July 1, 2020

Reviews

# Balanced Sheets

### Trade Wars Are Class Warsby Matthew C. Klein and Michael PettisYale 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.