Economist Joseph Stiglitz recently published an interesting piece in Project Syndicate called “The US is at Risk of Losing a Trade War with China.” I am always surprised by claims that deficit countries like the United States stand to lose more from a trade war than surplus countries (that is certainly not what history suggests). I suspect it is because many commentators just do not understand why China is so susceptible to a trade war and why Beijing is so worried. Otherwise, I agree with much of what Stiglitz says about tariffs in the article (as I usually do). This includes the article’s main point—that tariffs are likely to have a limited or even adverse impact on U.S. and Chinese overall imbalances, even if they ostensibly improve bilateral imbalances. His article begins by saying this:
The “best” outcome of President Donald Trump’s narrow focus on the US trade deficit with China would be improvement in the bilateral balance, matched by an increase of an equal amount in the deficit with some other country (or countries). In fact, significantly reducing the bilateral trade deficit will prove difficult.
Regular readers of my blog know that I have made many similar arguments. In April 2017, for example, I explained why clumsy attempts to reduce the large U.S. bilateral trade deficit with Mexico are likely actually to increase the U.S. deficit with the rest of the world by more than they reduce the U.S. deficit with Mexico. This may seem counterintuitive at first, but there is nothing complicated about the logic that drives this process. It only seems counterintuitive because the trade models most people carry around in their heads involve implicit assumptions that used to be true but no longer are. Because these assumptions are almost never explicitly stated, it’s easy to fail to notice how changes in the dynamics of global trade and investment have made the old models that drive the debate obsolete.
The same dynamics apply to trade with China, as Stiglitz points out. While tariffs on Chinese imports are likely to reduce the bilateral U.S. trade deficit with China, they are unlikely to reduce the overall U.S. deficit, nor will they reduce the overall Chinese surplus. Tariffs will merely cause shifts in global trade patterns that might raise prices on some goods marginally but that do not affect the underlying causes of the imbalances.
Do Americans Save Too Little?
But for all my agreement with Stiglitz on how tariffs affect trade, I disagree with him on what drives U.S. trade imbalances and, more generally, on balance-of-payments dynamics. Stiglitz argues that the United States has been running trade deficits mainly because Americans save too small a share of their income.i According to this logic, if Washington wants to reduce its deficits, it must implement policies that force up U.S. savings:
The US has a problem, but it’s not with China. It’s at home: America has been saving too little. Trump, like so many of his compatriots, is immensely shortsighted. If he had a whit of understanding of economics and a long-term vision, he would have done what he could to increase national savings. That would have reduced the multilateral trade deficit.
The United States has indeed been saving “too little.” But it is easy to show that under certain conditions—ones that most of us, perhaps even Stiglitz, would agree characterize today’s global economy—low U.S. savings are an automatic consequence of balance-of-payments pressures originating abroad.
In fact, the same basic arithmetic shows that the United States cannot raise domestic savings relative to domestic investment (that is to say, it cannot reduce its trade deficit) without addressing problems that do indeed originate in China, and in all the other major surplus countries. The United States, in other words, doesn’t have a trade deficit because it saves too little: it saves too little because it has a trade deficit.
Again, I know that this may seem at first incredibly counterintuitive. (And here, inevitably, someone will foolishly intone that no one is putting a gun to a U.S. consumer’s head and forcing him or her to buy a flat-screen television.) But in fact this claim follows inexorably from the basic balance-of-payments arithmetic.
Before going on to explain why, I should point out that Stiglitz is not the only one who believes that low U.S. savings cause U.S. trade deficits. This has been an almost overwhelming consensus among economists and analysts for decades. In May 2017, for example, two other eminent economists, George P. Schultz and Martin Feldstein, proposed a seventy-word explanation of “everything you need to know about trade economics. . .” They wrote:
If a country consumes more than it produces, it must import more than it exports. That’s not a rip-off; that’s arithmetic. If we manage to negotiate a reduction in the Chinese trade surplus with the United States, we will have an increased trade deficit with some other country. Federal deficit spending, a massive and continuing act of dissaving, is the culprit. Control that spending and you will control trade deficits.
While Stiglitz argues that Washington must implement policies that raise national savings to reduce the U.S. trade deficit, Schultz and Feldstein are more specific and far more ideological: they state that Washington must reduce government dissaving by reducing the fiscal deficit.
Either way, these economists agree that only by taking steps to force Americans to save more—whether U.S. households, businesses, or the government—can Washington prompt the U.S. trade deficit to contract. They argue that this line of reasoning follows inevitably from the accounting identities that explain the relationship between savings, investment, and trade deficits.
