A Great Rebalancing Is Coming

The trade imbalances that have come to characterize the global economy are fundamentally untenable. China, Germany, and a handful of other economies run large, persistent trade surpluses, while the United States absorbs much of these surpluses by running the world’s largest trade deficit. Sooner or later, something must give. For an advanced, capital-rich economy such as that of the United States, an enduring trade deficit will bring with it either rising unemployment or rising debt, neither of which is sustainable.

In theory, the major surplus and deficit economies could agree on a coordinated adjustment in which surplus countries would expand domestic demand and deficit countries would gradually reduce their dependence on debt-fueled consumption, allowing the imbalances to shrink without a sharp contraction in global demand. That would be the sensible solution.

But because the major players disagree about the causes of the imbalances, they are unlikely to come to such a solution. China attributes them to excessive U.S. consumption and fiscal deficits; the United States blames foreign industrial, trade, and currency policies; and Europe has yet to settle on a coherent diagnosis. As a result, they all have proposed remedies that are at odds with one another. Beijing wants deficit countries to save more and prefers not to change China’s growth model. Washington wants surplus countries to reduce their surpluses by redistributing income to the household sector. European leaders continue to advocate for multilateral cooperation and rules-based trade. This makes the chances of a coordinated response slim. And as the economic analyst Martin Wolf wrote in the Financial Times earlier this year, if there is little prospect of preemptive action, “the second-best option is to prepare for a crisis.”

Individual economies are now doing just that. History shows that trade imbalances of this scale almost always end painfully—and that the pain of the adjustment is not distributed evenly. High levels of debt combined with low productivity makes a country more likely to bear the burden of a trade adjustment, but economic and political power can also give it the tools to pass the burden off to others. Among the three main economic players today, China is the most vulnerable, the United States has the most capacity to reduce its exposure, and Europe possesses latent power but a dubious ability to use it. None of their maneuvers to protect themselves are likely to reduce the risk or overall cost of a crisis. The question is only who will feel the brunt of the losses when it arrives.

HISTORY REPEATS ITSELF

Large, persistent trade imbalances have cropped up periodically over the past century, and they are rarely benign. One such episode occurred during the 1920s, when a surge in American productivity was not accompanied by rising wages. Production soared past consumption, and the United States ran enormous trade surpluses. Europe ran the corresponding deficits, as many countries borrowed heavily abroad to rebuild economies devastated by war. Germany in particular borrowed extensively to finance both domestic growth and its reparations payments. American domestic debt also rose rapidly, much of it to fund consumption and asset speculation.

As the imbalances persisted and U.S. manufacturing expanded at the expense of European manufacturing, protectionist pressures intensified. France devalued its currency in 1927, the United Kingdom abandoned the gold standard in 1931, and the same year Germany imposed import restrictions and rationed access to foreign currency. Even the United States, whose manufacturers and farmers complained that weak demand was threatening domestic production and employment, passed the Smoot-Hawley Tariff Act in 1930.

The adjustment came in the form of a collapse in global trade during the Great Depression of the early and mid-1930s. Nearly every major economy suffered from the contraction, but they did not suffer equally. Those with large deficits, such as the United Kingdom, recovered more quickly and suffered less severe financial distress than the United States, which absorbed a disproportionate share of the costs. American exports fell faster than imports, domestic investment imploded, banks failed, and bankruptcies surged.

The next major episode of persistent trade imbalances was the rare case in which the imbalances faded away without causing major disruption. During the 1950s and 1960s, the United States again ran very large surpluses while Europe and Japan ran corresponding deficits. Similar to the situation in the 1920s, these deficits financed the reconstruction of postwar economies as resources poured into infrastructure and manufacturing. But unlike in the earlier period, governments maintained strict controls over capital flows and imported capital mostly to fund investments that generated enough future income to service the associated liabilities. Because the investments were so productive, debt rose little relative to GDP. There was also minimal protectionist pressure, largely because Europe and Japan urgently needed imports and the United States actively encouraged reconstruction in both places. As a result of these unusual conditions, trade imbalances disappeared gradually without any countries bearing severe costs.

