Debt

As you can see in the chart below, China has a sizable and growing industry deficit. That table is via Brad Setser, who is really a one-man troops in terms of tracking global trade and financial moves.

Here’s a much more in-depth discussion of China’s glut in a Setser&nbsp string. Incidentally, China’s exports to the developing world are &nbsp, a bit bigger of a factor here &nbsp, than its exports to the US and the EU, though the latter are up by a little bit.

This is the Next China Shock, in other words. Trade deficits like this can’t be explained by the great old principle of comparative advantages — a Chinese business surplus is only countries writing China IOUs in trade for physical goods. When writing Securities, places don’t really have a comparative benefits. ( 1 )

Why trade deficits and deficits&nbsp, do &nbsp, occur is an important and fascinating and complex topic, and my general idea from reading a bunch of economics documents on the subject is” No one really knows”.

It probably has something to do with the fact that China’s authorities is directing its banks to lend a lot of money to producers and, on top of that, pay companies a ton of subsidies.

But there also has to be some kind of&nbsp, financial&nbsp, component involved that prevents China’s forex from appreciating and allowing Taiwanese people to buy more goods. This might be everything the Chinese authorities does on purpose, or it might just be a result of China’s financial difficulties. More on this afterwards.

What should be done in response to the enormous flood of Taiwanese imports? Overwhelmingly, from all sides of the commentariat, there has been one main policy proposal ( 2 ) &nbsp, for the world outside of China: &nbsp, tariffs&nbsp, on Chinese goods. Taxes are one of their main plan ideas, and MAGA people undoubtedly support this.

In contrast, some commentators suggest that China may change its economic type toward promoting private use instead of yet more production. Many of the people who make the suggestion are private-sector economics who work for businesses, &nbsp, authors, or other private-sector analysts.

But somewhat, Paul Krugman&nbsp, has said related issues. Although many commentators don’t directly support taxes, they will continue to say that the world will eventually impose tariffs on Chinese goods if China doesn’t start to consume more of what it produces.

The “other nations should put tariffs on China” thought and the” China should change its business toward domestic use” plan are unified in the view of&nbsp, Michael Pettis, who has advocated both things.

He has been arguing for well over a century that China needs to increase its share of domestic use, and it seems more than anyone that he is to blame for bringing this notion into the conversation. And in&nbsp, an essay in&nbsp, Foreign Affairs&nbsp, in December, Pettis laid out a case for levies:

Americans now import the majority of their produce from overseas because they consume far too much of it, unlike in the 1930s. In this case, tariffs ( properly implemented ) would have the opposite effect of]the ] Smoot-Hawley]tariffs of the 1930s].

Modern-day taxes would divert a percentage of US demand toward increasing the total amount of goods and services produced at home by hard usage to support production. That may lead US GDP to fall, resulting in higher jobs, higher pay, and less loan. Yet as use as a percentage of GDP decreased, American households would be able to eat more.

Thanks to its somewhat open industry profile and even more open investment account, the American economy more or less quickly absorbed excessive production from trade partners who have implemented beggar-my-neighbor policies. It is the last resort’s global consumer.

The purpose of tariffs for the United States should be to cancel this role, so that American producers would no longer have to adjust their production according to the needs of foreign producers. For this reason, such tariffs should be straightforward, straightforward, and widely used ( perhaps excluding trade partners who pledge to maintain a domestic trade balance ).

The aim would not be to protect specific manufacturing sectors or national champions but to counter the United States ‘ pro-consumption and antiproduction orientation.

Some economists have criticized Pettis ‘ views on trade policy and his entire way of thinking about global economics.

For example, in September 2023, Tyler Cowen&nbsp, questioned the focus on Chinese domestic consumption&nbsp, as a target for Chinese growth policy. He suggested that China should concentrate on enhancing some dysfunctional service industries like health care, which will increase both production and consumption.

In November, Pettis&nbsp, vented his frustration&nbsp, with the academic economics establishment in an X thread:

It’s okay to ask economic historians, but never ask economists if you want to understand the effects of trade intervention. That’s because their answer will almost certainly reflect little more than their ideological position…It was direct and indirect tariffs that in 10 years transformed China’s EV production from being well behind that of the US and the EU to becoming the largest and most efficient in the world… Tariffs may not be an especially efficient way for industrial policy to force this rebalancing from consumption to production, but it has a long history of doing so, and it is either very ignorant or very dishonest of economists not to recognize the ways in which they work…To oppose all tariffs on principle shows just how ideologically hysterical the discussion of trade is among mainstream economists.

