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Trade Incentives and Whoppers: A Finger Exercise

Nick Rowe was looking for the role of money in the Heuristic Macro Model, which is often used to introduce students to Trade economics. The problem he discovered is that there is only a role for money if there is friction in the model, and therefore a two-household (or household-firm or firm-firm) model makes money if not superfluous, then at least a poor substitute to direct barter.

Following is a “finger exercise” for introductory economics the way (I think) it should be taught, using that heuristic model and the Whopper story that often is used at the start of Introduction to Economics.1

Telling a Whopper

The Whopper story basically has the eager student challenging talk about scarcity and optimal reource allocation by saying, “But I can go into Burger King and get a Whopper for $1 and I can keep ordering $1 Whoppers all night.” The general Professorial Counter runs “well, that wouldn’t really happen because you run out of money and/or they run out of supplies,” which is a missed opportunity.

First, relax all of the normal constraints. You have an unlimited cash availability, and the Burger King has unlimited supplies and is open 24/7. Both the workers and any other customers are nether going to be irritated by you buying a new Whopper every five or ten minutes nor start calling their friends/hitting social media to get others to see the “spectacle” (no external incentives to start or stop). Oh, and the $1 price includes any taxes.

All Hail Declining Marginal Utility

For the first few rounds, both parties will act in keeping with the premise. You get your second, third, fourth, and even fifth Whopper and have spent $5.

You also are now less hungry than when you bought the first Whopper. That first Whopper cost you $1–and you valued it at least that much, if not more (consumer surplus >=0). The second was almost as good as the first; still well worth its dollar. The third, fourth, and fifth aren’t being eaten to satisfy hunger pangs, but you enjoy them at the $1 price.

You always have the same choice: give a dollar, get a Whopper. But sooner or later,2 you will decide that keeping that next $1 in your pocket is worth more than eating another Whopper (consumer surplus<0).

On to the Model

Trans Pacific Partnership Bad for the Middle Class, but How Bad? UPDATED

What you don’t know can hurt you. I think that’s a clear lesson of some so-called trade agreements the United States has signed over the last 20 years, and illustrated further by the few that have been defeated, most notably the Multilateral Agreement on Investment, negotiated by the Organization for Economic Cooperation and Development from1995 to 1998, but then abandoned in the face of ever growing protests.

Haven’t heard of the Trans Pacific Partnership? That’s no surprise: while the negotiations are not really being conducted in secret (the Office of the US Trade Representative provides periodic updates here), the level of disclosure from the USTR office rarely ventures beyond bland statements like this:

On November 12, 2011, the Leaders of the nine Trans-Pacific Partnership Countries – Australia, Brunei Darussalam, Chile, Malaysia, New Zealand, Peru, Singapore, Vietnam, and the United States – announced the achievement of the broad outlines of an ambitious, 21st-century Trans-Pacific Partnership (TPP) agreement that will enhance trade and investment among the TPP partner countries, promote innovation, economic growth, and development, and support the creation and retention of jobs.

The USTR website continues by claiming that the agreement will be “increasing American exports, supporting American jobs.” This is all too similar to the Clinton administration’s reporting on NAFTA, which would point out all the gains from increased exports while omitting any mention of increased imports (Journal of Commerce, Nov. 18, 1994, via Nexis, subscription required) which quickly turned a small trade surplus with Mexico into a huge trade deficit. Recent evidence suggests this may already be happening with Korea (thanks to Daniel Becker in private correspondence).

How do we evaluate the TPP? We have to see it as having at least three major elements: a trade agreement, an investment agreement, and an intellectual property agreement.

From the trade agreement alone, we can conclude that it is a bad deal for the middle class. As I explained last year, the Stolper-Samuelson Theorem in economics tells us that more trade is actually bad for labor in this country, because by global standards, the U.S. is labor-scarce (low population density), meaning that we expect trade to lead to more intense competition in labor-intensive goods, putting downward pressure on wages. Alas, that isn’t the end of it.

There is a lot of controversy about the investment side of the agreement. As discussed here by Daniel Becker, the investment chapter was leaked and published by the Citizens Trade Campaign. Before I discuss the TPP investment provisions, a little context on investment agreements first.

