The global trading system has been broken for decades. A well-functioning trading regime would permit neither the large, persistent trade imbalances that characterize the current global trading system nor the perverse flow of capital from developing economies to advanced economies. The system needs new rules that encourage a return to the benefits of free trade and comparative advantage.
Until this happens, trade imbalances will persist. This matters especially to the United States because of the role it plays in anchoring global imbalances. Countries that run large, persistent trade surpluses must acquire foreign assets to balance these surpluses. American assets are particularly attractive for this purpose, and the United States allows nearly unfettered access to these assets. As a result, surplus countries prefer to acquire assets in the United States in exchange for their surpluses, which also means that the United States must run the corresponding trade deficits.
This has important implications for U.S. manufacturing, unemployment, and debt. It means that the U.S. share of global manufacturing must decline while that of surplus countries must rise. Because surplus countries are those that subsidize their manufacturing at the expense of domestic consumption, American manufactures are forced indirectly to subsidize U.S. consumption. This is why, during the past five decades, manufacturing has consistently migrated from deficit countries (mainly the United States) to surplus countries (mainly China). Until global rebalances are resolved, this will continue.
It also means that for all the talk of reshoring and friendshoring, the U.S. trade deficits cannot decline as long as surplus economies can continue to acquire assets in the United States with the proceeds of their surpluses. The United States, in other words, has no choice but to run deficits to balance the surpluses of the rest of the world.
What’s more, while many mainstream economists assume that foreign inflows lower U.S. interest rates and finance U.S. investment, as occurred in the nineteenth century, this hasn’t been the case for decades. Foreign inflows instead force adjustments in the U.S. economy that result in lower U.S. savings, mainly through some combination of higher unemployment, higher household debt, investment bubbles, and a higher fiscal deficit.
To rebalance its economy toward manufacturing while reining in debt and generating higher-paying employment, the United States must either transform the global trading regime or unilaterally opt out of its current role. Not only would this benefit the U.S. economy, but it would also benefit the global economy by eliminating the persistent downward pressure on global demand created by the surplus countries.
This won’t be easy, however. Any meaningful resolution of global trade imbalances will be strongly opposed by surplus countries and would result in a diminished global role for the U.S. dollar.
HOW DOES INTERNATIONAL TRADE AFFECT THE U.S. MANUFACTURING SECTOR?
Last month, Yao Yang, former dean at the National School of Development at Peking University, said on his blog that “America’s industrial base has already been hollowed out. How can it possibly compete [with China]? The United States has obviously made a strategic mistake.”
He’s right, but perhaps not for the reasons he thinks. While manufacturing comprises roughly 16 percent of global GDP, according to the World Bank, the manufacturing share of China’s GDP is 28 percent, among the highest in the world, whereas for the United States it is 11 percent, among the lowest for any major economy. The opposite is true for consumption. While consumption accounts for 75 percent of global GDP, it accounts for 80 percent of the United States’ GDP and only 53 percent of China’s GDP.
To put it another way, while China comprises less than 18 percent of global GDP, it accounts for over 31 percent of global manufacturing and less than 13 percent of global consumption. The United States, which accounts for 24 percent of global GDP, accounts for less than 17 percent of global manufacturing and nearly 27 percent of global consumption.
While the differences in the two countries’ manufacturing and consumption shares of GDP may seem unrelated, it turns out that they are different expressions of the same imbalance. China and the United States are extreme representatives of a common pattern in the global economy. Manufacturing typically represents a disproportionately large share and consumption a low share of the GDP of non-commodity economies with large, persistent surpluses. The reverse is true for advanced economies that run large, persistent deficits.
This clearly isn’t a coincidence, but in which direction does the causality run? Do countries have larger manufacturing sectors because they are surplus countries, or do they run surpluses because they have larger manufacturing sectors? For many years, economists have argued that it is the latter. Surplus economies, they claim, have a comparative advantage in manufacturing that leads them to produce tradable goods more efficiently, and this is why they export more than they import. Deficit countries like the United States, on the other hand, have a comparative disadvantage in manufacturing.
But this misunderstands altogether the meaning of comparative advantage. As I explain below, surplus economies run surpluses mainly because of industrial policies that implicitly or explicitly force households to subsidize the manufacturing sector. Their competitive advantage in manufacturing comes not from comparative advantage but rather from transfers that distort comparative advantage and reduce domestic demand.
