Assigning Blame for Trade Imbalances

Finance professor Michael Pettis writes often about trade imbalances, and as I've followed what he has to say on this subject over the years, I've tried to figure out where exactly he and I disagree. This exchange about fiscal/trade deficits in an interview he did with Jacobin late last year may get at the core of the disagreement:

Dominik A. Leusder:

Right. Let’s assume that the current administration actually reduces the fiscal deficit. What happens to the trade deficit?

Michael Pettis:

Let’s say Donald Trump reduces the American fiscal deficit. What most American economists will tell you — because I think Americans don’t really believe that foreigners have agency — is that if the US fiscal deficit goes down, then savings go up by definition. If savings go up, the US trade account contracts. This assumes that net foreign inflows into the United States will also contract.

But if you were a Chinese or British or Swiss or Malaysian investor, or a Belgian dentist or the central bank of Korea, would a reduction of fiscal deficits make you less likely or more likely to invest your surpluses in the United States?

I would say you’re probably more likely to invest in the United States, because suddenly American debt has become much more valuable and much safer. In that case, you could actually see the trade deficit rise. So the question is: Is the American trade deficit driven by low American savings or by high foreign savings? If it really is all about low American savings, then I agree that raising the American savings rate and the trade deficit will come down. But if it’s driven by foreigners, then reducing the American fiscal deficit will probably be balanced by a rise in unemployment, not a reduction in foreign inflows.

This idea that trade imbalances are "driven by foreigners" is, I think, fundamental to his view. The high savings of foreigners, he argues, are the cause of imbalances, and relatively low American savings are of less interest to him (you may think this is all about China, but he tends to bring in Germany, Japan, South Korea, among others, as well). Consequently, his proposals for changes to the system involve new rules for the high savings/trade surplus countries only (from the perspective of a low savings/trade deficit country such as the U.S., this would mean only foreigners are subject to any new constraints):

I would argue that the most efficient way to do this is to have a new global Customs Union along the lines that Keynes proposed at Bretton Woods, in which you penalize countries that run deep and persistent imbalances. Keynes’s argument was: I don’t want to tell you how to run your economy. You can be communist, capitalist, fascist, socialist, whatever you like, but whatever your domestic problems are, you cannot externalize them through the trade account. So we will not allow you to create persistent imbalances. That would be the best solution — a new form of globalization.

We don’t want a world in which real economies must adjust to hot money flows. So anything that reduces them is good for the global economy.

Many people say this can’t be done: at Bretton Woods everybody hated everybody, and the United States ruled the world. Back then only one country needed to be convinced, now it’s many. But I think that’s a little pessimistic. If you include the United States, Canada, England, and a few other developing countries with deficits, such as Mexico or Colombia, then you’ve got 80 percent of global deficits. If you create a Custom Union that says “if you trade with us, you cannot run surpluses,” that will force the whole world to adjust.

To me, one of the biggest problems with the Pettis approach is that he seems to be looking for one side to blame here, in effect asking the question: "Is the American trade deficit driven by low American savings or by high foreign savings?" In his mind, it has to be one or the other – either the Americans or the foreigners are to blame. He then decides to put the blame for imbalances on the foreign surplus countries that have high savings, with low-savings deficit countries such as the U.S. being innocent victims. The surplus countries save too much, he says, and that's the source of all the troubles.

As I see it, however, explaining the existence of imbalances requires more than just looking for one side to blame. The trade imbalances at issue here are more accurately described as resulting from differences in savings levels (both government and private), rather than coming just from the savings behavior of one side. There is no particular savings level that is the objectively correct one. With government savings, there is disagreement about what constitutes an appropriate fiscal policy; and with private savings, my sense is that the role of cultural factors is pretty strong (and that Pettis and others underestimate it). Thus, it doesn't make sense to blame the countries with high savings rates for trade imbalances (or, for that matter, to blame the countries with low savings rates). The issue is simply that differences in savings rates can have an impact on the trade balance, especially when governments have policies that get in the way of the currency adjustments that could help bring things into balance.

Relatedly, I think this is part of why the Pettis view appeals to many people across the political spectrum in the U.S.: They can use his arguments to put the blame for U.S. trade deficits on foreigners. However, if someone is genuinely concerned (for whatever reason) about trade imbalances, I think it's important to emphasize the differences in savings levels, in combination with factors such as policies that affect the exchange rate, as the explanation. That's not likely to be a popular approach among U.S. politicians, but it seems to me that it's the right way to think about the issue.