Via Michael Pettis:
On July 31, 2019, U.S. Senators Tammy Baldwin and Josh Hawley submitted a bill “to establish a national goal and mechanism to achieve a trade-balancing exchange rate for the United States dollar, to impose a market access charge on certain purchases of United States assets, and for other purposes.” According to an earlier memo that further explains the bill:
The Competitive Dollar for Jobs and Prosperity Act would task the Federal Reserve with achieving and maintaining a current account balancing price for the dollar within five years. It would create an exchange rate management tool in the form of a Market Access Charge (MAC)—a variable fee on incoming foreign capital flows used to purchase dollar assets. The Fed would set and adjust the MAC rate. The Treasury Department would collect the MAC revenue. The result would be a gradual move for the dollar toward a trade-balancing exchange rate. The legislation would also authorize the Federal Reserve to engage in countervailing currency intervention when other nations manipulate their currencies to gain an unfair trade advantage.
Whether or not this bill is passed, it marks the beginning of a necessary reappraisal of the forces driving international trade and U.S. trade imbalances. The heart of the bill would be a stipulation that the Federal Reserve levy a variable tax on overseas capital used to buy U.S. assets whenever foreign investors invest significantly more capital in the United States than U.S. investors send abroad, which has been the case for more than forty years. The purpose of the tax would be to reduce capital inflows until they are largely in balance with outflows. A country’s capital account and current account must always match up exactly, so a balanced U.S. capital account would mean a balanced current account, and with this the U.S. trade deficit would disappear.
PUTTING THE INVESTMENT CART BEFORE THE HORSE
Some might think that imposing tariffs on imported goods is a more effective way to reduce U.S. trade deficits than levying duties on imported capital, but that’s the wrong approach. The key is to understand what drives the trade imbalances. If the recent Senate bill had been proposed in the nineteenth century—when trade finance dominated international capital flows—the proposal to tax capital inflows wouldn’t have made much sense. But today, as I have explained before (including here and here), the global economy is overflowing with excess savings. The need to park these excess savings somewhere safe is what fuels global capital flows, in turn giving rise to trade imbalances. As I explained in a recent Bloomberg piece, “Capital has become the tail that wags the dog of trade.”
After all, even though interest rates are historically low and U.S. corporate balance sheets are amassing heaps of nonproductive cash, the U.S. economy is still absorbing massive sums of capital from overseas. Clearly, this isn’t happening because U.S. firms need foreign capital. The reason for these imbalanced capital flows is that foreign investors need a safe place to direct their excess savings. With the deepest, best-governed, and friendliest capital markets, the United States is the obvious destination.
Economists who contend that the U.S. economy needs foreign capital to compensate for low domestic savings rates are mostly confused about why U.S. savings rates are so low and how they respond to capital inflows. A fundamental requirement of the balance of payments is that net capital inflows must boost the gap between investment and savings, and if capital inflows do not cause domestic investment to rise, they must cause domestic savings to decline. There is no other possibility, and as I’ve explained elsewhere, capital inflows force the U.S. economy to adjust either by increasing unemployment or, more likely, by setting off conditions that cause fiscal or household debt to grow. Put another way, the United States doesn’t absorb foreign capital because the country has a low savings rate—the country’s savings rate is low because it has to absorb so much foreign capital.
This is why it is a mistake to think—as many do—that Americans need foreign capital to counter low domestic savings rates, or even that the U.S. current account deficit is driven in part by a burgeoning fiscal deficit. If one country saves more than it invests, another country must save less than it invests: that is how the global balance of payments works. Americans automatically tend to assume that it must be the United States that sets the savings schedule of the whole world, but this is unlikely. The high savings rates of countries like China, Germany, and Japan are too obviously a function of the distribution of domestic income (see here and here for why), making it far more likely that excess savings in those countries drive down savings elsewhere.