Tyler&nbsp, blasted harshly:

I am usually loathe to turn]Marginal Revolution ] space over to negative attacks on others, but every now and then I feel there is a real contribution to be made. Michael Pettis is consistently portrayed as an authority in the serious financial press despite my constant complaints that he completely does not understand international economics. Here is&nbsp, his recent tweet storm. It is incorrect.

As you know, any time there’s an economist food fight, especially over macroeconomics, I am here for it! I wish Tyler had given more details about how he felt about Pettis ‘ paradigm, and I believe Pettis is being unfair with his blanket accusations of ideological bias.

But in any case, I think I have four points to make on this topic.

International economics is really, really challenging.

The first point is that as far as I can tell, &nbsp, nobody&nbsp, really understands international economics. It’s basically macroeconomics on steroids. There are a huge number of factors that make issues of tariffs, trade surpluses, and the effect of trade on consumption vs investment very complex. Some of these elements are:

There are &nbsp, many countries&nbsp, in the world, not just two. Although we typically think about bilateral trade deficits, there are many of them, and in fact, third parties are important. For example, if China’s trade surplus with America goes down, it&nbsp, might&nbsp, be because China is exporting more components to Vietnam for cheap final assembly, to be shipped onward to American consumers.
• Business cycles  are important. If countries are in a depression-style situation where interest rates are at the zero lower bound ( a “liquidity trap” ), a number of standard results about the effects of trade policies— and results about how monetary and fiscal policy affect trade — go out the window. There are currently indications that China is in that predicament, but the rest of the world is not.
• Tariffs interact with&nbsp, monetary and fiscal policy. For instance, China might try to impose tariffs on China by printing a lot of money to reduce the yuan’s value. These sorts of interaction depend on understanding&nbsp, how monetary and fiscal policy work&nbsp, ( which we don’t really ), and also on understanding&nbsp, how policymakers in countries around the world make decisions&nbsp, about monetary and fiscal policy ( which we definitely don’t understand ).
• Why international trade occurs in the first place isn’t well understood. Exactly  There’s the classic theory of comparative advantage. There are theories based on investments in labor-intensive nations, as well as theories. There’s Krugman’s” New Trade Theory“, which focuses more on differentiation and variety as the motivation for trade. And so forth. The most empirically successful models of trade are just very simple equations called&nbsp, gravity models, which are agnostic on why trade happens, and could arise from&nbsp, a variety&nbsp, of different processes. This implies that we are not really aware of the fundamental principles of what trade between the United States, China, and other nations would look like, without regard to Chinese industrial policies or currency market intervention.
• There are all kinds of wrinkles and complications that affect trade, called “frictions“. These include things like home bias in both financial and consumer investing, sovereign default, currency market frictions, and other issues. Economists argue back and forth about which of these frictions cause the various&nbsp, “puzzles” in international trade&nbsp, — disconnects between theory and evidence — or whether that’s just how trade works in the first place.
• Competition&nbsp ( also known as “market structure” ) can stifle everything in this. Trade is carried out by companies, and whether Chinese companies and American companies end up making profits on their exports and their domestic sales will affect how they behave. Both domesticated competitive environments and international competitive environments are important, and neither one is particularly well understood.

In graduate school, I took a class in international finance. The professor who taught that class was renowned for creating models using advanced mathematical techniques borrowed from engineering that involved two distinct frictions that interacted with international trade. That was a big improvement over the standard theories that could only handle one friction. But what if you have seven? It’s hopeless.

Any more complex than that quickly turns into an absolute nightmare is one reason no one has developed an alternative to Michael Pettis ‘ ultra-simple way of analyzing international economics.

Making big sweeping assumptions about how tariffs will affect production and consumption isn’t exactly the most rigorous or empirically testable way to think about trade and industrial policy, but if the alternative is a blizzard of unworkable math that probably&nbsp, still&nbsp, makes way too many simplifying assumptions, maybe you just go with the simple thing.

Additionally, Pettis ‘ paradigm isn’t all that dissimilar from some of the heuristic theories that orthodox economists have used to evaluate trade policy. For example, Ben Bernanke ‘s&nbsp, early-2000s warnings about a global” savings glut” &nbsp, bear more than a little similarity to Pettis ‘ ideas, and the IMF’s&nbsp, calls for China to “rebalance” its economy&nbsp, toward domestic consumption in the mid-2000s are very similar to Pettis ‘ prescription.

