Wednesday, March 28, 2018


President Donald Trump’s policies to balance trade and increase employment will fail because of an iron law of international economics: If a country spends more on goods and services than it produces, the difference has to be imported. This equation summarizes the law:

Imports – Exports ≡ (Investment - Savings) + (Government Spending - Taxes).

Steve Hanke at Johns Hopkins University showed that US data are consistent with this identity. During the years 1975-2016 investment minus savings were $9.6 trillion, government spending minus taxes was -20.0 trillion, which makes the right side of the equation come to -$10.4 trillion. Over the same period Imports minus Exports – the left side of the equation – came to $11.2 trillion. The $0.8 trillion difference between the two sides of the equation represents statistical measurement errors.

The reason why Trump’s import-reducing and export-increasing policies will not create balanced trade is that the existing overspending in the United States causes market forces to appreciate the dollar exchange rate, which leads to higher imports and lower exports until the trade deficit again matches the domestic overspending and the initial effect of these policies has disappeared.

Unfortunately, Trump’s protectionist policies combined with domestic overspending has a possible serious, rarely discussed negative effect on US national income: It endangers the country’s lucrative export of US dollar notes and Treasury securities because it threatens the confidence the users of dollar notes and treasury securities have in the future stability and value of the exchange rate, credit-worthiness of the federal government and the growth and relative size of the US economy in the world. 

As will be documented below, the size of the Euro zone and the stability of its economy in recent years when the US economy was unstable and growing slowly already has increased the world demand for Euro notes and short-term government securities. If and when the growth and stability of the Chinese economy approaches that of the United States, the world might replace US dollar notes and securities with those of China.

The amount of currency notes exported cannot be observed directly. However, in a study published by the Federal Reserve Board of Governors, $550 billion worth of US dollar notes (mostly in $100 denominations) were held abroad at the end of 2011. These dollar notes are used by foreigner as a store of value and in commercial transactions, many of which are likely to involve underground and illegal activities. Considering past growth rates, in 2017 the export of such notes probably was about $200 billion.
Since these notes cost virtually nothing to produce, their export adds to the profit of the Federal Reserve, which is transferred annually to the Treasury and thereby decreases the government deficit as if tax revenue had increased. The sum of $200 billion in 2017 was large enough to cover the cost of four of Trump’s coveted Mexican border walls.

The story does not end there. According to the IMF, governments around the world in 2017 held official reserves worth $9.6 trillion, of which $6.1 trillion were in the form of short-term securities issued by the US Treasury. These securities are very liquid and are held by governments for propping up the value of their national currencies during crises.

US income is created through the foreign holdings of these securities by the fact that they are short-term and require the Treasury to pay low interest rates while the money they raise can be used to buy longer-term bonds or make direct investment at home or abroad. Assuming that the short rate is one percent and the long rate is five percent, the $6.1 trillion of US short-term securities held by foreign governments currently brings the Treasury an implicit annual return of $244 billion and reduces the deficit correspondingly.

In the 1960s Valéry Giscard d'Estaing, who was then the French Minister of Finance suggested that the world’s use of dollar denominated securities and currency notes conferred on the United States an “exorbitant privilege”. At the time, French politicians were particularly upset about direct US investment in the country’s profitable industries, which they considered being financed by the same money they had provided America when they acquired US short-term securities for their official reserves.

The profitable export of US currency notes and securities is the result of the world’s need for a universally accepted standard of value, the efficiency-enhancing use of dollars in trade and the properties of US short-term securities that are highly liquid and have a low risk of default. These properties of the dollar developed spontaneously after the end of the Second World War together with the status of the United States as the world’s largest and open economy with a solid record of political and economic stability. Protectionism and chronic domestic overspending bring the risk that these roles of the dollar will be diminished and ultimately lead to the use of other countries’ short-term securities in their reserve portfolios.

This development has already begun. Between the third quarter of 2016 and 2017, dollar denominated reserves held by foreign governments rose 13.3 percent from $5.4 trillion to $6.1 trillion. Over the same period Euro-denominated assets increased 18 percent from $1.6 trillion to $1.9 trillion while reserves denominated in Yen, Pound Sterling, Australian and Canadian dollars together increased 20 percent from $1.0 trillion $1.2 trillion.

Advice to Trump coming out of the preceding analysis: Do not pursue protectionist policies. They will not succeed and they threaten your government’s business of supplying the world with dollar notes and short-term securities. Remember that this business in 2017 brought a profit of $444 billion, which is much more than enough to finance your Mexican wall and increased defence spending without having to raise taxes.

Monday, March 26, 2018

In praise of real estate speculators

Throughout history, politicians and the public have hated speculators on the grounds that they create scarcities, raise prices and cause hardships for consumers. This view is behind the recent decision by the B.C. government to impose a tax on unoccupied housing presumed to be owned by speculators and which is expected to lower the cost of housing.
The implementation of this policy has run into a number of problems that can be solved by some tweaking of the law, but it will do nothing to reduce prices in the long-run. Speculators raise house prices when they buy and keep them empty or rent them out. The speculators realize profits only when they sell them later, at which time they lower prices. In effect, speculators do not add to the demand for and cost of housing, but only smooth it through time. The real cause of the high and rising cost of housing is a continuous excess of demand over supply.
The excess demand in Metro Vancouver is determined by the high level of immigration, which in recent years has brought 250 families to the region every week. Under the policies announced by the current government, by 2020 this number will be 375 families a week. Adding to this demand are the housing requirements of foreign students, who in 2017 numbered 130,000 and are expected to grow substantially in the future.

In principle, in a market economy the supply of housing should keep up with the growth in demand. However, as the record shows, this has not happened. The reason given by the construction industry is that it faces delays and cost-increasing obstacles due to the scarcity of building sites, zoning restrictions, regulation affecting building codes, and a shortage of skilled workers. Another reason explaining the scarcity and high cost of rents is the existence of rent controls, which lower returns from investment in rental units over their lifetime to levels at which investors are staying away in troves.
Neither demand nor supply are likely to change soon. Politicians will not reduce demand coming from immigration. Their electoral success depends too much on the votes of immigrants and on the financial support from the real estate industry, employers of cheap immigrant labour, and producers and retailers whose markets are increased by immigrants. Any politician proposing the end of rent controls faces sure electoral defeat at the hands of renters subsidized by the existing law.
Neither will there be a decrease in the number of foreign students. Public universities increase their financial resources through the tuition paid by foreign students. Many private educational institutions depend entirely on income from foreign students.
Given the prospect of future growth in the demand for and continued limits on the increase in the supply, the public will have to live with these facts unless they show their displeasure at the ballot box with the policies of Canada’s virtue-signalling elites who are lobbying for ever-larger numbers of immigrants in the future but show little concern for the blight of ordinary Canadians facing a housing affordability crisis. Asking these elites for taxes on speculators, empty housing and tougher rent controls will not do the job.
Published in the Vancouver Sun on March 25, 2018