Finding a balance: how should global trade work?

World Finance’s Alex Katsomitros sat with Professor Michael Pettis for a conversation on the role of the dollar as the global reserve currency, the US exorbitant privilege (or burden), and the difficult choices China will soon have to make about its economic future


Michael Pettis is a rare breed. A Wall street veteran-turned-academic who once owned a punk rock nightclub in Beijing, he has been teaching finance at Peking University since 2004, while being a prominent critic of Chinese economic policy. His latest book Trade Wars are Class Wars: How Rising Inequality Distorts the Global Economy and Threatens International Peace, co-authored with Matthew Klein, questions almost everything we know about modern trade: the usefulness of the dollar’s reserve currency status to the US; the origins of the China-US trade war; and Germany’s much-celebrated trade surplus. In the book, Pettis and Klein argue that modern trade wars start at home, with British and American bankers and owners of financial assets benefitting from open markets at the expense of ordinary households.


Trade Wars are Class Wars is an idiosyncratic book. It’s part economic history, part financial analysis and part polemic. What prompted you to write such a book?
When I moved to China, the government was keen on making the renminbi a major reserve currency. That interested me in the role of reserve currencies and their cost. It was obvious that the role of the US as an absorber of excess global savings creates problems for its economy. I realised this by going back to the basic balance of payments, and seeing what the role of an excess savings absorber is, because that’s what gives you reserve currency status. I don’t think that the dollar gives the US an exorbitant privilege; it’s more of an exorbitant burden. And out of that came the recognition that much of what we discuss about trade is obsolete. Matthew and I discussed these ideas, so I asked him if he was interested in working with me on a book.


Should the international community drop the dollar as a global reserve currency and opt for something else, Bancor {a supranational currency proposed by Keynes} or some form of digital currency?
I don’t think a digital currency would solve the problem. In the Bretton Woods conference, Harry Dexter White and John Maynard Keynes agreed that trade should be more or less free, although they didn’t believe in totally unlimited free trade; that the more trade there was around the world, the better; and that free capital flows would be a big mistake.

They argued – and it’s even more true today – that the trade account and the capital account have to balance each other, and there’s no reason to assume that it’s the capital account that balances the trading account. As we show in the book, capital tends to be more volatile than trade. So, it’s trade that has to balance to the capital account. To the extent that the capital account primarily represents transfers of fundamental investment flows, it’s not a bad thing. However, most capital flows today are speculative, so trade is constantly adjusting to speculative flows. If you look at trade patterns over the last decades, the US absorbs 40 to 50% of global excess savings. Interestingly enough, the other Anglophone countries run about half of the remainder, so along with the US, account for roughly two thirds to three quarters of the global trade deficit.

All other rich countries primarily run surpluses, they account for roughly three quarters of global trade surplus. Why are Anglophone countries so different from other rich countries? I believe it’s because they have open, well-governed capital markets, so they attract excess savings. These are countries that have been running persistent large deficits since the 1970s, which violates our idea of trade. In trade theory, you can’t run persistent deficits, because they force adjustments that reverse the imbalance. But imbalances persist for decades, so that has to do with capital flows rather than trade flows.


So what should the US do?
The best option would be to organise a new Bretton Woods conference and redefine the rules of trade and capital flows, going back to Keynes’s original proposals. I suspect that’s unlikely to happen. So the alternative for the US is to unilaterally withdraw the dollar from its current role. The problem is that this role, the so-called ‘exorbitant privilege,’ gives the US geopolitical benefits at an enormous economic cost. So it would be difficult to do that because there are US constituencies – including banks – that want the dollar to maintain that role. However, other constituencies, notably producers, farmers and workers, should want the opposite. Ultimately, I think the US is going to withdraw the dollar as the dominant trade and reserve currency.