Four more episodes of trade imbalances would follow, all of them ending in pain for the countries involved. One happened in Latin America during the 1970s. The oil shocks of that period, in which the global price of oil soared from roughly $2 per barrel at the beginning of the decade to around $30 per barrel by the end, generated massive petrodollar surpluses in the oil-exporting economies of the Middle East and other members of OPEC. Much of this was deposited in major international banks that, eager to find new customers, loaned the funds to Latin American and other developing economies, eventually leading to overvalued currencies and large trade deficits. By the early 1980s, rising global interest rates made their debt unsustainable. Debt crises resolved the trade imbalances but left the deficit countries with the overwhelming share of the adjustment costs: recession, inflation, austerity, and lost decades of growth.

The next case developed during the late 1970s and 1980s. Japanese productivity growth outpaced Japanese wages during this period, and the country began running enormous trade surpluses. The same happened in Germany, allowing the country’s manufacturing sector to become increasingly competitive internationally. The United Kingdom and the United States ran deficits that accommodated both Japan’s and Germany’s surpluses. Japan in particular saw a spectacular surge in domestic debt during the 1980s, as extremely high levels of investment flowed into projects whose returns fell far below expectations.

Protectionist pressures rose steadily, culminating in the Plaza Accord of 1985, in which the world’s major economies agreed to appreciate the yen and the deutsche mark against the dollar in an effort to reduce trade imbalances. Yet a real resolution of the imbalances did not come until Japan’s economic downturn in the 1990s, which brought collapsing asset prices, persistent deflation, and years of stagnation. It is difficult to compare this to Germany’s experience, however, given that the 1990 unification of East and West Germany fundamentally altered the economy at precisely the same time.

The Asian financial crisis of the 1990s in some ways resembled the Latin American trade imbalances of the 1970s. In the early part of the decade, foreign capital poured into a group of East Asian economies. These economies developed large trade deficits, which were balanced by surpluses in Japan, European countries, and, increasingly, China. Although their domestic and external debt rose rapidly, protectionism remained limited. Even so, when investor confidence broke in 1997, the adjustment was swift and brutal. Currency collapses, banking crises, and deep recessions struck the East Asian deficit countries, while the surplus countries bore few costs.

Finally, between roughly 2002 and 2008, Germany accumulated large surpluses after implementing labor reforms that pushed wage growth down relative to productivity growth and caused huge increases in saving. It exported more and more to Greece, Portugal, Spain, and several other eurozone economies, which in turn accumulated deficits financed by rapidly rising debt. Because this dynamic emerged within the eurozone, where most members shared a common currency, countries could not impose protectionist measures and exchange-rate adjustment was impossible. When the 2008 global financial crisis triggered the eurozone crisis, the deficit countries experienced sovereign debt crises, unemployment, austerity, and prolonged stagnation that unwound the imbalances.

COST ANALYSIS

These events demonstrate that trade imbalances become dangerous when they are accompanied by rapidly rising debt and growing financial fragility in either surplus or deficit economies. If a country with a surplus uses its high savings to finance productive investment at home or abroad, the imbalance can persist for many years without causing serious economic disruption. But if instead its excess savings finance unproductive investment at home or drive high household consumption, asset bubbles, or persistent fiscal deficits in the economies of its trading partners, the whole system becomes increasingly shaky.

Protectionism is generally not the cause of trade conflicts, but rather a symptom of imbalances that have endured for too long. Its absence does not make the eventual adjustment less painful. Yet when countries adopt protectionist policies, they can influence where the adjustment occurs and who bears the costs.

