President Donald Trump is right about one thing: The U.S. trade deficit with the rest of the world -- which topped $500 billion last year -- is unhealthy. It puts upward pressure on U.S. unemployment that can only be countered with policies that lead to rising debt.

Michael Pettis
Pettis, an expert on China’s economy, is professor of finance at Peking University’s Guanghua School of Management, where he specializes in Chinese financial markets.
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It doesn’t follow, however, that the worst culprits are always the countries that run the biggest trade imbalances with the United States. Global trade is complex, and trade imbalances between any two countries may be the result of imbalances generated by policies elsewhere. Interventions that target specific nations can actually make the overall U.S. trade deficit worse.

Mexico is a case in point. The country is America’s third-largest trading partner, with $525 billion in annual trade between them. It exports goods to the U.S. worth nearly $63 billion more than it imports. Only three other countries run larger surpluses with the U.S., making Mexico an obvious target for the Trump administration.

The headline number, however, doesn’t tell the full story. Despite its surplus with the U.S., Mexico has the world’s seventh-largest current account deficit overall, equal to 2.8 percent of its GDP; trade accounts for half of the deficit. Countries with current account deficits invest more than they save and must fund the difference with foreign capital. Mexico is thus a net importer of capital.

Compare this with China’s $347 billion bilateral surplus with the U.S., Japan’s $69 billion and Germany’s $65 billion. All three of these trade surpluses are only part of the larger surpluses each country runs with the whole world. Countries with trade surpluses, of course, must export the excess savings that they are unable to invest domestically, making these three also the world’s three largest net exporters of capital, at $293 billion, $138 billion and $285 billion, respectively.

Their high savings rates reflect low consumption levels in each country as a share of GDP. Consumption is weak, in turn, because ordinary households retain disproportionately low GDP shares relative to government, businesses and the wealthy. Because their own consumers can’t absorb all that these nations produce, they must export their excess production, along with their excess savings, into a world reluctant to take either.

Countries can limit their vulnerability to these excesses by directly or indirectly restricting capital inflows. But the U.S., with its deep and flexible financial markets, imposes no capital barriers, making it the automatic shock absorber for the world’s excess savings. Nearly half of the world’s net capital exports flow intothe U.S. The only way to accommodate all this money is by running persistent trade deficits.

Most economists misunderstand the relationship between trade and capital flows, perhaps because for most of history it was much simpler. In the past, trade between two countries mainly reflected differences in production costs; capital flowed between them mostly to balance imports and exports. In other words, trade determined the direction of net capital flows.

No longer. Capital flows have grown many times larger than trade flows, with merchandise trade accounting for just over 1 percent of daily foreign-exchange trading volume, according to the United Nations Conference on Trade and Development. Independent investment decisions now force trade to adjust, shifting the relative prices of traded goods by altering interest rates or exchange rates.

Unlike China, Japan or Germany, Mexico doesn’t export capital or run trade surpluses with the rest of the world. Instead it absorbs excess global savings and manufactured products, just as the U.S. does. Mexico’s large bilateral trade surplus with its northern neighbor is mainly a consequence of the logistical convenience of a shared border and streamlined regulations. Japan, for instance, might directly export excess savings to the U.S. and indirectly export excess production, in the form of intermediate goods shipped to several countries in the value chain, including Mexico, which in turn run trade surpluses with the United States.

If the Trump administration were to penalize Mexican imports, U.S. trade deficits with Mexico would almost certainly shrink. But the deficits America runs with other countries would expand even more. Why? Because U.S. intervention would make Mexico less attractive to foreign capital. Instead that capital would end up in the U.S. -- and the problem would intensify if other Latin American countries suffered contagion effects from Mexico. Higher net inflows into the U.S. would inexorably force accommodating price adjustments that raised the total U.S. trade deficit by equivalent amounts, even as the deficit with Mexico receded.

Mexico’s trade surplus with the U.S. is a red herring. Its large trade deficit with the rest of the world reduces global imbalances and so helps moderate the U.S. deficit. While the global trading system clearly needs fixing, punishing Mexican exporters would do little to address the fundamental problem of excess savings in certain countries. Worst of all, it would only make U.S. trade even more unbalanced.

This article originally appeared in Bloomberg.