In the book you talk about domestic imbalances in the US, with its role as the world’s absorber of excess savings benefitting the financial sector at the expense of almost everyone else. The Biden administration has launched a stimulus programme focusing on infrastructure spending and will also increase corporate tax. Is all that towards the right direction in terms of addressing these imbalances?
The US has an investment problem. The reason businesses don’t invest is not that the cost of capital is high because of insufficient savings, but because there is not sufficient growth in demand. The Biden administration is trying to boost demand by spending on infrastructure and redirecting income from the wealthy to the middle class and workers. By increasing both forms of demand, they will increase incentives for businesses to invest. So what Biden is doing is the right thing, assuming he can pull it off in Congress. Even if that happens, the US will continue to run large deficits, perhaps even larger ones. But at least the counterpart to deficits will be higher investment.

We live in a world where investment isn’t constrained by the lack of savings. American companies are sitting on huge hoards of cash, but they are not investing. They are using them to buy stocks, which is just rearranging savings. If you export $100 into the US, investment will not go up, so it must cause savings to go down by increasing unemployment, household debt or fiscal deficit. So the US has to constantly choose between more unemployment and more debt to accommodate these inflows.


How do you think Biden’s domestic policies will affect the trade conflict with China?
In the long run, it would lead to better global relations, because trading imbalances would be associated with positive economic outcomes in the deficit countries. The problem with China is that the world is suffering from weak demand. And the only response China has is supply-side. It’s been talking about demand, in other words, boosting consumption, since 2007. More recently, the whole ‘dual circulation’ model is about boosting domestic demand. They haven’t been able to do it. All they do is subsidise manufacturing and infrastructure. It will involve substantial reforms, including political changes. So I’m pessimistic about US-China relations, I think they will continue to deteriorate – and not just US-China relations, but also relations with everyone else.


What’s the reason for China’s difficulty in reforming its economic system? Is it the nature of the regime or something else?
It requires significant political adjustment. During periods of great change, it’s democracies that can adjust. The problem is that the adjustment process is always complicated, and that’s why democracy seems to lose its prestige during these periods, like the 1930s or the 1970s. Ironically, that’s also when democracy proves its superiority compared to other systems.

It’s hard for countries like China to make these adjustments. After 50 years of war and Maoism, China was hugely underinvested for its level of social development in the 1980s. So the best it could do was force up the savings rate, and pour those savings into investment, because China needed commercial airports, it didn’t have a single subway system or many factories and the roads were bad. It did that very successfully, but the problem is that like every country following this growth model, it went too far and was seriously over-investing by the early ’00s. It took them a while to recognise that, but Beijing now accepts that all this investment in real estate and infrastructure is non-productive and is the source of the incredible rise in debt recently.


So what can they do now?
If you want to reduce non-productive investment there are four options. One is to allow growth to slow down, so have growth rates of up to two or three percent. They don’t want to do that. Much of what is happening in China assumes growth of five to six percent for many years, which is impossible anyway. The second option is to replace investment with a rising trade surplus. However, China is too big and the world cannot absorb an increase in Chinese trade surplus.

The third option is replacing non-productive investment by discovering new areas of productive investment. That’s what every country at this stage of growth tries to do, but it’s impossible. In China they believe they can shift all this investment into the tech sector, but there’s a limit to how much this can absorb. Even in a technologically advanced country like the US, the tech sector is small. In China, it might be about five percent of GDP, but investment in tech is about 45 percent and at least half of that is in non-productive property or infrastructure. You can’t transfer this huge amount of investment into the tech sector.

That leaves only one way: reduce investment and balance it by increasing consumption. The problem is that the consuming part of the Chinese economy, ordinary households, has the lowest share of GDP in history. In most countries, that is between 70 and 80 percent of GDP. In China it’s around 50 percent, with business and government retaining another 50 percent.

So if you want to solve the problem you have to increase the household share. If you want to raise the household share by 15 percent, it goes from 50 to 65 percent and the non-household share drops from 50 to 35 percent. How do you decrease the non-household share? Not from the business sector, because private businesses are the efficient part of the economy. If you force them to pay for the adjustment, you will destroy the Chinese economy. So that leaves the government. It’s hard to know what share the government retains, because there is no clear definition of government, but it is around 25 percent of GDP. So the relationship between the share of households and government must shift from 50-25 percent to 65-10 percent. Household consumption would have to move from being twice as big as government consumption, to being seven times bigger. You can’t do that without a significant shift in political power. From a historical perspective, there is no way to do it without political instability.


