«More free trade does not solve the problem»

Beijing-based economist Michael Pettis explains why ideas about trade benefits are outdated and why saving imbalances are the real problem. The pandemic has made everything worse.

The news about the signing of the Regional Comprehensive Economic Partnership (RCEP) was well received. The new asian free trade zone with China and fourteen other nations in Asia-Pacific is seen as a game changer and a historic shift. But Michael Pettis, Professor of Finance at Peking University and an expert on China and global trade imbalances, is skeptical. «RCEP solves the wrong problem», Pettis says. Frictional costs of trade such as tariffs are already low and are not important anymore, he argues. The real problem are trade imbalances which are caused by saving imbalances and income inequality.

Mr Pettis, the new trade block RCEP is seen as a historic win for China. Do you share this view?
That might be true politically, even though I don’t think Australia, Japan or Korea would agree. But I am not an expert on politics. My point is that the economic implications of RCEP are vastly overstated.

Why?
RCEP solves the wrong problem. Frictional costs of trade such as tariffs are already quite low, lowering them further will not really increase growth and wealth.

RCEP covers a third of world trade and could add hundreds of billions to world trade and GDP. How can it not be of great importance?
Comments about a historic transformation remind me of the things we heard when the Asian Infrastructure Investment Bank was founded in 2015. But now the AIIB is almost forgotten. For many of the same reasons this will also be the case for RCEP.

What are these reasons? Why are these regional agreements not important?
We are applying an old understanding of the world to new circumstances. In the fifties, when there was the rebuilding after the two World Wars, there was this huge need for savings in Europe and also in Japan where savings were destroyed. There were not enough savings but investment needs were huge. And the world desperately needed someone who exported savings. Back then it was the US.

What has changed since then?
By the seventies, these economies were rebuilt and by the eighties it was clear that the world had too much savings. The ability to generate savings and export them was really important in the post-war period, but not today, when there is the opposite problem of too much savings. That’s why it was clear from the beginning that the AIIB was not of any importance. If you create an institution that enables investments around the world, it is a big deal. But nobody wants to invest in the developing countries, and all the excess savings end up in the US.

But RCEP is about trade, not about funding investments.
With trade, things are similar. The models applied in the fifties were based on the experience from the thirties when the world economy went through a period of harmful protectionism and beggar-thy-neighbour-policies. It made sense to reduce the cost of trade. But they have been driven down so much that reducing them further has low benefits. Trade’s share of GDP is already higher than ever before. The problem of trade today is not the problem of frictional costs.

What are the problems of international trade today?
Today, the problems of trade are the imbalances, and they are really driven by saving imbalances which are themselves driven by the distortions in the distribution of incomes. Surplus countries have a current account surplus for structural reasons. Their savings are too high because businesses and governments have a too high share of income. The ordinary people have a low share of GDP. The part of the economy that does not save is too small.

And what is the role of the countries with deficits in the trade and current account balance?
A trade block is held together not by the surplus countries but by the deficit countries, because of their ability to absorb all of the excess savings of the world. In today’s world, it’s basically the US, UK, Canada and Australia. A trading block only matters when there is a deficit country willing to stabilize it.

How does this apply to the RCEP?
Most of its members are countries with structural surpluses. On average, their current account surplus is between 2 and 2,5% of GDP. The problem with the trade block is that there is nobody to absorb the surplus. As India left the project there is only Australia left as a major deficit country, but it is way too small to absorb all. Instead of establishing a free trade zone with lower tariffs they should do something to increase demand in the surplus countries.

But what about the welfare gains from free trade? Are all those estimates of the benefits of the trade block nonsense?
The estimates are very linear and one of the basic assumptions of the underlying trade models is that reducing frictional costs is always good for growth. But that view is going to change. Globalisation is only good for growth up to a certain point. But that is not included in the model, it is hard to calculate. And by the way, net welfare gains from trade have always been tiny, even ignoring the costs.

At what point does globalisation hurt growth?
At a certain point, lowering frictional costs means lowering wages to make you more competitive, either directly or indirectly through lower social standards. If one country does it, it benefits. When more and more countries do it, we end up in a cycle where you constantly put down wages making the whole economy worse. Then the only way to grow is by piling up more and more debt.

