The financial news media is reporting that China’s lending policies are undergoing another shift, away from troubled real estate and local land development back to manufacturing. This is not the market speaking. It is a decision made from the center, by the Chinese Communist Party (CCP), and carried out by the central bank. The target is, of course, mainly U.S. manufacturing, electric cars, and “green energy” capital such as solar panels.
In other words, the CCP is back to following the playbook that has worked for decades: deploy leverage capital, much of it in the form of secure U.S. debt, to underprice U.S. market advantages. It will work again just as it has for decades. Then the United States will be again forced to give up its industry or erect trade barriers and tariffs.
There was a time when U.S. politics talked often about restoring competitiveness. That term came along in the late 1980s, when it alarmed many in the United States to see how easy it was for Japan to take out the U.S. watch industry and then the consumer electronics industry, and eventually hit the U.S. auto industry so hard. At the time, many people credited Japanese management strategy and tried to emulate it.
What people did not understand was that Japan was just the beginning. One industry after another was blown up by foreign competition, first from Japan and then from China, Mexico, Vietnam, and many other countries. It seemed after a time that no U.S. industry was safe from foreign raids. Eventually, the term competitiveness disappeared from U.S. politics, not because the problem was solved but rather because it seemed hopeless.
The list of lost industries is long: watches and clocks, pianos, shipbuilding, tools, consumer electronics, microchips, furniture, textiles, apparel, household appliances, steel, and, of course, cars. From there, there are many spinoff industries that have also been blown up. The carnage dates back at least four decades to the point that the United States has been transformed from a nation that builds things for people to one that languishes in medical and financial services, with exports mostly of oil, debt, and intellectual property.
You could look at this and say, hey, it’s just free trade. Other nations are better at this than we are. It’s called comparative advantage. So be it. U.S. consumers benefit. We get products, and all they get are silly pieces of paper.
I can tell you that as a longtime free trader, I’ve heard this line countless times from extremely thoughtful people who just have not considered the larger problems and issues behind the scenes. Once you see them, you cannot unsee them.
The most telling aspect of all of this is found in the trade deficit numbers. The last time that the United States ran a merchandise trade surplus—the value of exports exceeding the value of imports—was in 1976, just following the end of the gold standard and the rise of the first big inflation wave that would hit the country in that decade. The deficits started and grew, with no relief at all, now totaling $100 billion.
It strikes me that there are two mistakes one can make when looking at such an extreme trend reversal. One is to say it doesn’t matter. This is an accounting fiction. We should just stop collecting these figures. The bleeding of red here does not mean anything of any importance. It’s goods in and paper out, and no one is harmed.
This is incorrect for reasons I will explain shortly. But another error is the interpretation popularized by former President Donald Trump, which is that these other nations owe us money, we are otherwise being ripped off, and the best approach to fixing it is tariffs. This is wrong for two big reasons: These are not normal accounting losses, but simply a failure of traditional clearing systems, and tariffs operate only as a bandage that ends up taxing domestic producers and consumers. It’s not a solution.
To understand the real problem and issue, we have to dive deep into free-trade history. When in the 18th century, the UK was considering opening up to the world, repealing its tariffs, and trading with the United States, the free trade advocates faced down the claim that this would wreck domestic industry.
The case for free trade was wrapped up in what was called the price-specie flow mechanism. It was explained at a time when all of the currencies in the world were one or another name for some specie backing in gold, silver, copper, or some other metal. They could all be accepted and traded with each other and priced and valued according to their underlying value.
In such a world, nations need never fear “that all their gold and silver may be leaving them,” said Hume. This is a “groundless apprehension.” The reason, he explained, is that every exporting nation is also an importer of money, while the reverse is also true. This rise and decline of the money stock causes prices to adjust. Prices (and wages) fall in the importing nation, causing its manufacturing to become more competitive for export, while the exporting nation faces increases in price because of more money stock and thus faces price pressure that flips the advantages toward importing.
