The media’s obsession with the ongoing saga of the U.S.-China trade war has given people skewed impressions of how the two economies interact. Most journalists have focused on the minutiae of tariff levels and who is actually paying for them. But this obsession is based on an outdated understanding of global trade.
The real problem is that the United States’ open capital markets keep the U.S. trade balance from adjusting regardless of what level tariffs are set at and who pays for them. The recent phase-one trade deal won’t change that fact, nor will the tariffs that the deal has left in place. If Washington actually wants to move the needle on the trade front, it should pay more attention to the U.S. capital account.
Why Tariff Costs Are a Red Herring
In late November 2019, Liberty Street Economics, a publication sponsored by the New York Federal Reserve, released a paper that has added fuel to one of the most contentious trade-related debates in Washington: who is paying for President Donald Trump’s tariffs on Chinese goods? The paper argues that because prices on imported goods from China have not fallen, U.S. consumers and businesses clearly must be footing the bill:
U.S. businesses and consumers are shielded from the higher tariffs to the extent that Chinese firms lower the dollar prices they charge. U.S. import price data, however, indicate that prices on goods from China have so far not fallen. As a result, U.S. wholesalers, retailers, manufacturers, and consumers are left paying the tax.
The fact that this study is being cited as evidence that U.S. tariffs on Chinese goods harm the U.S. economy only shows how muddled the trade debate has gotten. Tariffs on foreign goods aren’t simply failures if they raise import prices for U.S. consumers. On the contrary, that’s precisely how tariffs are supposed to work. By raising the cost of foreign imports, they effectively transfer income from consumers to businesses, automatically reducing the consumption share of GDP or, to say the same thing another way, raising the aggregate savings share.
One traditional argument in favor of tariffs is that they allow infant industries eventually to move up the productivity scale enough to compete with foreign producers. Ignoring that infant industry argument for tariffs for a moment, the pointed question of whether tariffs benefit or harm the economy that imposes them depends mainly on how that economy fits into the global structure of trade and how that economy adjusts to these higher savings:
- In surplus-running countries, in which domestic savings exceeds domestic investment, tariffs reduce domestic demand and force the economy to become even more reliant on foreign demand to resolve domestic production.
- In deficit countries, in which investment is constrained by limited domestic savings (this mainly applies to developing economies), the economy typically adjusts to higher domestic savings by increasing domestic investment.
- In countries in which investment isn’t constrained by domestic savings (that is, the United States and most other advanced economies), the economy typically adjusts by lowering unemployment, forcing up wages, or reducing household debt. That is why when tariffs supposedly work, as they did during most of the nineteenth century, the higher prices U.S. consumers pay are more than matched by the higher American income they create.
Tariffs may in some cases be harmful to the economy and in other cases they may benefit the economy, but the point is the only way tariffs can boost domestic growth is if they cause the prices of imported goods to rise. If U.S. tariffs on Chinese goods did not cause import prices to rise, either because Chinese businesses lowered their prices or because Beijing devalued its currency, there would be no effect on the U.S. economy, except a small increase in government revenues representing effectively an economically unimportant transfer from Chinese businesses to the U.S. government.
So does the Liberty Street Economics paper that argues that American consumers, not Chinese producers, are paying for the tariffs prove that U.S. tariffs on Chinese goods are good for the U.S. economy? Unfortunately, this isn’t the end of the story. Even if American consumers do pay higher prices for imported goods, U.S. tariffs on Chinese goods will fail to boost growth in the U.S. economy, but not for the reasons most economists think. In reality, the tariffs will fail because the role the U.S. economy plays in stabilizing imbalances in international capital flows in effect prevents tariffs from raising the American savings rate. That’s important because it is the impact of tariffs on the savings rate that determines how they will affect the economy. The special role the United States plays in the global economy means that tariffs do no good.
Why Capital Flows Are the True Culprit
This is because the strategy behind tariffs is based on an obsolete understanding of trade. For much of history, when most countries suffered from scarce savings and a significant amount of slack (that is, underutilized resources and high levels of unemployment and underemployment), trade imbalances were driven mainly by differences in production costs. At that time, more productive producers outsold their more expensive foreign rivals and ran trade surpluses against their deficits. During that period, with most international capital consisting of trade financing, capital inflows adjusted to the trade imbalance, and as tariffs raised the savings rate, it reduced the trade deficit and required less foreign financing.