A Hidden Assumption
I have often argued that economists too easily make categorical statements when they should be making conditional ones. Stiglitz, Schultz, Feldstein, and others base their argument on the accounting identity in which a country’s current account deficit is always and exactly equal to the excess of domestic investment over domestic savings. (For those who are interested, in a May 2017 blog response to the Schultz and Feldstein article, I list and explain the very simple equations behind the relevant accounting identities.)
The point is that U.S. investment has exceeded U.S. savings for decades, and the accounting identities let us see that, as long as this is true, the United States must run a current account deficit exactly equal to the gap between investment and savings. Narrow the gap between the two, Stiglitz argues, and you automatically reduce the U.S. deficit. This is true by definition.
Because very few economists would recommend reducing investment, Stiglitz then takes what seems like the logical next step. He argues that if the United States were to implement policies that caused U.S. savings to rise, the resulting higher savings would reduce the gap between U.S. investment and U.S. savings. Doing this, in turn, would reduce the U.S. current account deficit. In theory, this could perhaps be done by reducing the fiscal deficit, by making it harder for consumers to borrow, by increasing business profits at the expense of workers, or by increasing income inequality more generally.
But there is a hidden assumption at work here. It turns out that policies that increase domestic savings in the relevant sector of the economy would narrow the investment-savings gap only if U.S. investment and savings were wholly determined by domestic forces. If that were the case, it would also mean that Americans imported foreign capital specifically to bridge this investment-savings gap. To put it slightly differently, increasing domestic savings would narrow the investment-savings gap only if foreigners exported capital to the United States mainly in the form of trade finance, and only if this trade finance were designed specifically to fund the trade deficit or to fund the difference between domestic U.S. investment and domestic U.S. savings (which would amount to the same thing).
This is how the world used to work, but that is no longer true today. Economists too often fail to identify explicitly the assumptions that allow their models to work. This is probably why so many economists retain an obsolete model of balance-of-payments dynamics.
Why Does Capital Actually Flow to the United States?
There are, in fact, two very different explanations of why foreign savings flow into the United States, and each has completely different implications:
- One explanation assumes that trade or capital imbalances originate in the United States, perhaps because Americans save too little and consume too much, in which case the rest of the world accommodates these imbalances. According to this explanation, the United States has domestic investment needs that cannot be satisfied by domestic savings, so Americans must bid up the cost of capital to attract foreign savings to fund the gap. This was almost certainly the case for much of the nineteenth century.
- The other explanation assumes that trade or capital imbalances originate abroad. The thinking goes that the United States accommodates these imbalances, partly because it has very deep, liquid capital markets with highly credible governance, and partly because of its role as the capital shock absorber of the world. According to this explanation, surplus countries—usually, I might add, because of policies that suppress domestic consumption—have savings that exceed their domestic investment needs and must export these excess savings abroad to run trade surpluses and avoid unemployment. These surplus countries prefer to export a substantial portion of their excess savings to the United States and, as they do so, they push down the cost of capital.
The first explanation—which was valid for most of modern history—assumes that most capital flows consist essentially of trade finance. The second explanation—which was probably valid in the late nineteenth century and has now become valid again since the late twentieth century—assumes that most capital flows are driven by central banks, sovereign wealth funds, capital flight, and investors managing their capital. The presumption is that these capital flows represent independent investment decisions based on expectations of risk and returns.
Whichever explanation is correct, it is clear that the world must balance. And unless we believe that balance is achieved by an extraordinary coincidence at every point in time, causality must flow one way or the other. There is nothing in the accounting identity that tells us which way causality runs, but run it must.
It is wholly incorrect to assume, however—as most economists implicitly do—that it is the rest of the world that automatically accommodates U.S. imbalances. It could easily be the reverse. And I think it is very likely the reverse that holds true, given that interest rates do not typically rise as U.S. trade deficits rise. Interest rates suggest very strongly that capital isn’t sucked into the United States from abroad, but rather is pushed into the United States from abroad.
More importantly, capital flows into the United States do not consist only of trade finance. Instead, this influx does indeed consist mainly of independent investment decisions driven by central banks, sovereign wealth funds, capital flight, and investors managing their capital. Because of the depth and quality of its financial markets, the United States acts as an investor of last resort, absorbing excess foreign savings that need a safe home.
Whichever explanation any reader might prefer, my point is not to assert that one or the other is right. It is rather to insist on a fact that any trade model must recognize explicitly: a world in which U.S. capital imports are determined abroad, by countries and investors seeking to manage their excess savings, works very differently from one in which U.S. capital imports are determined domestically, as a reflection of structurally low U.S. savings rates that require the country to import foreign capital.
In the latter case, Stiglitz would be correct to argue that policies that force up U.S. savings must reduce the gap between savings and investment, and so must reduce the current account deficit. In the former case, however, the U.S. capital account surplus (that is, imports of foreign capital) is determined by conditions abroad, which in turn determine the gap between U.S. investment and U.S. savings. In this case, because policies aimed at increasing domestic savings have no predictable effect on the U.S. capital account surplus, the gap between U.S. savings and U.S. investment will remain unchanged, as will the current account deficit.
