Michael Pettis on rising trade tensions

With Donald Trump’s apparently escalating trade war very much in the news, here are some wise words from Peking University’s Michael Pettis, taken from the final pages of his 2013 book The Great Rebalancing – Trade, Conflict, and the Perilous Road Ahead for the World Economy (p.192-194). They seem particularly relevant right now.

“In a world of deficient demand and excess savings, every country will try to acquire a greater share of global demand by exporting savings. This will be called trade protection, currency war, local content requirements, tariffs, and many other things, but these all amount to the same thing. It will be an attempt by each country to gain a greater share of global demand.

The problem may be that the balance of trade power rests clearly with one side while the popular perception has it resting on the other side, and this can cause each side to exert more pressure on the other than can be justified. Trade surplus countries often feel that their surpluses rest on unassailable virtues – thrift and hard work – and that because they provide the capital flows that “permit” deficit countries to finance their deficits, they are in a strong position to resist rising protectionism by threatening to revoke credit.

But they are not. Revoking credit is exactly what deficit countries want them to do, whether or not they realize it. In fact it is deficit countries that hold most of the cards. Economists are not supposed to say this because trade intervention is always suboptimal for global growth, but trade war can actually increase employment in diversified economies with large current account deficits. It reduces employment, however, in trade surplus countries. In a world of weak demand growth, demand is the most valuable economic asset. Deficit countries have excess demand and surplus countries are deficient. This is why in most trade conflicts – think of the United States in the 1930s or Japan in the 1990s – the leading surplus countries have eventually suffered the most.

The evidence for the contrary is also pretty clear. For much of the nineteenth century the United States ran trade deficits and consistently used high tariffs (in the second half of the century, judging by tariffs, the United States was the most trade interventionist major economy in the world) to promote employment and manufacturing growth. Tariffs were also used successfully by the United States even late in the twentieth century, for example in 1973, when “the Nixon administration again devalued the dollar by 10 percent. Trade moved back into surplus, the economy picked up speed, and unemployment declined.”

The British experience was similar. Tim Booth’s study of British protection in the 1930s strongly suggests that until the United Kingdom gave up on its free trade principles in the late 1920s and early 1930s, it was unable to grow and suffered from high unemployment. After devaluing sterling and raising tariffs, however, Britain’s economy turned around and reversed its earlier abysmal performance.

This is not to argue in favor of trade protection – there is little disagreement among economists that a world of free trade increases wealth at a faster pace than otherwise. It is only to point out that historically, during periods of global crisis and demand contraction, international trade always suffers and protectionist tensions always rise, and for the reasons that are rational among the participants in trade.

Because deficit countries do not understand how difficult the adjustment will be for  surplus countries, and surplus countries do not understand how vulnerable they are to unilateral action by deficit countries and how limited is their ability to retaliate, it is hard to see how conflict can be avoided. It is especially incumbent on the surplus countries to defuse these tensions, even at the cost of some growth. Unfortunately the historical precedents are not very comforting, and the experience of the United States in the 1930s indicates just how dangerous the arrogance of virtue can be for surplus countries.”


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