What Explains Today's Trade Tensions?

Michael Pettis—

In our book Trade Wars Are Class Wars, Matthew C. Klein and I argue that the root causes of global trade imbalances—and the tensions they create—are not primarily geopolitical conflicts between nations, even if they are widely seen as such. Rather, they are domestic and deeply structural: they stem from policies that determine how income and wealth are distributed within countries. Because a country’s internal imbalances can drive its external imbalances, which in turn must drive the external imbalances of its trading partners, the struggle over who gets what within a country inevitably spills over into trade and financial conflicts with other countries.

This framework continues to explain today’s trade tensions. The rising protectionism and contraction in global trade that we’ve seen in recent years are—as the British economist Joan Robinson explained in 1937—the almost-inevitable consequences of large trade surpluses driven by industrial policies that distort the distribution of income in major surplus economies. She called these “beggar my neighbor” policies.

In countries like China and Germany, these policies have long suppressed the income of workers and households relative to production in order to boost manufacturing growth. When a large share of national income is captured by businesses, the rich, or the government, and not redistributed to households, this may benefit the production side of the economy, but it leaves domestic consumption too weak to absorb the bulk of what is produced. That’s because consumption weakness is the flip side of transfers that subsidize production.

There are only five ways to address the resulting excess supply. The best way—but often politically the most difficult to implement—is to reverse the original policies that prevented wages from rising in line with overall productivity. A second way is to boost domestic investment, but this is often hard to do, especially in countries like China that suffer from many years of overinvestment in property, infrastructure, and manufacturing capacity. A third way is to cut back on production and allow unemployment to rise, something no government wants to see. A fourth way is to boost consumption by increasing household or fiscal debt. And the fifth way, of course, is to externalize the domestic costs by exporting the excess to trading partners.

It is the fifth way that characterizes today’s global trade imbalances, with large trade surpluses that require the rest of the world—particularly countries such as the United States and the United Kingdom, whose capital markets accommodate global surpluses—to run corresponding trade deficits. These deficits are created by conditions that implicitly tax production while subsidizing consumption and so create the opposite imbalance between supply and demand, which, in turn, is financed by debt or asset sales to surplus countries.

The critical point is that trade imbalances are largely the result of internal decisions about how to allocate income. When wages are too low relative to productivity, and when household consumption is systematically underpowered, countries end up relying on foreign demand to sustain their output.

The U.S. runs chronic trade deficits, in other words, not because it is intrinsically unable to compete globally, but because it has allowed itself to become the “consumer of last resort” in a world in which other major economies suppress domestic demand. The process by which it must play this role is also the process by which its manufacturing sector becomes less able to compete globally.

This imbalance has profound implications, especially for the U.S. It means that American debt levels must rise if it is to avoid rising unemployment. It also means its manufacturing sector suffers long-term erosion. And finally, it exacerbates income inequality within the U.S. itself. As jobs are offshored and production weakens, lower- and middle-income Americans see stagnant wages and limited opportunity, while capital owners benefit from cheaper imports and rising asset prices.

The global landscape is now shifting. The U.S. is pursuing aggressive industrial policies that aim to rebuild domestic manufacturing and create high-quality jobs. Europe is considering similar initiatives. Meanwhile, China is attempting to reduce its dependence on exports and boost domestic demand—but with mixed results, as household income growth remains sluggish.

The changes in the deficit economies reflect a growing recognition that production matters and that trade imbalances are unsustainable if one side consumes more than it produces while the other side produces more than it consumes.

To create a more stable and equitable global trading system, countries—especially surplus countries—must focus on raising domestic consumption through more equitable income distribution. This means higher wages, stronger social safety nets, better public services, and reduced credit support for politically favored industries—the opposite of what created those surpluses in the first place.

This won’t be easy, as Albert O. Hirschman warned many decades ago. That’s because the most powerful parts of the economy are precisely those that most benefited from policies that created the imbalances. As Japan showed in the two decades after 1990, a rebalancing of demand toward greater domestic consumption also means an undermining of the manufacturing share of the economy. Because countries that run persistent manufacturing surpluses are also countries in which the manufacturing share of GDP tends to be much higher than the global average, a contraction in their manufacturing shares is likely to be especially painful—and especially difficult to manage politically.

But what are the alternatives? If the U.S. decides to reverse the long-term decline in its share of global manufacturing and to reduce its trade deficit, the rest of the world has no choice but to adapt. This means either that surplus countries must reduce their surpluses and accept the consequences of globally less competitive manufacturing sectors, or that some other region of the world must replace the U.S. as the global consumer of last resort and, as such, must allow its own version of industrial decline.

Either adjustment will be extremely difficult and much resisted. But when an irresistible force meets an immovable object, something must break. Unfortunately, it will be many years before the consequences of that break work themselves fully through the global economy and the global trade and capital regime, and during that time we are likely to see the disruptions in global trade that Joan Robinson predicted.

That is why trying to reverse course and prevent these disruptions makes little long-term sense. On the contrary, the world should be working to speed up—at the lowest possible cost—the adjustment process toward balanced trade, and individual countries should try to position themselves for what will be a major transformation of the global trade and capital regime. I hope our book will provide some insight into that process.

Michael Pettis is professor of finance at Peking University’s Guanghua School of Management and a senior fellow at the Carnegie Endowment for International Peace. Matthew C. Klein is the founder of The Overshoot.