Will Raising U.S. Savings Cause Investment to Rise?
To put it in simpler terms, assume for a moment that foreigners have $100 in excess savings that they have decided to invest in the United States. Obviously, this creates a $100 U.S. capital account surplus and a corresponding $100 current account deficit; this also requires that U.S. investment exceed U.S. savings by exactly $100.
What would happen if, as Stiglitz proposes, Washington were to implement policies that are designed to raise U.S. savings by say $20? If foreigners continued to direct $100 of their excess savings to purchasing U.S. assets, the gap between U.S. investment and U.S. savings would not drop to $80, as Stiglitz assumes. It would still remain at $100 dollars because this gap is determined by the decision abroad to invest $100 in the United States.
How is it possible that savings rise without contracting the savings-investment gap? It turns out that if Washington were to implement policies designed to raise U.S. savings by $20, and if the gap between savings and investment were to remain unchanged at $100, there are basically two ways that the new policies could be accommodated (or some combination of the two):
- In the first instance, U.S. investment would rise by $20 as Americans took advantage of the higher domestic savings to increase domestic investment. This would be true if the United States were a developing country in which desired investment exceeded actual investment, but the country was limited by insufficient domestic and foreign savings. In that case, both savings and investment would rise by $20, and the current account deficit would be unchanged.
- But in the second case, if savings are already plentiful and interest rates are low, to the extent that all desired investment has been funded, U.S. investment wouldn’t rise. If the gap between U.S. investment and U.S. savings is unchanged (and investment doesn’t rise), then savings cannot rise. This means that policies designed to raise U.S. savings by $20 can only cause savings in one part of the economy to rise by $20 while simultaneously causing savings in another part to decline by exactly the same amount.
This is the tricky part that is almost always missed. Policies designed to increase savings will only do so if the additional savings fund additional investment or are exported abroad. Otherwise, they simply cause savings to rise in one sector of the economy and to decline in another, as I explained in a May 2016 blog entry called “Why a Savings Glut Does Not Increase Savings.”
There are two important points here. First, if the U.S. capital account surplus is determined by conditions abroad—which is almost certainly the case—policies designed to raise U.S. savings will have no impact on the U.S. trade deficit. This is because (contrary to conventional opinion), in today’s world, the capital account drives the trade account, not the other way around. Again, this may seem counterintuitive, but I explain why this must be the case in a February 2017 blog entry called “Why Peter Navarro is Wrong on Trade.”
Second, this doesn’t mean that policies designed to raise U.S. savings will have no impact at all on the economy. What matters is whether or not these policies result in higher investment. If they do, the U.S. economy is probably better off. This is basic supply-side economics. But if these policies don’t result in higher investment, then the U.S. economy is almost certainly worse off.
Before I explain why these policies would leave the U.S. economy worse off, let me explain why investment is unlikely to rise. In a world characterized by excess savings, there is unlikely to be a significant amount of unfulfilled U.S. investment needs. The United States does need to invest in infrastructure, to be sure, but its failure to do so is political, not because of a lack of capital. In fact, capital is easily available to any credible U.S. borrower (and to quite a few noncredible ones) at the lowest rates in history, no less. And yet rather than invest massively in productive projects, U.S. companies (and those of most advanced economies) refuse to raise money to invest and instead sit on hoards of cash for which they seem unable to find productive use.
Increasing U.S. Savings Means Higher Unemployment or More Debt
This is why policies designed to raise U.S. savings are likely to leave the country’s economy worse off. If Washington were to cut the fiscal deficit, or to reduce taxes on the rich so as to increase income inequality, the result would not be higher domestic investment (as the supply-siders say) or a smaller current account deficit (as Stiglitz says). The result would be either higher unemployment or higher debt.
Why? Let’s return to the previous example. Assume Washington were to implement policies designed to raise U.S. savings by $20. If foreigners or conditions abroad determine the U.S. capital account surplus, there will be no reduction in the U.S. trade deficit. Living in a world of excess savings means that there is no pent-up demand for the additional productive U.S. investment that could theoretically be unleashed by a potential $20 increase in savings, so investment cannot rise.
But the gap between investment and savings must remain unchanged (because there was no change in the amount of money foreigners invested in the United States). This being the case, policies designed to raise U.S. savings by $20 inevitably can only cause savings in one part of the economy to rise by $20 while simultaneously causing savings in another part to decline by exactly the same amount. Total national savings cannot rise if the trade deficit doesn’t contract and if investment doesn’t rise.
