Simple economics tells us Donald Trump’s stated reasons for starting a trade war with China make no sense. But more advanced economics tells us it’s no surprise he’s 'P’d off' over China’s economic rise.
Trump complains that the United States buys more from China than China buys from the US, meaning his country runs a trade deficit with China. He sees this as an obvious injustice and a sign China is cheating.
But economics teaches that bilateral trade imbalances are natural and normal, the inevitable consequence of countries’ differing “comparative advantage”. (Australia’s strength is rural and mineral commodities, for instance, whereas China’s is manufacturing.)
What matters is a country’s trade with all its trading partners. But, even here, economics teaches it’s not necessarily bad for a country to run an overall trade (or, strictly, current account) deficit.
Why not? Because a country runs a current account deficit when its investment in new homes, business equipment and public infrastructure exceeds its ability to fund this investment with its own saving by households, companies and governments, thus requiring it to call on the saving of foreigners.
Conversely, a country runs a current account surplus when it saves more each year than it needs to fund that year’s investment spending, thus allowing it to lend some of its saving to foreigners.
Because some countries (such as China, Germany) save more than their profitable investment opportunities can take up, they run current account surpluses most years.
On the other side of the coin are countries (the US, Australia) that have more profitable investment opportunities than their savings can cover, so they run current account deficits most years.
Put the two groups together and – at least in theory – the world’s annual saving flows to the most profitable investment opportunities to be found on the planet, thus leaving everyone in the world better off.
But a deputy secretary of the Department of Prime Minister and Cabinet, Dr David Gruen, noted in a recent speech that, at a more advanced level of analysis, some of the recent tension over trade is a consequence of the strong and sustained growth of Asian economies, including China.
“As economies in our region have grown and moved up the value-added chain, they have increasingly competed with more entrenched, influential and valuable industries in advanced countries [such as the US],” Gruen says.
When rapidly developing countries embrace some new technology, the consequent increase in their productivity constitutes an increase in their real income (because they’re producing more output per unit of input).
This should also help raise the income of the developed countries with which they trade, since the rich guys are usually getting access to imports that are cheaper than they can produce themselves.
“While some advanced-country industries [and their workers] have undoubtedly been harmed by a rising Asia-Pacific, a rising Asia-Pacific has also meant more demand for other goods and services from advanced countries [as the developing countries spend some of their higher income on imports from the rich world],” Gruen says.
So better technology and increased trade between the rich and poor countries don’t reduce the real incomes of the advanced countries, but they are likely to change the distribution of income.
More income is likely to flow to the owners of capital and to highly skilled workers, while some lower skilled workers’ real incomes stagnate or fall.
“Such disruption is likely to continue as technology makes it easier to trade services across borders, and economies in the Asia-Pacific become increasingly sophisticated. Some of these newly threatened advanced-economy jobs rely on intellectual property or skills premiums, providing an economic rent worth protecting.
“It is no surprise that the generally open-trade stance of those in places like Silicon Valley sits alongside [Trump’s] demand for strong enforcement of intellectual property rights,” Gruen says.
And, although the rich world is better off with free trade, as technology continues to bring down natural barriers to trade in sectors previously considered “non-tradeable” – particularly services – politically influential opposition to free and open trade is likely to continue, he says.
But there’s a second implication of the economic rise of Asia I bet you haven’t thought of. “It makes less sense for the largest economy in the world to bear the costs of maintaining an open trading system as its economy becomes a relatively smaller share of global output.
“Free trade is a 'public good' – we all benefit from it, but each country has an incentive to shift the cost of maintaining it to others.
“The United States shouldered that burden when it was the world’s largest economy. When you are half the global economy you tend to benefit wherever in the world trade is occurring.
“The logic of [it] continuing to do so is now less compelling. The rules-based [trading] system, including the World Trade Organisation, emerged at a time when the US was the dominant global superpower."
Small or medium-sized economies with limited bargaining power in global markets (such as us) are better off with free trade – even when other countries are being protectionist. Why? Because protecting a few of your industries against imports hurts the rest of your industries more than it hurts the countries whose imports you don’t take.
But that’s not always true for large economies with significant market power, such as the US. They can sometimes use tariffs to drive down the prices other countries charge them for imports.
How? Their market is so lucrative the country supplying the imports absorbs some of the cost of the tariff to keep its retail prices competitive. The lower price of imports across the docks improves the big country’s terms of trade, increasing its real income.
Get it? The US has less to lose from an outbreak of protectionism than do smaller countries like us. That’s why the rest of us have to put more effort into preserving and abiding by the WTO’s “rules-based system” and Trump isn’t quite the madman he seems.