Which brings me to my second point: Regardless of what you think of Pettis ‘ theories, I believe he is the most significant and influential international economics theorist in the world today.

His framework for understanding China’s economy and China’s trade policy might not please academics, but from what I can tell, it has been implicitly accepted by most private-sector economists and commentators, and many policymakers as well. It’s a more modernized, simplified version of the fabled” savings glut” and “rebalancing” concepts.

When I see China’s top economic policymakers&nbsp, use language like this, I’m almost certain they’re reading Pettis:

Senior leaders at a meeting of the 24-member decision-making body led by President Xi Jinping, the official Xinhua News Agency, agreed that the focus of economic policies should shift toward promoting spending and benefiting people’s livelihood, according to China’s ruling Communist Party, as weak domestic demand threatens the nation’s annual growth target.

Pettis isn’t the only person to talk about China’s low level of consumption as a share of GDP as an important problem, or to advocate “rebalancing”. Not at all necessary that he was the first. But he has been the most consistent and relentless, and these days I see him&nbsp, cited&nbsp, very&nbsp, frequently. Simply put, Pettis is winning this discussion.

A pretty simple way that Pettis could be ( sort of ) right

Thirdly, I can see a pretty straightforward way in which an approximation of Pettis ‘ view might be useful, if not to understand global economics in general or at least to understand the Second China Shock in particular. Basically, it’s all about&nbsp, the profits of Chinese companies.

China’s main strategy to combat its real-estate-induced recession has so far been to pump up manufacturing output, especially in the highly capital-intensive high-tech sectors like machinery, ships, planes, cars, batteries, drones, semiconductors, and so on. The Wire China had&nbsp, a great interview with Barry Naughton&nbsp, ( probably the top American expert on China’s industrial policies ) in which he explains what Xi Jinping is trying to do:

Of course, we have no idea what exactly goes through Xi Jinping’s mind. But I think we can characterize his approach as this: ‘ Billions for tech, but not one cent for bailouts. Because that would be just regular GDP, Xi Jinping doesn’t really care what Chinese people want to buy or make. He’s asserting that there’s something more fundamental than that: high quality GDP, which is determined, at the end of the day, by Xi Jinping himself…

This causes a significant misallocation of resources, which in turn causes a decline in the economy’s productivity. When we look at total factor productivity growth…China’s not really experiencing significant productivity growth. That is astonishing because, when we examine this economy that is implementing all these new technologies, we think, wow, that must result in some sort of explosive growth in productivity. But we don’t see it…

And it’s in part because, for instance, China is investing in a lot of semiconductor equipment factories, which are losing a lot of money, and it’s investing in thousands of miles of high-speed rail, which go where nobody wants to go.

In other words, Xi is making the Chinese economy look a little bit more like the old Soviet one, where production was determined by plans instead of by the market. He is telling Chinese companies to build a number of specific high-tech manufactured products using industrial policies and banks, and they are actually doing what he’s telling them to.

Why did this approach fail in the USSR? In the end, it was because Soviet manufacturers were ineffective; they produced a lot of stuff but were at a loss. That was unsustainable.

Chinese factories are much better than Soviet ones were. But if you tell enough different manufacturers to all produce the same stuff at the same time, they’re going to compete with each other, and their profits will mostly fall, and they’ll start taking big losses.

In fact, this is already starting to occur in China:

And here ‘s&nbsp, the ever-excellent Kyle Chan:

China’s solar-manufacturing sector is struggling to stop price wars and excessive capacity expansion. One set of tools Beijing uses to control over-expansion is tighter regulatory requirements on financing, resource use, and tech. However, of course the devil is in the enforcement.

You see similar policy efforts across a range of industries facing similar challenges in China: steel, coal, shipbuilding, batteries, wind. Other policy options include the elimination of subsidies and outright moratoriums on new projects or new businesses, such as China’s temporary moratorium on new shipbuilding companies following the global financial crisis.

Even in&nbsp, China’s vaunted auto industry, profits are collapsing and a shakeout is occurring. SAIC, the once-legendary auto giant, is flailing.

( Fun historical side note: From the 1950s through the 1980s, a major aspect of Japan ‘s&nbsp, industrial policy&nbsp, was about trying to prevent the profits of Japanese companies from collapsing via overproduction and over-competition, usually by forming cartels to restrain production in manufacturing industries. Xi’s China, in contrast, is simply moving forward with ease in order to increase production.

