While some countries still enact mercantilist policies that directly affect the relative prices of traded goods in ways that David Ricardo would have understood two hundred years ago, in today’s global trading environment, persistent trade surpluses are usually caused by distortions in income distribution that force up savings rates. These high savings rates, which are almost always mistakenly attributed to a country’s thrifty habits— just as low U.S. savings rate are foolishly attributed to spendthrift American habits— create demand deficiencies that must be resolved with trade surpluses.
For most of modern history, however, it wasn’t this way. Trade imbalances reflected mainly the relative costs of producing goods. If British textile manufacturers could produce and ship textiles to France at a much lower cost than French producers could manage, for example, England would run a trade surplus in textiles with France, and bankers would finance the trade imbalances. During this time, 90 percent of all international financial transactions in London consisted of trade finance. A country’s trade balance consisted of the sum of all its various bilateral trade imbalances, and net flows of capital were primarily driven by trade finance.
Trade and capital flows today follow a completely different dynamic, but the older model is so intuitively appealing that it implicitly underlies, and confuses, most trade discussions today. Two fundamental differences have transformed trade and should have transformed the way we think about trade. First, the collapse in transportation costs has stretched value chains across sometimes dozens of countries, so that most trade consists of intermediate goods, not finished goods. Second, international finance is no longer trade finance. Capital flows have grown so much that investment flows wholly overwhelm trade flows. A s a result, one country’s trade imbalances with another can easily be the consequence of capital flows created by distortions originating elsewhere.
Mexico’s Global Trade
Mexico is a case in point. Ranked third among major US trading partners, after Canada and China, Mexico’s $525 billion in total trade with the United States in 2016 is a major focus of complaints by the Trump administration. This might at first seem reasonable: Mexican exports to the United States last year exceeded imports by $63 billion, constituting the fourth largest bilateral U.S. trade deficit, after those with China ( $347 billion), Japan ($69 billion), and Germany ( $65 billion).
Mexico, however, is a net importer of capital and runs an overall current account deficit that is the seventh largest in the world, equal in 2015 to 2.8 percent of GDP. This makes it very different from the other three countries. Their large American bilateral trade surpluses are subsumed within even larger overall surpluses with the world. This means these countries are also the world’s three largest net exporters of capital—China ($293 billion), Germany ($285 billion), and Japan ($138 billion)—as they invest more abroad in stocks, bonds, and other assets annually than they take in.
This isn’t a coincidence. Countries with trade surpluses have savings rates that exceed domestic investment rates mainly because ordinary households in these countries retain too small a share of their country’s GDP— relative to their governments, businesses, or the wealthy— to consume a high share of total GDP.1 This is why these countries must run surpluses. Their high savings rates have little to do with thrifty households and instead are structurally embedded within the economy. They can only be resolved with politically difficult wealth transfers. If they cannot export their twin excesses of production and savings to a world that wants neither, they must close production facilities and fire workers.
Imbalances were not always driven by distortions in income distribution. In the nineteenth c entury, and for much of history before that, trade typically reflected specific cost differences between two countries in the production and exchange of final goods, and capital flowed across borders mainly to balance trade gaps. Bilateral trade conditions explained most demand and supply for traded goods, and its financing needs drove net capital flows.
Since the late nineteenth c entury, however, trade has increasingly consisted of intermediate goods as collapsing transportation costs have spread trade across widely-dispersed value chains. At the same time, capital flows have grown to become several times larger than trade flows, with merchandise trade only accounting for just over 1 percent of daily foreign-exchange trading volume, according to the United Nations Conference on Trade and Development. Cross-border investment decisions are now made independently of trade, and in fact force adjustments that drive overall trade.
Capital Imbalances Drive Trade
We can see how this works by considering what drives shifts in capital flows and how these have affected trade. Before the LDC Debt Crisis of 1982, for example, huge petrodollar hoards were recycled into developing countries, and these capital flows funded increases in consumption and investment that led to the large trade deficits that balanced the net capital inflows. When U.S. interest rates started to rise, however, frightened global banks pulled credit lines and net capital inflows reversed, leading to lower investment, soaring unemployment, and currency devaluations.
