Smith… Keynes. Pettis... Klein

A Review of “Trade Wars Are Class Wars”

This is meant to be a neutral description of Pettis & Klein developed from the point of view of Continuous Variation, rather than a true review. The review was meant to be followed by comments from Continuous Variation contributors. However, an increased administrative workload made the decision to scale down the project to a review irresistible. Without further ado, let’s begin.

Pettis & Klein’s argument begins, as all economic arguments do, with Smith’s pin factory. Smith imagines, or rather read about in a French encyclopedia, a pin factory whose efficiency (output per unit cost - at the time and for all practical purposes, per laborer) rose as more workers were employed. Smith argues that this is due to the “division of labor”. That is, the pin factory, far from being like many pin makers in parallel, is a complex structure of well defined firm-like “branches” in series. Each branch, like a firm, has a well defined input, a well defined output, well defined income (the portion of firm costs, largely wages, that go to said branch), well defined costs (the portion of firm costs, largely wages, that go to the inputs of the branch) and thus well defined profits.

Smith’s theory of the firm as branches in series, at first sight, seems to overcomplicate economics into an infinite theory of massively multilateral semi-monopolies - one for each branch. There are thus at least 18 semi-monopolies in a single pin factory! But Smith has a key: the division of labor is limited by the extent of the market. On the top end, a branch of the firm which takes in cut and pointed proto-pins and outputs proto-pins ground on the top for receiving the head is a semi-monopoly (no other branch in the firm produces ground & pointed proto-pins). But the semi-monopoly branch is only free to act insofar as the upstream branches do not prefer to take their business to outside firms. On the bottom end, just as a firm has certain fixed costs which must be cleared if the firm is to exist, so a branch cannot exist unless its fixed costs can be taken care of.

The superiority, in terms of efficiency, of employing a population in complex branches in series instead of individuals in parallel is Smith’s “system of natural liberty”. The efficiency gains allowed by natural liberty are the manifestation of natural liberty’s superiority over systems of restraint and regulation which limit the extent of the market. Smith’s vision was very beautiful. But, on account of its beauty, the vision is also quite incomplete. Some have found quite little to praise about the process in practice.

Keynes took the vital step beyond this harmonious vision. To do this, Keynes drew on his intellectual background as a logician. Though Keynes was no anti-capitalist, the way he laid bare the logic of markets shocked especially capitalism’s most ardent defenders. For example, common sense and Benjamin Franklin tell us that man is the tool making animal and should be valued as such. But Keynes demonstrated clearly that the logic of the market values man only as a consumer. As a producer, a man is just an unfortunate cost.

For Pettis & Klein, the vital part of Keynes’ logic is his rationalization of income accounting. Keynes’ clearing up of income accounting follows the principle of quantifying the quantifiable. Keynes’ notion of income accounting gives a quantitative description of the current state of the world, measures of the choices of the complex mass of actors. In order that these measures should range over the quantifiable, all aggregate accounts must be functions of the actual and current behaviors of economic actors, i.e. entrepreneurs, households etc.. The measures can not depend on, for instance, what they potentially could do tomorrow.

Look for example at Keynes definition of income: total sales reduced by factor and user cost. Factor cost is those firm’s purchases from other firms and user cost is the loss of value involved in business practice. Income thus is a function of current household decisions (sales) and current entrepreneurial decisions (costs). Prior accounts of income (in Keynes, net income) amounted to total sales reduced by factor, user and supplementary costs. Supplementary costs are those costs which are involuntary but expected. Those costs which are involuntary and unexpected are called “windfall loss” (or gain). Thus, the level of income (in Keynes, net income) depended on how the entrepreneur wishes to constrain his future actions. Wishes are not necessarily quantifiable. Keynes even shows that many of Hayek’s sermons on unmeasurability & aggregability in economics are just a consequence of choosing an income concept that both cannot be measured (and is thus not aggregatable) and is not a function of the choices of economic actors. Excluding supplementary costs with their mysterious border on the land of windfall loss was one step of how Keynes was able to rationalize the world of income accounting.

The particular application of Keynes’ rationalization of income accounting that is core to Pettis & Klein is his analysis of consumption, investment and savings. Consumption is total sales to households, or total sales minus sales from entrepreneur to entrepreneur. Investment is output purchased by entrepreneurs less user cost. Total savings is the excess of total sales over total consumption, which is exactly total output purchased by entrepreneurs less user cost or “investment” for short.

A dialectical way to see the appropriateness of these definitions is to start with the “old view” that an act of saving simply is an act of investment. The only way for a winemaker to fund a film tomorrow is to plant seeds today. Outside of a hypothetical rude state of society, this is incomplete and misleading as an entrepreneur can save by inducing another entrepreneur or household to dissave. The winemaker can also “save” by purchasing a planted vineyard, thus having sales in 12 hours rather than tomorrow. But because accounts are chosen in a manner which is numerically unambiguous and thus aggregatable, all methods of saving by inducing dissaving necessarily cancel out. The result is: aggregate savings level equals the aggregate investment automatically, with all concerns about “genuine” vs “forced” savings taken care of.

