A Dangerous Crack in Economic Theory:

Why growth is slow and world trade is not always win-win.

robert-ayresAs Larry Summers and many other economists have lamented (and even Donald Trump has said in several campaign speeches), it is true that the global recovery from the financial collapse of 2008 has been extraordinarily slow. Explanations vary widely. My own explanation up to now has focused on the shift from growth based on the exploitation of natural resources (especially oil and gas) to growth based on ICT technologies incubated in Silicon Valley but employing very few people. Another explanation centers on the working class reaction (in the US) to globalization and “free trade deals” favoring the export of manufacturing jobs to low wage countries.

A related explanation centers on the rise of the financial industry, along with its preference for moving money into the creation of asset bubbles rather than investment in small businesses in the “real” economy. A cousin of this explanation is that the money available for investment by the richest few is increasingly devoted to increasing the power of money in the political process. There is probably some truth in each of them.

The end of the era of increasing debt, with near zero interest rates is coming very soon. When it does, the cost of those deficits will explode, and the pressures for a major revolution in economics, capitalism and democracy, will also explode.

The global minotaur.

I want to call attention here to the work of a contrarian economist who achieved global fame during a few short weeks in 2015, during the negotiations for yet another Greek bailout under the auspices of a socialist government. At that time he was the Greek Minister of Finance. His sin was to speak painful economic truths while also being smarter and more knowledgeable, but less polite, than his counterparts among the EU financial elite. The Greek economist I am talking about is Yanis Varoufakis, author of  The Global Minotaur (Varoufakis 2011). I will try to explain briefly the metaphor hidden in that title and why it is relevant today.  

First the legend: the Minotaur was a monster, half bull, half man, born to Pasiphae, the queen of King Minos of Crete and fathered by a bull, sent by the boss god, Zeus.) The Minotaur was kept in a “labyrinth” under the palace, from which nobody ever escaped until the hero, Theseus, (another legend) came along later. Theseus invented bull dancing and killed the Minotaur– but that is another story.

Queen Pasiphae also had a son, Androgeus, who went to the Pan-Athenaic Games in Athens and won several events. But during the marathon race he was killed by followers of rival competitors (they played rough in those days), who claimed that he had been gored by the same bull that had impregnated his mother. King Minos of Crete – the military super-power of that time — did not buy this story. He blamed Athens for the death of his son. In compensation he demanded tribute: seven boys and girls must be sent from every city in Greece, every nine years to feed the hungry Minotaur.

Varoufakis sees the US as a military superpower, comparable to Crete in Minos’ day. He sees the US as receiving “tribute” from all its trading partners. The tribute, in this metaphor, is the special position of the US dollar as the world’s reserve currency. Almost all world trade (except within Europe) takes place in dollars. This results in large inflows of dollars (e.g. “petrodollars) to US “money center” banks. They subsequently lend it to international borrowers, also in dollars. This puts all the risk of changes in dollar-exchange rates (usually due to inflation) on the borrower.  

Greece suffered such a disaster when rampant inflation, during the post-WW II period of political instability weakened the drachma drastically. This led to a huge increase in the number of drachmas needed to buy the dollars needed to pay interest on the Greek debt, which was in dollars. It was the equivalent of a drastic increase in the magnitude of the debt.

Much the same story can be told about Latin American debt (especially Argentina, Brazil, and Mexico) in the 1970s, and several SE Asia countries in the ‘90s. In every case the local currency collapse resulted in a large increase in the cost of debt service. In each case the IMF has stepped in with “bailouts” that protected the banks but cut social services, increased taxes and left the people poorer.


The problem of twin deficits.

Varafoukis points out that the US has twin, chronic financial deficits (budgetary and trade) that are both being financed by debt. The US budgetary deficit in the 196o’s was due to costs of the Viet Nam war and the failure to pay for it by raising taxes. (The political slogan at the time was “guns and butter”). It has ballooned due to increased “cold war” military spending starting with President Carter and accelerated by Reagan tax cuts, although there was a brief surplus during the Clinton years (1990’s). This deficit is financed by domestic debt, but the cost is kept tolerable by the Federal Reserve Bank, which sets the interest rates based on domestic economic data: core inflation and unemployment.

