June 28, 2024

Analysis

Trade and the Manufacturing Share

Tariffs, manufacturing, and US capital controls

One of the concerns in American policy circles in recent years has been the long-term impact of foreign trade and industrial policies on the health and strength of American manufacturing. The Trump and Biden administrations tried to address this weakness when the former, in 2018 and 2019, put into place tariffs on hundreds of billions of dollars of Chinese imports, and the latter announced in May of this year that it was raising tariffs on other goods. It is clear that whoever wins the election in November, this attention to trade among US policymakers will only continue, and indeed is spreading throughout the world.

But as long as the US continues to play its role of global consumer of last resort—as long as it continues to run trade deficits large enough to absorb up to half of the trade surpluses of the rest of the world—we are unlikely to see a revival of US manufacturing overall. That’s because when it comes to trade imbalances and the strength of manufacturing, the global pattern is pretty clear: while manufacturing comprises 16 percent of global production (GDP), according to the most recent World Bank data, it comprises a much lower share of GDP for advanced economies that run persistent trade deficits, and a much higher share for those that run persistent surpluses.

Among advanced economies that in recent years have run persistent trade deficits, for example, manufacturing comprises 11 percent of US and Spanish GDP, 10 percent of France’s, 9 percent of Canada’s, and 8 percent of the UK’s. Among those that run persistent surpluses, it is 18 percent of German and Swiss GDP, 21 percent of Singapore’s, 26 percent of South Korea’s, and 34 percent of Taiwan’s.1

The graph below shows the relationship between the manufacturing share of GDP and the current account deficit for the ten largest advanced economies during three different years—2000, 2010, and 2020.2 As the graph shows, advanced economies with current account surpluses mostly have manufacturing shares of GDP that are above the global average, and advanced economies with current account deficits mostly have manufacturing shares of GDP that are below the global average. On average, the manufacturing share of GDP is 3.4 percentage points above the global average for surplus economies and 3.5 percentage points below the global average for deficit economies.

Japan’s history is especially instructive in this respect. In the 1980s and early 1990s, when Japan ran the world’s largest trade surpluses, the manufacturing share of its GDP averaged between 25 and 27 percent, among the highest of any advanced economy. With the end of the Japanese asset bubble in the early 1990s, its trade surplus began to decline, and as it declined, so did the role manufacturing played in Japan’s overall GDP, until in the past two to three years, at a time when it has been running trade deficits, manufacturing has comprised just 19 percent of its GDP.

Why does manufacturing play a markedly more important role in surplus economies than in deficit economies? The relationship isn’t just coincidence. While economists often assume that the strength of the manufacturing sector in any country has more to do with intrinsic drivers of comparative advantage than with trade imbalances and other external factors—and often argue that the declining share of manufacturing in the US economy represents a natural evolution among advanced economies—in fact the circumstances that lead to trade imbalances also affect the ability of that country’s manufacturing sectors to compete globally.

This is because what matters is whether success in exports is driven by rising productivity or by suppressed labor costs. In the former—i.e. in economies with highly efficient manufacturing—rising productivity drives rising wages, so that the more productive workers are, the more they get paid. This allows them to consume in line with what they produce, which also means that the country imports as much as it exports. Successful manufacturing exporters with balanced trade are economies that export a specific set of products, enjoy comparative production advantage, and use the revenues generated by those exports to pay for imports in those areas of manufacturing in which they do not enjoy comparative production advantage. This is the classic role trade is meant to play.

But this is not the case in economies that run persistent surpluses. Surplus economies tend to export a much wider set of manufacturing products, and they import less than they export largely because domestic demand is insufficient to convert export revenues into an equivalent amount of imports. A trade surplus, in other words, simply means that domestic demand is too weak to allow the economy to absorb the equivalent of what it produces. 

And it is almost always too weak because of the low share workers in these economies—compared to their counterparts in deficit countries—directly and indirectly retain of what they produce. This is why these economies must run surpluses to sustain employment and growth: their citizens cannot consume in line with what they produce.

Successful exporters with balanced trade are very different from successful exporters with persistent trade surpluses. In the latter case, the policies that prevent wages from keeping up with the productivity of workers explain both their global competitiveness and their weak domestic demand. But what economists often fail to realize is that the policies that prevent wages from keeping up with the productivity of workers don’t just affect the surplus economy that implements them. They have the obverse effect on the economies of their trade partners. 

Consider, for example, a country that devalues its currency to make its exports more competitive on global markets. Undervalued currencies affect the domestic distribution of income by penalizing net importers within a country (by raising the cost of imports) while benefiting net exporters (by raising their sales and profits). This redistribution of income within the economy acts as a transfer in which net importers are effectively forced to subsidize net exporters.

Because all households are net importers, and net exporters are mainly producers of tradable goods, undervaluing the currency effectively forces households to subsidize producers. In that case, manufacturers become globally more competitive while households become less able to consume. This is what it means to say that the export competitiveness of producers in such an economy is simply the obverse of weak domestic demand.

But the impact doesn’t stop there. The opposite happens with its trade partner. If one country’s currency is undervalued, by definition the currency of its trade partner must be overvalued. In that case its trade partner has the obverse transfer, and so its manufacturers are forced to subsidize its household consumers. This mirror reaction of one economy to a trade policy in another economy is the automatic consequence of the need for trade to balance globally, and for global investment to balance global savings. If one country forces its household consumers to subsidize its manufacturers to the point where it must run trade surpluses, those manufactures must subsidize household consumers in another country.