Though the level of savings in a time period is always numerically equal to the level of investment in that time period, it is not the case that savings and investment are interchangeable concepts. The old Knightian insight of the “wheel of wealth” taught us that investment and consumption are the active parts of the economy, savings mere residual. True we talk of “saving money” rather than “investing in our checking account” but we also talk of “sun down” rather than “earth turn”.

The consequence of income accounting fundamental to Pettis & Klein is:

domestic savings - domestic investment = net exports

Again, the wheel of wealth insight tells us that investment is the active part of the economy. On the left hand side of the equation, we have one active variable and one passive. The result is the right hand side is, in the main, a function of the one active variable. In economic language, net exports are essentially a function of domestic investment. A debtor country is a country with a high level of domestic investment and nothing else. A lender country is a country with a low level of domestic investment and nothing else.

Finally, the level of domestic investment of an advanced state is, as Abba Lerner painstakingly demonstrated, an essentially political variable. Political variables largely follow class interests. Thus current net exports largely follow class interests.

A subtle distinction is important here. Remember that “savings” and “investment” and all other accounts, unless otherwise stated, are within period savings and investment. Nothing is being held constant, nor are we making dynamic assumptions - we are only discussing within one period. The income accounting and the wheel of wealth relations are functions, not fluents. It might be the case that “yesterday’s investments are today’s savings” or somesuch rot, but that is a dynamic hypothesis not an accounting identity. A debtor country is one with a high level of domestic investment today. The evolution of net exports - unlike its current level - is influenced by many factors other than class interest, especially technological change. The distinction between the current level and evolution of net exports is frequently invoked by Pettis & Klein.

Even with that caveat, the “net exports = f(class interests)” insight can be used to answer questions. Why does big agriculture support Trump when his policies are devastating to their industry (reducing their access to labor and shrinking their market)? They are aware that Trump will simply undo this devastation by increasing their subsidies (as he did last time) as he is the leader of the right wing party that serves their class interests. Thus we see that net agricultural exports are simply a political variable. One can call these interests foolish and benighted, but that is just a roundabout way of calling them class interests rather than universal interests.

A distant but still memorable example may help. In the early 90s, economist Paul Krugman was asked by a trade official what the effect of NAFTA would be on US jobs. Krugman dutifully answered NAFTA would make no difference, as the above simple arguments show that net exports are simply a function of the level of domestic investment landed on by the political process. NAFTA would have political consequences in Mexico. NAFTA protected foreign investment in Mexico, reducing the reliance on domestic investment and driving up net exports. But its consequences in the US were basically the decision of Gingrich and Clinton. Krugman kept talking about finger accounting exercises and his interviewer pressed on the economic, political and philosophical consequences of a massive bilateral trade agreement. Eventually, the trade official exploded,

“It’s remarks like that which explain why people hate economists!”.

Here is where the logic of capitalism as exposed by Keynes interferes with the development of the “system of natural liberty” advocated by Smith. To recapitulate, Smith’s system achieved efficiency by organizing production within branches. As expounded in Marshall’s beautiful chapters on industrial organization show, this system is conducive to growth and class harmony. To quote

“When an industry has thus chosen a locality for itself, it is likely to stay there long: so great are the advantages which people following the same skilled trade get from near neighbourhood to one another. The mysteries of the trade become no mysteries; but are as it were in the air, and children learn many of them unconsciously. Good work is rightly appreciated, inventions and improvements in machinery, in processes and the general organization of the business have their merits promptly discussed: if one man starts a new idea, it is taken up by others and combined with suggestions of their own; and thus it becomes the source of further new ideas.

…

[A] localized industry gains a great advantage from the fact that it offers a constant market for skill. Employers are apt to resort to any place where they are likely to find a good choice of workers with the special skill which they require; while men seeking employment naturally go to places where there are many employers who need such skill as theirs and where therefore it is likely to find a good market. … Social forces here co-operate with economic: there are often strong friendships between employers and employed: but neither side likes to feel that in case of any disagreeable incident happening between them, they must go on rubbing against one another: both sides like to be able easily to break off old associations should they become irksome.”

Harmony, however, is but one possible end point of the system of natural liberty, the other being disharmony. A firm that produces pins can choose to have its pointed pins to be ground for application of the head in house as Smith assumes, or the same firm could purchase semi-pins pointed at one end and ground on the other to apply the head from another firm - even another firm across a national border. In market equilibrium, the costs to the firm would be the same. In income accounting terms, the firm is indifferent between a user cost (producing in house) and a factor cost (purchasing from another entrepreneur). Recall the Keynesian insight that man as a producer is an unfortunate cost and only man as a consumer is valued. The “social forces” which Marshall discussed are sometimes called “implicit contracts”. There is great value to be had in breaking these implicit contracts, which is done by separating ownership and management perhaps by making sure they are in different countries speaking different languages. Smith’s pin making firm was made up of 18 multilateral semi-monopolies which developed to a game theoretical equilibrium with maximal output given the state of technology, largely because they shared the same profit. Other things equal, maximizing the pie to be sliced was everyone’s interest.