According to the United Nations Conference on Trade and Development (UNCTAD),at the end of 2011 there were 3190 international investment agreements, of which 2860 were between two countries, usually known as bilateral investment treaties or BITs. Investment agreements can also be part of larger agreements, such as the investment chapter of NAFTA, the WTO’s Agreement on Trade-Related Investment Measures (TRIMS), and various regional trade agreements. Since the TRIMS agreement, in force since 1995, applies to all WTO members, it is a global benchmark; thus, people will refer to agreements with stronger provisions as “TRIMS+.”

The purpose of investment agreements is to protect foreign investors, which are by definition multinational corporations (MNCs). At the same time, they place no corresponding duties on investors, only on the host government. Most significantly, these agreements remove dispute settlement from the host country’s court system to binding arbitration in an outside body, most commonly the World Bank’s International Center for the Settlement of Investment Disputes (ICSID). As with domestic arbitration clauses, this removal from the courts favors the business interests involved. So the investment agreement element of the TPP will tend to be bad for host governments (the U.S. is host to more foreign investment than any other potential TPP country) and by extension the middle class.

But “how bad” is the question. This depends on what restrictions the agreement puts on governments. Originally, MNCs wanted to be protected against having their property nationalized (“expropriated”) by the host, but more recent agreements such as NAFTA’s investment chapter (Chapter 11; text here) have opened the way to defining “expropriation” in ways that include regulatory actions that may reduce the value of the investment, even if they are non-discriminatory among firms and taken in the public interest. This is why I say above that investment agreements are bad for the middle class, because it normally benefits from public interest regulation.

For these reasons, there is in fact significant pushback regarding the content of investment agreements. Three good sources for this are UNCTAD, the Vale Columbia Center on Sustainable International Investment, and the International Institute for Sustainable Development.

So what’s in the TPP investment chapter? As far as I can tell, nothing that isn’t already in NAFTA, other U.S. free trade agreements, or a U.S. bilateral investment treaty. The problem is, that’s bad enough. Under NAFTA, for example, Metalclad won a dispute against Mexico over a local government’s refusal to grant it a permit to open a hazardous waste facility, and was awarded $16.7 million. Ethyl Corporation successfully challenged a Canadian ban on the import of gasoline additive MMT, leading Canada to withdraw the ban and pay the company $13 million in compensation. To have unelected bodies that (in the words of Citizens Trade Campaign) “would not meet standards of transparency, consistency or due process common to TPP countries’ domestic legal systems” overturning democratically adopted laws or regulations is profoundly undemocratic.

At the same time, I think Becker reads a little too much into some of the language. He quotes section 12-6bis (Becker’s emphasis):

Notwithstanding Article 12.9.5(b) (Non-Conforming Measures, subsidies and grants carveout), each Party shall accord to investors of another Party, and to covered investments, non-discriminatory treatment with respect to measures it adopts or maintains relating to losses suffered by investments in its territory owing to armed conflict or civil strife.

 He goes on to speculate that this could give rise to compensation claims due to interpreting protests against the Keystone pipeline, or even strikes, as “civil strife.” However, the exact same language is in NAFTA’s investment chapter, and there have been no such claims in its entire history. Moreover, this is what we would expect since the language only pertains to government behavior (“it adopts”), not private behavior.

So, that’s two strikes against the agreement. The third strike is intellectual property, something Matt Yglesias caught over a year ago. As I analyzed then, the TPP “would ban government health services from negotiating prices with pharmaceutical companies.” Given that many countries already do this and the U.S. ought to do it to help rein in health costs, if these provisions stay in the final agreement it will be a very bad development.

Hooray for baseball season, but that’s three strikes against the TPP. This is a bad deal that will put further downward pressure on real wages which have gone 40 years since reaching their peak, that will undermine governments’ ability to regulate, and will strengthen a small group of pharmaceutical, software, entertainment, and publishing companies at the expense of the rest of us.

Update: Citizens Trade Campaign reports that  the U.S. has listed numerous target policies among its TPP negotiating partners, including everything from health care policies in New Zealand to Malaysia’s ban on imports of pork and alcohol, both of which are forbidden to the Muslims who make up the majority of the population.