It was the effect of the sudden reversal of capital flows that converted the Latin American trade deficits of the 1970s into the surpluses of the 1980s. Something similar happened a decade later, when East Asian countries, after years of mercantilist trade surpluses, began running large trade deficits. These shortfalls occurred when South Korean, Malaysian, Indonesian and Thai businesses gorged themselves on cheap dollar loans, spearheading large net capital inflows. When concerns about burgeoning debt suddenly caused inflows to reverse in 1997, the result once again was collapsing currencies and rising unemployment that violently converted trade deficits into surpluses.
Capital continues to drive imbalances in the post-crisis world economy. Capital has been fleeing China, for example, since 2012, at first mainly in reaction to the anti-corruption campaign, but later these outflows were exacerbated by worries about the slowing economy. China ran huge trade surpluses even before then, when it was the Chinese central bank that exported capital as it accumulated one of history’s largest hoards of central bank reserves in its efforts to keep down the value of the renminbi. In Germany, ever since the 2003–20 05 labor reforms that caused business profits to soar at the expense of wages, German banks have exported the gap between rising savings and declining investment— a figure that rose in less than five years to become among the largest ever recorded. Along with excess savings, Germany exported the manufactured goods that German households couldn’t consume and German businesses wouldn’t invest, first to the rest of Europe and later to the rest of the world.
In today’s environment of weak global demand, there has been little appetite among any major economies for the excess production and savings of these major surplus nations, but the absence of capital controls has made the United States the default adjustment for global capital imbalances. Because of its deep financial markets and lack of discrimination between domestic capital and foreign capital, the U.S. economy automatically absorbs nearly half of the world’s net capital exports. A s a corollary, the United States must also automatically absorb nearly half of global trade imbalances, usually adjusting to the capital inflows by way of a stronger dollar, rising debt (driven by lower real interest rates), and higher unemployment, all of which inexorably force down the U.S. savings rate. Predicting the exact form of adjustment is impossible, but it is an iron-clad requirement that a change in the capital account must be matched by an equal adjustment in trade.
This is why American concerns about the adverse impact of trade on employment are misplaced when it comes to Mexico. Unlike surplus countries, Mexico doesn’t suffer from domestic demand deficiencies that require trade surpluses and the export of excess savings. As a net importer of capital and with its large current account deficit, Mexico helps absorb excess global savings and production that might otherwise force even larger U.S. trade deficits.2 It does so in two ways. First, trade imbalances originate in other countries that resolve them directly by exporting excess savings to the United States, and indirectly by exporting excess production in the form of intermediate goods shipped to several countries in a value chain, which in turn run trade surpluses with the United States. Mexico is often the last stage of the process mainly because of streamlined regulations governing Mexico-U.S. trade and the logistical convenience of a shared border. These surpluses, in other words, don’t originate in Mexico. Mexico is simply one step along the way, and for geographic reasons it is usually the last step.
Bilateral Trade Balances Tell Us Nothing
The second way Mexico helps absorb global imbalances is through its own growth prospects. NAFTA creates incentives for Mexican producers to expand manufacturing and export goods to the United States, but the success of Mexican exports creates the need for investment or raises domestic income and consumption, so ultimately this success automatically increases Mexican imports of goods from the rest of the world. Some of these goods are imported directly from the United States. The rest are imported from elsewhere, although in many cases they include American-produced intermediate stages, but even when they don’t, they still reduce the overall U.S. trade deficit because of the aforementioned role the United States plays in resolving global capital imbalances. By absorbing excess production and excess savings from elsewhere, much of it intermediated through the United States, Mexico reduces the amount of capital and exports that must ultimately be absorbed by the U.S. economy.