Pettis & Klein ask us - is it plausible that 18 firms in 18 countries under at least 18 legal structures with 18 different profits will land on maximal output given the state of technology? South Korea is a famous hub for condensed matter research, China a famous producer of microchips - an economic output dependent on condensed matter research. Even if the market relationships between Chinese and Korean firms are not minimizing efficiency, one cannot say that Korean condensed matter physics lore is “in the air” in China. In market equilibrium, Chinese and Korean firms will be allocatively efficient but may still be x-inefficient.

There is an obvious solution to global x-inefficiency caused by too small industrial districts that are the result of production being spread across industrial districts globally. That solution is: each country domestically invests in its industrial districts, bringing balance to net exports. Balance in domestic investment is actually seen in some countries, Mexico for example, as shown by their switching between positive and negative net exports. But other countries, such as Germany and China consistently have low domestic investment (positive net exports) and the US has had high domestic investment (negative net exports) since 1975.

Now comes the problem that Pettis & Klein confront. Surely class interests are determined by … the class. Why is Germany and China’s ruling upper class so dramatically different from the US’s upper class? Why is Mexico’s upper class served by balanced domestic investment?

Here Pettis & Klein must move from economic laws to economic history. Class interests are shaped not merely by class but by class and history. Further states have a degree of autonomy distinct from the class interests they serve deriving from their limited administrative capacity. A state may serve a class but they can only serve that class insofar as that state can do something possible for a given state in a given situation.

Let’s now summarize the relevant economic history. In 1949, China and Germany were ravaged by war. Their leadership had a mandate from the class they represented to restore equilibrium to the country, i.e. to have high levels of domestic investment. Necessarily, they ran trade deficits during this time. However, as they progressed from low income to middle income states, their upper classes became exposed to volatility. Smith’s insight that the division of labor is limited by the extent of the market worked against them. The branches of its firms must have costs and profits higher than a certain minimum and lower than the global market maximum. The second of these is beyond the capacity of a small state to manage. Over time, the states of Germany & China hit upon the “solution” of guarding class interests within its administrative capacity by moving away from domestic investment, as demonstrated by persistent positive net exports.

Meanwhile, the US’ leadership had a mandate from its ruling class to invest abroad - especially after 1953. This was a confused and confusing policy that balanced Rooseveltian anti-imperialism with fierce anti-communism. During this period, the US necessarily ran a trade surplus. As anti-communism triumphed over anti-imperialism, the US began a policy of courting the upper classes of middle and lower income countries by protecting their investments, i.e. allowing them into the US. As we have seen, in Mexico this led to a modest decline in domestic investment (increase in net exports). But the history of the US has endowed it with a unique institutional feature which causes a paradox. The US state wholly owns a bank called the Federal Reserve. The main products of this bank, US Bonds and US dollars, are the most liquid assets on the market at any given time. Therefore, allowing foreign investors to buy physical assets in the US means that US investors are freed from the burden of having to own physical assets (‘fear of goods’) and flee to liquid financial assets (‘love of money’).

The historical story of the previous paragraphs completes the logical survey of Pettis & Klein’s theory. Pettis & Klein’s theory thus combines the basic insights of industrial organization, income accounting, historical & political development and unique features of the global financial system to explain the persistent features of net exports across countries - positive for China and Germany, negative for the US and zero for Mexico. But there must be a conclusion, what is to be done with these insights?

There are some simple and politically possible “solutions”, such as tariffs and beggar thy neighbor “competitiveness” drives. But these mistake the residual (net exports) for the driver (domestic investment), the symptom for the disease. Indeed, they will only serve to increase x-inefficiency by blocking the division of labor in the first place (tariffs) and breaking the implicit contracts that serve much of the value of localized industry (“competitiveness” drives).

Pettis & Klein’s own solution is “to end the trade war, end the class war”. That is to say,

1. Make it possible for countries that consistently underinvest domestically (China & Germany) to grow the size of their industrial districts to an appropriate level and

2. Definancialize the unique US economy.

Pettis & Klein make specific proposals towards these ends. Item 1 is to be done by allowing Chinese consumption to grow, which validates Chinese domestic investment and puts them on a virtuous cycle back to zero average net exports. For item 2, the US government is to prevent foreign investment from competing with domestic investment into private physical capital by absorbing such investment directly and applying the money absorbed to public physical capital. This would redirect private investment from the financial sector to the private physical capital sector, turning the US into a “normal country” whose upper class interest is served by non-negative net exports.

This has aimed to be a neutral description of Pettis & Klein’s Trade Wars Are Class Wars. As mentioned in the opening, to this we were to have comments from expert contributors to Continuous Variation which describe their reactions, intellectual or otherwise and positive or otherwise, to the theory neutrally described here. Feel free to fill in that gap in the comments below!