Original article cross-posted at Middle Class Political Economist.

China’s Industrial Policy vs. US Random Behavior…Firedoglake


Firedoglake presents a well written piece on US and Chinese trade policy:

China’s Industrial Policy vs. US Random Behavior

The U.S. China Economic and Security Review Commission has issued its annual report {giant .pdf}. Robert Borosage of the Campaign for America’s Future hosted a conference call for the Co-Chair of the Commission, Carolyn Bartholomew, and Clyde Presotwitz of the Economic Strategy Institute, who was U.S. Trade Representative under Reagan. The call offered these experts an opportunity to talk about China’s industrial policy.

Prestowitz said something that focused the entire issue for me. He pointed out that labor is not a significant factor in chip manufacture. Why then are so many chip manufacturing facilities located in China? He says it’s because the Chinese wanted these as part of their industrial policy, so they seized the land, built the infrastructure, provided low-cost loans, granted energy and water subsidies, trained a work force, and gave the manufacturers tax breaks. Now they offer more subtle incentives, funding for research and development, refunds of the value added tax and space in industrial parks. As Prestowitz said, the plants are there for financial reasons.

This is Chinese policy. They want to grow their economy by attracting foreign capital and foreign technology. They intend to maintain state control over crucial industries.

China’s overall industrial policy … is characterized by three main parts: (1) the creation of an export-led and foreign investment-led manufacturing sector; (2) an emphasis on fostering the growth of industries such as high-technology products that add maximum value to the Chinese economy; and (3) the creation of jobs sufficient to reliably employ the Chinese workforce, thereby allowing the Chinese Communist Party to maintain control.

Many Chinese subsidies violate the requirements of the World Trade Organization, and the US has sought sanctions, but the Commission says that the WTO rules are meant to deal with narrow issues, not the broad national practices of China. The WTO rules require consultations as well as litigation, and even after a victory, they are able to delay. By the time the US and Canada won a WTO ruling barring favoritism in manufacture of auto parts, many manufacturers had moved production to China, so those jobs were lost.

Don’t think that we will be able to compete with our high tech products. China uses industrial policy to achieve technology transfer. Here’s an example from the call. China had not mastered several crucial issues in the manufacture of jet propulsion blades.

Several thoughts come to mind:

1. Appeals to the notion that command economies fail is not re-assuring at best and grossly misleading at worst. Since 1992 Chinese leaders took a different turn from our old notions of ‘command’ economies of cold-war stories.

2. China is wrenching a pre-industrial economy into the 21st century, at a speed that is breathtaking. The US is struggling with shedding 20th century notions of what we think we are…

3. There is no reason to think that ‘green shoots’ industries are assured in the US as a jobs policy. Such industry building is already occurring in China (and Germany).

4. We insist China re-direct its drive to a domestic consumer orientation, and talk about how the government deliberately keeps the economy as an export platform, but if many times more money is made currently exporting due to high prices for exports than if sold domestically, would you change direction in a hurry? Who is getting the bargain overall? Many Chinese businesses are still learning new standards.

5. Chinese leaders are taking a big gamble. And Chinese society is taking a big hit overall, with great disruption in people’s lives. The US is also experiencing great change…slower perhaps, but we haven’t really accepted the fact nor figured out that we have change to no matter what.

6. Some of the unease on right and left is due to some sort of view of this change. Is it along the lines we are used to, and/or simply myopic?

Free, freer, and trade…what flavor cool aid?


Trade policy and actual trade are related but different matters. This post from last year caught my eye, partly due to the discussion on tires from China. While any blog post has to be simplified due to the nature of a short post and comment format, such discussion at times seems amazingly simplified beyond recognition of what trade entails…

Cafe Hyek Don Boudreau offers a thought on tariffs, but more broadly on what is free about trade. I assume he knows something of the rules of the WTO and trade restrictions imposed by these agreements.

So, how does one deal with claims of a theoretical ‘free’ trade versus what?, ‘restricted’, ‘constricted’, ‘protectionist’ trade? Do multi-national companies not have rules? Trade always has rules.