Today, the causes of a trade surplus and the relationship between the trade and capital accounts have completely changed. Surplus countries do not run surpluses because of production cost advantages. They run surpluses because domestic households are paid so low a share of total income that consumption is too low and savings too high to absorb all that these countries produce. Put differently, the income that surplus countries generate from exports must be recycled not by importing foreign goods but by exporting domestic savings.
That is what has changed the way tariffs work. Because of its deep, flexible, and well-governed capital markets, the U.S. economy is the top destination to which much of the excess savings of the rest of the world flows automatically. The U.S. trade deficit, consequently, cannot adjust as long as the United States has open capital markets and is forced by weak foreign demand and excess foreign savings to run a capital account surplus.
U.S. tariffs on Chinese goods are an overall failure, in other words, but not because the costs are mainly borne by American consumers. Rather, they are a failure because the mechanism that converts high import costs into higher American savings cannot function as long as the United States is forced to absorb the excess savings of the rest of the world. The problem for the U.S. economy is not that China and other surplus countries are more efficient, or that they subsidize domestic manufacturing. It is that their weak domestic demand and excess savings are transmitted into the United States through its open capital account.
That is why U.S. tariffs on Chinese goods will fail: they work mainly by forcing up domestic savings, and it is the way in which the economy adjusts in order to raise savings that ultimately determines whether tariffs will benefit or harm the economy. But flexible financial markets and an open capital account prevent U.S. savings rates from adjusting. That is where the problem truly lies. Whether one thinks it is American consumers who pay for Trump’s tariffs or Chinese businesses is completely irrelevant.
Aside from this blog, I write a monthly newsletter that covers some of the same topics. Those who want to receive complimentary subscriptions to the newsletter should write to me at chinfinpettis@yahoo.com, stating affiliation. Twitter: @michaelxpettis
Comments(32)
This is light years above the levels of comprehension in the US administration. For that reason the insanity will continue
I don't think this administration is any different than any other recent administration on this matter. My concern is the U.S. treasury and economic advisors who circle back and forth from Wall Street. Whether these advisors understand the capital accounts issue or not, Wall Street likely relishes it's role as the main intermediary for the enormous amount of excess global savings that the dollar attracts.
However, current state of global economy is surely driven by US as the main consumer (and some other deficit country). I can't imagine the state where US (or other deficit country) suddenly reverse their open capital market and going into thrift mode. Deflationary pressure likely to intensify and devastate the economy as a whole.
You may be right, Fakhrul, but I don't think the US can be expected to play the role of global consumer to its detriment for much longer.
Hi Michael. I hope that i am not right about it.. Unfortunately for this issue, problem is not only from US as world largest consumers. Nowadays, some developing nation who experienced deficit against China is also moving into thrift mode, going into race to the bottom, lower the labor standard to gain FDi which unintentionally will rise their national savings and effectively reduce demand for Chinese products and capital. It will be evem tougher for China to rebalance going ahead. Anw, do you ever think that we need 21st century version of fordism? Note that this scheme is working to sustain the balance at some periods in 20th century.
Great post Michael. Do you think the Balwin-Hawley capital tax bill will gain much steam? Do you have much thought on the idea Warren Buffett talked about several years ago using Import Certificates as a way to balance trade? Would it impact the economy the same way as taxing capital? Thanks
I think import certificates are far too clumsy and will work by creating unintended inefficiencies in trade. If the problem is imbalances on the capital side, it is better to address the capital imbalances.