How can policies that cause a $20 rise in U.S. savings in one sector of the economy also cause a $20 decline in savings in some other sector of the economy? I have discussed this issue before, perhaps most extensively in a May 2016 blog entry. To put it briefly, such policies can result in a rise in unemployment, which reduces household savings, or the policies can increase household debt by lowering interest rates, expanding credit, or setting off wealth effects.
This is the main point I hope to make here. Policies that Washington implements to try to raise U.S. savings rates can have very different effects on the U.S. economy, some benign but some very damaging. The outcome depends on underlying conditions that are implicit in the assumptions behind the balance-of-payments model that we use. We can broadly summarize the implicit assumptions and their consequences in this way:
- If foreigners exported capital to the United States mainly to finance the U.S. trade deficit, policies designed to raise U.S. savings would cause the U.S. trade deficit to contract.
- If foreigners export capital to the United States mainly to dispose of excess domestic savings, and if desired investment in the United States exceeds actual investment, policies designed to raise U.S. savings will cause U.S. investment to rise but will have no impact on the trade deficit.
- If foreigners export capital to the United States mainly to dispose of excess domestic savings, and if there is no shortage of capital in the United States, meaning that desired investment in the country is broadly in line with actual investment, policies designed to raise U.S. savings will have no impact on the trade deficit but will cause an increase in either U.S. unemployment or U.S. debt.
What Can Washington Do?
So what are the policy implications if Washington is serious about reducing the current account deficit? Again, it depends on which underlying conditions apply.
- If foreigners exported capital to the United States mainly to finance the U.S. trade deficit, Washington must implement policies that force up the domestic savings rate if it wants to reduce the trade deficit.
- But if foreigners export capital to the United States mainly to dispose of excess domestic savings, Washington must implement policies that make it harder for foreigners to dump excess savings in the United States or policies that make it easier for Americans to send these flows abroad. Only by reducing net foreign capital inflows will Washington be able to drive down the trade deficit. (One way Washington might be able to reduce foreign capital inflows would be to require that central banks no longer accumulate U.S. dollars in their reserves but rather that they accumulate a synthetic currency that is backed by all major global currencies—perhaps even the International Monetary Fund’s Special Drawing Right (SDR).)
If I am right, then it is not the case that the United States runs a current account deficit because Americans save too little. It is the reverse: Americans save too little because the United States runs a current account deficit or because it runs a capital account surplus: foreign capital inflows automatically depress U.S. savings.
As counterintuitive as this conclusion may seem, this is the implication of very plausible assumptions about how the world works. The reason most economists are not aware of this is simply because they have not made explicit the assumptions that underlie the models they use. Consequently, they have not recognized how changes in global markets have made their models obsolete.
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Notes
i In this sentence’s reference to trade deficits, the term current account deficit would be more correct, but for the purposes of this essay we can ignore the difference between the two.
Comments(34)
Cudos to Michael Pettis for articualting a nuanced Balance of Payments argument.
Michael your point 2 in the chapter headed 'What can Washington Do?' has two practical difficulties. First is the limited power Washington has to dictate to Central Banks other than its own. How can you force them to stop holding dollars when the currency is he world's trading medium? Currently those overseas-held dollar reserves are not standing idle but are invested in US government securities. That leads to the second difficulty. SDRs cannot be held in the form of securities issued by the IMF or the World Bank at present. If such securities did exist the flimsy backing (of the IMF and WB relative to the US Govt) would require a bigger coupon to be attractive. Can you suggest how your point 2 might be implemented?
The answer would be a full Keynesian clearing union with more than de minimis issuance authority. JMK couldn't get that at Bretton Woods because the chief creditor nation - the US - was both short-sighted and in possession of all of the cards. We've a brief window, for now, in which the chief debtor nation - again the US - still holds a good many cards. What remains to be seen is whether it is less short-sighted now. I am metabolically optimistic, but I must admit I'm not betting good money on *either* the US *or* China's getting serious soon about a bona fide ICU.
Michael has addressed the SDR many times, and has wonderful evaluations of such, at length, likely referencing SDR, was referring reviewers back to those, issues related, and such, would mean greater use of currencies, long-resisted to be used, likely some additions, and some way forward. Perhaps, without the US at the level it currently occupies, but demanding to be held as a lower percentage for its participation at all, I suppose if necessary and a new institutional framework at the US demand. Notions to the inability to use SDR, likely dates to discussions after Michael addressed in lead up to inclusion of RMB, that have spread more widely. Overseas held dollar reserves are only partially in government securities. Washington, of course, could do many things. It may have no "dictate" over other Central Banks, but it does have dictate over its Financial System, in many ways, than, over those who would like to use it, trade in USD, or have the ability to recycle services as we the electorate, our representative and/or other forces may find necessary (unfortunately if history is any guide). Quite more capable to do so than mere statements of inability to imagine not. Work the scenario's yourself, especially as global "growth" as become more reliant on overuse of this gits to the common. Actually, these necessary elements for system maintenance. Indeed, rethink central bank postulation.