Chinese companies are responding to this in a very natural manner — trying to export their products when they can’t sell them at home. This is what people are talking about when people talk about “overcapacity,” &nbsp. Export profits are keeping many Chinese manufacturing companies— and, increasingly, the Chinese economy itself — afloat.

Exporting your way out of a recession is fine and good — it’s basically how Germany and South Korea shrugged off the Great Recession in the early 2010s. However, China’s export boom is heavily subsidized, both with explicit government subsidies and, more importantly, with incredibly cheap bank loans.

Subsidies are distortionary — they mean that China is making the cars that Germany and Thailand and Indonesia and other countries would be making for themselves if markets were allowed to operate freely. China is distorting the entire global economy by subsidizing exports on such a massive scale.

But, you may ask, as long as China’s taxpayers ( who pay the cost of explicit subsidies ) and savers ( who pay the cost of underpriced bank loans ) are footing the bill, why should people outside China worry about those distortions? In essence, China pays for Indonesians, Thai people, and Germans to purchase inexpensive automobiles rather than having to produce them themselves. Why should anyone be angry?

There are three reasons, I suppose. First of all, if a wave of underpriced Chinese exports forcibly deindustrializes the rest of the world — a possibility I’m sure Xi Jinping has considered — then it could weaken the world’s ability to resist the military power of China and of Chinese proxies like Russia and North Korea. That is frightful.

Second of all, even if a bunch of cheap Chinese stuff looks like a gift in the short term, it can create financial imbalances that cause bubbles and crashes in other countries. The” savings glut” theory accounts for the collapse of the world economy following the First China Shock in 2000.

And third, a flood of cheap Chinese stuff can cause disruptions and chaos in other economies, &nbsp, hurting lots of workers&nbsp, a lot even as it helps most consumers a little.

Additionally, according to Michael Pettis, cheap Chinese goods actually cause Americans to become poorer because they actually use less of it because they lower domestic production. I ‘m&nbsp, highly&nbsp, skeptical of this argument, since a basic principle of economics is that people don’t voluntarily do things that make them poorer. ( 4 )  But perhaps the labor market disruptions, financial instability, and military weakness are enough to frighten.

So what should countries do to prevent this? One obvious response is tariffs. If the world raises tariffs on China high enough, exchange rates will have difficulty adjusting, and Chinese products will have difficulty penetrating foreign markets. Chinese businesses will then have to revert to their domestic markets. This will intensify the effect of competition, and reduce their profits much more quickly.

The sooner Chinese businesses’ profits fall, they will reduce their production. They’ll also probably pressure the government to stop subsidizing overproduction, in order to lessen the competitive effect and keep themselves in the black. This political pressure may be what ultimately causes Xi Jinping and the CCP to alter the country’s economic model, lowering the incentives for overproduction.

This would be good for Chinese consumers. When Chinese companies flood the domestic market, they are given a temporary flood of cheap goods. If and when China’s government reduced the fiscal and financial incentives for overproduction, China’s taxpayers and savers would get a much-needed reprieve. And a less distorted Chinese economy would be beneficial for productivity in the long run because resources would be shifted to areas with more room for improvement, such as healthcare and other services.

This scenario isn’t &nbsp, exactly&nbsp, what Pettis envisions, but it’s reasonably close. It is impacted by tariffs, which will ultimately benefit regular Chinese citizens by rebalancing its production-to-consumption model. And it’s pretty easy to understand this scenario in terms of pretty standard orthodox economic concepts — subsidies, distortions, productivity, and competition — plus a little bit of political economy thrown in.

This wouldn’t necessarily mean that Pettis ‘ paradigm would be correct&nbsp in general. This scenario would only work because of unique features of Chinese industrial policy and Chinese domestic politics. However, I believe there is a chance that Pettis ‘ paradigm is becoming useful given that the Second China Shock is one of the most significant events currently taking place in the global economy.

Pettis needs to think harder about the downsides of tariffs

Having said that, I believe it’s also possible that Pettis is downplaying or ( more likely ) downplaying some of his biggest mistakes. This is my fourth point.

Pettis posits that tariffs would cause US manufacturing to surge so much that US GDP and US consumption would rise due to America’s enormous trade deficit. He&nbsp, writes:

Modern-day tariffs would redirect a portion of US demand toward increasing the total amount of goods and services produced at home by taxing consumption to subsidize production. That would lead US GDP to rise, resulting in higher employment, higher wages, and less debt. Even as consumption as a percentage of GDP decreased, American households would be able to consume more.