The US had a large trade surplus in the 1950s and 1960s, but it shrank naturally as countries in Europe and Japan rebuilt and modernized their industrial bases, helped by the Marshall Plan and by progressive reduction in tariffs. The US trade deficit began in the late ‘60s when the US ceased being the major oil exporter (as Middle East production increased) and became an oil importer for the first time.

The deficit ‘took off’ after the “Oil Crisis” of  1972-73, triggered by the Arab-Israel conflict and the Arab embargo. The gold-based post-WW II monetary system, supervised by the IMF, had kept international exchange rates comparatively steady since 1950. But that old system allowed countries with trade surpluses (notably Germany, France and Switzerland) to demand US gold instead of accepting paper dollars. Nixon ended that system to stop the outflow of US gold at very low fixed prices. After 1971 gold became a commodity with a much higher (variable) market price.

But since the war-related Viet-Nam inflation in the 1970s was stopped by the Fed (under Paul Volker) in 1983, most countries outside of Europe have kept their financial reserves in dollar-based bonds. The US international trade deficit is partly financed by the rest of the world, especially Saudi Arabia, Kuwait and the Gulf States, Japan and China. Those countries send oil or manufactured products to the US, and accept US Treasury bonds in exchange. But the interest rate paid on those bonds is determined by the US Federal Reserve Bank (FRB), not by a competitive free market. This fact is part of what Yanis Varafoukis regards as “tribute”.


The Accounting Identity.

In standard economic theory (which assumes that free markets actually work) a country cannot have both a continuing domestic deficit and a trade deficit – actually an international payments deficit — at the same time. This is presented as an accounting identity (savings minus investment equals exports minus imports). It was especially cited by Paul Krugman back in 1995 (Krugman 1995). Krugman, a Nobel laureat and strong advocate of free trade, attacked critics of trade deals that allowed manufacturers to export capital to build factories in low wage countries. Krugman insisted in that article that “no country can simultaneously be a capital exporter and have a deficit in its current trade account.” He was quite rude to other writers who didn’t seem to understand this law of economics. Krugman also insisted in 1995 that the value of a country’s currency must decline until the monetary flows balance.

By a curious coincidence the Euro was created shortly after Krugman wrote that article. And, despite Krugman’s assurance, things didn’t happen as he said they would. The US has had (Varafoukis would say “enjoyed”) a growing twin deficit (i.e. the Minotaur) since the 1970s. The twin deficits (budget and trade) have been “fed” by importing real goods (oil, electronics, cars), “paid for” by providing military security for the exporter’s trade and a safe haven for their surplus funds.  In the 70s and 80s it was Japan that exported its manufactured goods (watches, cameras, motorcycles and cars) to the US in exchange for US security guarantees and promissory notes. In the 90’s it was increasingly China that provided the goods and bought the bonds. (However, China does not want – or appreciate —  US-based military protection. This is one of the problems looming today).

The world’s largest economy, whose currency is used for virtually all international trade, is able to sustain its twin deficits indefinitely because the “accounting identity” turns out to be false. The identity would be true for a society (or a world) where the money supply is constant and fixed (as economic theory assumed at the time). Many economists still assume that the identity is valid because it is what they learned in grad school.

But the identity does not hold in the real world because the money supply is not fixed.

The global money supply was “un-fixed” in 1971 when Nixon stopped selling gold at a low fixed price and the IMF lost its role as the supervisor of global money. Since then, contrary to Krugman’s assertion, money has been created by unregulated bank lending. Because the identity doesn’t hold, it is possible for a country to have twin deficits (or twin surpluses). And thus, because its currency is still regarded as a safe haven in uncertain times, the US is still able to consume imported goods with borrowed money while interest rates remain near zero. By some estimates, the growing US debt has absorbed 80 percent of the world’s savings, since 1970. Yanis Varoufakis has described this phenomenon as “The Global Minotaur”, because it uses the world’s savings to pay for US consumption rather than being invested productively. Thus, he argues (and I agree) that the twin US deficits constitute a strong headwind against global economic growth, even while the US itself is still growing. I wonder why this contradiction elicits so little attention from mainstream economists.