Ian, Washington cannot dictate policy to foreign central banks but it can certainly impose various forms of capital control on inflows into the US, for example a tax on foreign purchases of US government bonds. As for SDRs, they could be issued by an SPV, probably set up by the IMF, whose only purpose is to make SDRs available to central bankers and other investors. The SPV would issue SDRs and simultaneously purchase the relevant currencies so that it was always perfectly hedged. The effect of this would be to spread out the purchase of central bank reserves more evenly, so that instead of accumulating dollars, central banks would accumulate a basket of currencies. Basically we would be reviving a form of Keynes’ bancor. It would Also separate the management of the global reserve currency from the needs of domestic US monetary conditions.
Wouldn't a third option be to incentivize foreign consumption?
The problem, TN, is that Washington cannot do much to incentivize foreign consumption as this would involve domestic wealth transfers in countries like Germany and China.
Agree. If international trade is to be rebalanced, accumulated monetary reserves of surplus countries ultimately need to be used to buy goods from deficit countries, not invested in monetary assets denominated in a basket of currencies of which the USD would still be a large component. To achieve this, domestic consumption must ultimately rise in countries in external surplus.
Dr. Pettis: I agree with your analyses but would like to add some thoughts from a slightly different direction. The Stiglitz article gets the economics wrong, apparently for the same reason Martin Feldstein has got it wrong in postings on the PS site, i.e. misuse of the accounting identities. While underlying analyses are not provided in these postings, the only obvious way I find to reconcile conclusions of Stiglitz/Feldstein with accounting identities is to assume that total US based production is essentially fixed and cannot be affected by trade actions. This unstated assumption is demonstrably invalid. A primary objective of most trade actions is to attempt to increase total production within a country. If production in the US becomes profitable it is reasonably predictable that production will begin to increase, and production in industries that are struggling or marginally profitable due to import competition will stop declining. Some industries have slack and could increase production fairly quickly; others will take some time to build the needed production capacity. RE: the accounting identity given in the May 2017 MP post: Trade deficit = Total investment – (Household savings + Business savings – Fiscal deficit). The effect of changes in production is easier to see if one replaces “savings” with “production-consumption” or “income-consumption spending” in the accounting identity. Any change that causes an increase in production more than the related increase in consumption will increase (Total investment -Trade deficit). Changes that increase production more than consumption but require little or no investment will tend to reduce the trade deficit in the short term (like increasing production of an underutilized factory or power plant, or restarting production at an idle facility). Changes that require significant investment may cause a near term increase in the trade deficit but will typically reduce the long term overall accumulated trade deficit. Labor reforms (e.g. Hartz), tax changes (e.g. consumption/VAT taxes with rebates on exports), etc. in Germany have resulted in large trade surpluses both because of suppressing consumption and because of increasing production by improving profitability of producing tradable goods (or as the Germans like to say increasing “competitiveness.” Conversely, aggressive actions by exporting countries resulted in shutdown of thousands of factories in the US with consequent reductions of production greater than the related reduction of consumption, and hence large increase in the trade deficit.
You are right, G. Stegen. This is one of the reason Stiglitz’s recommendation wouldn’t work. Raising the savings rate could well cause total production to drop if it causes unemployment to rise.
Thanks so much for this, Michael. I read Joe's piece when it came out and marveled over how the same thoughtful fellow who's done so much to highlight the dangers and injustices latent in widening wealth-inequality and private debt buildup could be calling on Americans to 'increase their savings.' Like Whitman, Joe is large enough to contain multitudes; but unless one's a dialetheist, calling both for greater equality and for more savings 'to narrow the current account deficit' is at least one multitude-member too many!
Had to look up dialetheist, but I thought the same thing, and frankly after JS's Discontents, couldn't read him anymore. Because, at that time it should have been quite apparent what was occurring, rather than what he was expressing. It seems that most need to get better appreciation (intuition) of geometries, volumes, vessels, proportions, and paces before so easily resorting to value-strewn and adjective-laden declarative statements.
Thanks, Robert. I didn’t really make this explicit, and I so am glad you caught it. It’s all very well to talk about raising the savings share of GDP, but this means reducing the consumption share, which almost always means reducing the income share of ordinary and poorer Americans, most of whose income goes to consumption. As we know from supply-side economics, the trick to forcing up savings is quite simple: force up income inequality. It is hard both to reduce income inequality and to increase savings.
