On the eve of new NAFTA-related trade discussions in October, President Trump warned of his continued opposition to the agreement. Emily Davis, a spokeswoman for US Trade Representative Robert Lighthizer added: “The president has been clear that NAFTA has been a disaster for many Americans, and achieving his objectives requires substantial change.”
Trump’s administration is almost certainly right to decry the costs to the US economy of persistent trade imbalances. While many blame these deficits on bad American work and saving habits, their arguments are based on an obsolete understanding of global trade. There is no room in trade theory for advanced economies to experience decade after decade of deficits. The deficits themselves force adjustments that automatically correct for the domestic distortions, so that only developing countries in need of foreign capital and technology can run persistent trade deficits because of domestic distortions.
Deficits in one country must be the result of surpluses elsewhere. Advanced economies like the US can only run persistent trade deficits as a result of policies generated abroad. While analysts often seek the source of these distortions in bilateral trade imbalances, that is the wrong place to look. Global trade is complex, and thus bilateral trade cannot be analyzed in a vacuum.
Mexico is perhaps the most obvious case in point. With $524 billion in total Mexico-US trade last year, Mexico is America’s third largest trading partner and the source of its fourth largest deficit – after China, Germany, and Japan – with exports to the US exceeding imports by $64 billion.
Mexico, however, is not the source of the imbalances. It ran a current account deficit equal to 2.8 percent of its GDP, meaning Mexico invests more than it saves. Mexico imports foreign savings in order to fund this deficit.
Compare this with China’s $367 billion bilateral surplus with the US, Germany’s $75 billion surplus, and Japan’s $69 billion surplus. Unlike Mexico’s, all three of these surpluses are subsumed by the larger surpluses that each country runs globally. Countries with trade surpluses save more than they invest domestically and must export the excess savings, making these three also the world’s three largest net exporters of capital, at $293 billion, $285 billion, and $138 billion respectively.
Low household consumption is the distortion in each of the major surplus nations that leads to their trade surpluses and subsequently to American trade deficits. Because low consumption prevents surplus countries from absorbing all they produce, they must export their excess production, along with their excess savings, into a world reluctant to take either.
Countries that directly or indirectly restrict capital inflows can limit their vulnerability to these excesses. The US, however, with its deep and flexible financial markets, imposes no capital restrictions at all, making it the automatic shock absorber for the world’s excess savings. With nearly half of the world’s net capital exports flowing into the US, it is by default the world’s largest net absorber of capital, and it must accommodate these capital inflows with lowered savings and the corresponding trade deficits.
There are many ways foreign capital inflows lower US savings. They can inflate asset bubbles that encourage spending through wealth effects or they can strengthen the currency, shifting income from savings to consumption. They can boost borrowing by reducing interest rates on consumer credit or by weakening lending standards. They can also reduce savings by increasing unemployment.
Net capital inflows to advanced economies, in other words, don’t cause investment to rise, they cause savings to decline. It is no coincidence that other economies with open and flexible capital markets, like the UK, also run persistent current account deficits. Unfortunately, the relationship between capital flows and trade is misunderstood by most economists, perhaps because for most of history it was simpler. Capital flowed between the two trading countries mainly to balance trade, so that the direction of trade determined the direction of net capital flows.
However, this simplistic model holds no longer. Capital flows now exceed trade flows, and independent investment decisions made by fund managers, not trade finance, drive most capital flows. We can no longer understand trade without understanding capital.
Unlike trade-surplus countries, Mexico doesn’t export capital. Instead, it absorbs excess global savings and manufactured products that would otherwise have worsened global capital imbalances and increased the US trade deficit. Mexico’s large bilateral trade surplus with the US is mainly a consequence of streamlined regulations and the logistical convenience of a shared border. A country with deficient domestic demand, like Japan, will directly export its excess savings to the US, which requires that the US run a trade deficit with the world. Japan will indirectly export its excess production to the US by running a trade surplus in intermediate goods with another country in the value chain, perhaps Mexico, which in turn runs a surplus with the US.
The US deficit in this case originated in Japan but only manifested itself in the deficit with Mexico. US trade deficits with Mexico would almost certainly fall if Washington penalizes Mexican trade imports rather than Japanese capital exports, but paradoxically American trade deficits elsewhere would expand even more. Why? Because US intervention would make Mexico less attractive to foreign capital.
As capital inflows recede, Mexico’s overall current account deficit would have to drop, probably driven down by a combination of peso weakness and higher unemployment. Inevitably, capital that would otherwise have gone to Mexico will end up in the US, which acts automatically to absorb most of the world’s unemployed savings. Higher net inflows into the US would inexorably force accommodating price adjustments that raise the total US trade deficit by equivalent amounts, even as the deficit with Mexico recedes.
Washington should not misinterpret Mexico’s trade surplus with the US. Mexico’s large current account deficit with the world reduces global savings imbalances and so helps moderate the US trade deficit as the automatic consequence of its moderation of the US capital account surplus. Because the Trump administration wants to protect American workers, it should encourage Mexican growth so that Mexico can absorb a larger share of the world’s excess savings, and the US a smaller share. This would cause the overall US trade deficit to narrow, even if the US deficit with Mexico widens. The global trading system clearly needs fixing, but punishing Mexican exporters would contradict Washington’s decision to reform global trade. Worst of all, it would only make US trade even more unbalanced.
Michael Pettis is a Beijing-based senior associate at the Carnegie Endowment.