After months of threatening a trade war with the European Union, Donald Trump abruptly reversed himself. Following his meeting on Wednesday (July 25) with European Commission president Jean-Claude Juncker, Trump hailed a vague deal for liberalizing trade and proclaimed transatlantic love.
But neither love nor liquefied natural gas are likely to fix the dynamic what so outrages Trump: the fact that the US runs a chronic trade deficit and the EU doesn’t. This is simply because trade policies can influence the overall trade volume. But they little affect trade flows—the difference between a nation’s total exports and imports. Trump, in other words, is making the wrong deals.
To understand why, it helps to understand current accounts, the measure of how much more a country—or currency union—saves than it invests.
In a closed economy, savings always equal investment. To fund investments—which is how the nation’s total wealth grows—businesses can draw only on the income that hasn’t been consumed.
Let’s imagine the case of a hypothetical place called Basketania, a remote island economy closed off to the outside world with an uncanny knack for making baskets. Despite its mastery of basket production, it can’t really produce more baskets than its people will consume. When its entrepreneurs have ideas for how to make better baskets, or weave them faster, the only funds they can scrape together to finance their investments are the earnings that the island economy doesn’t consume (i.e. what it saves).
Then one day, a fleet of boats pull up on its shores and out step business delegations from a nearby archipelago of Fruitlandia. Struck by the deficiencies of their local containers, these newcomers are keen to buy Basketania’s baskets and maybe sell some of their fruit in return.
How does this sudden opening-up of Basketania’s trade and capital account change its economy? Thanks to new trade routes, now Basketania’s weavers have scores of new Fruitlandian customers for their baskets, meaning that their production is no longer limited by local demand.
Suppose a basket craze sweeps Fruitlandia. Basketanian traders now have baskets crammed full of Fruitlandian money. They spend some of the money buying fruit from their new trading partner. But since Basketania already has plenty of orchards of its own, overall it winds up producing more than it consumes domestically or via imports from Fruitlandia. This surplus production takes the form of a trade surplus. Or, to look at it from the capital flows perspective, thanks to its net exports, Basketania earned more than it spent buying local goods and imports, and investing domestically.
What happens to those extra Fruitlandian money that Basketanians didn’t spend? Basketanians lend these savings out—possibly directly to Fruitlandians, or perhaps by investing it in a local basket factory to meet new Fruitlandian demand.
With its excesses of production over consumption, exports over imports, lending over borrowing, and savings over investment, Basketania is now running a trade and current account surplus (which is, for our purposes, the same thing).
That’s exactly what the euro zone has been doing of late.
What about Fruitlandia? When trade opened up with Basketania, Fruitlandia could suddenly consume more goods than it made domestically, and invest more than its people saved. When a country imports more than it exports, it also borrows from the rest of the world, translating to a current account deficit.
Which is where the US is today—and has been for quite a while.
As a share of GDP, the US has one of the world’s biggest current account deficits—which is Trump’s big bugbear. And it should be.
A lot of mainstream economists will tell you it’s fine for the US to run current account deficits year after year—that it simply reflects how keen foreigners are to invest in US growth.
It’s true that borrowing from abroad isn’t ipso facto bad. But while this logic applies to developing countries, it doesn’t makes sense for the US—or, for that matter, for other advanced economies, as Michael Pettis, finance professor at Peking University and a pioneering voice on these dynamics, has long explained. The US already has the savings it needs to fund productive investments. So instead of funding new factories, other countries spend their excess foreign capital on things like US real estate, which doesn’t expand America’s ability to repay its debts on things like real estate and consumer goods that don’t expand America’s ability to repay those debts. That fuels dangerous asset bubbles and leads to long-term structural unemployment, fundamentally weakening the American economy.
Trump is also mostly justified in being mad at the world for the US’s chronic trade deficit. In an open system, countries’ trade and capital should balance in the long term, so that no countries run surpluses and deficits for longer than a couple years.
The fact of chronic surpluses in, say, Germany and China, and deficits in the US, signals that something is deeply wrong with the current world economic system. Some countries’ economic policies are keeping the system from adjusting naturally.
Where Trump errs is in why this is happening—and, therefore, how to fix it.
It’s certainly possible—likely, even—that Trump’s “deal” with the EU will boost American exports to Europe, shrinking the bilateral trade deficit. But remember: America’s big problem isn’t bilateral trade deficits. It’s the overall trade deficit. As long as the the level of domestic savings versus domestic investment remain unchanged, the overall US trade deficit can’t change either. Instead, as the extra US exports or diminished European imports will simply be offset by other countries so that America’s total trade deficit remains the same.
So instead of, say, trying to get Germany to buy Chevys, Trump should encourage its leaders to invest more and save less. To restore balance in Germany—and the whole of the euro zone—the country’s leaders should boost its fiscal spending, particularly on upgrading its aging infrastructure, and encouraging more business investment. Among other things, the resulting boost in demand should help inflate away the competitive advantage gained by Germany’s exports from the undervalued euro.
And indeed, exchange rates are major way of shifting a country’s balance between savings and investment. Germany’s advantage isn’t precisely deliberate. But many countries actively buy dollars to make their exports more competitive—a practice commonly known as “currency manipulation.”
This brings us to the key reason why Trump’s trade policies won’t fix the deficit: It is these inflows of capital—not trade—that force the US to run persistent trade deficits.
And this glut of savings pumped into the US is not, as many economists contend, because of the irresistible appeal of American growth. Think about the trillions of dollars other countries have shelled out on low-yielding US government bonds in the last two decades. Pretty shabby investment strategies—unless you consider that they keep domestic unemployment artificially low.
This is a problem for other countries beside the US. (Curiously, they’re mostly countries of Anglo-Saxon origin like the UK, Canada, and Australia.) But America’s position is uniquely tricky because the dollar is the primary currency of the global monetary and trade system.
Think of it this way. When the US buys imports or invests overseas, it hands over dollars to other countries. If foreigners used all those overseas dollars they earned to buy US goods and services, the US wouldn’t run a trade deficit. But that’s not what they’re mainly used for. Because of the US’s completely open capital markets, foreigners use those dollars to buy American stocks, bonds, real estate, or other assets. As other countries freely accumulate these assets, they force the dollar’s value to rise against their own currencies, which makes it relatively more expensive to make goods in the US.
Since the 1970s, between two-fifths and half of the world’s excess savings have been foisted on the US, says Pettis—and this lack of control over capital inflows is exactly why the US must run current account deficits.
“In fact, as long as its capital markets remain wholly open, it cannot even take steps to reduce its trade deficit except by making it harder, or less attractive, for investors to bring money into the United States,” he writes. “Because the US trade deficit is set wholly by the net amount of excess foreign savings it has to absorb, it is not able to alter its overall savings rate.”
Though the world’s dollar habit will be hard to change, getting US allies to agree to keep their current account deficits in check and limiting purchases of US government debt might be good places to start. Those are less tweet-worthy achievements than cheek-pecks and soybean pledges from Jean-Claude Juncker. But they would be a real step toward putting America first.