Consider what would happen if Washington were to implement interventionist policies that reduce Mexican exports to the United States. By undermining the Mexican economy, trade intervention would make Mexico less attractive as an investment destination. As net capital inflows into Mexico drop, Mexico’s trade deficit would also drop, probably resulting in a weaker currency and higher unemployment. If net capital outflows from the rest of the world to the United States are unchanged (in fact, they would probably rise, as the Mexican contagion spread to other Latin American countries), the automatic consequence would be a bigger U.S. capital account surplus. Such a surplus—by forcing up the dollar, lowering credit standards, or some other mechanism—must inexorably and automatically result in a bigger U.S. trade deficit, even as the U.S. trade deficit with Mexico contracts. Because of U.S. trade intervention, in other words, U.S. jobs gains in industries competing with Mexico would be more than offset by U.S. jobs losses as a larger overall American trade deficit undermined other American industries.
This is why we must be careful about how we interpret Mexico’s large bilateral trade surplus with the United States. As the seventh largest absorber of excess global capital in the world, Mexico and its trade helps reduce the U.S. trade deficit by moderating global imbalances. It absorbs excess savings from other countries, along with the excess production of consumer or investment goods. Because the world’s excess savings always end up in the deep, unrestricted, and sophisticated U.S. capital markets, it is an iron-clad necessity that the world’s excess production must end up in the United States as well.
The global trading system clearly needs fixing, but punishing Mexican exporters does nothing to address the fundamental problem of excess savings in certain countries. These excess savings abroad are the root cause of American deficits. Punishing Mexican exports would risk destabilizing the economy of an important country whose prosperity adds to U.S. prosperity, would only increase pressure for poor Mexican to emigrate, and in the end would almost certainly make the U.S. trade deficit even larger.
Notes
1 Although the current account includes far more than just the trade account, for clarity, we will ignore the difference between the two. This does not in any way change the underlying argument.
2 See Michael Pettis “Is Peter Navarro Wrong on Trade?”, Carnegie Endowment for International Peace, February 2, 2017, http://carnegieendowment.org/chinafinancialmarkets/67867.
Comments(24)
The two largest energy importers into the US are Mexico and Canada. Mexico imports a lot of oil and other energy into the US, which's mostly the source of the trade deficit. I remember watching Peter Navarro's most recent interview with Bloomberg. In there, he discussed how it makes sense for Canada to run a trade deficit with the US cuz it's a large energy exporter to the US. Mexico is the same way. I know Trump demagogued his position on Mexico, but I think most in his admin realize that the real problem with the imbalances isn't Mexico. The real problems are China, Japan, and Germany (as you point out in your piece). The Trump admin has a very negative view of Germany and Trump's been very vocal about his views on China.
I also saw the part where you say bilateral balances mean nothing, but the global balance is the sum of the bilateral balances. If the US were to run a positive current account balance with all of the other 9 largest economies in the world, the chance of the US running large, persistent current account deficits with the entire world would be tiny cuz that'd assume huge surpluses by countries that account for ~1/3rd of world GDP. So if the US took up a trade policy to run a non-negative current account balance with each of the top 15-20 countries, it'd be virtually impossible for the US to run a current account deficit. Why? It's just an issue regarding math unless you get a bunch of countries with a very small portion of world GDP running massive current account surpluses. Considering many of these countries are dirt poor, lack basic institutions, and many are run by warlords states or other regimes of the kind, I find such a scenario extremely unlikely. I was mentioning Navarro's Bloomberg interview in my comment above. In that interview, Navarro (Wilbur Ross said the same thing in a different Bloomberg interview) said the ideal way to fix this problem is for the US to increase exports to the rest of the world. Now, this may or may not be practical to varying degrees, but it does seem reasonable.
