Summary

Michael Pettis and Erica Hogan in their recent paper highlight the systemic imbalances in global trade. They argue that the current system is not working on the basis of comparative advantage, as generally assumed, but on large-scale industrial and trade policies that causes some countries to run persistent large trade surplus at the expense of trade deficit countries. The topic is espeically relevent in the runup to new US administration, which is likely to put higher tariffs on imports from China and other countries.

In this review, my goal is to summarize briefly the key points of the paper, and discuss some likely research directions, and policy implications of the paper.

Summary of Key Points

  1. Conventional Argument for Free Trade. The conventional economists argue that countries should specialize and export goods in which they have more comparative advantage, and import goods in which they have less comparative advantage. Thus, the likey explanation for some countries such as China, Germany, and Korea having large manufacturing sectors and running trade surpluses is that they have a comparative advantage in manufacturing. That is they can produce goods at a lower cost than other countries. Michael argues that the purpose of the exports is to generate enough income to support the imports, thus maximizing domestic welfare.

  2. Hidden Trade Subsidies. In the current global trade system, the trade surplus countries employ industrial and trade policies to subsidize the manufacturing at the expense of the domestic consumption. This is done through a variety of ways including undervalued currency, low interest rates, overinvestment in transportion, and other infrastructure, and regressive labour laws, and other policies. These policies are not aimed at maximizing domestic welfare, but at maximizing the trade surplus. This gives manufacturing firms in these countries an unfair advantage over the firms in the trade deficit countries such as US. Thus, the surplus countries are subsidizing the manufacturing at the expense of the consumers.

  3. High Savings Rate. This repressed demand in the surplus countries leads to higher saving rates, not because the households value hard work and thrift more compared to the deficit countries, but because they have no other choice. The high saving rates is the result of distribution of income towards the businesses and rich households which naturally save more compared to others.

  4. Causal Link of higher savings in the surplus countries lead to lower savings in the deficit countries. The high savings in the surplus countries leads to lower