July 1, 2020


Balanced Sheets

Trade Wars Are Class Wars
by Matthew C. Klein and Michael Pettis
Yale University Press, 2020

Good writing on international macroeconomics reads like a detective novel. There’s a suspicious event—hundreds of millions of dollars in phantom FX swaps, a container port’s worth of missing exports—and an enormous cast of closely-linked characters. But instead of a preternatural ability to see the clear-cut means, motive, and opportunity of fictional characters in a pulp whodunit, the macroeconomic detective is armed with the knowledge that balance sheets always balance. This simple insight, that every transaction has two sides, means that there are certain aggregate relationships between transactions that must obtain for the world economy. Knowing this, it’s possible to chase actors across seemingly unrelated balance sheets to find where the system as a whole was forced to balance. From here, the skillful economist can identify the long-run tendencies that a given balance is likely to create. (Wynne Godley famously predicted the Global Financial Crisis in just this way, following US mortgage debt around the world and back.) This kind of detective work is difficult, and often unpopular. The balance sheet approach cuts through political and media platitudes to reveal who the winners and losers are in a given regime. By taking this approach to examining trade policy, Michael Pettis and Matthew Klein have, with Trade Wars Are Class Wars, written the ideal book for understanding the long-run trends that have shaped our dysfunctional present.

Pettis and Klein tell a broad story about the last fifty years of global economic development, which links the dynamics of global supply chains and tax evasion, and the historical shift from wage-led to profit-led growth.

The book argues that elites in all countries want to capture economic output while developing the capital stock of their economies. To do this, they invest massively, which mechanically creates savings. Rather than sharing those savings with the household sector in the form of wage increases, the elites hoard and move them offshore. This destroys local demand for the goods produced by their capital investments. At this point, they turn to the export market to make up for the missing local sales. The problem is that, to be competitive exporters, they have to produce tradeable goods at a lower unit cost than their competitors. Capitalists must then further suppress domestic wages to ensure those lower unit costs, and thus increase their dependency on export markets.

The problem is, not every country—or bloc, in the case of the Eurozone—can be a net exporter. This spells trouble, if every country’s capitalists are dependent on the export markets to validate their investments. Absent a country willing to import everyone else’s surplus, this kind of arrangement would set the capitalists of all countries against one another before falling apart. It’s at this point, however, that the US steps in to backstop the global order as a hegemonic debtor, allowing nearly every other country to be a net exporter. As many have pointed out, this is the natural role for the US to play, given nearly all transactions the world over are denominated in its currency. To update Robert Triffin, if the whole world uses your currency for trade, then the whole world economy needs you to issue dramatically more debt than your domestic economy requires. This extra debt, combined with massive offshoring of profits, means that annual US investment flows abroad—in dollar terms, not physical ones—vastly outstrip the rest of the world’s annual investment in the US. This capital account surplus produces a matching current account deficit. The imports that make up this current account deficit are largely manufactured goods that the US used to produce domestically. Such an influx in turn hollows out domestic production in tradeable goods, and the industrial middle class of the US, brought into being by the second world war, falls apart into opiates, suicide, and nativism. By acting as debtor to the world, the US benefits from imported goods, while elites of all countries—the US included—win at the expense of all workers.

This story is a novel one because most economists and popularizers envision macroeconomics as the simple aggregation of microeconomic decisions: in a vacuum, all the actors come to their own conclusions about how to behave, and the sum of these decisions is expressed in macroeconomic figures. What those decisions add up to is ultimately a residual, only useful as a measurement of how well agents in general are making decisions, and how good some countries are at producing certain kinds of goods. In this view, for example, the Chinese simply prefer to save more, and Americans simply prefer to save less. Chinese workers will work for less money, and individual US consumers will decide that they prefer imports over American-made goods. In reality, individuals make decisions from the space of options dictated by macroeconomic conditions. To take this fact seriously, as Pettis and Klein do, means working from balance sheets—adhering to the accounting identities of the world economy and reconstructing the interrelated financial and real flows within it.

Without going through sets of T-accounts like a first-year accounting student, consider the following example. Someone buys a television. The buyer doesn’t have cash on hand and puts the $500 purchase on a credit card. The consumer gains a television and a debt of $500. The credit card company gives $500 to the store and gains a debt of $500 from the buyer. The store gains $500 from the credit card company but loses a television. Simple enough. But say the store has to pay its international suppliers, and the credit card company chooses to sell the debt of the original purchaser. Now some chunk of the original $500 is going through foreign exchange (whose rate has been hedged, naturally) to a Chinese company that keeps some portion in a bank, which in turn keeps some portion in properly hedged US Treasuries. At the same time, the debt held by the credit card company is securitized and sold to a European bank looking for exposure to that particular kind of risk.