Is there a difference between ‘free’ and ‘freer’? ‘Free’ reminds me of lunch, and who picks up the tab. And even that simple example becomes rather convoluted. Is it even a useful term, or simply propaganda?

Persons who, fancying themselves observant realists, insist that “free trade doesn’t exist” have their visions and brains distorted by political boundaries.

It is quite true that national governments almost universally erect barriers that hinder their citizens’ freedom to trade with citizens ruled by other national governments. Some governments erect higher barriers than do other governments. But, indeed, it’s rare to find a national government that doesn’t indulge the greed of politically powerful interest groups, as well as the prejudice and economic ignorance of much of its population, with trade barriers.

And yet free trade is ubiquitous. Freedom to trade generally reigns within political borders. For example, the 50 U.S. states are united on one very large and very successful free-trade zone.

Karol, Thomas, and I live in Burke, Virginia. We are free to trade not only with cabbage growers in Culpeper, Virginia, but with cabbage growers in California. We trade freely with residents of any state, from the Atlantic to the Pacific, from the U.S. border with Canada to the U.S. border with Mexico. That is, whatever taxes and burdens Uncle Sam might impose (however wisely or foolishly) on economic activity within the U.S., those burdens are nation-wide. No special space-specific burdens are placed on my and my family’s ability to trade with other Americans; no extra tariff or restriction applies to our exchanges with an Alaskan or with a Floridian simply because we do not live in those states.

Practically speaking, therefore, there is free trade throughout the United States. My family and I routinely buy wine from California and Oregon, oranges and lemons from Florida, computer software from Washington state, maple syrup from Vermont, peaches from South Carolina, television newscasts from New York and Atlanta, lumber from Alabama, spicy sauces from Louisiana, crabs from Maryland. The list is long.

On a random note, I am also reminded of Orrin Hatch’s amendment to the Baucus health bill that excludes any state beginning with the letter U from the excise tax on fancy plans. It seems government can be merely a part of a business plan. Do we ever approximate a ‘free’ market, or are there more usefull approaches and language? (Before the terms are co-opted, that is)

Update: I was reminded in comments that I should have included these links to aid discussion and definition from previous posts. There were more than I remembered.
See these posts:
and directly this one on buy America and the question of how does one do that anymore with vertical specialization, which is not a sexy title??
Vertical specialization
Trade policy for mid-terms 2010
WTO rulings
American jobs are not the same as American companies
Tariffs not for labor, but good for banks and pharma

Silliness from Time Magazine

Via Brad DeLong, I see Time magazine has identified the “25 people to ‘blame’ for the financial crisis.” [my sarcastic quotes on blame; Time appears to be serious]

Amazingly, none of TWX’s (mostly former) top management—who pushed LBOs in the 1980s and Internet bubbles in the 1990s—makes on the list.

More amazingly, Lew Ranieri is on the list, while David Malpass is not.

Also making the list: Wen Jiabao, because the Chinese government “supplied the U.S. with an unprecedented amount of credit over the past eight years.” Let’s leave aside whether that credit wasn’t primarily to support Chinese exports (see, e.g., Brad Setser) and ask the obvious question:

Given that an external economy is providing you with (realtively) “easy” credit, what does that imply your Monetary Policy should be?

UPDATE: DeLong takes M2 to the next step, with predictable results.

What Policies Cause High Food Prices?

by Tom Bozzo

Over at his FT blog, Willem Buiter sensibly calls for an end to biofuel subsidies and mandated levels of biofuel use, and suggests that the money be spent on environmentally friendlier renewable energy research instead. He delivers a great bit of wonk snark after reciting various biofuel targets, then saying:

All this will have to go. It is part of a process called ‘learning’. More governments and official institutions should try it.

Buiter does deliver a “Paging Dr. Baker” moment in adding a more general call for agriculture liberalization in the rich world to the pitch:

End all policies to subsidise or protect agriculture as well as all policies to restrict agricultural production through set-asides (paying farmers not to grow stuff) and other idiocies.

Do subsidies and restrictions on production both affect price in the same direction? (Not all set-asides are “idiocies” either, notably those on the margins of waterways.)