WHAT IS THE RELATIONSHIP BETWEEN COMPETITIVE MANUFACTURING AND WEAK DOMESTIC DEMAND?
In these persistent surplus economies, weak domestic demand is simply the flip side of policies that result in manufacturing competitiveness. The manufacturing sector is subsidized directly or indirectly by households, which leaves them more competitive and leaves households less able to purchase a substantial share of what they produce.
But in order to balance these surpluses, the opposite transfers must occur in the deficit countries. Just as consumers are forced to subsidize producers in the surplus countries through various explicit and implicit transfers, producers are effectively forced to subsidize consumers in the deficit countries.
There are many forms these transfers can take, but the easiest one to understand is through currency values. An undervalued currency, typical of surplus countries, affects trade imbalances by raising the cost of imports and increasing the profits of exporters. It results, in other words, in an implicit transfer from importers to exporters. Because households are all net importers, and because net exporters are mostly manufacturers, these implicit transfers subsidize the manufacturing sector at the expense of households. This makes the manufacturing sector in that country more competitive while reducing the capacity of households to consume.
The opposite happens in the deficit countries. An undervalued currency for one country is the obverse of an overvalued currency for its trade partner, and this overvaluation also represents an implicit transfer, in this case from net exporters (manufacturers) to net importers (households as consumers). Just as manufacturers are subsidized by consumers in the former, so are consumers subsidized by manufacturers in the latter, making their manufacturing sectors less competitive globally.
It is not surprising, then, that global manufacturing naturally migrates from deficit countries to surplus countries, while global consumption migrates in the opposite direction. This has nothing to do with comparative advantage. Manufacturers in both economies are simply responding to the direction of subsidies.
Although I use undervalued and overvalued currencies as an easy illustration of how these transfers between producers and consumers affect trade, they are not the only, nor even the most important, of such transfers. Repressed interest rates, for example, have often been far more important, along with overinvestment in infrastructure, wage repression, and several other implicit or explicit transfers that subsidize manufacturers at the expense of households. (See appendix 1 for a list of such transfers and how they subsidize manufacturing at the expense of households.)
CAN TRADE INTERVENTION BE USED TO MAKE TRADE FREER?
There is no meaningful difference between trade-oriented policies and most forms of industrial policy. Any economic, monetary, or fiscal policy that affects the balance between a country’s domestic savings and its domestic investment must necessarily affect that country’s trade balance, and through its trade balance, it must necessarily affect the balance between the domestic savings and domestic investment of its trade partners. In a closed global economy, where savings must equal investment, any policy that forces up the savings rate in one sector must be balanced by either higher investment or lower savings elsewhere.
That’s where trade intervention can lead to freer trade. Trade surpluses that are caused by beggar-thy-neighbor industrial policies—designed to improve international competitiveness by suppressing domestic demand—can only exist to the extent that they are matched by trade deficits in other countries. In that case, if the deficit countries implement interventionist trade or capital polices directed at reducing their deficits, these will automatically force surplus countries to reverse their own beggar-thy-neighbor policies. This in turn will force an adjustment in the global trading regime such that global trade is once again based on comparative advantage and contributes to expanding global production, not to suppressing global demand.
The point is that there are a wide range of policies that can cause global trade distortions, and while some of these policies can target trade, many of them don’t do so explicitly. That’s why in the interests of a well-functioning global trade environment it is better to target overall trade imbalances, as John Maynard Keynes proposed at the Bretton Woods Conference in 1944, than it to target specific trade violations.
While the World Trade Organization and other existing trade regulatory entities have focused on the latter, they have left us with a world of massive, persistent trade imbalances and perverse capital flows. These conditions are prima facie evidence that existing trade regulatory entities have failed to manage global trade appropriately. That’s why the United States, and most of the rest of the world, would be better off with a radical reorganization of the global trading system.
Michael Pettis is a nonresident senior fellow at the Carnegie Endowment for International Peace. An expert on China’s economy, Pettis is professor of finance at Peking University’s Guanghua School of Management, where he specializes in Chinese financial markets.
To read the full analysis as it is posted on the Carnegie Endowment for International Peace’s China Financial Markets blog, click here.