There are many potential sources of conflict between the world's two largest economies. But President Trump has forecast that his meeting Thursday and Friday with Chinese President Xi Jinping would be a "very difficult one" for a particular reason: Trade deficits.
Trump has long been focused on the trade deficit, the excess of imports over exports, as a sign of failing U.S. competitiveness abroad. In the past, he has proposed a variety of trade-related fixes, including protective measures like taxes on foreign imports.
But that strategy is unlikely to lessen the U.S. trade deficit with China, and it could actually backfire, economist Michael Pettis says. Pettis, a professor at Peking University and a senior fellow at the Carnegie Institution who is one of the leading voices about global imbalances in the flows of trade and capital, says that the U.S. trade deficit is a problem -- but not for the reasons that Trump, Bernie Sanders and other critics seem to think. The key, Pettis says, is that the trade deficit is due to a deeper problem, which is imbalances in the flow of international investment. In his view, this is an issue that China could fix, but which the United States is ultimately powerless to do much about.
I spoke with Pettis on April 5 about Xi's upcoming visit and the debate over the trade balance. This interview has been edited for length and clarity.
We’ve seen varying opinions on the trade deficit of late. The Trump administration has emphasized that bilateral trade deficits are bad for the U.S. But there are many other economists who say bilateral trade deficits aren’t a good metric to focus on.
So is the U.S. trade deficit with China something to be concerned about?
Yes. The problem is that the debate over whether the deficit is a good or bad thing is pretty sterile. The answer, as it is in most questions in economics, is maybe. It depends on the underlying conditions. There are times when running a trade deficit is positive for growth, and there are times it is negative.
It is a bad thing for the U.S. currently. The Trump administration is the first that has put the trade deficit at the center of its policies, but complaints about trade have existed for a while and they are legitimate. The problem is they are being addressed the wrong way. That’s because people are looking at flows in trade, when the cause is really flows in capital.
The thing you have to remember is the balance of payments [the total value of payments into and out of a country] by definition balances to zero. So if you run a trade surplus, which means you export more than you import, like China does, you must also run a capital account deficit, which means more money leaves your country than comes in. In that case, money is coming in through the trade account and leaving through the capital account. Of course, the opposite is also true. If you run a trade deficit, like the U.S. does, money leaves through the trade account and comes back in through the capital account. If you run a surplus on one account you must run a deficit on the other.
If you are a developing country, and you have insufficient savings to fund your investment needs, then you want to run a trade deficit and bring in foreign capital. The U.S. in the 19th century ran a trade deficit, which it needed to do, because as a developing country it needed huge infrastructure spending, and American savings were too low to finance it. In that case, the U.S. trade deficit was positive for growth, because it meant English capital was coming into the U.S. And that meant American investment could expand without significantly cutting into American consumption. Of course, when you have high investment and high consumption, you’re going to have a trade deficit.
So what is the situation like today?
This is still the pattern, but the U.S. is no longer a developing country, and it’s no longer constrained by savings. If you want to make an investment in the U.S. today, there are many reasons you might not be able to make it, but never because of lack of capital. So why would the U.S. run a capital account surplus today? Because its capital markets are completely open, and other countries have forced up their savings, because that gives them an advantage in trade.
There are two ways to become more competitive in trade. The first is to become more productive, but that’s hard and no one does that. The other way is just effectively to cut wages, which both Germany and China did. Germany did this through the so-called Hartz reforms, which weakened the bargaining power of the unions. In China, this happened mostly through interest rates, which were negative in real terms for decades. Because the Chinese don’t have a social safety net, they have to save a lot, and if you have a negative interest rate, the value of their savings goes down. In both cases, households ended up earning less money, they consumed less, and as a result the country ended up saving more. Thanks to open capital markets, these countries exported their excess savings. Germany exported them to peripheral Europe, and China exported them to the U.S.
What has been the effect of that on the United States?
Foreign money coming into the U.S. has changed the U.S. economy in a way that results in a deficit. It can make the dollar more expensive, which can result in a trade deficit. It can lower interest rates and set off a debt fueled consumption binge. The other thing that can happen with the trade deficit is that China will sell more goods to the U.S., the U.S. will stop producing these goods, and unemployment will go up. And that can force debt up as well.
Roughly half of all the excess savings in the world end up in the U.S., because the U.S. is a safe haven, there are no controls on capital flows, and it has very deep liquid markets. In the case of China, there’s a huge amount of flight capital flowing from China to the U.S. Chinese people are nervous about their economy so they’re taking money out of the country. Whenever there’s a problem in the world, flight capital goes up, and it mostly ends up in the U.S. That means the U.S. has always run a capital account surplus basically since the 1970s, which means it has also run a trade deficit.
Now, when Donald Trump, Bernie Sanders and others say the U.S. is forced into a trade deficit position because of distortions abroad, they’re correct. The question is what do you do about them? If you put on your 19th century hat, then you address the problem through the currency or tariffs. That’s the mistake the Trump administration is making. We still have this mentality where the reason you have a deficit is because of the cost of producing goods, but actually it’s due to the capital account. The trade is simply responding to the distortions to the capital side. And the distortions in the capital side are that these countries, to gain trade advantage, are effectively pushing down their own consumption.
So is there anything that can be done?
China could increase its household consumption. China has been trying to change this since 2007, but it’s politically difficult. The problem is that Chinese people earn too little as a share of gross domestic product [GDP], and that local governments and businesses earn too much. If you want Chinese household consumption to go up, the only way to do it is to transfer wealth from local governments and state-owned companies back to Chinese households. But politically that’s tough to do. The government said they would do that in March 2007, and it was later that year we first saw the phrase “vested interest” appear in Chinese in the newspapers. It’s become a common phrase now, and that’s not a coincidence. When the government tried to increase the household share of GDP, it discovered that powerful interests opposed that.
Can the U.S. do anything to influence this situation?
Well, raising tariffs to reduce the trade deficit could backfire. Let’s say Trump raises tariffs on Mexico. The Mexican economy will weaken, and money will stop flowing into Mexico and start flowing out. Notice what happens there: Mexico could go from being a deficit country to a surplus country. People are always surprised by that because trade surpluses seem like good things, but you can have a surplus for a perfectly bad reason.
During the crisis of the 1980s, all Latin American countries ran trade surpluses because the people there were too poor to buy things. If the Mexican economy stops importing savings and starts exporting savings, that just makes the problem worse for the U.S., because the U.S. is a residual for global investment. The total amount of foreign savings in the U.S. will rise, the dollar will be stronger, or interest rates will be lower, and the U.S. trade deficit will actually go up, not down. That’s the great irony.
The other irony that strikes me is that Trump has been very welcoming to foreign investment in the U.S., including from the Japanese and Chinese.
It’s crazy. Everyone thinks investment is a good thing, but the U.S. doesn’t need foreign money. The reason we have a crappy train system between Washington and New York and that we don’t repair all our roads is not because we can’t raise the money, it’s a political problem. Making more money available isn’t going to do that. Meanwhile, the U.S. is still running a deficit because of foreign investment.
What China can do is build a factory in the U.S. that competes with an American factory and puts it out of business. That might look like an increase in investment, but it’s really a transfer. This is what the Japanese car companies did. They were more modern and more productive, so they put American companies out of business, but total American employment didn’t go up, it just shifted from old decrepit American companies to new shiny Japanese ones. The problem is, we are so used to thinking investment is good, we don’t really look at the details.