Agriculture subsidies is one of those areas that tends to unite economists against politicians; the elimination of them seems to offer benefits across the political spectrum — a little expansion of the “free” market for the right, a little reduction in corporate welfare for the left, say. Much as I might be receptive to both under the right circumstances, this is not enough reason to pursue the near-total liberalization of ag markets.

It can be argued that there are goods where we should be willing to trade some efficiency of provision for reliability and/or affordability, which favors the intervention of the visible hand; I’d argue that food staples are among them. To the extent this is the policy aim, then economists should be more aware than most that there’s no theoretical reason to expect free markets to provide them reliably or affordably for all, or even all important, values of “reliable” and “affordable.” It’s part of a process called ‘learning,’ natch!

It’s necessary to actually make the case that subsidies aren’t warranted, or at least that the effects of existing as opposed to ideal subsidy programs in total are worse than whatever could be reasonably expected under liberalization, and that’s a tough one to make categorically. Even Buiter is willing to countenance subsidies for production of staple crops in poor and underdeveloped countries. The question is whether that should be the limit of them, and there isn’t a simple answer.

You, Me and China make Three, part II

Back on April 20th I presented my introduction to a book by Will Hutton: The Writing on the Wall.

First, the book is 334 pages. The list of references 39 pages. There is a lot I could cover. But this is the Angry Bear which I view as being about US(of A). It is this part of Mr. Hutton’s writing that caught my attention. As much as I am interested in China’s life influencing ours, I am more interested in understanding what happened to us.

I presented his concept of values coming out of the Enlightenment as being the basis for what the USA (as a stand-in for referencing Western processes) had achieved and what China has to move more toward. It is not that China must model us exactly, but that it’s current structure is limited. It needs to be more democratic based on values from the Enlightenment. Mr. Hutton presents the democratic Enlightenment concepts as four: “accountability; representativenesss; respect for the rule of law; and the capacity, through free speech, for debate, exchange, and interaction.”

As much as the book looks at China and how it does not meet these concepts sufficiently to allow it to grow such that it will meet the needs of it’s people, I want to focus on his view of us. In this case, the USA specifically. I believe he points to the USA because it was the leader in the world, as he presents the case, for manifesting the democratic Enlightenment concepts. I believe, his view of the Enlightenment is in agreement with Wiki’s presentation:
The Enlightenment is held to be the source of critical ideas, such as the centrality of freedom, democracy and reason as primary values of society. This view argues that the establishment of a contractual basis of rights would lead to the market mechanism and capitalism, the scientific method, religious tolerance, and the organization of states into self-governing republics through democratic means. In this view, the tendency of the philosophes in particular to apply rationality to every problem is considered the essential change.

The discussion of Enlightenment begins with free trade and that the USA is “not a natural candidate to support an open world trading and financial system…” We benefit, but we are “ambivalent”. “An open trading system tempts every country to pursue strategic trade policies that are much more mercantilist in their rationale…All genuflect to the rules-based openness of the trading system as regulated by the World Trade Organization. But they believe in it more because it is the means to secure their strategic, mercantilist aims than because of any desire to create gains in which everyone would share.”

Mr Hutton is pro free trade. He makes a case that America’s growth was less do to protectionist positions taken early on and more the result of a growing population with access to free land. Space and ambition were the key. As the coasts were joined, we moved to substitute foreign trade for the loss of our frontier. “The aim was not to create an overseas empire but to export the American idea…” unlike the European expansionism. And as expected, he flatly states that free-trade is not the cause of the condition we find ourself in currently. Though he thinks both sides, one portrayed by Lou Dobbs and the other by Friedman need to be “cooled down”. They are both “vastly exaggerated”.

The source of our mis-thinking is found in how we view liberty. “Liberty, in the American narrative, is the sun under which everything flourishes. Liberty permits individuals’ hard work, courage, and application to produce wealth and happiness. Government should not get in the way…Liberty and the American dream are linked…The great conservative counterrevolution …has been grounded in its brilliant capacity to exploit these cultural icons to support its own cause.”