Michael is correct in saying that the old trade-finance model is obsolete. What has replaced it is a focus on the "interlocking matrix" of corporate balance sheets. In the familiar twentieth-century "island" model of international economic integration, the basic units were national economies that traded with one another, ran trade surpluses and deficits and accumulated national claims and liabilities. Now, though, in discussions of international trade it is commonly accepted that it is no longer national economies that matter. What drives global trade are not the relationships between national economies, but multinational corporations coordinating far-flung "value chains." The new macro-financial economics focuses on corporate balance sheets (think Apple, Alphabet, etc.) where the real action in the financial system is. According to this analysis, the financial system does not, in fact, consist of "national monetary flows." Nor is it made up of a mass of tiny, anonymous, microscopic firms - the ideal of "perfect competition." Rather, we live in a world dominated by business oligopolies, and the overwhelming majority of private credit creation is done by a tight-knit corporate oligarchy. At a global level, there are twenty to thirty banks that matter. Allowing for nationally significant banks, the number worldwide is perhaps a hundred big financial firms This is the unpalatable and explosive (but unacknowledged) truth behind the the FED's policy of global liquidity support after 2008. It involved handing trillions of dollars in loans to that coterie of banks, their shareholders and their outrageously remunerated senior staff. Democratic politics - on both sides of the Atlantic - has choked on this. Unless and until that changes, control of "trade deficits" will be elusive. Worse, expect, sooner or later, a replay of 2008.
Hi Prof Pettis! A bit off topic, but I just received my copy of Crashed by Adam Tooze. Having loved the Deluge and Wages of Destruction, and remembering that you recommended those two books several years ago, I was wondering if you have read Crashed yet, and if so, what are your thoughts?
Not yet, Jacques, but I will as soon as I get my copy.
Look forward to hearing your reaction!
The US trade deficit; what can be done to stop this trend? Usually competitiveness comes up first as with ADAM TOOZE in NYT: "Trump is wrong so is everyone else". MICHAEL PETTIS not so sure about higher savings equaling higher investment to save the days. As an example take Germany blessed with an export machine with full employment and high savings rate; no government deficit spending might be the real key to their success? But Germany also imports US commercial aircraft and other US services without thinking about this being a competition? Raising standards of efficiency more important making enough profits by using a trained workforce on high wages as a byproduct; compare average wages of Germany and Britain. US now applying tariffs with mixed results. Higher import prices inevitable with higher interest rates following in hot pursuit. Then consumer spending shrinks as people tempted to save more with more downward economic pressure unleashed? People spending merrily seen as a good thing; just a pity more of it not spent on US made products. China provided years of economic expansionism which the US took advantage of without complaining until now: GM APPLE STARBUCKS. China made things cheaper and in so doing allowing employers to lower average wages since 2000 in low inflation environment. China never intended to cross swords with US. Europe less inclined to confront China but did take raise tariffs on Chinese steel imports. More important the "automatic accommodation of US balances" questioned by MICHAEL PETTIS should concern everybody as China reacts to the unfolding US trade war. US deficit spending may come to a screeching halt and currency crisis as a direct consequence. US an accomplished debt nation; reliant on foreign goodwill?
You write that China is very worried about a trade war and also that they will not reduce the overall trade surplus. The latter point makes complete sense (providing that other countries are willing to accept Chinese imports), but could you explain how that meshes with the former point? Moreover, if China needs to rebalance anyway and Xi has already consolidated his power, wouldn't China react by beginning to transfer wealth from the state and business sector to the household sector?
That's the big question, Claire, and the proof is in the pudding. We have to wait and see if Beijing thinks it is able to manage the transfers.
In fact China is already starting this process to stimulate domestic demand and taking steps to reduce their US trade surplus. For example the consolidation of the Chinese steel industry resulted in huge job losses. Generally governments do not necessarily target key industries as export champions which certainly was the case with JAPAN and their car industry pushing into the US from 1972. Eventually that problem solved itself by the devaluation of US dollar against the YEN from 270 to below 100; plus some tariffs by mutual agreement. Also important to check the composition of the US trade deficit to see how it can be addressed over time; if at all. Of all exports from China to US exclusively for US based companies like APPLE? Chinese exports for WALMART low value items and much cheaper to make in China? And consider Chinses tourism to the USA? Many Chinese people fascinated with American modern-day culture; as long as it remains open? That raises the question of other tangible benefits to the US-Chinese relationship given there must be over 10 million US citizens of Chinese descent. If American consumers are to be strictly disciplined and penalized for buying any foreign goods based on their personal preferences perhaps they might feel victimized through no fault of their own. The consumer will be the big loser in any prolonged US trade war; without end. China has good reason to worry the US embarking on self-destructive high-risk course of hostile actions; with only the certainty of a global depression.