In the book you claim that “the euro area is now the world’s biggest source of global imbalances,” mainly because Germany runs ludicrously high trade surpluses. The Green Party may win the forthcoming election and they are talking about running deficits, which is a taboo in Germany. Would that solve the problem?
I have met the leaders of the German Green Party and they seem to understand the problems. Germany is obsessed with international competitiveness. There are two ways you can achieve this. One is to invest domestically and increase the productivity of workers. The other way is by lowering wages or some form of social or environmental degradation. If you increase your productivity, the reward of becoming more efficient in manufacturing is not a trade surplus. I don’t believe that some countries work harder than others, but even if you are a hard-working country your reward is not a trade surplus, but the ability to import more for a smaller unit of output, so basically you improve your terms of trade.

Germany’s way of achieving international competitiveness is lowering wages, the famous Hartz IV reforms. This is a classic beggar-thy-neighbour policy, because by lowering wages you lower your contribution to global consumption, and you are rewarded by taking a bigger share of everyone else’s consumption through a trade surplus.

Keynes warned us about this. He argued that countries compete by worsening their contribution to global demand, basically by constantly lowering wages. So today American companies tell their workers “if we don’t pay you less, we’re going to go out of business”, and you either accept lower wages or they move abroad. This is one reason why we see rising income inequality and demand growth has been low. It’s only with rapid increases in debt that we can keep growth and demand at reasonable levels.

If the Greens have a bigger impact on German policy, and it doesn’t even have to be running a deficit, it would be a positive change. As long as they eliminate the trade surplus by raising wages, Germans will be better off and Germany will be contributing net growth to the world, rather than subtracting growth. It’s true that Germany has lent a lot of money to other EU countries. But as long as it doesn’t run a deficit with its EU partners, it’s impossible for them to repay Germany.


In the UK, when we talk about trade it’s all about Brexit. You don’t discuss this in the book, but some of your arguments echo some of the arguments made by Brexiteers, notably left-wing ones. They talk too about domestic imbalances, particularly between the financial sector, which allegedly benefited from Britain’s EU membership, and other parts of the economy. Am I right to read it as a book that is indirectly pro-Brexit?
In the long term, politics will determine whether Brexit was a good idea. My instinct is to say Britain would have been better off as part of the EU, but it’s not a hill I am willing to die on. I don’t think it will make much difference from an economic point of view in the long-term.

The problem of the UK is that it has been running deficits since the 1970s. And that’s not surprising, because the UK shares with the US a friendly investment market and open capital markets. Like other Anglophone countries, it is a net recipient of foreign inflows, so it has to run a deficit. If it were a developing country, that could be a positive deficit driving domestic investment higher. But it’s an advanced economy and there is no savings constraint. So these inflows are bad for the economy.

One of the reasons Keynes opposed free capital flows was that the UK experienced this in the 1920s, a spectacular period for much of the world, but not for Britain. Under the gold standard in the 1920s, there were a lot of capital inflows and that hit its export industries. In 1931 they abandoned the gold standard and started implementing protectionist tariffs and the UK economy did relatively well, given the horrible performance of the rest of the world. To a certain extent, you could argue that Brexit may be a repeat of that story.


Some economists say that leaving the EU could end the country’s overdependence on finance and boost manufacturing. Does that make sense to you?
I am a Wall Street guy, I spent most of my career running trading and capital markets desks, but I think a country needs a decently sized financial services sector. Up to a point, the more sophisticated your financial system is, the better it is for the economy. But beyond that, what’s best for the financial system often comes at the detriment of producers, farmers and workers. There’s a real conflict between bankers, what I would call the State Department or Foreign Affairs constituency, and the domestic workers and producers constituency. I think in England, like in the US, the financial constituency is way too powerful.