But this is an error of our self perception. It is more correct to view liberty as a goal within “…a highly sophisticated Enlightenment political infrastructure.” Look at the United States…and you will see an economy and society characterized by pluralism, diversity, and investment in individual capabilities.”

He bolsters this view by presenting Alexis de Tocqueville’s work about America. “Public engagement and never-ending argument leavened what otherwise might have been a culture of egoism…and transmuted it into a culture in which egalitarianism and individualism enriched each other. Self-interest was not only a matter of bettering oneself; it was also a mattter of ensureing that there would be a vigorous public life and opportunity for others…The same impulse–wanting the best for oneself and for others— prompts much of American civic activism.” Our liberty “always included conceptual egalitarianism, which provided the tension between the ambition and appetites of the propertied rich and their accountability to society.” “This is not the egalitarianism of income or opportunity; rather, it is the equality of self-esteem, self worth and possibility…there is no obstacle of title, birth, accent or social rank…”

It make you feel proud, does it not? Unfortunately he notes we are losing it through “neglect and willful disparagement of their importance, in particular by American conservatives.” We are losing the “fecund interaction” of markets and the price mechanism with the Enlightenment infrastructure and resultant culture. Mr Hutton states it was our genius.

This is where I will go next. What has changed. I believe it was my very first post via an invite from Cactus (he posted it for me) that I made the statement that we had changed. We no longer were making money as we had. We no longer were focused on what we use to. It was more than just tax rates that changed in the Reagan years.

Free trade, Republican’s no like (along with others)

From a poll by the WSJ/NBC reported in October, 2007 comes:

While 60% of respondents said they want the next president and Congress to continue cutting taxes, 32% said it’s time for some tax increases on the wealthiest Americans to reduce the budget deficit and pay for health care.

Can you imagine? They have started to figure out that their pocketbooks matter.

In a December 1999 Wall Street Journal-NBC poll, 37% of Republicans said trade deals had helped the U.S. and 31% said they had hurt, while 26% said they made no difference.
The new poll asked a broader but similar question. It posed two statements to voters. The first was, “Foreign trade has been good for the U.S. economy, because demand for U.S. products abroad has resulted in economic growth and jobs for Americans here at home and provided more choices for consumers.”
The second was, “Foreign trade has been bad for the U.S. economy, because imports from abroad have reduced demand for American-made goods, cost jobs here at home, and produced potentially unsafe products.”
Asked which statement came closer to their own view, 59% of Republicans named the second statement, while 32% pointed to the first.

I don’t think these questions are the best framed. They seem kind of load in that it states “foreign trade” instead of Free Trade, or NAFTA. But, the qualifications I’m sure are what the people responded to.

From Fortune Magazine, January, 2008:
This is a poll of the general public.

With much of the country worried about the state of the economy, many (67%) Americans say they now closely follow news about US trade policy with foreign countries. Americans see the current trade policy as a reason for the economic woes the US is currently facing.
Almost 7 in 10 (68%) Americans believe international trade benefits other countries more than it benefits the United States.
International trade is seen as having a largely negative impact on American workers (78% negative) and the Untied States as a whole (63%).
Eight in ten Americans (79%) feel the US Government has not done enough to help workers who have lost their jobs to increased foreign competition. A majority of Americans would support the following proposed policies aimed at helping workers who have lost their jobs to foreign competition and outsourcing:

Policies with the greatest amount of support include: providing special training programs (90% support), providing tax incentives for companies to relocate to areas where workers have lost their jobs because of foreign imports (84%), allowing imports only from countries that ban child labor (82% support), and allowing imports from countries that meet certain clean air and water standards (78% support).
About two-thirds (64%) of Americans are willing to pay more to keep down foreign competition.

There is a disconnect in the above responses. 90% want training, but in another question about boosting the economy, 41% opposed extending unemployment benefits. Though 67% support public works projects. This shows me that the public has not made the connections between our current trade environment and the economy. But, how about that 64% would pay more to keep down foreign competition. Can you get a more patriotic response? I don’t think the Republican’s had this kind of patriotism in mind.