This back-and-forth balance of trade is what kept trade deficits from ever becoming chronic in a single country. This is why the great free-trade economist Frédéric Bastiat said to stop paying attention to the international balance of payments: They take care of themselves. Crucially, this balance depends on 1) limits on money-stock expansion based on specie backing, 2) a domestic price level that adjusts to prevailing market conditions, and 3) an unregulated and enterprising economy that can adapt to changes along the way.
This idea—the price-specie flow mechanism—really amounted to an observation that the market works across borders in the same way as it does within borders. Supply and demand adjusted in ways that lead to a productive balance, with no one harmed. Seeming destruction is always matched by creation, and no nation needs ever let go of any comparative advantage in industry, particularly not ones with intellectual capital, institutional knowledge, and robust supply chains. There is nothing to fear from free trade, the argument went, and this view dominated the West from the 18th through the 20th century.
What broke starting in the 1970s? The gold standard was abandoned in favor of the paper dollar standard, with the U.S. dollar serving as the reserve currency of the world. That achieved two things: It removed the limits on the expansion of money and credit by the U.S. central bank, and it created an unlimited international demand for the deployment of the U.S. dollar, in cash or dollar-denominated U.S. debt assets.
The rest of what unfolded over the decades could have been foreseen. The United States became an importing nation, gradually at first and then more and more. There was nothing wrong with that, it seemed; it is good for consumers and even for inputs for U.S. producers. Under the Humean system, two forces would have been engaged: First, the loss of dollars from imported goods would have seen prices in the United States fall, and second, the dollars that went abroad would have been repatriated eventually in the form of a growing export sector.
But with the loss of gold as an anchor, the U.S. money spigots were turned on full blast for the 1970s, half blast in the 1980s and 1990s, and full blast against after 2000 with zero-interest rate policies. This meant there would be no downward adjustment in U.S. prices and no revival of manufacturing exports, and the dollars would never be repatriated. Why not? Because the dollars sent abroad would serve as a reserve asset for central banks around the world.
And what would that reserve asset be used for? It’s obvious now: It would be used to build out industrial sectors that directly compete with U.S. manufacturing. That is precisely what happened, on an amateur level first in Japan and then with tremendous precision and focus from a newly opened China. In 2000, $1.8 trillion, or 18 percent of total debt, was foreign-owned. By 2014, this grew to $8 trillion, or 34 percent of total debt—the highest percentage in U.S. history.
This shows no signs of abating, for as long as the United States is cranking out the debt to fund Congress’s passage of unbalanced budgets, there will be international markets for it that will in turn be deployed to build direct competition to U.S. industry. And as long as the Fed keeps pushing for more inflation (for fear of deflation), U.S. prices will never permit a rising purchasing power to make its export sector anywhere near being competitive on the international scene.
Indeed it does! The trade deficit is not by itself some kind of accounting problem, but rather it illustrates a fundamental dysfunction in the entire operation of 21st-century free trade. It was never supposed to be this way. Again, tariffs will not fix this, and an industrial policy of our own is not a sustainable fix for the long term.
The only real path out is not to dismantle international trade but rather more obvious: Balance the U.S. budget, stop the debt-production machine, and put an end to the Fed’s nonstop feeding of global demand for dollars. Also crucial will be tearing down all barriers to domestic enterprise, including high taxes and regulations.
I’m highly aware that all of these connections of forces seem very complicated and even counterintuitive, to the point that economists themselves are often unwilling to think much about them. There are trade specialists and there are monetary specialists, but the two rarely overlap in academia as they do in the financial world, where this problem is well known.
There is nothing broken about free trade as such. There are tremendous breakages in the monetary systems used to conduct free trade. It has enabled governments to do terrible things to their people. Sadly, this has wrecked traditional U.S. manufacturing, and it threatens to overthrow the United States as a freedom-based prosperity beacon for the world