Is this the reason for the secular trend of rising debt and inequality?
In the US for example, GDP grew over the past twenty years but wages of the bottom 50% did not change. But it’s not only in the US: We are stuck with rising income inequality, rising debt and greater trade imbalances. We have to solve these imbalances, if not, free trade agreements such as RCEP are just a bunch of surplus countries hoping to find someone taking the other side.

The surpluses of Germany and Switzerland are persistently large. How should they rebalance the economy? By lowering wages and a stronger currency?
Trade theory tells us that surpluses and deficits are self-dissipating because movements in the exchange rates or wages lead to an adjustment. But the fact that countries have been able to run large surpluses for decades proves that there is a distortion that prevents the adjustment from taking place. One of such a distortion was the German labour market reform.

What happened?
In the nineties, Germany was running a current account deficit. It all changed with the labour reform which meant lower wages. As result, the household income share of ordinary people went down. Savings went up, consumption went down.

How could the problem be fixed?
By raising the relative income share of the ordinary people, because their propensity to consume is higher. This can by achieved by strengthening the labour unions and the social safety nets. In China, environmental degradation is in effect a tax on the people. A factory dumping waste into a river might make more profit at the cost of the health of the people. Stopping it would increase the income share of the ordinary people.

Global trade imbalances have been here for long. Why should we now worry about them?
The way they are generated is by depressing real demand by reducing household income and business investment that serves consumption. So the only way to overcome this is by adding more debt. The other problem is that the surplus countries are able to force deficit countries to absorb the excess savings. The extra savings are not invested where it’s needed the most. 90% of global savings go into rich countries, and half of it goes to the US. But they don’t need it. US companies are sitting on huge piles of cash. When you invest money in the US, American investment does not go up, therefore their savings must go down, because savings and investment has to balance globally.

How does the US lower its saving rate and what are the consequences?
When US companies shift production abroad and fire workers, the saving rate goes down. Because the unemployed do not save or have a negative saving rate. Accumulating debt is also a form of reducing savings as debt is negative savings. Hence, other ways to lower the saving rate are to expand the fiscal deficit or to encourage an expansion of household debt with expansive monetary policy and by lowering lending standards.

So it all depends on the US?
Clearly the key to solve the international imbalance problems is the US, the big absorber. But this can’t go on forever, because the weight of the US in the global economy is shrinking. The part of the world with surpluses that the US have to absorb is now four times the size of the US. I argue, it is better to stop it intelligently than to wait for it to break.

How?
The US could say, forget it, we do not play this game anymore. That is what the Trump administration did. But they thought that the problems were bilateral trade deficits and tried to solve them in the old way. But the solution is the saving balance. The US should install a tax on foreign capital inflows to the US.

Is there anyone in Washington who is open to such an idea and does it have a chance under a new Presidency?
We don’t know yet who will be in Biden’s team but I hope the new administration will change the approach towards trade imbalances. Last year, Senators Tammy Baldwin and Josh Hawley introduced a bill requesting the Fed to tax capital inflows to balance the capital account. It was the first such approach and I was surprised. Five years ago, that would have been impossible. But now there is a great deal of debate about my suggestion. I am not inventing something new, I am reviving ideas that are more than 100 years old.

What is the effect of the pandemic to the global imbalances?
The pandemic has made everything worse. It had a negative impact on the distribution of income all over the world. The rich did quite well, and the bottom of the income distribution was hurt the most. It worsened income inequality and hence it worsened the consumption problem.

And what has happened to China’s need to rebalance its economy from exports and production to a more consumption-oriented growth model?
The rebalancing that was happening slowly has come to a halt and has even reversed. The consumption share of GDP is shrinking again. The overall economy is growing while consumption is still down for the year. We might win back some ground when a vaccine is available but the poor were badly hurt and some losses are permanently. In China too, the pandemic made everything worse: More inequality, more debt, and the imbalances are not disappearing.

But at least it seems that China is now finally allowing companies to default instead of keeping zombie firms alive.
We will see. It is true, there have been some important defaults recently. But that does not mean that the system and the lending mentality is going to change completely. Before, there was no lending discipline because everybody knew that the government would take care when the company goes bankrupt. That led to a terrible misallocation of capital. But when the whole market assumes moral hazard, in the moment when creditors realize that they can actually lose money, it can get chaotic. So every time we reach that point the authorities get frightened and back away.