When it comes to China:
Where a product is manufactured does not impact Americans’ purchasing decisions except when that product is made in China.
Nearly three-in-five (57%) Americans are less likely to buy a product if it is made in China.
When products are manufactured in other areas, such as Eastern Europe (57%), Western Europe (55%), Canada (53%), India (52%), Africa (51%), Mexico (48%), Japan (47%), and South Korea (46%) nearly a majority say it doesn’t matter.

I can ‘t imagine that people are specifically boycotting Chinese made goods. Walmart et al would be in trouble. I think this is more of a gut response.

Over all, the public is waking up and seems more sophisticated in their understanding than I believe the Beltway crowd is willing to accept. But, I believe some work needs to be done so that they connect the dots of the US economy as a function of trade policy. I would like to see a de-emphasis of the fear and a disconnecting of foreign trade equals free trade policy. I really don’t believe anyone is against trading, they just have a major problem with the current rules and the referees.

Trade, Sovereign Wealth Funds, An Awkard Corner

In remarks to the U.S.-China Economic and Security Review Commission, Professor Morici poses some troublesome issues concerning Sovereign Wealth Funds:

What Is a Sovereign Wealth Fund?

In purest form, a sovereign wealth fund is a pool of resources, owned and/or controlled by a government, invested in public or private assets, including debt instruments, equities and direct investments in property.

Clearly, the China Investment Corporation (CIC) is an example of such an entity, but so too are national and subnational government interests in European industrial companies. In turn, the investments of CIC in Blackstone and European companies with part government ownership in U.S. companies would be examples of sovereign wealth investments in the United States.

Also, the California Pubic Employees’ Retirement System (Calpers), which invests widely in equities, and similar foreign national and subnational government retirement systems around the world are sovereign investment funds. Those have holdings in U.S. companies.

My point is identifying sovereign wealth is usually easy, but identifying sovereign investments that should concern U.S. policymakers is difficult. Clearly, investments by the national government of China and its state controlled companies raise issues, but generalizing policy from those concerns is a tangle of string…pull one piece and you get more string than you anticipated.

U.S. and Foreign Government Policies

As a common law country and culture, much of U.S. policy must be deduced from piecemeal practice and by generalizing from fragments of legislation and policy directives. For example, the U.S. social security fund is not permitted to make private investments, in part, because Americans don’t want the U.S. government engaged in allocating capital and influencing business decisions in the U.S. private enterprise system. However, U.S. state governments are permitted to do as they please…Calpers is a significant example, and it has not always been silent about the management of U.S. companies. The fact is, with its voting powers, it can’t always be silent.

In contrast, in China and Europe, national and subnational governments make investments expressly for the purposes of promoting industries and affecting competitive international outcomes among businesses. Often, earning a decent return on capital is not a motivation; rather, the objective is creating employment or establishing a national presence in an industry that the market would not otherwise support.

Sometimes the results have strong and lasting effects on the U.S. economy through international commerce and competition. For example, Airbus is a strong competitor today, but McDonnell Douglas no longer exists as an independent entity.
Sovereign wealth fund investments could have the capacity to influence important U.S. investment decisions…the choice of location of major production facilities in the United States or abroad; similarly, the location of R&D facilities; and the structure of investments by U.S. firms that may compete with companies domiciled in the home countries of sovereign wealth funds.

For example, how would a major CIC investment in a major U.S. automaker affect the location of facilities to produce small cars that could be made and exported from China? Or the location of an auto design facility? Chinese inward foreign investment policies have already had such effects. Given the size of Chinese sovereign holdings of U.S. dollars seeking investment opportunities, those issues will quickly move from the hypothetical to tangible.

The influence of sovereign wealth on the U.S. economy through the political process is another issue that will soon emerge. New York banks are busy selling significant minority interests to sovereign wealth funds. The employees of those banks are significant sources of campaign contributions for both political parties, because those banks have large numbers of employees that may contribute the maximum amounts permitted under campaign financing laws.

Through the Committee on Foreign Investment in the United States (CFIUS), the U.S. government has the means to review and screen sovereign investments; however, the recent rush to invest in U.S. banks by sovereign funds and the CFIUS response provides yet further indication that that agency is fairly passive. It seems great public controversy and Congressional out cry are necessary, as was the case in the proposed Dubai Ports investments in the United States, to spring CFIUS into meaningful action.