Twin surpluses?  Supposedly impossible.

Just as no country can supposedly have a continuing trade and budgetary deficit for a long time, the same accounting identity (Krugman 1995) says that no country can have a trade surplus and a budget surplus at the same time. Yet Germany has been doing exactly this since the 1990s. Its currency should have gotten stronger (like Japan’s), discouraging exports and encouraging imports and increasing domestic consumption. But this was not allowed, thanks to the Maastricht treaty that created the common currency (the Euro).

Instead, the German trade and budget surpluses became European surpluses, for some years after the creation of the Euro. The German double surplus made the Euro as a whole quite strong compared to other currencies, until very recently. The strong Euro discouraged exports and encouraged imports, for the whole EU. Meanwhile, a significant portion of global savings – especially from southern Europe, but also from Africa and elsewhere has moved into German  government bonds, instead of investing in new ideas, or expansion. The reason for slow growth in Europe is clear: Germany absorbs money from its neighbors as trade surplus within the EU, while offering no financial recycling mechanism for them. The result is to increase the debts of those countries without financing compensating economic growth.


And so, low growth.

This has resulted in economic stagnation for Europe, and zero (or negative) financial returns on savings for everybody, including the Germans themselves. The de-industrialized Greeks will suffer the most and soonest (as Yanis Varafoukis correctly predicted several years ago). This is because Greek debts have now accumulated to the point where they are quite literally unpayable. (Even the IMF has recently acknowledged this fact.)

But the Germans (at least the ones in power) are unwilling to acknowledge their central causal role in the situation. They remain adamant believers in the comforting myth that balanced budgets and austerity and will invariably yield growth, even for countries lacking a strong industrial base. They insist that all sovereign debts must be repaid, on moral grounds, regardless of the cost to the population (and regardless of the fact that in 1953 their own Hitler-era debts (mostly to the US) were nullified.

The Eurozone, as currently structured (i.e. without a currency recycling system), cannot survive. Britain has gone. Greece will have to follow unless Minister of Finance Schauble has an unlikely epiphany. Portugal, Spain and others on the periphery will follow after. But France, the spoiler, might be the first one to bring down this house of cards.


The Minotaur is not all bad.  

I should add that there are two sides to this story of twin deficits, but less so as regards German twin surpluses. Of course, the “reserve” status of the US dollar has helped US consumers by keeping US interest rates lower than they should be. But it also provides liquidity (and safety) for trade. Since 1971 or so the US has unquestionably been consuming—some would say over-consuming — goods bought with borrowed money. On the other hand, from 1947 to 1970 the shoe was on the other foot: It was the US that paid most of the military costs of defense against Soviet-communist aggression (Korea, Hungary, Prague), and exported both petroleum and financial capital for the benefit of postwar Europe and Japan.

Moreover, during the whole of the post WW II period, the US has pressed for free (i.e. low tariff) trade, based on the theory that “protectionism” is bad for everybody and that trade barriers were the primary cause of the Great Depression in the 1930s. Consumers have enjoyed lower prices. But large numbers of manufacturing jobs have moved out of the US, especially to Japan, South Korea and China. This opening of markets has unquestionably been a greater boon for those countries, especially China and the “Asian Tigers”. The loss of manufacturing jobs is partly, if not largely, responsible for the fact that real wages in the US have not increased since 1973 even though US productivity has soared.

In contrast, Europe was much slower than the US to open its doors to Asian imports, by means of non-tariff barriers. I remember when Asian imports of specific products (say bicycles or watches) had to be processed through health and safety checks located in a remote inland city, nowhere near a major port. Partly by utilizing such devices, France and Germany have kept most of their manufacturing jobs within their borders or in neighboring countries in the EU. This is why Germany, in particular, still exports industrial chemicals, electrical goods, automobiles, trucks, and other heavy machinery. Yet Germany has kept Europe (and itself) from growing economically, whereas the US continues to grow, albeit at a slow rate compared to the past.