Then, with this is the nature of trade in intermediate goods. A slew of trade could be affected that could negatively impact US producers and mexican producers, the bottom lines and vitality of both. For example, while Reagan forced the Japanese, through the use of VER's, Voluntary Export Restraints, to move production to the US, hence the growth of Southern States, Right to Work States, as production sites, they also increased their exports of parts, from Japan, and other Japanese export platforms globally. Many of which are bound up in the deficits the US might be experiencing with Mexico. An irony that social dialogues have often revolved around competition regarding social models, US vis a vis EU vis a vis Japan, that these corporates, whose governance boards, even States in the case of Germany, include Union membership at the table, but when their hands were forced they chose Right to Work states in the US. Success, likely is a speaking point of proponents of open markets in the US, despite the clear implications of such (that is why the always use moral groundings, which points back to the irony, and social models discourse). More than this, the utility and prosperity of Mexico, has many benefits, wealthy neighbors, location economies, etc... As Zeihan notes, the further enhancment of the Texas triangle, the National Security implications, etc... Obviously Trump speaks from the cuff, knows the Mid-West had been hurt by NAFTA, but less so of the manipulative practices of those who obviously use Mexico instrumentally, to support the descent of unsustainable models at home (this would apply to all of the Structural Surplus takers Michael notes). Trump, keep going, just be more careful with where you find your bogeyman, and the Mid-West will be the better for it. There is greater likelihood that intermediate goods pass back and forth between Detroit or Cleveland and Mexico in mutually beneficial trade then Shenzhen and NA city.
<< So if the US took up a trade policy to run a non-negative current account balance with each of the top 15-20 countries, it'd be virtually impossible for the US to run a current account deficit. >> I think the point that Michael is making is that so long as there is a Capital Account Surplus, there must (identically) be a trade deficit. The fact that we don't know how the trade deficit will occur doesn't change the fact that it must occur somehow. I could be wrong, of course. As an aside, is there any way for the moderators to allow, if not hypertext, at least carriage returns? It makes for much more readable posts without introducing security risks...
really i can´t find any information for my school report. THANKS!
An analysis that adds another colorful layer to the intricate tapestry that is global trade and economics. Intermediate goods and the difference between bilateral trade surpluses and net trade surpluses. These being important considerations in determining the true nature of a nations global trade citizenship.
But what underlies the financial flows? Why, while the US was off-shoring jobs by the million, everyone was buying dollars driving up the exchange rate and accelerating the off-shoring of jobs? How to explain the apparent contradiction? In part the explanation is that while offshoring of many low-skill jobs in textiles, electronics assembly, had little impact on the dollar because the imports that replaced goods manufactured at home were so dirt cheap, the increase in corporate profits due to off-shoring caused a flood of investment in the US stock market. This drove the dollar up, which in turn attracted hot money into US bonds, and real estate. In addition, millions of Chinese (and other Asian) millionaires, looking for a bolt hole in the event of trouble at home, have invested billions on second homes in the US. If these are the chief factors, a time may come when the tide begins to recede. Then the hot money that has poured in may pour out very quickly, resulting in better job prospects for blue collar workers, a rise in interest rates and a collapse in the RE market.
Everyone buying dollars driving up value..... prior to Chinese WTO entry and accelerated thereafter... MNC's (all nationalities) engaging in borrowing in US financial markets then investing in China, into investment for production, USD deposited in Chinese banks, purchased by PBOC, driving up value of USD. Then the resultant acceleration in US deficits creating market concerns for sustainability, during a time that the Euro was introduced, over time, Central bank reserve diversification into USD, creating anxiety for Investors, and the USD declined. 2008 global financial crisis, world HNW and MC's, flooded back into US, driving USD strength, flatlined global economy, decelrating trade, collapse of commodity values, reduction in opportunity horizon of Manufacturing and Productive EM, along with debt dynamics in China accelerating (Money Printing, Asset Bloat) and staid developed world horizons and Equity bloat in US. Seems to me. A fair amoiunt of the increase in offshore USD denominated assets, might very well be MNC's profits not re-shored, and off course HNW seeking yield, deferring taxation. But the size of what has occurred, necessary is an element of the Current Accounts that exist, maybe a very large element, no. It seems that the world has been bloating assets, in lieu of global demand in the real economy, and that that function will inevitably reach a wall. Values of currency, for me, are so 1998, 2003.