The simplest transaction can become very complex in a financial economy, if one maps every other transaction it touches. It can also fan out into accumulations of seemingly unrelated financial products, as participants hedge away unwanted risks and speculators demand exposure. But it is always possible to trace these relationships through to find their financing and final funding. Goods and money must come from somewhere, and every sale is also a purchase. Someone is always ultimately using credit, and someone else is ultimately providing credit. These kinds of transactions happen billions of times per day—hedged to one another, and contracted forwards and backwards in time—and are individually relatively unimportant. The promise of economics as a field of study is that, when aggregated together through a constellation of balance sheets, the functional relationships between different economic and financial quantities can be identified.

Some of these outcomes are set endogenously by parameters internal to the model, and some exogenously by the world at large. Although all financial variables are ultimately endogenous to nature and society, some can be treated as exogenous to—set externally and without reference to the calculations of—the model. In this approach, the trick is to find which incentives and patterns of behavior are sufficiently strong to be exogenously given in the model, such that the model closes by adjusting endogenous variables. Strong exogenous factors are often historical, political, or social events, and endogenous changes—whose movements condense into new trends—are often hard to see clearly or quickly.

When, for example, the rest of the world wants to accumulate assets denominated in US dollars, and the US government does not want to run a budget deficit, those assets have to come from somewhere. They could come just as easily from the rest-of-world banking sector in the form of Eurodollar loans as they could from dissaving in the US private sector. Postkeynesian economists associated with Stock-Flow Consistent modelling often take this approach to understanding the world of international finance, which can uncover these endogenous changes. Wynne Godley, Hyman Minsky, and the sectoral balances framework for macroeconomics lurk behind the scenes for much of Trade Wars Are Class Wars, while Keynes himself is cited throughout.

Readers already invested in international macroeconomics will recognize many of the names and arguments in the book, which functions as a brilliant primer on the field. It’s almost like a reverse Freakonomics. Instead of claiming that a couple of economics papers provide the only valid method for answering every question, and that every human activity is simply a veil for econ 101-style supply and demand, Pettis and Klein pull in insights from a variety of nearby disciplines—corporate finance, tax accounting, supply chain management—to actually explain the economy. The arguments, citations, and allusions here—Brad Setser, Hyun Song Shin, Marc Levinson, a past-life Paul Krugman—provide a great starting point for a deep and flexible understanding of the global economy.

Common approaches to trade policy take an overly literal view of bilateral trade balances. The folk-Ricardian story—still dominant in American political discourse—is that countries that are not good at making things have to import lots of things. Importer countries become indebted to their trading partner, see their exchange rate devalued and their interest rates rise, until eventually a plague of locusts overtakes them for their inability to be sufficiently productive. In this shopworn story, the correct policy response is to apply tariffs on goods from the countries from which you presumably import too much, so that imports fall, and the wolves are kept from the door.

In Pettis and Klein’s account, however, the path from bilateral trade deficit to current account deficit in a globalized economy is both circuitous and resilient. When they aren’t driven by a capital account surplus, current account deficits arise from a demand for imported tradeable goods in general, not those from any particular country. This means that the global economy can—and does—reroute around bilateral tariff barriers with ease. For example, tariffs between China and the US lead to proxy lobster trade through a third party: Canada. Instead of the US selling lobsters to China, China buys more lobsters than usual from Canada, who in turn buy more lobsters than usual from the US. After the bilateral lobster tariffs are applied, the US, Chinese, and Canadian current account balances are unchanged on net, despite the shift in bilateral trade partners.

More forcefully, Pettis and Klein also demonstrate that current account imbalances can equally be driven by changes in the capital account, to which changes in the current account balance are mere residuals. This is a rebuttal to the proposed trade policies of both America First reactionaries like Josh Hawley and friendly social democrats like Bernie Sanders, who regret the loss of the industrial Midwest. In the case of the US, the status of the dollar as global reserve currency mechanically forces sizable current account deficits, regardless of any domestic desire to import. Financial outflows mean that some marginal good—blenders, spark plugs, pork bellies, whatever—will be cheap enough to be imported rather than produced, owing to exchange rate movements. This doesn’t say anything about the conditions in the market for those goods in the trading countries, just that the world is demanding more US dollars than it currently has. Were the US to throw up trade barriers in response to the global demand for its financial assets, it would only worsen its own terms of trade—get fewer blenders, spark plugs, or pork bellies in exchange—as the capital account imbalance was driven by external demand for dollars, not domestic demand for products. Pettis and Klein demonstrate that pressure can come from either side of the “current account balance = negative capital account balance” equation. This is something which escapes many economists and policymakers on the left and right alike, who believe that the federal deficit is a problem that can be solved by closing the trade deficit, and that the trade deficit can be closed by tariffs alone. The US is no longer a developing country protecting infant industries. Pretending that it is will not bring the kinds of employment gains people claim to expect. To cut down on the US current account deficit, Pettis and Klein argue, capital controls are necessary.

