Saturday, November 26, 2016

The Fallacy of Composition: Return of Global Imbalances and the Possibilities of Trade War

Excess saving is a major problem for the global economy. Just like those painful colleagues who think that arriving early is always virtuous, many commentators and policy-makers see export surpluses as a sign of moral superiority.

Such a view of the world is wrong not only in an ethical sense, but also in a rational one. For every export surplus there must be a deficit. The virtue of the mercantilist must be matched by the supposed iniquity of the consumer. Unless we start trading with another planet, there is no other outcome.

This is a fallacy of composition - the belief that what is true for the part is true for the whole. Not every country can run a trade surplus and absent the willingness of some countries - particularly the Anglosphere countries - to run deficits the whole model would fall apart. 

The surplus countries need to adjust, just as much as the deficit countries if we to restore some sort of balance to the world economy. 

According to Brad Setser  
East Asia’s current account surplus—its excess of savings over investment—has recently amounted to about as large a share of world gross domestic product (GDP) as it did prior to the global financial crisis. In 2015, the region’s four major economies—China, Japan, South Korea, and Taiwan—along with the city states of Hong Kong and Singapore had a combined current account surplus of $700 billion. Their combined surplus significantly exceeded Europe’s surplus. No region of the world currently contributes more to the global glut in savings. Outward flows of capital from East Asia present a challenge to the world economy, and this problem may grow in the next few years. 
East Asia’s surplus is all the more remarkable because it has reemerged despite two factors that act to reduce it. China’s investment remains at historically high levels and Japan’s budget deficit is around 5 percent of GDP. Both high investment and large fiscal deficits absorb significant amounts of savings at home. These two surplus-reducing factors are overwhelmed, however, by East Asia’s extremely high rate of saving. At close to 40 percent of GDP, it appears to be at a record level relative to the size of the region’s economy. Without a reduction in the savings rate, there is a risk that East Asia’s already large surplus will increase. To control its bad-debt problem, China may reduce credit creation and investment. To control its government-debt problem, Japan may opt for fiscal consolidation. In either case, policies that reduce domestic risks could give rise to new global risks.

While before the crisis the net European surplus was low (i.e. European trade and financial interactions with the rest of the world), it has been growing since that time as austerity reduces consumption and as the export surplus countries have continued to repress consumption in the belief that export surpluses are virtuous. If only Greece could be more like Germany they argue. But as we pointed out at the beginning this isn't possible for every country. Germany doesn't have to become like Greece, but it does need to reduce its export surplus and export some of its demand to southern Europe.

The United States trade deficit is likely to become an important marker of the success or failure of Trump's Presidency and while the deficit on petroleum products has been reduced since the crisis due to the US oil boom, its deficit in other goods has grown rapidly.

As Setser points out, despite the high investment of East Asian economies, savings are still higher leading to current account surpluses. It is important to remember that the current account = savings - investment. A surplus means an excess of saving over investment and a deficit means not enough saving to fund investment. The latter is the case for Australia.

All of this leads to global imbalances as captured by the graph below,  On top are the surpluses, which include the East Asian and European surplus economies. Note that with the decline of oil prices, the oil exporting countries are now running deficits. The largest share of the deficit side of the equation is taken up by the Anglosphere economies - the United States, the United Kingdom, Canada and Australia.

East Asia is the major contributor to global surpluses, but the European surplus economies have also expanded theirs. This is exactly the opposite of what needs to happen in Europe. To help solve the crisis in Southern Europe will require the surplus countries to increase their consumption and lower their savings. They need to increase demand in their own economies rather than importing demand from southern Europe. This is all the more important given that monetary union has negated adjustment via the exchange rate. 

The major global problem, however, are the East Asian surpluses. This is partly because they are larger and partly because they affect the United States to a much greater extent. Setser contends: 
There is an urgent case for a strategy to reduce East Asia’s savings rate to a level that the region can more easily absorb internally. The adjustment should be centered on China, where exceptionally high levels of savings no longer serve the same purpose as during the country’s catch-up phase of economic development. In the past, high savings allowed China to finance high levels of domestic investment without drawing on potentially risky, reversible, cross-border capital flows. However, with the gains from high levels of investment now reduced, a national savings rate that still approaches 50 percent of output is simply too high to be absorbed effectively at home or abroad. China’s high savings rate increasingly implies either bubbles in credit and investment domestically or large capital surpluses that have to be exported and that add to global risks. 
Although China is the prime source of the savings glut, South Korea, Taiwan, and Japan also contribute. Savings rates of 35 percent of GDP in South Korea and Taiwan generate more capital than can be absorbed domestically. South Korea’s current account surplus is just under 8 percent of GDP, about the same share of its GDP as the surplus of Germany, the leading non-Asian contributor to the savings glut. Taiwan’s surplus is at an even higher 14 percent of GDP, although the effect is mitigated by Taiwan’s smaller economy. Japan’s surplus of 3 percent of GDP is comparable to that of the eurozone as a whole. 
Over the past few years, the nature of the policy challenge posed by East Asia’s external surplus has changed. The region’s surpluses are no longer maintained primarily through intervention in the foreign exchange market, with the result that moving toward floating currencies is no longer a sufficient policy response to Asia’s trade surplus. The traditional U.S. economic agenda in the region— aimed at liberalizing trade, investment, and exchange rates—also misses the threat that East Asia’s savings glut poses to global prosperity. U.S. economic diplomacy now needs to advance policies that lower national savings in East Asia directly. These include the use of fiscal policy to support an increase in household consumption and reforms in high-saving East Asian economies to strengthen the social safety net and thereby lower private savings.
Given that the 'savings glut' or global imbalances were a major factor in the global financial crisis we should all be worried by these developments. A Trump administration is unlikely to accept the United States' traditional role in soaking up these surpluses. This means that unless East Asian surplus countries reduce their savings (and surpluses) we can expect a Trump administration to focus on what the United States can do. The easiest 'solution' will be to impose new restrictive measures on East Asian trade. 

This means that either East Asia adjusts its policies or the United States will force adjustment through trade measures. This could lead to a trade war as nationalist sentiments awaken in the trade arena and the surplus countries maintain their belief in their moral superiority for running trade surpluses. 

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