discussion. Let's recap. 

Post Quick Synopsis

  • I mean what what I say about Pettis being the foremost expert on global trade.
  • I also agree with Pettis that NAFTA is actually a blessing and not a curse. It is not the cause of that "giant sucking sound" as widely believed. 
  • I disagree with Pettis regards excess savings. Pettis says "These excess savings abroad are the root cause of American deficits."
  • But there is no such thing as "excess savings". One cannot be too prepared for the future.
  • When Pettis speaks of excess saving, I am pretty sure he means a saving imbalance, not an excess as in Bernanke's glut thesis. The word "abroad" in his sentence is a subtle but easily missed point. 
  • We have imbalances for sure and they are worsening, but the root cause of these imbalances and debt buildups is lack of an enforcement mechanism, not excess savings.
  • Those imbalances and money printing at will directly result from a decision by Nixon to end convertibility of gold. 
  • Here is the key sentence courtesy of Pettis. The "absence of capital controls has made the United States the default adjustment for global capital imbalances.
  • Prior to 1971, current account deficits were financed by an outflow of gold. Gold convertibility acted as as the ultimate capital control. Nothing has replaced it.  
  • Money has been diluted endlessly as a direct result. Politicians like their power to spend without restraint. Central banks want to impose inflation on the world, and properly measured, they continue to do so.
  • Those with first access to money benefit the most from these distortions. The primary beneficiaries of this massive monetary printing and deficit spending are the banks, the politically connected, and the already wealthy. 
  • I agree 100% with Pettis that "The global trading system clearly needs fixing." However, no governments want to return to the only fix that works.

How much longer this setup can continue before it blows up in a currency crisis, war with China, or some other major economic disruption remains a key mystery.

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