Even as U.S. President Donald Trump and Chinese President Xi Jinping announce and then cancel tariffs in a seemingly endless back-and-forth, it is a mistake to view the ongoing trade dispute as simply a spat between the two. It is not a Trump-Xi fight or even mainly a U.S.-China one.

In fact, when it comes to creating global trade imbalances, China is not the only—or even the worst—offender. Its current account surplus is no longer the world’s largest; the most recent data suggests China’s annualized surplus stands at about $130 billion, significantly smaller than Japan’s (roughly $180 billion) and Germany’s (roughly $280 billion).

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.
More >

The real problem is that, over the past two decades, it has become increasingly difficult for the world to fix its massive trade imbalances; the very mechanisms that created them also make them harder to absorb. That is because trade surpluses and deficits are mainly the result of domestic savings surpluses and deficits, which are themselves a result of domestic income inequality. Until such inequality is substantially reversed, high-saving countries will continue to use trade as a way to pass the effects of their distortions onto other nations, such as the United States. This makes global trade conflict nearly inevitable—regardless of who sits in the Oval Office. For the United States, the only way out may be reconsidering how willing it is to absorb everyone else’s excesses.

Contrary to conventional wisdom, today’s trade surpluses are not the result of exceptional manufacturing efficiency or unusually hard-working and high-saving workforces. In fact, the household savings rate in Japan, the country with the world’s second-largest trade surplus, has been roughly zero for the past 15 years. Instead, in countries such as Germany, Japan, and South Korea, large trade surpluses were the natural consequence of policies that, in the name of competitiveness, effectively lowered citizens’ purchasing power for the benefit of the banking, business, and political elite—and the companies they controlled.

Because its imbalances are so extreme, China is the most obvious case in point. By definition, a current account surplus is equal to an excess of domestic production over domestic spending on consumption and investment. With the highest investment rate in the world, perhaps in history, China ought to be running a current account deficit. However, because China’s consumption rate is so low, the value of everything China produces still eclipses the value of everything China consumes or invests domestically. To offload the excess income, it runs a trade surplus and invests in financial assets abroad.

For a long time, observers such as Kishore Mahbubani, the former dean of the National University of Singapore’s Lee Kuan Yew School of Public Policy, pinned China’s low consumption rate on Asian values that supposedly prioritized hard work and saving. That explanation is wrong. It confuses household savings with national savings, and while the Chinese are indeed hard workers, so are workers everywhere. China’s extremely high national savings rate, like that of all the major surplus countries, is not driven by the thrift of ordinary households but by the fact that the country’s workers and retirees earn a disproportionately low share of national income, which diminishes their purchasing power.

In fact, during the past two decades, the share of Chinese income earned by Chinese households has been the lowest of any country in modern history. That means that Chinese workers can consume only a small share of what they produce.

During the past two decades, the share of Chinese income earned by Chinese households has been the lowest of any country in modern history.

The corollary is that an unusually high share of income goes to Chinese businesses and to local governments—largely a result of direct and hidden subsidies for production that are paid for by ordinary households. Beyond sluggish wage growth relative to productivity growth, these hidden subsidies include an artificially depressed exchange rate, lax environmental regulations, and, most importantly, negative real interest rates that have the effect of transferring income from household savers to subsidize the borrowing of state-owned enterprises and local governments. Rather than being spent on new goods and services, the resulting profits are invested in financial assets abroad. Trade surpluses are the inevitable consequences.

China is not unique. For different reasons, Germany has also been a model of wage suppression to the benefit of business profits. Since the Hartz labor reforms of the early 2000s, suppressed wage growth has led to rising income inequality and has boosted the relative share of business profits, both of which automatically forced up the country’s savings rate and shifted Germany from a country with a small current account deficit to the nation with the largest surplus in the world.

About half of the world’s excess savings tend to end up in the United States.

Chinese and German workers’ woes may seem like primarily domestic problems, but in a globalized world, distortions in the way income is distributed in one country can be transmitted to others through trade. That matters especially to the United States, which plays a unique role in meeting the financial needs of the rest of the world.

Because the U.S. economy is the world’s largest and most diversified, and supports the most flexible and best-governed financial markets in the world, it has been the natural home for individuals, businesses, and governments looking to store wealth abroad that they cannot or will not invest at home. About half of the world’s excess savings tend to end up in the United States, with another quarter flowing to other economies with similarly open and sophisticated financial markets (such as the United Kingdom).

The United States, in other words, for decades has been a net importer of foreign capital, not because it needs foreign capital but rather because foreigners need somewhere to stash their savings. But inevitably that also means the United States has had to run trade deficits that have persisted for decades. From a net exporter in the 1950s and 1960s—when the United States shipped food, manufactured products, and capital to the rest of the world’s major economies, whose productive capacity had been destroyed by two world wars—by the 1970s the balance had started to shift.

By then, the advanced economies had been largely rebuilt, and the world was no longer short of productive capacity. On the contrary, it now needed additional demand to absorb all the goods and services being provided by the rebuilt economies of countries like Germany and Japan. As the American consumer became key, the U.S. trade surplus, through which it shipped savings to a world desperately short of investment, was transformed into a seemingly permanent U.S. trade deficit.

Trade theory tells us that these kinds of imbalances cannot persist indefinitely. Usually, automatic adjustments—including rising consumer prices, strengthening currencies, and soaring asset values for surplus countries and the reverse for deficit countries—eventually eliminate deficits and surpluses. The fact that certain countries have nonetheless run surpluses for decades, while others have run deficits, is evidence that the global trading system is not working as it is supposed to.

