Trade Wars – Not a cure for structural problems - November 1, 2020
Every economy in the world has its own dynamics with varying levels of productivity, natural resources, quality of assets, strength of currency, rule of law etc. which all work together to produce a level of output measured as Gross Domestic Product (GDP). Countries, just like corporations go through periods of prosperity and/or extreme difficulties through the course of their history.
Economic theory stipulates that every country has a comparative advantage and an absolute advantage in producing some goods and services but will not have such an advantage in all goods and services. Comparative advantage is what you do best while also giving up the least. Absolute advantage is anything a country does more efficiently than other countries. Just because a country has an absolute advantage in an industry doesn’t mean that it will be its comparative advantage. That depends on what the trading opportunity costs are.
In the past decades, the world order promoted free trade and encouraged countries to open up and trade so that everyone can be better off. Up to 1870, the sum of worldwide exports accounted for less than 10% of global output. Today, the value of exported goods around the world is close to 25%. As trading costs go down and volumes of trade keep increasing, imbalances occur in financial and economic positions of countries in the long run. Trade wars are economic conflicts arising when countries raise tariffs and other barriers to entry for another country’s good and services, which forces the other country to retaliate.
The US has been running large negative balance of trade account from the early 1990s. This implies that the country has been importing way more than what they exported. Trade deficits are big contributors to budget deficits which in turn create capital account surpluses. Capital account surpluses are funded by savings from domestic savings and international savers, which increases debt levels. On the other hand, the Chinese have been running large positive balance of trade accounts and current account surpluses, thereby running large negative capital account deficits. This implies that the savings that arose from the difference of the exports and the imports have been allocated abroad to countries like the US who need it.
When a country like US imports more than its exports, what the imports are used for is critical. If the imports are used for current consumption, the resulting increase in debt will be difficult to payback. But if the imports are overwhelmingly used for increasing productive capacity, the debt (the amount taken from savers) is likely to be paid back.
The below chart shows that the Chinese have a high propensity to save with average savings rate of close to 40% of GDP while the US, with high propensity to consume, saves only around 20% of GDP on average. Savings and income are likely to converge to the higher echelons of society and concentration of wealth, as we currently see, may continue to rest in the hands of few.
The core problem is that, over the past several 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 domestic savings patterns creates the surpluses and deficits, which are themselves caused by domestic income inequality. Until the inherent income inequality and wealth distribution mechanisms are non-normal, 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 conflicts nearly inevitable. China’s current account surplus is no longer the world’s largest; the most recent data suggests China’s annualized surplus stands at about $130 billion, smaller than Japan’s approximately $180 billion and Germany’s roughly $280 billion.
Initiating protectionist trade policies without attempting to alter the underlying structural savings and consumption patterns are unlikely to yield the intended results of balancing trade balances, but only distorts the structural equilibrium.
