The Real Economics Behind Today’s Trade Wars

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Many discussions of trade imbalances focus on what the deficit countries are doing wrong. The framing usually puts the blame on borrowers in the deficit countries for spending beyond their means and saving too little. There’s a more useful frame that reorganizes the entire analysis: Trade imbalances are income imbalances. When you accept that observation, almost everything that has happened in global macro over the last 25 years starts to look a bit different.

The frame is not new, as it runs through Keynes, Joan Robinson, Michal Kalecki, and Ragnar Nurkse. Mainstream economics drifted away from it during the 1970s and 1980s, in part because price-effect models are easier to teach than income-effect ones.

The current generation of policymakers and investors is rediscovering the income view through experience.

Germany's 2003 labor reforms caused Spain's property bubble

One clean historical example sits inside the Eurozone. 

When the euro launched in 2000, the so-called peripheral countries of Spain, Italy, Portugal, Ireland, and Greece ran small surpluses or small deficits. None had serious debt problems or asset bubbles. Then, around 2003 and 2004, all of them at the same time began to borrow heavily, ran current account deficits, and developed property bubbles.

The shared timing was no coincidence. 

Germany implemented the Hartz labor reforms in the same window. Wages stopped growing in line with productivity, and corporate profits surged. German aggregate savings rose sharply, even though German household savings actually fell. The increase in saving showed up on corporate balance sheets rather than in household budgets.

That capital had to be deployed somewhere. The euro made it easy to recycle German savings into peripheral economies through bank lending. Spanish banks lowered lending standards, and Irish banks did the same. 

By the mid-2000s, credit was so easy that getting one credit card meant nothing because everyone had 12. The countries that received those flows did not lose their financial discipline at random. They received German savings through a channel that mathematically required an offsetting current account deficit, and the property bubble was the form that adjustment took.

Lower wages improve competitiveness without improving productivity

Wage suppression works as a competitiveness tool rather than a productivity tool. 

Lower wages let a country win export share, but they do not improve actual productivity. After the Hartz reforms, German productivity growth slowed while German competitiveness rose, because lower wages widened the gap between price and cost. The policy literature usually blurs these two outcomes, which makes the political conversation about labor reform harder than it should be.

The Polish economist Michal Kalecki described what happens when this logic spreads: A single firm can raise its profits by cutting wages. If every firm cuts wages, total demand falls, and profits fall with it. The same applies to countries: a single country can run a surplus by suppressing domestic wages. If every country tries the same thing, global demand contracts and the surpluses become harder to sustain.

China's growth model is locked into excess manufacturing

China's rise as a manufacturing power has run on the same mechanism that drove German exports. Wages as a share of GDP fell to among the lowest levels recorded for any meaningful economy. Chinese unit labor costs became the lowest of any major exporter. The trade surplus that followed was not an accident.

The problem with this model, which the economist Albert Hirschman pointed out decades ago, is that successful growth models build political and economic institutions that depend on them. Switching to a new model requires dismantling those institutions, which always involves accepting slower growth in the interim. 

Japan tried in the 1980s and 1990s. The household consumption share of GDP took 17 years to rise by 10 percentage points. During the same period, Japan's share of global manufacturing fell by more than half.

China is roughly where Japan was in 1986. The Maekawa Commission Report could be rewritten today for Beijing with minor edits. Chinese officials understand that the consumption share has to rise. Doing it would require accepting a sharp loss of manufacturing share, slower growth, and political stress. Most economies in this position have chosen to delay the adjustment and let debt absorb the gap. Chinese debt-to-GDP is officially around 315 percent, growing at 10 to 12 percentage points per year, and accelerating rather than slowing.

The US trade deficit is caused by foreign capital inflows

The American conversation about trade usually treats the deficit as a consequence of US savings habits. The causality runs the other way. 

The United States has the deepest, most liquid capital markets in the world, with stronger investor protections than most jurisdictions. When surplus countries need to invest their dollars, the Anglophone economies of the US, Canada, and the UK absorb 70 to 80 percent of those flows.

Those inflows force an offsetting current account deficit. US domestic saving then adjusts through some combination of rising unemployment, rising household debt, or a wider fiscal deficit. All three are versions of negative saving. 

The income distribution within the US, with inequality at historic highs, would normally produce a high savings rate because the rich save more than the poor. The US does not have high savings because foreign inflows push the adjustment in the other direction.

The dollar's reserve currency role therefore works as an exorbitant privilege for Wall Street and the foreign affairs establishment, and as an exorbitant burden for American manufacturers and middle-class savers. The internal political fight over the dollar's role reflects which part of the economy you sit in.

Europe's hardest test arrives when the US fixes its own deficit

The US, the UK, and Canada together account for roughly 70 percent of global trade deficits. Most surpluses still come from China and a small group of other manufacturing economies. 

The Chinese surplus with the US has fallen, but the Chinese surplus with the rest of the world, including Europe, has risen. The US deficit with China has fallen, but the US deficit with the rest of the world has risen by more. Nothing fundamental has yet rebalanced.

If the US succeeds in reindustrializing and reducing its deficit, those surpluses have to land somewhere. A very likely destination is Europe, which then faces a choice between absorbing the surplus and accepting further de-industrialization, or intervening in its external account through tariffs, capital controls, or other tools. 

Whether Europe is politically unified enough to take the second path is unclear. The Draghi report acknowledges the need to act, but the institutional capacity to do so is harder to assemble.

Keynes' Bretton Woods proposal would have prevented this

Keynes' original Bretton Woods plan included a mechanism that penalized persistent trade surpluses until they were drawn down to zero. 

The US rejected it at the time, because the US was the world's largest surplus economy and did not want to be penalized for its own success. The system built instead allows imbalances to persist for very long stretches before they correct, and the corrections are usually painful.

A growing list of mainstream institutions, including the IMF, the OECD, and the Bank of England, has begun to acknowledge that persistent imbalances are a problem. The intellectual ground for revisiting Bretton Woods is being slowly rebuilt. Whether it gets revisited in time for the next adjustment is the open question.

The macro question is who pays the cost of the next adjustment

Every major imbalance episode in modern history has ended in difficult adjustment. The interesting variation is who absorbs the cost. 

In the 1920s US/Europe imbalances and the 1980s Japan/US imbalances, the surplus countries paid most of the price. In the 1970s Latin American crisis, the 1990s Asian crisis, and the 2000s Eurozone crisis, the deficit countries paid most of the price.

Historical patterns suggest that when the deficit countries are large and powerful, they can force the adjustment onto the surplus countries. When the deficit countries are small or weak, the surplus countries push the cost onto them. 

This setup features the US, the UK, and Canada as the dominant deficit economies, all relatively large and powerful, and China as the dominant surplus economy, which is arithmetic suggesting that the surplus countries will absorb most of the next adjustment. China's manufacturing share will probably fall in line with what Japan experienced after 1990, possibly faster.

The macro outlook describes how the costs of an inevitable adjustment will be allocated, rather than predicting who comes out ahead. Watching the policy responses in Beijing, Berlin, and Washington over the next several years will likely reveal more than watching the next inflation print.

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DISCLAIMER: This article is based on a conversation from Top Traders Unplugged and reflects themes, ideas, and perspectives discussed during the episode. The views expressed are those of the guest and participants in the conversation and should not be interpreted as investment advice or as the official views of Top Traders Unplugged.

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