Real assets or financial assets

The two main English speaking countries (the US and the UK) both have outsized financial sectors and have the world’s deepest and most liquid capital markets. These are coincidentally the two main hegemonic powers of the last two and a half centuries. Their exaggerated financial assets mean that they have nominally high GDP figures compared with countries relying on manufacturing and tourism. But is this real?

Britain became the most influential country in Europe over the course of the 18^th century. Previously that position had been held by Spain. Spain’s wealth derived from the discovery and exploitation of the Americas but it was precisely this same wealth that led to it’s decline. Rather than manufacturing for itself Spain was able to use the gold and silver from the Americas to buy goods manufactured in the north of Europe. These northern countries thus acquired technical skills and a base for continuous innovation while Spain forfeited these same attributes.

France was the natural heir to Spain as the most powerful country but through the course of the 18^th century France became involved in wars that overstretched it’s resources and Britain was waiting in the wings to take advantage. Thus in the nineteenth century Britain was the first and by far the largest industrial country in the world.In the twentieth century Britain passed the baton over to the US which throughout that century was the largest industrial economy.

Now two decades into the 21^st century we have a situation where both of these countries have been running large trade deficits stretching back before the Millennium and shedding their manufacturing bases. This has been compensated by oversized financial sectors but what does this involve exactly?

If a country runs a trade deficit it borrows in a foreign currency and this must be paid back from foreign currency earnings on exports. This forces a discipline on most countries in the world to keep their external trade in balance as otherwise they would be forced to cut consumption and accept austerity. The other side of that is that they need to continuously invest in their internationally traded sectors to boost competitiveness.

For historic reasons both the US and the UK are able to borrow in their own currencies. This means they can run trade deficits without having a foreign currency problem since the repayments are in $$ and ££. They can also use their Central Banks to create money through quantitative easing. Thus they benefit from other countries money and can create magic money to pay it back. Most of their assets are financial and the trade deficits cause their real assets to deteriorate.

However the downside of this is that they are missing the discipline forced upon other countries to correct the underlying causes of the imbalances by checking consumption and investing in their export sectors. Thus complacency sets in and their manufacturing sectors continue to decline. Their oversized financial sectors are only worth the confidence outsiders place in them and if that vanishes they are in for a major shock. It’s a bit like a company share that is valued far above what it’s fundamentals would suggest.

The decline of Spain was due to having too many financial assets and letting manufacturing disappear and it took Spain quite some time (several centuries) to put that behind it and find the path of progress once more. If we compare Spain and Britain today what we can see is that Spain leads in real assets - high speed trains, ports, housing etc - whereas Britain leads in financial assets. Spain’s external sector is, in general, in balance as it’s trade deficit in goods is made up by it’s tourism surplus. Britain runs a large trade deficit which is covered through the London financial sector but as alluded to above this depends on confidence.

America’s recent trade war with China is a belated recognition that it needs to do something about it’s trade deficit but the tariffs won’t work on their own. They need to rein in consumption and increase savings and investment but this is unlikely without addressing various internal issues in the US economy such as Health Care.

One way of addressing the trade deficits would be for the US and the UK to adopt capital controls and limit outside access to it’s capital markets. This would then force them to follow the disciplines that other countries follow but it would also mean the US and the UK relinquishing their roles in the world. If they don’t change course they will forfeit their roles in any event albeit further down the road.