Michael, a first rate and very important note. Let's hope that it helps the world in general and the US government in particular understand why tariffs are not going to balance US trade. Two quotes stand out in your note: "The U.S. trade deficit, consequently, cannot adjust as long as the United States has open capital markets and is forced by weak foreign demand and excess foreign savings to run a capital account surplus," and your observation that tariffs will fail to balance US trade "as long as the United States is forced to absorb the excess savings of the rest of the world." You do not say how to fix this serious problem here, but as you have noted separately, perhaps the most promising approach is a Market Access Charge on all excess savings from the rest of the world that seek profits and safe haven in US financial markets. By reducing the net yield on investing such money in US markets -- money that harms the US economy by overvaluing the US dollar, the MAC will moderate the excessive inflows of excess foreign savings and will allow US savings to rise, thereby helping to eliminate the US trade deficit. The MAC is now the centerpiece of the Baldwin-Hawley Bill (S.2357) and additional information on this innovative solution is available on the relevant US Government website. Thanks and best regards,
Thnaks, John. I agree.
Clarifying the ideas and concepts of basic economics is a good educational job to enlighten readers. Certainly, the "global crowd" of lynchers who have joined against Donald Trump has easily taken him to the gallows, because they do not see, or simply want to see, the hard and slightly incorrect language of the American president ... Michael Pettis' article is really good, but I think he should also have explained that anything that seems "irrelevant," like the New York Federal Reserve report, is part of the Washington intelligence game needed to contain the blatant attack. . from China. on all fronts against the United States of America. China is not only a formidable economic competitor to strip the United States. of world hegemony, but it is also the most serious military danger that has appeared in the history of the United States ... Therefore, the "levels of understanding" in the current US administration, evoked by Mr. Jack Monroe, they are difficult to understand if economics is not first understood as one more piece of artillery on this battlefield that the geopolitics genius, Zbigniew Brzezinski, once showed us; This world council in which the worst enemies have pledged to overthrow the American giant by military means, in a war of the highest level ... This imminent tragedy has already begun, attacking and cornering the US army. UU. In many places on the planet, even in space, he added to the massive theft of intellectual property and the commercial imprudence of the Chinese not to comply with any "Rule" of world trade. We must bear in mind that Russia and China are aggressively attacking all Western computer systems ... Discover, friend Jack Monroe, that he wants to expel us from the "council" by all available means, including destruction. and disappearance of democracies and economic liberalism. Perhaps, I hope for my part, it is perfectly explained that, for a war that some call "hybrid", others "economic", others "secret" and obscure or "competition of great power", a particular type of president; apparently "strange", "confusing" or "unconventional" so that the enemy is confused and never knows what the next blow on the great world platform will be. The fog of war on the battlefield shows nothing more than what Washington wants you to see. The enemy is very dangerous. And if ordinary people believe that the United States is ruled by an idiot who fires cannons at flies, in all directions, it is an inculturation and its alarming intellectual poverty, an absurd opinion that "portrays" the mob. Of course, this is not the case with friend Jack Monroe; That is why I humbly believe that Michael Pettis should make it clear that what is really irrelevant are not tariffs or the so-called "trade war"; but the great world show exhibited by the Trump administration so that the Chinese mentality understands that the touch of combat crab has not yet begun ... Or maybe yes ...
I am not nearly as impressed by the"China threat" as you are, Alfonso.
Let me tell you, with all due respect, that you do not live in the real world. U.S. military intelligence and Japan, they already fear an assault on Taiwan by Beijing and prepare for a military conflict of incredible proportions ... And in the fog of war North Korea will join to occupy, South Korea, militarily ... That can Occur at any time. Xi Jinping has sworn that he will ...
Surely US tariffs can operate to reduce the deficit a little according to the traditional mechanism that Michael describes (even if China tariffs work in the opposite direction)? Or is their an argument that unwanted capital inflows might actually increase to offset a tariff induced reduction in US imports from China? If the two mechanism are, in fact, not independent how do they interact? I feel the need for some algebra really ... I have been following these China pieces for a long time now - they are so good. Thank you!
Thanks, Peter. I think the key point is that as long as it's capital markets are completely open and it is the default destination for global excess savings, the US cannot control its domestic savings rate.
"the higher prices U.S. consumers pay are more than matched by the higher American income they create" That's the famous trickle-through effect, right? I think that has been proven very contentious and only true under certain circumstances.
No. As I have discussed many times before in earlier blog posts, "trickle down" only works in economies in which high investment needs are constrained by low savings.
