Michael Pettis on the High Odds of Trade War

Beijing-based fiance professor and commentator Michael Pettis gives a typically sobering outlook in a Financial Times comment today, seeing the seemingly irresistible force of trade surplus countries’ resistance to shifting towards more internal generated demand colliding with the immovable object of trade deficit countries’ inability to tolerate the high unemployment rates that result for a prolonged period.

There are some interesting elements of his presentation. First, although he thinks a trade war is a bad outcome, he also see the odds as low that the trade surplus countries will take the steps needed to rebalance their economies. That brings us to the second point, Pettis, without invoking the word mercantilist, sees the trade surplus countries as taking overly aggressive measures to preserve their positions. This may sit poorly with some readers, who tend to see trade surplus/high savings countries as virtuous, and the trade deficit/debtor nations as wastrels. But the existence of surplus countries requires debtor nations. Deriding the debtors while praising the surplus nations is like saying you think sex is sinful but consider babies to be a blessing. Unless you believe in storks as the mechanism for procreation, that position can’t be reconciled.

Pettis gives a useful bill of particulars: even though China has moved to liberalize its currency further (a measure we derided as a headfake), its small steps have been more than offset by continued extension of cheap credit to domestic companies, with the result that they are even more competitive, thanks to continued government intervention, than before. The recent and likely continued fall of the euro has been a boon to Germany. Japan has, relatively speaking, been a good sport, allowing its yen to rise, but it appears to be on the verge of intervening.

Pettis sees these imbalances worsening until they become intolerable, and he anticipates that the US Congress will (as in the 1930s) act as the heavy. But from his vantage, the proximate cause of a trade war, US retaliation, would not be the underlying cause, which is surplus countries pushing an unsustainable arrangement to its breaking point. But in a perverse way, this is understandable, since in past financial crises, the surplus countries have found adjustment much more painful than the debtor nations. But trying to forestall the inevitable may make the eventual dislocations even more severe.

From the Financial Times:

After jumping to $42bn in May, the US trade deficit rose to $50bn in June, a number not seen since the summer of 2008 and never before mid-2004. As it continues rising there will be renewed criticism about US consumers embarking on another ill-judged buying spree, but this time the finger-waggers will be wrong. The surge in the trade deficit is the automatic consequence of a shift in global trade imbalances.

Five countries or regions have largely driven these imbalances in the past decade. Three of them – China, Germany and Japan – run huge trade surpluses on which they are dependent for domestic employment growth.

Counterbalancing them have been the two trade-deficit champions – the US and trade-deficit Europe, dominated by Spain, Italy and Greece.

The financial crisis has undermined the precarious decade-long equilibrium between these blocs by forcing trade-deficit countries to reduce debt, especially household debt. As they do, the excess demand they provide to the rest of the world must decline. Trade-surplus countries, which depend heavily on this demand to absorb their excess capacity, have resisted this adjustment fiercely by trying to maintain or even increase their surpluses.

They are succeeding. The combination of a collapsing euro and German fiscal constraint will raise Germany’s trade surplus sharply and generate rapid growth. Any rise in the value of the renminbi has been more than offset by a surge in cheap credit to Chinese manufacturers, increasing their competitiveness, so China’s surplus is also rising. Recent strength in the yen has set off alarm bells and Tokyo, too, will do what it can to maintain its trade surplus…

But global trade must balance. The rest of the world will have to absorb, with rising trade deficits, the combination of rising surpluses among surplus champions and declining deficits in trade-deficit Europe. Given its openness and financial flexibility, the US will, in practice, absorb most of the adjustment, its trade deficit rising inexorably – until Congress implements vigorous anti-trade policies. The US lacks the industrial, currency intervention and interest-rate management policies available to the main trade-surplus countries, and so will be forced to use other forms of trade protection – tariffs and import quotas.

This should not be allowed to happen….It is up to the surplus countries to ensure their urgent dependence on foreign demand does not result in a collapse in the willingness of deficit countries to continue providing that demand…

Trying to avoid sharing the cost of the necessary global adjustment is how the major economies reacted in the 1930s, and those policies are widely and correctly referred to as beggar-thy-neighbour. We know how that game ends.

Originally published at naked capitalism and reproduced here with the author’s permission.