Three recent articles caught my eye re international trade. First, there’s Neil Irwin reprising his theme, an important one, that the trade deficit isn’t a report card. Sometimes such imbalances are a problem, other times they’re not, so; as the balance of payments serenity prayer says: “Keynes, give us the wisdom to tell the difference.” Second, an oped by the Trump Administration’s trade guy Peter Navarro, who clearly does view the trade deficit as a report card that’s been bringing home F’s for about 40 years. Finally, an article about internal investment in China that needs to be seen in the context of the other two pieces.
First, Irwin’s correct that trade deficits can be harmful or benign. But how can we know which is which? A compelling answer, offered in this long essay by Michael Pettis or this distillation by Matthew Klein, involves the other side of the trade deficit, i.e., the capital account surplus. In order to finance the consuming of more than we’re producing—the trade deficit—we must borrow from abroad. So the trade deficit is always matched dollar-for-dollar by a capital surplus. What Pettis et al explain, and this is key to all three of these pieces, is that the balance-of-payment identity works in both directions.
That is, world trade must balance, so when some countries produce more than they consume, or save more than they invest, other countries must do the opposite—consume more than they produce and spend more than they save. Yes, when we spend more than we save, that adds to our trade deficit. But when other countries save more than they spend, and export those savings our way (capital inflows), that too drives our trade deficit. Thus, our trade deficits are not, as scolds often tell us, exclusively a function of shop-till-you-drop Americans buying favorably priced stuff from abroad. They’re also driven by capital flows from countries that maintain trade surpluses. It makes no more sense to yell at Americans for dis-saving than it does to yell at Germans (and the Taiwanese, the Koreans, and others) for saving too much.
We still haven’t determined “the wisdom to tell the difference” as per when trade deficits are harmful, and we’ll get to that. My first point is that Navarro does not seem to understand this nuance, and thus falls into the trap that Irwin warns of: trade deficits subtract from growth, so they’re always and everywhere bad. This leads him down all sort of false paths. The Chinese, the Mexicans, and whomever else we run a bilateral deficit with are the enemies.
But he’s missing the forest for the trees. Follow the money–the capital account–not just the individual trade balances. As long as the world’s excess global savings continue to flow to our shores, our trade deficit will persist, and going after bilateral deficits one at a time becomes a game of whack-a-mole that we can’t win.
Pettis points this out in his discussion of Mexican/US trade. Navarro and Trump will argue that we run a deficit with Mexico which must be balanced (perhaps through renegotiating the NAFTA). But Mexico also runs a trade deficit. Pettis:
This means Mexico is importing excess global savings and, rather than contributing to global and U.S. trade imbalances, is in fact helping to absorb them. If Washington takes steps to reduce or eliminate Mexico’s bilateral surplus with the United States, and this causes net capital inflows into Mexico to decline, Mexico’s [trade] deficit must decline, regardless of what happens to its bilateral surplus with the United States.
The paradoxical consequence could very easily be a wider American trade deficit even as the American trade deficit with Mexico contracts. This may seem counterintuitive, but only to those for whom international trade is the sum of independent bilateral trade balances. Once we recognize that bilateral trade reflects the complexity of trade in the global economy, and not the sources of the trade imbalances it becomes clear that Mexico is not a source of American trade imbalances, and is in fact far more likely to be providing relief.
You might ask, as one reader did: why does Pettis assume foreign savings would flow here as opposed to some other country? Good question, but Pettis’ assumption is a fair one. The dollar is still the world’s main reserve currency, and especially now, given our stronger relative growth rates and Fed’s “normalization” (rate hiking) campaign, dollar demand is strong. We also have the most liquid, accessible financial markets, and finally, we consume a far larger share of GDP (70%) than Europe (55%) or China (35%!–the flipside of their large trade/savings surplus).
At any rate, these dynamics are why the China article caught my eye. The piece tells of China’s “…$300 billion plan to become nearly self-sufficient by 2025 in a range of important industries, from planes to computer chips to electric cars, as it looks to kick-start its next stage of economic development.” But various officials and business reps from elsewhere, especially those that service the Chinese market, are crying foul, arguing that the program, with its heavy government subsidies “would force out competitors from abroad and lead to government-subsidized global players that would compete unfairly.”
But if China is reinvesting a chunk of its own savings in its own economy, that means less capital flowing into the US, and less pressure on our trade deficit. The more they absorb their own savings (of which, to be clear, $300 billion is a small piece), the less countries like the US and the UK will continue to play our symbiotic consumer-of-last-resort role.
True, it matters what they do with the money, and there are lots of examples of China’s over-investment in inefficient sectors and projects. But as Brad Setser convincingly argues, encouraging countries with large surpluses (which must show up as deficits somewhere else) to engage in more internal investment is a far preferable way to reduce our own imbalances than tariffs and trade barriers (though Brad’s thinking more about investing in public goods than in private industry).
So, enough beating around the balance-of-payments bush: when are trade deficits a problem? Again, we must come at the problem from the side of the capital flows—the borrowing from abroad—that support our trade deficits. If we have truly productive uses for that capital, then trade deficits can be a plus. If there exist underfunded investments that generate a return higher than the rate of interest, the surplus on the capital account can be put to good, productive use. If such investments do not exist, there’s an all-to-good chance that the capital flows into a wasteful, damaging asset bubble.
Second, Navarro is not wrong to worry about the drag on demand from negative net exports, but only when there’s nothing in the pipeline to offset it. The Federal Reserve can lower interest rates to offset the drag, but not if they’re near zero, or in rate-raising mode, both of which conditions apply today. Fiscal policy can pick up the slack, but not if Congress refuses to step up.
So yeah, today’s trade deficits are a problem. They’ve not been large enough to keep the economy from growing and unemployment from falling, but remember, it’s year eight of an economic expansion and we’ve still not fully closed the GDP output gap (and that’s even the case as potential GDP has been lowered). In the absence of offsets, we could have used that extra demand.
One final thought. Hovering over this conversation is the specter of secular stagnation, a persistent demand shortfall that stems from excess savings colliding with insufficient investment opportunities. Note again the role played by excess savings, which, as I’ve stressed, are the flip side of our trade deficit. But what if we were to take a deep dive into public infrastructure investment – for example, green technology? Suppose we were to channel the excess savings from the surplus countries into standing up an industry that developed the next generation of batteries for storing renewable energy.
I know. This Congress and this president aren’t going there. But given the existential threat of climate change, or for that matter, the general state of our public goods, I find it awfully hard to accept the contention that there’s nothing productive in which to invest the excess savings surplus countries continue to send our way.