This is such a friendly an intelligent group of posters, I hoped someone could me understand how one of the mechanisms for savings to decline, in addition to a consumption boom, is an increase in unemployment. Dr. Pettis has previously stated that an American manufacture no longer able to increase unwanted inventory must close production and fire workers. I probably missed some earlier context in his explanation, but why would inventory increase be forced?
Employed workers have positive savings rates, even when they are low. Unemployed workers have negative savings rates: they consume more than they produce.
I don’t follow the argument in your last four paragraphs. If the U.S. imposed tariffs that were large enough to make production cheaper in the U.S. than abroad, would multinational corporations not shift production of goods intended for the U.S. market to the U.S.? Thus shrinking the surplus countries’ incomes?
I am not sure where your confusion is, Karen. The key point is that the US current account can adjust only to the extent that it capital account adjusts.
To me it doesn’t make sense that policy changes have to be aimed only at one side of this two-sided coin. With the exception of goods that have no price elasticity, surely the imposition of tariffs must decrease the total U.S.-origin incomes of foreign countries, whether by reducing sales, reducing prices, or some combination of the two? If income is reduced, then capital available for export would also be reduced. In the extreme, for a country as large and resource-rich as the U.S., it is possible to imagine a level of tariffs which would be sufficient to choke off virtually all foreign trade (which is of course one way to balance imports and exports).
Looking at the tariffs in a purely economic fashion is an easy slight of hand. It fails to understand both the purpose and intent of the tariffs for the purpose of stating an irrelevant fact. However in taking a purely economic focus on a geoplotical manner, I'm surprised to note that not once did you mention substitute goods, especially since substitutes exist for around 70+% of the goods we purchase from China. Then again that sort of lends to the irrelevance of this article, as the availablity of substitute goods does not have significance when you're arguing only about the economic benefit to the US.
Sleight
Danny, nothing in your post makes any logical sense. But two things stand out: you're pretentious and you wanted to put Mike down.
The US is not forced to aborb the excess savings of the world. It is the world that is forced to acquire US dollars to pay for oil and other commodities that are paid in US dollars because of the dominant role of the dollar (well defended by the US) in world trade.
The medium of exchange for oil and other commodities isn't what drives the dominance of the dollar. It's what the Saudis and other oil producers do with those dollars. They hold much of their excess savings in U.S. assets including U.S. treasuries. The Saudis and other trade surplus nations could accept (or convert dollars to) any currency, but its really what they do with the money that matters. If the Saudis started accepting or buying Japanese Yen or Euro, their respective Central Banks would likely resist such influx of capital into their economies . Prof. Pettis in his previous writings goes into great detail on how the U.S. absorbs excess savings driving the U.S. capital account surplus. The parallel to the surplus in the U.S. capital account is the U.S. trade deficit (current account). The U.S. is the only economy large enough and currently willing to accept this capital inflow absorbing the globe's excess savings.
Great article Michael! I wonder are you aware that some countries like Thailand and Singapore are under the US Treasury watchlist for currency manipulation. How effective is this method compared to your propose taxes on capital inflow. I would like to know your views
In which direction are you suggesting Thailand and Singapore have manipulated their currencies v USD?
I'm brand new to your blog. It will take me some time to wrap my mind around your articles. 😊 What do you make of Steve Mnuchins comments on Fox. That the world's central banks are holding 1.5 trillion dollars in cash. How does this translate to your theory of savings vs spending countries.
Sukh’s Thoughts: Why would tariffs not just shrink corporate profits (which are not being invested anyways because of overcapacity and wealth concentration levels, and therefore being absorbed by businesses) and either reduce government deficits, or allow this money to be funnelled through government into the hands of consumers most likely to spend it, on say things like food or services provided by fellow Americans?
"Whether one thinks it is American consumers who pay for Trump’s tariffs or Chinese businesses is completely irrelevant." Sukh’s Thoughts: What if it is American businesses that are forced to absorb these costs? Then it is just a corporate tax increase that offsets the tax cuts corporations were given early on in the Trump presidency? Would this change things considerably?
Am I correct in deducing that what prof. Pettis states about tariffs does also apply to exchange rate manoevres such as a devaluation of the US Dollar? ...And a Happy New Year to all!
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