Whether it is surplus or deficit economies that take on those costs may also depend on which side has the greater ability to use trade, financial, or exchange-rate policies to compel the other to adjust. Deficit countries more often bear the costs when they are politically weak and unable to finance themselves independently, defend their currencies, or restrict capital and trade flows without triggering a financial crisis—as Latin American countries were in the early 1980s, much of East Asia was in 1997, and southern Europe was after 2008. Surplus countries are at risk, meanwhile, when deficit countries have sufficiently strong economies and political systems to reduce their own deficits by restricting imports, limiting capital inflows, depreciating their currencies, or otherwise preventing the surplus countries from exporting their excess savings. This is what happened to the United States in the early 1930s and to Japan beginning in the 1990s. Their trade partners reduced their deficits by intervening to reduce imports and increase exports, forcing the U.S. and Japanese surplus-based growth models to unravel as investment collapsed and exports, profits, and asset prices fell.

The main takeaway for governments today is twofold. First, the place where debt has risen furthest without a corresponding rise in productive capacity is most at risk when an adjustment to a trade imbalance eventually arrives. Second, the countries involved in imbalanced trade can take action to push adjustment costs onto others, but their success depends largely on economic power and their ability to wield it.

THE CRISIS TO COME

Today’s global trade imbalances are unusually large, and the coming adjustment is likely to be especially difficult. China looks most vulnerable. Its debt burden is already among the world’s highest; the country has experienced perhaps the fastest increase in debt relative to GDP in history. Much of this debt has funded investment that has generated progressively lower—even negative—economic returns, including excess residential real estate, underutilized infrastructure, and manufacturing capacity that far outstrips demand.

This huge and growing debt burden creates enormous pressure on Beijing to take any steps necessary to avoid absorbing the bulk of the adjustment costs. China will almost certainly try to push as much of this burden as possible onto its trade partners. It has every incentive to maintain the largest possible trade surplus for as long as it can, allowing excess production to be absorbed abroad rather than forcing a sharp contraction in domestic production and employment. In doing so, China can spread the adjustment over many years as it gradually works down its debt, while its trading partners endure greater costs in the form of larger trade deficits, rising debt, deindustrialization, or weaker growth. If foreign protectionist measures or weaker external demand make this strategy impossible, however, China’s economy would face some combination of slower growth, rising unemployment, falling investment, and financial distress.

Whether Beijing can offload the costs of adjustment depends on the willingness of the rest of the world to absorb them. Washington has little reason to continue allowing large, persistent trade deficits. As the world’s largest economy and by far its largest source of demand, the United States has the economic power to reduce its deficit and stop acting as the world’s consumer of last resort. And because U.S. trade policy is centralized within the executive branch—with the president able to impose tariffs, investment restrictions, and export controls under broad statutory authority—Washington has the political ability to exercise this power. If the United States uses industrial policy to expand domestic manufacturing capacity and, more important, takes greater control over its trade and capital flows using tariffs and other restrictive measures, China and other major surplus economies will not be able to maintain their surpluses with corresponding U.S. deficits. They will have to either reduce those surpluses with a painful contraction in domestic production or find new importers among countries that remain both willing and able to absorb them.

This leaves Europe in perhaps the most difficult position. The eurozone is the world’s third-largest economy and its second-largest source of demand, so Europe has economic power at its disposal. What is much less clear is whether it has the political ability to exercise this power, given its fragmented policymaking institutions and the often divergent interests of its member states. If the United States is able to reduce its trade deficit and expand its share of global manufacturing while China resists an equivalent contraction in its surpluses, a politically divided Europe could be forced to take on larger deficits almost by default. The costs could include deindustrialization, rising debt, and weaker growth. This process may have begun already.

Once the major economies stop asking how to minimize the global costs of adjustment and begin asking instead how to minimize their own risk, the opportunity to find a relatively painless solution to the global trade imbalance will have passed. Beijing seems set on trying to preserve its surpluses for as long as possible. Washington is just as intent on reducing its deficits. If Europe can develop the political capacity to do the same, the burden of adjustment will increasingly fall onto the surplus economies, which would have to rely more on domestic demand and less on exports. If it cannot, Europe will absorb more and more of the global surpluses, and what appears today to be a trade conflict mainly between China and the United States may become a conflict between China and Europe—and a struggle between the two of them to avoid bearing steeper costs down the road.

History makes clear that trade imbalances are always resolved eventually. What remains uncertain is how damaging the resolution will be—and for whom.

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