Nevertheless, with the massive overseas holdings of dollars created by U.S. trade deficits and the intervention in currency markets by foreign central banks, investments by sovereign funds in the U.S. economy will present troubling issues. After all, why would the U.S. government permit a foreign sovereign fund to invest in U.S. companies and wield influence when it does not permit the U.S. social security fund to do the same?

Yet, with all the dollars the United States has chosen to print and leave abroad, it can hardly deny completely sovereign investments in the United States.

Shaping U.S. Policy

Clearly, some sovereign investments are more troubling or benign than others, and I believe the answers to two sets of questions should help in identifying investments that should be the focus of concern and perhaps screened out.

First, does the sovereign entity share U.S. values about the role of markets and state intervention in managing its national economy and the global economy?

In China for example, sovereign investments have the purpose of creating a socialist market economy, with specific industrialization objectives. Investments by these Chinese entities in U.S. companies pose much greater issues than, for example, investments by Canadian provincial government pension funds.

U.S. experience with large, direct sovereign investments, beyond pension funds, is limited. Investments by sovereign entities whose governments have announced specific goals to cultivate competitors to U.S. enterprises raise much more poignant issues than those whose purposes are to merely earn a profit to finance pensions.
Second, does the sovereign entity share U.S. political values or does it see itself in competition with the West?

China remains an autocratic state. The United States offers to the world democracy and markets, while China offers order and prosperity as justification for shunning democracy and controlling markets.

Large investments by such a government in the largest U.S. industrial financial institutions would create important concerns regarding the independent decision making of U.S. banks. The potential to compromise the allocation of large U.S. investments and the enduring independence of U.S. political figures should not be denied.

Investments could be denied in the United States by U.S. corporations or moved abroad to appease foreign minority interests, and U.S. banks could choose to allocate loans away from U.S. companies that compete with foreign companies favored by sovereign investors.

The United States has campaign finance laws, because Americans believe campaign money can influence legislation and public policy; hence, major holdings by sovereign funds in U.S. banks that are now emerging should be a focus of attention. It is hard to imagine that U.S. executives will not be sensitive to the political concerns of large shareholders when they choose candidates to support for public office.

An Awkward Corner

The United States is in a box.

By running up large trade deficits and tolerating foreign government intervention in currency markets, the United States has contributed to large dollar overhang abroad…much of it in the hands of sovereign funds. Investments by those funds in Treasury securities helped keep long-term interest rates artificially low, and helped facilitate the real estate bubble and subprime crisis now besetting U.S. banks.

U.S. banks, owing to questionable lending practices, need massive infusions of capital, which are difficult to find solely from domestic or private sources. We will likely hear from bankers in that foreign sovereign capital will not have any influences different from those of U.S. shareholders. However, we need ask why should foreign sovereign shareholders behave differently in the United States than they do at home? The Chinese government is not a neutral investor in China, and it should not be expect to be a neutral investor here.

Similarly, if the U.S. government wishes not to continue to have growing pressure from sovereign funds to invest in the United States, the U.S. government must finally address the massive U.S. trade deficit and foreign government intervention in currency markets that help finance sovereign investments. After all that is how these sovereign funds are amassing so many dollars to invest in the United States.

Trade and currency manipulation are at the center of our problem. Currency manipulation exacerbates our trade dilemma; it is not the root cause. The last time we had a trade surplus was in ’75 or ’76. In 1994, Clinton signed NAFTA; in 2001, China, again on Clinton’s watch and with Congress and Clinton’s strong support, China entered the WTO. The dramatic rise in the trade deficit begins around ’96.

Clinton predicted that China’s WTO entry would be a win-win proposition, creating thousand of new American jobs and confidently predicting that the already huge deficit with China would fall.

Of course, as I pointed out in an earlier piece, some economists rarely worry about the trade deficit: Mankiw is more concerned with savings; Krugman, with official inflows. Neither is willing to look at trade. Mankiw is the godchild of the right; Krugman, of the left. And, of course, no one talks about NAFTA anymore.

Morici is right: We are now in an awkward corner.