Macroeconomic roots of trade frictions

In previous sections, we have focused mainly on US trade policy responses at the industry or product level, and also US efforts to address certain systemic features of the partner economy, especially industrial policy and exchange-rate undervaluation, that are widely believed to confer an artificial competitive advantage relative to US firms. In this section, we examine the trade imbalances from a macroeconomic perspective, and we indicate similarities and differences for the cases of Japan and the PRC. Insights from the macroeconomic roots of the imbalance help to explain how imbalance episodes develop and also why they end.

The macroeconomic analysis begins from the accounting identity that a nation's current account balance must be equal to the difference between the nation's saving and its domestic investment.²⁵ Equivalently, a nation's current account balance must be equal to the difference between its domestic production and its total domestic spending for goods and services—consumption, domestic investment, and government. Any shortfall must be matched by an equal net capital inflow from abroad. Roughly speaking, the country's ability to “live beyond its means” in a particular year must be financed through borrowing from abroad.²⁶ Likewise, a country with a current-account surplus must have saving that exceeds its domestic investment and thus makes a net addition to national holdings of foreign assets.

An identity is simply a relationship that must hold at all times; it is not a theory that relates cause and effect. In practice, many economic variables can adjust simultaneously to maintain the relationship described by the identity. These include not only the components of the identity, but also variables that influence them, such as interest rates, exchange rates, and capital-market development. Moreover, if a new policy changes one variable directly, other induced changes may offset its impact. For example, if a country attempts to improve its trade balance only by raising all tariffs on imports, thus reducing imports, induced changes might include an exchange-rate appreciation, which would in turn encourage imports and reduce exports. The identity, however, does show how the external imbalance relates to aggregates in the domestic economy, and particularly national saving. No set of policies can reduce the US current-account deficit unless they result in higher national saving, lower domestic investment, or both.²⁷

A country's saving consists of two parts: private saving and government (public) saving. Government saving is equal to the fiscal surplus or deficit. Private saving in turn consists of household saving and corporate saving. This decomposition is significant because the growth of US current account and trade deficits have occurred in tandem with rapid declines in US national saving. Although US saving dropped during both periods of bilateral conflict, the causes of the two drops were different.²⁸ In the 1980s, the growth of the US bilateral trade deficit with Japan occurred during a period when the federal budget deficit was also growing (i.e., government saving was falling). This is the situation often described as the “twin deficits.” However, the ballooning US-PRC trade imbalances since the late 1990s have been associated with a steep decline in US private saving, as well as a return to a substantial fiscal deficit that began only in 2002. In 2008, a large federal deficit together with negative gross private saving produced a drop in US gross saving to 11.9% of gross national product (GNP), compared with around 20% at the start of the 1980s and a peak of 18.2% as recently as 1998.

Throughout the paper, we have focused on bilateral imbalances. In a world of many countries, a US saving-investment gap must be matched by a US current-account deficit with the rest of the world as a whole. Since the early 1990s, the US has had a deficit on goods trade with most global regions, not only with Japan and the PRC (see Figure 5). Mann (2004) termed the alignment of US and foreign structural characteristics and policy choices during this period “global co-dependency”—with the US increasingly serving as a “buyer of last resort” for producers throughout the world (see Mann 2002, 2004).²⁹ How the resulting overall US trade deficit is divided across particular trading partners depends on other countries' own macroeconomic relationships, as well as the countries' exchange rates relative to the dollar and comparative advantages relative to the US. A necessary condition for a large bilateral deficit is a saving shortfall relative to domestic investment in the US together with a corresponding savings surplus in the partner country. Both Japan and the PRC (as well as smaller East Asian countries) have high saving rates, and both have overall current-account surpluses (i.e., they are net purchasers of foreign assets). Thus, we can also think of a given partner's net saving financing US spending (private or government) through purchases of US assets. In fact, both Japan and the PRC have accumulated large quantities of US assets, including but not limited to US government securities, in both cases helping to maintain a currency that many considered “undervalued” relative to the dollar.

One interesting comparison that cannot yet be completed concerns the ends of the two episodes. Japan-bashing was moderated by the rapid appreciation of the yen relative to the dollar that began in 1985 and slowed to a crawl during Japan's “lost decade” in the 1990s. Although Japan's overall trade surplus persisted, its share in the overall US trade deficit peaked in 1991 at about 66% and fell subsequently. By 2008, US-Japan trade accounted for only about 8% of the overall US merchandise trade deficit. In part, this shift reflects the relocation of some production for the US market from Japan to the PRC (including Hong Kong, China, which reverted to PRC control in 1997), with Japanese multinationals exporting intermediate parts to their PRC subsidiaries and a large share of the final output exported from the PRC to the US.³⁰

In a prescient discussion of a US external imbalance that was already massive and still rising in 2004, Mann (2004: 20) wrote, “There is a real possibility that the entanglements created by this co-dependency cannot be undone by anything short of a global economic crisis.” Indeed, the global recession that began in 2008 did reduce the saving/investment imbalances underlying the huge overall US trade deficit and the bilateral trade deficit with the PRC. US gross saving as a share of GNP reached a minimum in the second quarter of 2008 and then trended upward, while gross domestic investment began to fall in the third quarter. Although both imports and exports fell, exports fell by less. The US trade and current account deficits both narrowed in early 2009.

Meanwhile, slow or even negative growth of income in most countries worldwide caused demand for PRC exports to fall sharply. To maintain the pace of its economic growth, PRC policy makers implemented a major domestic stimulus, and saving fell relative to investment. In early 2009, the PRC's trade surplus also fell from the record level attained in 2008. Accordingly, the PRC's international reserves grew more slowly than in recent years. The PRC sold a substantial volume of US Treasury securities and other foreign bonds in early 2009 before resuming purchases in March.

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