TAXING CAPITAL INFLOWS IS THE SMART PLAY
If it is excess savings in surplus countries that drive capital and trade imbalances globally, then taxing capital inflows is not just the most efficient way to rebalance the U.S. trade ledger—it may perhaps be the only way. And there are more reasons why the United States should consider restricting the capital account. If designed well, a tax on capital inflows could have at least five other advantages:
- Balancing trade flexibly: A well-designed system of taxing capital inflows would help broadly rebalance the U.S. current and capital accounts over several years. Having the Fed impose a variable tax on capital inflows at its discretion would give the United States a tool for managing trade imbalances that is far more flexible than WTO interventions, trade negotiations, tariffs, or subsidies. At the same time, this approach would allow for the temporary trade imbalances that are a normal feature of any well-functioning global trading system.
- Enhancing financial stability: Because it would be a one-off tax on transactions, this tax wouldn’t treat all investment equally. It would more heavily penalize short-term, speculative inflows while barely affecting returns on longer-term investment into factories and other production and logistics facilities, much like a Tobin tax. Among other things, such a tax would not require huge shifts in the value of the dollar because it focuses so effectively on the most damaging kinds of capital inflows. For example, if the tax were 50 basis points (or half of a percentage point), the annual yield on a three-month investment in the United States would drop by more than two percentage points, making short-term investment a losing proposition. A one-year investment would fare better, but annual yields would still drop by just more than half of a percentage point.
A ten-year investment, on the other hand, would reduce expected yields by a mere five to seven basis points, hardly enough to matter to an investor interested in building a factory in the United States, while a twenty-year investment would see yields drop even lower, by three to four basis points. The impact of the tax, in other words, would be to skew foreign investment away from short-term, speculative inflows. Long-term investments in productive facilities, however, could even become more attractive to the extent that the measure would lower the value of the dollar. In effect, this would enhance the stability of the U.S. financial system.
- Treating economic actors more efficiently: Whereas tariffs subsidize some U.S. producers at the expense of others, taxing capital inflows would benefit most domestic producers with the costs borne primarily by banks and speculators. Major international banks would lose out on a tax on capital inflows because they profit from the intermediation of capital flows into and out of the country, and because they fund themselves with cheap, short-term money that they redirect to borrowers at higher rates. This is why the biggest opponents of a tax on capital inflows are likely to be major international banks. But to the extent that these banks, many of which are considered too big to fail, are too large and have an excessive role in the economy and in policymaking, forcing them to pay for the benefits accrued by U.S. producers might actually create a further benefit to the U.S. economy.
- Avoiding broader economic disruptions: Unlike issuing tariffs, levying a tax on capital inflows doesn’t disrupt value chains to anywhere near the same extent or distort relative prices on tradable goods. Tariffs favor some sectors of the productive economy over others, so they can be highly politicized as well as highly distorting to global value chains and the role of U.S. producers. Taxing capital flows works by forcing financial adjustments—by adjusting the value of the dollar, for example, or by reducing debt—so such a tax is likely to be both less politicized and less distortionary to the real economy. In fact, to the extent that trade imbalances are driven by distortions in global savings, taxes on capital inflows will even drive prices closer to their optimal level.
- Allocating capital more efficiently: Some observers might argue that, by reducing the capital available for U.S. investment, a tax on foreign capital inflows would distort productive investment and make the capital allocation process in the United States less efficient. This would be true if most international capital consisted of sophisticated investment capital seeking its most economically efficient use, but only academic economists believe this is the case. In fact, much of the flow of international capital is driven by temporary investment fads, capital fleeing from political or financial uncertainty, reserve accumulation strategies by foreign central banks, debt bubbles, and speculative plays on currency or emerging markets. For that reason, a variable tax on capital inflows would actually improve the capital allocation process by discriminating against nonproductive uses of capital and so preventing them from distorting the financial markets.
The biggest risk of a tax on capital inflows is that the U.S. economy might indeed experience periods when there are capital shortages and U.S. businesses are unable to access cheap capital. At such times, of course, the Fed would simply set the tax to zero.
The trade shortfalls that plague the U.S. economy are chiefly a product of imbalanced capital flows, which are driven by distortions in global savings. Selectively restricting capital inflows is the best way to address these imbalances. Tariffs are a far less effective tool: they mostly just rearrange bilateral imbalances and distort the underlying economy without addressing structural issues. Whether it passes or not, the recent Senate bill is the right approach and an encouraging sign because it is the first time lawmakers have sought to address the persistent U.S. trade deficit by way of capital imbalances.