This reaction occurs with any form of trade and industrial policy, and not just with currency devaluation. A wide variety of mechanisms create this dynamic—including direct subsidies to manufacturers, fragile workers’ rights, managed credit, weak social safety nets, and even overspending on business infrastructure—but they all work in broadly the same ways. They effect income transfers that force consumers to subsidize production in the economy that implements the measures, and force producers to subsidize consumption among their trade partners.3

In that case, it can be no surprise that the former must run trade surpluses to balance their weak domestic demand, and their trade partners must run deficits to balance excess demand—in other words, “excess” demand relative to weaker domestic production of tradable goods. That much is easy to understand.

But this dynamic also explains why manufacturing must comprise a higher share of GDP in the surplus economies than in the deficit economies, and consumption a lower share. To remain globally competitive in a hyperglobalized world in which communication and transportation costs are extremely low, global manufacturers have little choice but to migrate to jurisdictions where their operations are most heavily subsidized—to where workers are paid the lowest wages relative to their productivity.

There is no mystery, in other words, as to why advanced economies with persistent surpluses are also economies in which manufacturing plays a larger role in the economy, and why advanced economies with persistent deficits are those in which manufacturing plays a smaller role. In either case, global manufacturing is simply migrating to where the subsidies are greater, while consumption must migrate in the opposite direction.

And as long as the former continue running surpluses and the latter continue running deficits, distortions in the role of manufacturing in their economies are likely to continue. This has an important implication for countries like the US that are concerned about reviving their manufacturing sectors. It means that they must not only implement trade and industrial policies that support specific sectors of their economies. They must also exit from the trade-deficit dynamic of producing fewer manufactured products (and other tradable goods) than they consume.

There are broadly three ways a persistent deficit economy like the US can respond to its trade and manufacturing imbalances. One way is if Washington decides to do nothing, implementing neither trade nor industrial policies to counter policies implemented abroad. This refusal to impose countervailing measures doesn’t mean that the US economy is absolved from government intervention in the economy. It will continue anyway to be affected by industrial policy, but this policy will be designed abroad—in Beijing, Berlin, Tokyo, Seoul, Moscow, Riyadh, Tehran and other centers whose policies cause their economies to run persistent trade surpluses. In that case American “industrial policy” will effectively be the obverse of whatever policies its more aggressively mercantilist trade partners choose for themselves.

The second way the US can respond is if Washington chooses to implement its own countervailing industrial policies in order to protect and expand strategically important sectors of the economy. In that case, while the US can encourage specific manufacturing sectors, its continued trade deficits—a required condition as long as the US persists in absorbing the excess savings of its trade partners—mean that the overall US manufacturing sector will prolong its long-term weakness. Strategically important sectors of the economy may do well, in other words, but only at the expense of the rest of US manufacturing.

Finally, Washington can choose to opt out of its accommodating role in absorbing global trade and capital imbalances. This will allow it to protect American manufacturing in general, but not just in strategically important sectors in which other countries have already obtained a comparative advantage—like China with electric vehicles, solar panels, and batteries. The most likely way the US might opt out of its outsized role in absorbing global imbalances would be by imposing across-the-board tariffs on US imports or—more effectively—by restraining unfettered access to US financial markets.

The latter would involve some form of capital controls that restrict the ability of foreigners to dump excess savings into the US economy. Capital controls come in many varieties and are quite widely used around the world to prevent overvalued currencies, speculative money flows and disruptions in local credit markets. In the US they were used as recently as the early 1980s.4 The net impact of limiting access to claims on US assets is that countries who repressed domestic demand in order to subsidize their manufacturing industries would not be able to externalize the cost of those subsidies by acquiring US assets to balance their trade surpluses.

The recent tariffs imposed by the Trump and Biden administrations have set off a great deal of discussion about trade and industrial policies, but bilateral tariffs cannot address fundamental trade imbalances. While these tariffs may strengthen manufacturing sectors that the US considers strategically important, they will not result in an overall revival of American manufacturing. As long as the US is willing to run the persistent deficits needed to absorb global excess savings, it must accept the continued erosion of its share of global manufacturing. To revive US manufacturing requires much deeper structural changes that either eliminate persistent trade imbalances in the global economy, perhaps through new global trade agreements, or that unilaterally revoke the US role in absorbing them.

  1. Mainland China is not an advanced economy, but it is worth noting that along with running the largest trade surpluses in the world, China’s manufacturing sectors comprise 28 percent of its GDP, with the country representing 17 percent of global GDP, 13 percent of global consumption, and 31 percent of global manufacturing.

  2. These are Canada, France, Germany, Italy, Japan, South Korea, Spain, Switzerland, the United Kingdom, and the United States.

  3. While this convergence of policies is often forgotten, in fact it has been understood for a long time. In his 1924 Tract on Monetary Reform, John Maynard Keynes explained how capital levies, currency depreciation, tariffs, and other forms of transfers between economic sectors have the same effect on the economy and on different sectors within the economy, even when some such transfers are considered politically acceptable and others are not.

  4. More recently, in 2019, Senators Tammy Baldwin and Josh Hawley submitted a bill to the Senate (“Competitive Dollar for Jobs and Prosperity Act”) that would authorize the Federal Reserve to impose a Market Access Charge on the purchase of domestic assets by foreign entities. This charge would be designed to balance net capital inflows into the US economy.


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