The security side of the story is also important. The US paid almost all the costs of defending South Korea from invasion by the north in 1951-52, in both dollars and casualties. No peace treaty was ever signed, only a cease-fire. Since then the US has contributed significantly to South Korean recovery and 30,000 US soldiers have been permanently stationed in South Korea, at significant net cost to the US, along the demilitarized zone (DMZ). It is the presence of those troops that constitutes the “provocation” to the North Korean leadership and that—in their (blinkered) eyes —  justifies a continued nuclear buildup.


The next pressure point?

Since the Viet Nam war ended, the US navy has provided a security umbrella for sea-borne international trade. This service has undoubtedly been beneficial for Japan, South Korea, Southeast Asia and the countries of the Persian Gulf. It has been of considerable monetary value to both oil exporters and importers, who are quite vulnerable to bandits and pirates – of which there are many in those seas. The oil from the Middle East mostly moves safely to Europe, India and Japan via tankers. That keeps insurance rates down and consequently keeps fuel prices lower than they would otherwise be.

Actually, this global naval “security service” has also, up to now, also been beneficial to China. China gets less than half of its oil from domestic sources, including offshore fields but 94% of the rest comes through the Straits of Malacca while 77.5% also passes through or near the Straits of Hormuz at the mouth of the Persian Gulf. The latter area is now comparatively safe for tankers but the former is a pirate’s paradise, only 54 kilometers wide at the narrowest places, but 1500 km long. It is shared by three countries, Malaysia, Indonesia and Singapore. The US navy patrols the straits of Hormuz, but the Straits of Malacca are controlled (or not) by coast-guard vessels with some help from the Indian navy.

China certainly wants improved security for its tankers but without depending on the US navy. China also wants Taiwan to rejoin the mainland – which has been prevented by US military assistance to Taiwan — and it wants unchallenged naval hegemony over the South China Sea, in particular. The US Navy, based in Manila, is an unwanted presence for them, just as Chinese presence in the Caribbean would be unwelcome to Washington. As China grows in economic power, it invests more and more in its naval (and other) forces. Moreover, the worldwide US military burden is arguably becoming too expensive for the US public to bear, notwithstanding noisy complaints from some of the ‘neocons’ still in power who have not had enough war. It is the reason for President Obama’s reluctance to commit ground troops to Syria, thus opening the door for Vladimir Putin to expand Russia’s sphere of influence (and, conceivably, for his “pen-friend”, Donald Trump, to do the same in America.) We’ll know more in November.


Final comment:

As a “futurist” of several decades experience, I would love to be able to end this memo with a strong prediction about the future of the world. Or something. But, I can only recall Chairman Mao’s comment (was it his?) that prediction is difficult, especially about the future. The only strong statement I can make today is that the end of the era of increasing debt, with near zero interest rates is coming soon. When it does, the cost of those deficits will explode, and the pressures for a major revolution in economics, capitalism and democracy, will also explode. One can only hope that the explosion will not be as violent as comparable revolutions have been in the past.



Keen, Steve. 1995. “Finance and economic breakdown; Modeling Minsky’s financial instability hypothesis.”  Journal of Post-Keynesian Economics 17 (4):607-635.

Keen, Steve. 2012. “Instability in financial markets; Sources and remedies.” INET Conference, Berlin, 12-14 April.

Krugman, Paul R. 1995. “The illusion of conflict in international trade.”  Peace Economics, Peace Science and Public Policy 2 (2).

Varoufakis, Yanis. 2011. The global minotaur: America, Europe and the future of the global economy. 2013 ed, Economic Controversies Series. London, New York: Zed Books.

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One thought on “

  1. This is partly what MMT theory is on about Bob, but it neglects the role of credit. You’re quite right that the twin deficit argument ignores the change in the money supply, and when you include it you get three deficits: government, trade, and private bank credit. The sum of transfers from one to the others is necessarily zero, but the total amount of money can rise or fall.

    So a country can easily maintain “twin deficits” with the third providing the balance; and in the aggregate, the total money supply can be rising or falling. Since the GFC, we’ve passed from rising to either stagnant or falling money–hence the stagnation.



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