Is there a way the U.S. government could also adopt a policy of sterilizing such deficits? Perhaps they could set up a sovereign fund which could then invest abroad and thus basically achieve what is attempted in the second option - ie. diversifying away from USD into other currencies. In a way, I am wondering whether China's One Belt One Road investment program is not exactly that - an attempt to offload more excess savings to other countries other than the U.S. (knowing full well the U.S. has had enough of absorbing their excess savings) but disguised as a Marshall Plan for Central Asia.
There is not a huge number of possible combinations in that accounting identity. There are 2 I can add immediately to the ones you suggested in your text 1. The dream of Apocalypse. The US government actually succeeds in forcing higher savings across the board in the US, which produces a classic Keynesian slump, which makes the investment into the US completely unattractive, which stops foreign inflows, which devalues the USD, which balances out the Current Account. Presto, and a few trillion of USD of wealth less, there is a balancing solution. 2. Dream of mega hedge fund. The US, instead of finding a home for all those savings at home, re-exports them back into the world, i.e. they don't leave the Capital Account. Basically London and Paris mid to late 19th century model. You as Sultan of Egypt park your money in a London Bank to see them re-invested in Egypt on your behalf, or, in the modern version, you as a Russian oligarch park your money at BONY to find them re-invested in Russian GKO (real story back in 1998). As a result rates in the US rise and stimulate savings, yada yada yada
Thank you Michael for such an informative blog, as ever. I hope I'm not too late to the conversation but I have one query on the combination of the 2 outcomes you propose when US savings rise, (domestic savings displacement or rising investment). Couldn't the rise in domestic saving also displace FDI at the margin on the basis that, presumably, excess supply of saving leads to higher asset prices, and thus capital cost of investment such that the FDI at the margin itself is redirected to other economies - assuming that FDI investment generally requires a higher hurdle rate of expected investment return to compensate for risks that are less apparent to the domestic investor (e.g. currency risk - there is after all a swaps market premium payable to hedge out currency risk)?
$USD must come home if it isn't a reserve currency. My belief is that the US will absorb this $USD homecoming with about 10% price inflation over five or more years. ie The world will be forced to consume $USD that has been saved-by-the-world over the last thirty years. I don't think this scenario violates any formulas.
I don’t know whether prof Pettis’ thesis that the US current acct deficit may be caused by their capital acct surplus (and not the other way round) is correct, but it is certainly plausible. To find it so one has to think of one salient feature preceding the Great Financial Crisis, when tons of subprime-based financial products were originated, repackaged, rated and traded in the USA and acquired by the mythical (and by definition dumb) ”Dusseldorf investor”. This example gives a vivid characterization of the industrious Germans who, having amassed huge amounts of money (aka savings) by dumping their high-tech (real) products abroad, used up those hard-earned savings by gorging on presumably liquid assets readily available in the US financial market. The supposedly profligate Americans, on their part, did their utmost to satisfy with ever more abstruse contraptions the apparently insatiable appetite of German (but it could be Chinese) investors. As to why the average economist may find it difficult to swallow the sequence suggested by prof. Pettis, one has to bear in mind that economists are social thinkers who, to borrow Mike’s words, “could possibly agree with my description [...] ad yet reject it on the grounds of its theoretical incorrectness, except that of course this is almost always what economists do: they are far more interested in being precise than in being correct, and so they are usually precisely wrong, and much of what they claim as fact is simply ideology”. Correct?
Dear Michael, I agree with many points made here, but I find the presentation to be a bit problematic. In the section entitled "Will Raising US saving cause investment to rise?" the analysis starts off by assuming that foreigners have 100 dollars of "excess savings" that they choose to hold in the US. But how does any individual, or even a country, make such a choice in practice? If I buy US dollar financial assets, a portfolio decision, this has a completely neutral effect on the capital account of the BoP. Both gross asset and liability sides change, and there is no impact on the current account. You only get "savings" invested abroad when you accumulate (net) liabilities of the people you sell goods to. You don't get it by buying their bonds or other assets as you have to give them corresponding financial assets (money) in exchange. You only get a transaction affecting the both the capital and current account of the BoP when assets are exchanged for goods. In short, for gross capital flows (portfolio decisions) to affect transactions in goods, this must work indirectly, through asset prices (including exchange rates). But this is an empirical question. Suppose I choose to buy a million dollars of US bonds, as a foreign investment. There is no way of telling, a priori, what the size of impact on US financial variables will be from my investment decision. Nor is there a clear way of saying how big an influence these changes in financial variables would have on the US current account position through their effect on spending flows. It could be big or small, depending on a range of elasticities and so on. But I guess this is what you are saying. That due to the unique US financial position, US economic and financial variables (such as interest rates, exchange rates) are hugely influenced by these gross capital flows, and this in turn drives US spending decisions and essentially determines the