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Inflation Leads to Protectionism

March 4, 2004

The main argument for protectionism one hears today cites America's huge current account deficit, which is cited as evidence for the need for trade barriers.

One example of this was in the debate between CNN's protectionist News anchor Lou Dobbs and free trader James Glassman from the American Enterprise Institute. Dobbs kept harping about the current account deficit, while Glassman responded by claiming that the American economy was fundamentally sound.

Actually, both sides are wrong. The American economy is unsound, not because of free trade but because of the inflationist policies of Alan Greenspan and the deficit spending by President Bush. And the current account deficit is similarly not the result of free trade but of the policies of Greenspan and Bush.

What drives trade/current account balances are not, as protectionists would suggest, trade policy or wage levels but rather the level of national savings as well as a country's attractiveness for investments. A higher level of savings will, other things being equal, increase surpluses or decrease deficits, while increased attractiveness for investment will increase investments which in turn will lower surpluses or increase deficits.

If it were really the case that deficits arise as a consequence of free trade and high wages, then not only the United States but all other rich countries would experience current account surpluses. But in fact, there is a current account surplus in almost all northwest European countries except for Britain, and it is also true in the case of Canada and relatively rich East Asian countries like Japan, South Korea, Taiwan, Hong Kong, and Singapore.

Of particular interest are the huge current account surpluses of Hong Kong and Singapore. They are two countries with an income level at a West European level, are geographically close to the much maligned countries of China and India, they are 100% committed to free trade and have no trade—or capital movement restrictions whatsoever. If any countries should have deficits due to competition from low wage counties like China and India, then Hong Kong and Singapore should be the ones.

Yet, the reality is the opposite of what the protectionist's theory would predict. In the latest period where statistics are available (Q4 2002–Q3 2003) Hong Kong had a current account surplus of 10.6 % of GDP [1] (equivalent to a annual surplus of $1.2 trillion for the USA) while Singapore had a current account surplus of 28.4% of GDP[2] (equivalent to an annual surplus of $3.2 trillion for the U.S.) in the latest year.

The reason Hong Kong and Singapore have huge current account surpluses, while the United States has a huge current account deficit is because they have a very high savings rate (in Singapore partly related to a compulsory savings scheme) while the United States has an extraordinarily low savings rate.

Then why is the U.S. savings rate so low?

Partly, it may be for cultural reasons. Americans have long been very consumption-oriented while the Chinese and other East Asians value thrift. But perhaps more important are the policies of Greenspan and Bush. Greenspan has pushed interest rates all the way down to 1%. Even according to the government's inflation measures (which most likely underestimate inflation) this means real interest rates are negative. And of course, if there are strong disincentives for saving, savings will be much lower. Not surprisingly, the personal savings rate fell to a mere 1.3% in December 2003[3].

And not only are American households not saving due to Fed policy, the federal government makes matters much worse by dissaving in the form of a deficit of more than $500 billion. As Americans are not saving, this deficit must be covered by foreigners, which increasingly have come to mean the Bank of Japan and other Asian central banks. The current account deficit is actually roughly equal in size with the Federal budget deficit.

The combined effect of the artificial lowering of interest rates and the huge budget deficit is that 2003 is set to have the lowest national savings rate since 1935 at only about 13.1% for the first three Quarters of 2003, down from 14.6% in 2002 and the roughly 20% typical during the post-World War II era[4]. This decline is especially significant since this is supposed to be a "recovery" and since recoveries are usually associated with a rising savings rate.

And while Americans are saving less and less, Asians are still very thrifty. The national savings rate of Hong Kong was 33% for the latest year, while the savings rate in Singapore was 55%. While the investment rate was higher in Hong Kong and Singapore than in the United States, the difference in investment opportunities between Asia and the United States is lower than the massive difference in savings, causing a huge net flow of Asian capital to the United States. At the same time, the weakness of the dollar created by low interest rates is causing many Asian central banks to try to prevent a sharp appreciation of their currencies by buying U.S. treasuries at great cost to themselves.

Current account deficits are not necessarily a bad thing if they reflect greater investment opportunities. But the current American current account deficit reflects a very low savings rate depressed by negative real interest rates and massive deficit spending by the federal government. Aside from the negative direct effects that a low savings rate have, it has indirect consequences in the form of aiding protectionists who mistakenly believe that free trade is what causes job losses, the current account deficit, and the low savings rate.

We can here see yet another example of Ludwig von Mises's theory of how interventionist policies produce unintended problems, which are then used as an excuse for yet more interventionism. In this case, inflation and deficit spending produce low savings rates and a current account deficit which in turn are used as an argument for protectionism.

Stephan M.I. Karlsson (email) is an economist currently working in Sweden. Comment on this article on the Mises Economics Blog.

[1] Source: Hong Kong Census & Statistics Department

[2] Source: Singapore Department of Statistics

[3] Source: Bureau of Economic Analysis

[4] Source: Bureau of Economic Analysis


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