That would be a nice prospect, except that automation and increase power of AI (artificial intelligence) will get in the way. The rough numbers for manufacturer workers are: - China $3.60/hour - Mexico $2.20/r - India $0.70/hr - Unsupervised worker in US $20.62/hr - A robot from Kuka (the famous German industrial robot manufacturer now on Chinese hands) $5.38/hr As it can be seen China is getting close to have a labour rate that won't be competitive against industrial robots. So, yes the factories may come back to their original countries but those factories won't hire any factory workers. The only employees will be managers, the engineers/technicians that support the robots and those lower paid employees that pack the final product (a la Amazon). At $20/hr, the American worker won't be able to compete against a robot that is 4 times cheaper (and it well get cheaper with time), works 7x24 and don't join unions. So, the American blue collar worker is an endangered species with China or no China. It's interesting to think why Chinese bought Kuka. They know the threat is coming so they are working fast to automate their factories and impede a stampede of factories to lower cost countries -i.e. India. Automation requires a lot of capital, but if, as you said, the flows of capital move away from the U.S., then the prospect does look pretty grim for the job market.
The notion that there are not responses is ridiculous. I will point to Rodrik's Globalization Paradox. A Chinese gambit to assume that Chinese robots will be allowed to replace other robots, or that companies taxed on dollar assets held abroad, or financial flows, or what have you, is a marginal movement of thought to merely another corner of the same old old box. Why, see Rodrik's Paradox. See Neocons late 90's, early 2000's League of democracies. See populist uprisings globally. See, someone as prominent as Trump, so confused on these functions we discuss here. See, the movement of dialogue in short order from development economics on the post-modern social marxian critique, bound up in decades of thought from well before the vertical rise in its popularity in the 1960's to today. See how the contours of understanding are still cloudy. See how a very large country, able to yield heft not had by others previously, drives these same proponents, earlier users of the development process to excess, further fracturing the system that made possible their rises (Taiwan 12% of GDP CA surplus, a la Setser yesterday). See demand. See sustainable and functioning economies with minimal disruptions, rather see a global economy with some green shoots, but weighty asset values globally, and generally, near deflationary conditions despite, 9 years after the GFC began, a period of what I would describe as sub-par, when there has been a continued rise of global debt, in some paces as China, great verticality in such. So, they will just hold the dollar denominated assets offshore (well, unless the US prints a lot more paper money, all digits on a computer in USD, are decidedly within the US financial system), then Chinese robots, you do see the ground moving, and this when few understand the dynamics we have discussed here this past decade, and before on BS CFR FTM. Does anyone seriously think that there will be an allowance of such. Ironic, that it should be considered, on the back of all of the memes generated of the decolonization era economics globally. Then, the ground is new. The movements of governments like molasses in the wintertime. And as the ancient Greeks new, and BErgson reminded, "the only thing that is continuous is change". Regardless as to what Trump accomplishes, the dialogue is now firmly rooted in the consciousness of the people, not just in the US, but globally. Again, Rodrik, Globalization Paradox. Then of course Adair Turner, Debt and Devil, and Summers remedies for Secular Stagnation close the door on the no-option declinist memes. Lastly, while the techno-utopia stuff is fascinating, and as the world ages, robotics due offer some interesting potentials, what exactly will they be producing, and to whom will they be selling it to, while I do support direct monetary finance (in proportions far more limited that that which has been practiced by the Chinese), I don't suppose lack of ability to consume is a direction the world can walk down, even if we have all the robots in the world to help us to do it. After all, the amount of global GDP that has accrued to investment, as the global economy has "grown" these last two decades is why we have a demand-deficient, deflation prone, stagnant prospect, low-interest world, we have.
So if the US put in capital controls would it be able to drive down it's deficit? Also, would that be a bad thing or good thing or depends?
If the USD remains the reserve currency, we can throw capital controls out the window. What we could do is to impose something like a .5% tax on all American assets held in foreign banking systems. That's something I'd be in favor of.
@Suvy - wouldn't that simply shift the physical location of assets? I.E. foreign buyers would buy the same amount of US assets, just keep them in an entity that is domiciled in the US.