But Trump’s tariffs in his first term didn’t do anything of the kind. After Trump introduced his tariffs, industrial production actually decreased:

There was no surge in factory construction, either, that only happened once Biden came into office and&nbsp, enacted industrial policies&nbsp, ( the CHIPS Act and the IRA ).

The trade deficit also saw little activity. If you squint really hard you can see a small improvement right before the pandemic began, but then a total collapse afterward:

What transpired? Two things. First, the tariffs caused at least a portion of the effect, which the US dollar did as a result of. Second, US manufacturers suffered when they had to pay a lot more for parts and components. I went into both of these issues in more detail in this post, but they are very general issues with tariffs as a policy.

Instead of quoting my earlier post, I’ll quote Matthew C Klein, who co-authored the book&nbsp,” Trade Wars are Class Wars” &nbsp, with Pettis, and who recently wrote an op-ed&nbsp, explaining how tariffs could easily backfire:

The business cycle and new orders for American-made goods are frequently tracked when money is spent on imports&nbsp. Imposing “universal” tariffs high enough to force those imports to fall by more than 40 % to close the trade deficit would likely involve a severe economic downturn that hurts Americans more than anyone else.

Domestic production of those same goods would need to increase quickly enough to bridge the gap to prevent shortages and inflation in order to avoid that pain. The experience of the pandemic suggests that this is not a realistic option …

Another counterintuitive effect is that the dollar tends to increase in price in response to the imposition of new tariffs, or threat of new tariffs.[ This ] results in higher prices for customers in the US. The net effect is that tariffs often hit&nbsp, exports&nbsp, more than imports, even when foreign trade partners fail to retaliate.

Pettis doesn’t really seem to grapple with either issue. It’s possible that he believes that Trump’s first-term tariffs were a failure because China simply&nbsp, rerouted its exports through Vietnam, in this case, putting tariffs on all other countries, as Pettis recommends, would close off that loophole.

However, that wouldn’t address the issue of exchange rate appreciation. Unless tariffs on the rest of the world are so huge that they overwhelm the dollar’s ability to adjust to compensate, some sort of&nbsp, financial intervention&nbsp, to keep the dollar weak would be necessary in order to make tariffs effective. Pettis has suggested taxing capital inflows, which might be effective, ( 5 ) &nbsp, but the Trump administration doesn’t seem to be interested in doing this.

And Pettis also fails to grapple with the intermediate goods problem. The US would not benefit from returning to the quasi-autarkic economy of World War 2 because, unlike other nations, technology has evolved far too much to prosper while shutting itself off from the rest of the world.

The US can onshore and harden its supply chains to some extent, but no matter what, US manufacturers are still going to have to order some materials, parts, and components overseas. I haven’t yet seen Pettis suggest a solution to this issue or consider how unsuccessfully Trump’s tariffs were six years ago in terms of boosting US industrial production.

So while I think Pettis ‘ paradigm probably does a good job grappling with the unique characteristics of the Second China Shock and China’s political economy, I don’t think we should rush to make it our general default paradigm for thinking about trade, tariffs and international economics in general. It still needs to be developed a lot.

Notes:

1 Actually, this is not entirely true. There is a claim that America actually has a comparative advantage in writing IOUs because it has the reserve currency and does so for risk hedging and other things like that, and that this is because those IOUs are used for international payments and risk hedging and other forms of disguised financial services. But it’s hard to apply this argument to the developing countries that are accounting for more and more of China’s trade surplus. Few people believe that Vietnam, Brazil, or Saudi Arabia have a competitive advantage in terms of financial services.

2 I tried to suggest intentional devaluation of the dollar via&nbsp, exchange rate intervention&nbsp, as an alternative, but nobody has been particularly interested in this idea.

3 Germany may have caused some harm to its European neighbors by exporting too much to them, since at the time they were all at the bottom of the scale.

4 In order for cheap Chinese imports to actually impoverish Americans, there would have to be some kind of externality or coordination problem involved. That might be the case, but Pettis or MAGA people need to explain what they believe externality to be. It’s not readily apparent to me what it might be.

5 Though the Fed’s intervention in the currency market would be much more efficient and much simpler to carry out!

This&nbsp, article&nbsp, was first published on Noah Smith’s Noahpinion&nbsp, Substack and is republished with kind permission. Subscriber or subscriber can sign up for Noahopinion.com.

Continue Reading