US current account position. The corollary argument would then be that the attention focussed on potential domestic drivers (e.g. failing industrial competitiveness, or low consumer saving rates) is simply misplaced as these are symptoms, not causes. I can see the argument, but I wonder whether it is really quite so deterministic. I know you have addressed the connection to the global role of the dollar elsewhere. I'll have to read those pieces carefully. I agree with many points in this piece, but I find the core argument, or at least the presentation, to be problematic. In the section entitled "Will Raising US saving cause investment to rise?" the analysis starts off by assuming that foreigners have 100 dollars of "excess savings" that they choose to hold in the US. But how does any individual, or even a country, make such a choice? If I buy US dollar financial assets, a portfolio decision, this has a neutral effect on the capital account of the BoP. Both asset and liability sides change, and there is no impact on the current account. You only get a transaction affecting the both the capital and current account simultaneously when assets are exchanged for goods. But portfolio transactions do not do that, by definition. For capital flows (portfolio decisions) to affect transactions in goods, this must work indirectly, through asset prices, including exchange rates. In short, it is rather misleading to suggest any individual, or country, has an excess of saving that it "chooses" to invest elsewhere, and that this choice can be made through asset based transactions. It cannot. You only get "savings" invested abroad when you accumulate liabilities of the people you sell goods to. Where we can agree is that e I think that portfolio capital flows drive asset prices, and asset prices in turn can drive real expenditure flows (on goods and services), there is no necessary correspondence between portfolio choice (I hold more US bonds) and
apologies, my post job scrambled. It should end after “I’ll have to read those pieces carefully”. The rest is repetition.
You are absolutely right if I understand you correctly, RJW, and I promise to address this much more carefully in a future blog post (and certainly in my next book, slated for a September 2019 publication). In fact there is much confusion here, even in the way I argue that in today’s world it is more correct to assume that the capital account drives the current account rather than to assume the reverse. In fact technically neither assumption is right, but making the claim the way I do nonetheless makes it easier to understand how an imbalance in “China” may cause adjustments in “the USA”, which is why I do it. Otherwise you are right that a $100 investment by a Chinese does not represent a transfer of Chinese savings to the US. It mainly represents a transformation of one kind of asset for another, so that if a Chinese buys an apartment in NY for $100, for example, it is probably balanced by the $100 sale of PBoC holdings of USG bonds, or by a Chinese $100 borrowing from a US bank. There is no transfer of savings. It can only represents a transfer of savings if there is an actual transfer of goods from China to the US on the current account. A $100 Chinese capital account deficit with the US occurs, in other words, only when the Chinese take ownership of a $100 US asset for which they pay with $100 of Chinese goods. On the other hand, a $100 Chinese current account surplus with the US occurs only when the Chinese deliver $100 of goods to the US and receive in payment a $100 US asset. In other words they are exactly the same thing: a current account surplus is nothing other than a capital account deficit because each is defined as the exchange of $100 of US assets for $100 of Chinese goods. In that case it is technically meaningless to say, as I do, that the latter used to drive the former but now the former drives the latter. What is more, the adjustment occurs, as I think you imply, through the relative price changes when Chinese goods are offered for American assets. But my positing that a Chinese export of savings to the US “caused” a Chinese trade surplus and an American trade deficit, while incorrect, nonetheless allows me to show more clearly the counterintuitive ways in which the US can adjust to an income imbalance in China that creates a payments imbalance. Perhaps I should say that what really is happening is that China’s exchange of goods for American assets will affect the relative prices of American assets and Chinese goods in broadly one of two ways: either the imported goods cause the US to create additional productive capacity (i.e. assets), from which it “pays” China (in which case both China and the US can be better off) or the US must liquidate productive capacity (i.e. assets) with which to “pay” China (in which case China can be better off but the US is worse off). Is that clearer and am I addressing your objection? I promise to address this more fully another time.
Deutsche Bank is a vehicle for vendor financing. German tech is expensive and complicated and can be easily displaced by lower cost and simpler solutions. (can anyone with a straight face say German products are not expensive and are not complicated?) Lots of German innovation has been in finance.
Quite interesting
Very interesting!
I think it is worth remembering that the bulk of GDP accrued when - say - an iPhone is bought happens in the consuming country. Simply, the amount of GDP that comes from retailing is much larger than that that comes from manufacturing. So if 10% fewer iPhones are sold in America because of "a trade war", then the US GDP will decline more than Chinese.
If it is the case S - I = X - M and one wants to eliminate a trade deficit (NX<0), then instead of increasing S, as Stiglitz proposes, maybe the thing to do is reduce I? Especially if the amount of available investment $$$ exceeds the amount of productive investment opportunities. IOW, the idea is to drive down investment so much that the foreign investment actually does cover the difference between domestic savings and needed, productive investment. Just an idea...
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