Capital Flows Are the Core Concern

Samuel Hammond
Samuel Hammond is a senior economist at the Foundation for American Innovation and former director of social policy at the Niskanen Center.

Capital Flows Are the Core Concern

Samuel Hammond
Samuel Hammond is a senior economist at the Foundation for American Innovation and former director of social policy at the Niskanen Center.

With the demise of the Bretton Woods system in 1971, countries around the world began to open their markets to foreign investment, and the U.S. dollar emerged as the reserve currency of choice. Today, two-thirds of all foreign reserves and nearly 90% of foreign exchange trades are denominated in U.S. dollars‚ÄĒa phenomenon known as ‚Äúdollarization.‚ÄĚ

As the monetary safe haven to the world, the U.S. current account (or ‚Äútrade balance‚ÄĚ) has been in deficit ever since, growing to a record average of $247 billion in each quarter of 2022. A current account deficit means that the United States is a net borrower, absorbing more in foreign savings than we invest abroad. Those savings are largely held in the form of U.S. government debt, suppressing our borrowing costs and allowing Congress to run large budget deficits with impunity. This is often referred to as America‚Äôs ‚Äúexorbitant privilege,‚ÄĚ as the global role of the dollar allows the American economy to consume more than it produces‚ÄĒan apparent ‚Äúfree lunch.‚ÄĚ

Yet America‚Äôs exorbitant privilege is also an exorbitant burden. Soft budget constraints have atrophied Congress‚Äôs ability to make hard trade-offs, shielding new spending from the democratic scrutiny that would occur if new taxes had to be raised in equal proportion. And while economic dogma says current account deficits must eventually be balanced by matching surpluses and, therefore, don‚Äôt matter in the long run, it does not say how many decades or even centuries in the future the ‚Äúlong run‚ÄĚ might be. In the meantime, large trade deficits have hollowed out America‚Äôs productive capacity. Instead of factories and equipment, global savings have flowed into financial products and real estate as quasi-safe stores of value, leading to periodic bubbles. When the U.S. government does the borrowing, the proceeds are sent back out as transfer payments through underfunded entitlement programs rather than leading to any investment at all.

In short, the modern era of financial globalization is typified by enormous trade and financial imbalances‚ÄĒimbalances that will eventually come due. These imbalances are largely the responsibility of our foreign trading partners, particularly countries like China, which have engaged in one-sided industrial policies designed to suppress their domestic consumption. America‚Äôs role has simply been to absorb those imbalances with no questions asked.

Until the global economy rebalances, efforts to rebuild American industry are fighting economic gravity. To prepare for rebalancing, we should thus use our exorbitant privilege to finance industrial policies of our own.

Until the global economy rebalances, efforts to rebuild American industry are fighting economic gravity. To prepare for rebalancing, we should thus use our exorbitant privilege to finance industrial policies of our own. For example, an economic development bank dedicated to building up critical infrastructure and export industries would have to issue bonds not unlike those issued by the Department of Treasury‚ÄĒonly these bonds would go towards financing investments in the real economy rather than an ever-growing budget deficit.

In the medium term, America will need to revisit robust capital controls akin to those that defined the Bretton Woods era. While our trade deficit with China gets significant public attention, trade per se is largely a red herring. Investment flows matter much more. Indeed, the U.S. had robust trade in final goods with China prior to their entry into the World Trade Organization. It was only after normal trade relations were made permanent that U.S. companies felt confident not only to trade with China, but also to offshore their production, enter into joint ventures, and invest in Chinese industrialization more generally. It’s one thing for Volkswagen, a German company, to open shop on U.S. shores. It’s another thing entirely to entangle the capital structure of U.S. multinationals with the economy of a foreign adversary.

Capital controls can be broad or narrow. The broadest approach would be to apply a small levy on all foreign purchases of U.S. stocks, bonds, and other assets, as proposed by Senators Josh Hawley and Tammy Baldwin in 2019. Such a ‚Äúmarket access charge‚ÄĚ could be adjusted as needed to restore a balanced capital account, in turn ensuring a balanced current account. The primary downside of this approach is that it would fail to differentiate healthy sources of foreign investment from the countries engaged in problematic forms of market manipulation. If not enacted with care, this could risk the U.S. dollar‚Äôs abrupt depreciation.

A more targeted approach would aim to restrict foreign capital from entering sectors that are either politically sensitive or subject to financial speculation. In 2016, British Columbia, Canada, enacted a 20% tax on international home buyers. The measure was in response to rising home prices and the growing number of foreign owners of vacant properties. So far, it appears to be working. As the New York Times reported, ‚Äú[F]oreign investment in [British Columbia] real estate fell from a high of 9% of residential sales in June 2016 to about 1% in June 2022.‚ÄĚ Beginning this year, Canada has further banned most foreigners from buying residential property for two years.

Whatever the sector, the U.S. needs to bolster its capacity to enforce capital controls across the board. 

In the U.S. context, the job of reviewing foreign investments in real estate and sectors sensitive to national security falls on the Committee on Foreign Investment in the United States (CFIUS). Yet despite a Trump-era reform to strengthen CFIUS, large gaps remain in the committee‚Äôs purview. This includes U.S. agricultural land, of which China owns roughly 384,000 acres, including near U.S. military bases. As the policy analyst Lars Sch√∂nander notes, ‚ÄúU.S. Department of Agriculture data show that Chinese ownership of U.S. farmland leapt more than 20-fold in a decade, from $81 million in 2010 to $1.8 billion in 2020. Beijing hasn‚Äôt outlined a strategy, but large-scale state backing for these investments indicates there is one.‚ÄĚ

Unfortunately, foreign investment in U.S. farmland is not systematically tracked, much less regulated. The Protecting America’s Agricultural Land from Foreign Harm Act of 2023 from Senators Mike Braun (R-IN) and Jon Tester (D-MT) would change this by reforming the Agricultural Foreign Investment Disclosure Act (AFIDA). While the AFIDA already requires the Department of Agriculture (USDA) to collect data on foreign ownership of agricultural land, the USDA has failed to enforce the law for decades.

Whatever the sector, the U.S. needs to bolster its capacity to enforce capital controls across the board. Under the Biden administration’s export controls on semiconductors to China, for example, enforcement falls on the Commerce Department’s Bureau of Industry and Security. Yet if the bureau is not properly staffed and funded to fulfill its expanded mission, the new export controls will be worth only the paper they’re written on.

The Chinese Communist Party, for its part, controls China’s capital account with an iron fist, enabling the buildup of industrial capacity at the expense of U.S. producers and Chinese households alike. And while we might wish for a world in which trade and investment flowed across international borders unperturbed, we now know that this cannot be achieved unilaterally. Globalization without balance is unsustainable. It’s about time America leveled the playing field.