Probably, but that'd mean they wouldn't accumulate them abroad.
I could be wrong, but I think that follows automatically (meaning that I don't think that the US could implement capital controls and maintain its trade deficit even if it really wanted to). If limited the US limits the amount of foreign capital into its country, then the capital account deficit is limited (by definition), which in turn means that the current account is limited (by identity). Since the current account balance is almost wholly driven by the trade balance, limiting the capital account surplus must limit the trade deficit. It's been awhile since I've read it, but I think Michael did a very good job of explaining this in his appendix to The Great Rebalancing book. I might be misremembering the argument, though.
As for whether it's a good thing or a bad thing: in a world of excess production and/or limited demand, the US is basically getting hurt by allowing other countries to export their unemployment to the US by gaming the existing financial system. So capital controls of some sort would be beneficial to the US and harmful to the employment (and financial incustries) situation in Germany, China, and all the other countries that have artificially forced down their consumption rate (which is equivalent to forcing up their savings rates). However, in the long run, both the persistent trade deficit countries (e.g. US) and the persistent trade surplus countries (Germany, China, Korea, Taiwan, etc) must rebalance anyway--the only uncertainty is the mechanism by which they do so.
BTW, I thought about this a little more. Were the US to impose capital controls, the trade surplus countries would likely increase investment and reduce interest rates, thereby shifting more wealth from households (consumers) to borrowers (businesses). This would leave those countries worse off (by making the existing imbalances even more extreme), and it would effectively shift the trade surplus countries' reliance from exports to overinvestment and ever-increasing amounts of credit (which, I think--although I might be wrong--is even worse, since there is already too much production, and the capital-intensive exports will compete with US-produced exports). So either the world is in a complete mess, or my head is because I don't have the logic laid out correctly (or, malheureusement, very probably both...). Does anybody have any thoughts (ideally on my conclusions, and not on my mental state ;c) As an aside, it's hard for me to see any path by which Germany's currency (for now, the Euro) can possibly not increase strongly going forward.
As another thought, I guess that if the trade surplus countries could not explictly bid up the currencies of other countries directly, they could probably do so indirectly by, say, exchanging their forex reserves for commodities. I think this would subsidize exporters indirectly (reducing the currency value) and therefore increase invesment while also reducing domestic savings by forcing up consumption on "core" items, so that would reduce the current account surpluses. I can't figure out the next step, though--I'm guessing this simply forces the global imbalances onto the commodity-exporting countries, which would presumably experience a temporary economic boom eve while the rest of the world enters recession?
Thank you Claire for responding. My concern is that the trade environment is detrimental to the US but beneficial to much of the world. If that is the case then I don't see any way to reconcile that without one side losing. It all seems very complicated but there does also appear to be a movement in the US pushing for a 'hard landing' of reorganizing world trade.
Hi prof, hi everyone. I would like to have your thoughts on brexit. Because lot of people think UK will be better of without EU. Some because they hate EU, some because they UK fans others because of trade. I think trade won't play a big role for UK. Because UK problem to me, it's a highly monopolistic banking system around La City. Like a dutch disease for banks. What do you folks thinks?
The real winner of Brexit is the US (although if Brexit didn't happen in 2016, it would've happened later). It pushes the UK closer to the US. So I think it basically expands the American Empire. We could be headed into a period of rising American Expansionism, ironically as the US is less involved across the globe.
As reported here specific economic groups bear the cost and reap the benefits of economic policy. Someone who feels a pauper, still feels a pauper even if well dressed, housed and fed. Telling someone they are better off has little positive effect.
Wilbur Ross reiterated what was discussed in this post a few days ago (search Wilbur Ross CNBC on Google and it'll pop up as one of the first few links--the first as of right now). His argument was something along the lines of Mexico's deficit with China being roughly the same as the American deficit with China and that it wasn't coincidence. He said the goal of renegotiating NAFTA is to deal with that, which should help both the US and Mexico.
I was looking forward to your new book in Q1, when it's finally coming? I had high expectations about it . Thanks a lot professor!
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