Pettis and Klein take care to show how this process shakes out in political terms. Especially interesting is their treatment of the structural adjustment programs forced on Latin American countries by the US and the IMF in the 1980s. The origins and short-term impact of these programs, which cut welfare spending and liberalized capital accounts, are well-understood, but this book presents a fascinating new read of these programs’ long-term impact. In Trade Wars, Latin American countries could tell that they were getting screwed on currency pegs and capital account liberalization. Vowing to never again be in a position where IMF loans and programs were necessary, these countries committed to hoarding much larger volumes of foreign currency in the future. These government holdings steadily built up through the 90s and 00s to the point that now “foreign governments [own] roughly $8 trillion in dollar-denominated assets.” The necessary flipside of this insurance-through-hoarding is—in the absence of large enough deficits run by developed world governments—substantial shortfalls in global demand as the savings rate rises. Even Larry Summers has recognized this international paradox of thrift as contributing to “secular stagnation.” In the end, the structural adjustment programs forced through by the US and the IMF have come home to roost in the form of persistent anemic growth and weak export markets. This adds a somewhat different layer to the narrative that figures these programs as raw neocolonialist plunder. One is reminded that, in the long run, the gold inflows from Spain’s original murderous colonial project torched their domestic economy.

Pettis and Klein also offer an entertaining version of the 2015 eurozone crisis, which inverts the moralistic stance Germany took toward southern EU countries. To hear German ministers and media tell it, extending debt forgiveness to Greece or Spain would involve tremendous moral hazard and incentivize wasteful government spending. (German demands that wages and prices fall until the eurozone became competitive in export markets were of course eventually met, at great human cost.) But while German officials complained about wasteful spending by southern European countries, German elites saved a large and growing proportion of national output. To preserve their export advantage, this savings could not go to households. Instead, German savers invested abroad. The irony is that German investors made a substantial net loss on these foreign holdings, all while the German government allowed domestic infrastructure to crumble. (And given recent revelations, it’s no stretch to think some of these German investments were even locked up in the Trump organization!) The German government was right to think that their moral hazard arguments would forestall both international debt relief and domestic investment. Problem was, this ultimately prevented government spending on positive ROI projects in Germany and southern European countries, while subsidizing negative ROI investments abroad by the German financial sector. This story, too, is a little different from the popular narrative of prudent and efficient Germans saddled with the poor decisions of fraudulent and spendthrift Greeks.

By taking the macrodetermination of financial and trade flows seriously, and following where they lead, Pettis and Klein are able to arrive at these provocative accounts of recent economic history. But more is at stake in this book—both conceptually and methodologically—than a provocation assigning blame for the world’s economic suffering. In the third chapter, Pettis and Klein note in passing that the era of scarcity as the fundamental economic fact has ended, and in its place is the fundamental fact of demand. We have known since Keynes that the limiting factor in developed economies is not a scarcity of resources, but rather a scarcity of demand for finished output. In order to generate production and employ workers, someone has to want to buy what is produced. Capitalists, however, are driven to save and to hoard, and to park their savings somewhere beyond the reach of wage demands. In a prior era, this drive to save would be cheered: the folk-Ricardian wisdom on trade policy matched by folk-Ricardian wisdom on seed corn. Yet today, in the aggregate, savings, for lack of a better word, are bad.

In the General Theory, Keynes famously cites Mandeville’s Fable of the Bees—a story about a community driven to bankruptcy after outlawing luxury—to mark this shift. While the old moral and folk-Ricardian myths that saving is always prudent and luxury always wasteful may benefit an individual, using them to understand macroeconomic trends creates a pernicious blindness. In a demand-driven economy, Keynes noted, the minimization of suffering produced a moral imperative to spend. Pettis and Klein in turn show that reformers must carry out this moral inversion to meaningfully curb inequality and instability—and that it is workers who must be allowed the “luxury” of higher wages.

An almost “beyond good and evil” stance arises from examining balance sheets in a demand-constrained economy. Governments attempting to behave like prudent households—selling more than they buy, avoiding debt, living “within their means”—end up forcing people out of their jobs and homes. It bears repeating: not everyone can be a net saver, and not everyone can be a net exporter. If a country is borrowing too much, it does not mean they are profligate and morally deficient, but rather that another country is saving too much. Were every country to build fortress balance sheets, they would find themselves starving inside for lack of employment and production. This insight remains always out of reach if one views macroeconomics (and especially international financial macroeconomics) as the simple adding-up of individual decisions. With the balance sheet as the unit of analysis, Pettis and Klein are able to avoid the trap of simple moralistic stories to explain trade and its impacts.

The tensions in this book have all been thrust dramatically into view as economic dislocation from the COVID-19 crisis spreads across the globe. Rather than being superseded, the contradictions of our present situation—a globalized supply chain with a single hegemonic debtor—are being heightened. The US response to COVID-19 will have huge implications as to whether this system continues, or makes way for a new one. Given the response so far, the globalized world may fragment into several regional ones. In a more fragmented world, these trade wars would be more likely to intensify and spill over, as capitalists are set against one another. Now more than ever, prediction is a mug’s game. But Trade Wars Are Class Wars provides the reader with the single most important tool for making new predictions: an understanding of how we got here in the first place.

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