In this globalized system, rising income inequality is both the cause and a consequence of international trade competition.

There is a cost to this failure. Surplus countries’ ability to export their excess savings and production abroad sharply reduces the pressure on them to rebalance income at home. What is more, in the race for competitiveness with surplus countries, deficit countries must also allow, or even encourage, downward pressure on their own wages. In this globalized system, rising income inequality is both the cause and a consequence of international trade competition.

The question, of course, is what a U.S. president should do. In standard economic theory, the financial inflows from the rest of the world should have added to Americans’ own savings and led to higher levels of domestic investment. But with U.S. financial markets already flush with capital (offered at the lowest rates in history), and American businesses sitting on piles of unused cash, that is not what happened. Instead, overall spending outpaced production, and American savings declined. This, too, was inevitable: If foreign capital inflows do not cause investment to rise—as was clearly the case in the United States—they must cause savings to decline.

Put another way, foreign savings displaced domestic U.S. savings. This happens in countless ways. For example, foreign capital inflows can bid up the prices of stocks and real estate, making consumers feel richer and encouraging them to spend more. Local banks, responding to a glut of cash, can lower lending standards to domestic borrowers in order to increase credit. Infusions of foreign capital can cause the dollar to appreciate, which encourages spending on foreign imports at the expense of domestic production. Factories that can no longer compete can fire workers, who begin to tap into their rainy day funds or borrow. The government may expand the fiscal deficit to counter the economic slowdown.

Put together, these actions drive down U.S. savings. Indeed, the widespread belief that persistently low savings over the past four decades reflected spendthrift American habits turns out to have been wrong. The United States does not import capital because it has a low savings rate—it has a low savings rate because it is forced to absorb imported capital.

This was not as much of a problem several decades ago, when the U.S. economy was much larger relative to the others in its trade orbit. During the Cold War, meanwhile, there was added incentive to fill this role because it gave the country increased geopolitical leverage. However, as the size of the U.S. economy shrank relative to those of its trading partners, the cost of playing the balancer rose, and it was always only a question of time before the country would no longer be able or willing to play its traditional role.

The trade war with China ultimately has little to do with Trump’s personal animosities or reelection strategy.

Once the United States was unable to continue absorbing so much of the world’s excess savings, the global system risked coming to a chaotic stop: Because no other country was large enough to play this role—and no country wanted to—there was no replacement. Trade conflict was inevitable. That is why the trade war with China ultimately has little to do with Trump’s personal animosities or reelection strategy. It simply represents the most visible part of a much deeper global imbalance.

Once the United States was unable to continue absorbing so much of the world’s excess savings, the global system risked coming to a chaotic stop: Because no other country was large enough to play this role—and no country wanted to—there was no replacement. Trade conflict was inevitable. That is why the trade war with China ultimately has little to do with Trump’s personal animosities or reelection strategy. It simply represents the most visible part of a much deeper global imbalance.

oday’s trade war is not really a conflict between the United States and China as countries, nor is it even a broader conflict between deficit countries and surplus countries. Rather, it is a conflict between economic sectors. Bankers and owners of capital in both the surplus and the deficit countries have benefited from suppressed wages, rising profits, and increased mobility of international capital. Workers in the surplus countries paid for the imbalances in the form of lower incomes and depreciated currencies. Workers in the deficit countries paid for the imbalances in the form of higher unemployment and rising debt. Reversing inequality and other distortions in income distribution in both the surplus and the deficit countries is therefore the only durable way to end the trade war.

In the long run, future U.S. administrations will have to tackle income inequality either through tax reform or by tilting the playing field in favor of workers and the middle class—for example by reducing the costs of health and education, improving social infrastructure, raising minimum wages, or even strengthening labor unions. But before they can do that, they will have to fix the American role in the global imbalances by making it more difficult for foreigners to dump excess savings into U.S. financial markets. That could take many forms, but by far the most efficient would be a one-off entry tax on foreign capital inflows. Such a tax would eliminate the current account deficit by addressing it at its origin in the capital account surplus. It would have the additional benefit of forcing the cost of adjustment onto banks and financial speculators, unlike tariffs, which force the cost onto businesses and consumers.

In the long run, future U.S. administrations will have to tackle income inequality either through tax reform or by tilting the playing field in favor of workers and the middle class.

The alternative is ugly. As the British economist John A. Hobson argued in 1902, the economic driver of European imperialism at the end of the 19th century was extreme inequality that reduced domestic spending and lowered the returns on financial assets invested at home. Europe’s capitalists needed to find places to dump their excess savings and production. They did so by force, securing export markets abroad and guaranteeing returns on high-interest loans with armies and gunboats. That ended in imperialist conflict and, ultimately, war.

Less than three decades later, the cycle repeated. In the 1920s, a new wave of globalized trade and capital flows coincided with soaring income inequality and rising debt. The party came to a halt between 1929 and 1931 and was followed by a vicious trade competition that also ended in war. In each case, a conflict between economic sectors—one in which banks and the owners of capital were able to benefit at the expense of the rest—was represented as a conflict between countries. It wasn’t a trade war then, and it isn’t now. Only when U.S. policymakers realize as much—and get ready to tackle income inequality—will they be able to head off the worst of the consequences.

This article was originally published by Foreign Policy.