Michael Pettis: The Global Trading System Was Already Broken

From Foreign Affairs, April 21:

But There’s a Better Way to Fix It Than a Reckless Tariff Regime 

The sweeping tariffs announced by U.S. President Donald Trump on April 2, along with the subsequent postponements and retaliations, have unleashed an enormous amount of global uncertainty. Much of the world’s attention is on the chaotic, short-term consequences of these policies: wild stock market fluctuations, concerns about the U.S. bond market, fears of a recession, and speculation about how different countries will negotiate or react.

But whatever happens in the near term, this much is clear: Trump’s policies reflect a transformation of the global trade and capital regime that had already started. One way or another, a dramatic change of some kind was necessary to address imbalances in the global economy that have been decades in the making. Current trade tensions are the result of a disconnect between the needs of individual economies and the needs of the global system. Although the global system benefits from rising wages, which push up demand for producers everywhere, tensions arise when individual countries can grow more quickly by boosting their manufacturing sectors at the expense of wage growth—for example, by directly and indirectly suppressing growth in household income relative to growth in worker productivity. The result is a global trading system in which, to their collective detriment, countries compete by keeping wages down.

The tariff regime Trump announced earlier this month is unlikely to solve this problem. To be effective, American trade policy must either reverse the savings imbalance in the rest of the world, or it must limit Washington’s role in accommodating it. Bilateral tariffs do neither.

But because something must replace the current system, policymakers would be wise to start crafting a sensible alternative. The best outcome would be a new global trade agreement among economies that commit to managing their domestic economic imbalances rather than externalizing them in the form of trade surpluses. The result would be a customs union like the one proposed by the economist John Maynard Keynes at the Bretton Woods conference in 1944. Parties to this agreement would be required to roughly balance their exports and imports while restricting trade surpluses from countries outside the trade agreement. Such a union could gradually expand to the entire world, leading to both higher global wages and better economic growth.

Keynes’s plan failed to carry the day at Bretton Woods, largely because the United States—the leading surplus economy at the time—opposed it. Today, however, there is a chance to revive and adapt his proposal.

MIND THE GAP
To understand what ails the global trading system, consider how wages shape an individual economy. Higher wages are usually good for the economy because they boost demand for businesses while increasing their incentive to invest in efficiency. The result is a virtuous cycle. The growing demand spurs increased investment into ways of producing more with fewer workers, raising economic productivity which, in turn, drives further increases in wages.

Individual businesses, however, have different incentives. They can boost profits by suppressing wages. The problem is that although lower wages can benefit an individual business, they reduce the profits of others. In an economy in which business investment is mainly constrained by whether there is demand for more production, if businesses collectively suppress wages, either household and fiscal debt must rise to replace the lost demand, or total production and business profits will decline.

Although this phenomenon, sometimes called Michal Kalecki’s Paradox of Costs (named for the economist who first proposed it), mainly describes businesses, it also applies to countries in a global economy. If suppressing wage growth can make manufacturing in one country more globally competitive, it can generate faster growth for that country by subsidizing and boosting manufacturing exports. But if all countries suppress wage growth, growth in global demand is reduced, and all countries suffer.

In a highly globalized world where some states are more successful than others at suppressing labor costs, the result is an asymmetry in the demand for and supply of goods. Because businesses do not have to make products in the same places where they sell them, local labor costs become crucial to the competitiveness of manufacturers. Businesses that shift production to countries where labor costs are lower relative to workers’ productivity can produce goods more cheaply, making their products more attractive globally.

In any given state, wage suppression puts downward pressure on domestic consumption while subsidizing domestic production. This results in a rising gap between production and consumption which, if it remains within the economy, must be balanced by raising domestic investment (which can further exacerbate the gap between production and consumption). Otherwise, the gap invariably reverses, either via raising wages or by cutting back on production.

But in a globalized economy, there is another option: running a trade surplus. This allows the country to export the cost of the gap between consumption and production to trade partners. This is why, in 1937, the economist Joan Robinson referred to the trade surpluses that resulted from suppressed domestic demand as the consequences of “beggar-my-neighbor” policies.

It is also why, at the Bretton Woods conference in 1944, Keynes opposed a global trading system that allowed countries to run large, persistent trade surpluses. A system that accommodated these surpluses, he said, would encourage countries eager to expand manufacturing to subsidize it at the cost of domestic demand. The result, Keynes explained, would be downward pressure on global demand as countries fought to remain competitive by suppressing wage growth. The countries most successful at doing so would become the winners of global trade. Their share of global manufacturing would expand while that of their trade partners contracts.

Keynes instead called for countries to “learn to provide themselves with full employment by their domestic policy.” In such a world, he argued, there would not be “important economic forces calculated to set the interest of one country against that of its neighbours.”....

....MUCH MORE 

Also from Pettis at Foreign Affairs: 

How Tariffs Can Help America
Economists Have Drawn the Wrong Lessons From the Failures of the 1930s 

The High Price of Dollar Dominance
The Dollar Is the Worst Reserve Currency—Except for All the Rest