The very first on the list of executive actions that his administration would implement from “day one,” according to US President-elect Donald Trump in his November 21, 2016, video clip, involved a US retreat on trade: “I am going to issue a notification of intent to withdraw from the Trans-Pacific Partnership, a potential disaster for our country. Instead, we will negotiate fair, bilateral trade deals that bring jobs and industry back onto American shores.”

Three days after the video came out, the Wall Street Journal published an article I wrote in which I explained why I thought many analysts were wrong about the implications of a US retreat from the Trans-Pacific Partnership (TPP). In the next two weeks, I received a lot of queries about my article and the reasoning behind it, and so I thought it might be helpful if I set it out at greater length.

Before jumping into the full argument, I think the main points can be summarized in the following seven statements:

If the United States withdraws from its central role in global trade and capital flows, most analysts seem to expect a major global shift from a US-dominated trading regime to one dominated by China. It is virtually impossible, however, for this to happen because the US regime is built around large trade deficits, making it incompatible with a China-centered regime for which large trade surpluses at its center are a structural necessity. In a world of capital scarcity and high investment demand, membership in a trading regime built around large trade and current account surpluses is rewarded by access to equally large capital exports. In a world of abundant capital and weak demand, however, trade benefits countries if it creates additional demand in the form of a rise in net exports. The five decades after World War I, from roughly the late 1910s to the late 1960s, were dominated by the devastation wreaked by two world wars. These left the global economy with both a scarcity of savings and a great need for investment. The United States during this period ran large trade surpluses and capital account deficits as it exported its excess savings to fund its net exports while the growth of its trading partners was constrained by their urgent investment needs. Because they benefitted from access to US savings, it is not surprising that large American trade surpluses and capital exports made it the indispensable center of global trade. After the belligerents had been substantially rebuilt, the next five decades, from roughly the late 1960s to the present, have been a period of abundant, and even of excess, capital, driven by high savings and weak demand. What is more, unless there is a major war or a technological breakthrough that requires investment on the scale of the railroad manias of the nineteenth century, abundant capital will probably characterize most of the rest of this century. During this period, the United States has accommodated the excess savings of the rest of the world by running large capital account surpluses (that is importing capital), which has meant of course that it also has run the corresponding trade deficits. Because economic growth among its trading partners benefitted from trade surpluses to grow, it is not surprising that the large American trade deficits of this period have allowed the country to continue as the indispensable center of global trade. The Chinese economy is structurally incompatible with what is needed to replace the US-centered trading regime of the past five decades. Members of the US regime have been rewarded with the higher growth associated with trade surpluses, whereas members of a China-centered regime will be penalized with lower growth. The impact of shifting from one regime to the other is the equivalent of a demand contraction on average for every country of 2.0–2.5 percent of GDP. The consequence of a US withdrawal from global governance, in other words, is unlikely to be an orderly, rules-based global trading system in which leadership has shifted from Washington to Beijing. Far more likely is a return to the pre–Bretton Woods days of trade conflict and beggar-thy-neighbor policies. The only way for the world to avoid devolving into an unstable global trading regime is if leading nations gather to design and enforce a new system for global trade—effectively a new Bretton Woods—but this time more like the sustainable system proposed by John Maynard Keynes rather than the unsustainable one around dollar centrality proposed by Harry Dexter White.

Is the United States in Retreat?

TPP is a trade deal signed in 2015 between a dozen countries that together account for around 40 percent of the global economy. Although TPP is often seen as another in a line of treaties aimed at liberalizing trade further, a more important goal may have been to “raise the bar” on trade, and to set up a body of rules, including on environmental and labor issues, with which to create pressure for countries like China to comply. The agreement has yet to be ratified by the US Congress, and it has often been described, especially by the Chinese press, as the economic component of US President Barack Obama’s pivot to Asia and hostile to Chinese membership. That certainly may be part of the TPP strategy, but no more so than to create a more level playing field for countries like the United States whose manufacturers are often forced to comply with stricter domestic regulations while competing with manufacturers abroad who are not.

Donald Trump has nonetheless made very clear that he regards TPP as part of a complex of arrangements that together hamper US growth, and he seems determined that Washington withdrew from setting and enforcing the rules of the global trading regime. For most analysts and policymakers, Trump’s message spelled the end of TPP or at least a significant rewriting of the agreement. Japanese Prime Minister Shinzo Abe warned just before Trump’s video aired that without Washington’s involvement, TPP “has no meaning,” pouring cold water, in the words of the Financial Times, “on proposals for the other eleven members of TPP to go ahead without the US.” Japan went on to ratify TPP later that week anyway, mostly, as the Wall Street Journal characterized Abe’s words, for symbolic purposes, in the hope “that parliament’s ratification of TPP would send a message about the importance of regional free trade.”

The real meaning of Trump’s announcement is almost certainly not limited to TPP. It represents a rejection of the central role played by the United States in the governance of the global trading system. It has always been a fundamental, albeit highly controversial, part of Trump’s campaign platform, and one that resonated with a substantial portion of his supporters, that this system has been gamed by participants and creates significant costs to the United States in the form of lower growth, higher unemployment, more debt, and devastated industries throughout the country.

Unfortunately, the debate over trade is highly politicized and is almost never concerned with specifying the conditions under which interventionist policies can be helpful or harmful to the economy. Much of the controversy is fought along ideological lines, which is why the reaction to Trump’s announcement was fairly predictable. Traditional free-traders immediately condemned his statement, and traditional interventionists praised it.

There was, however, little disagreement among analysts for whom geopolitical affairs take precedence. Trump’s decision to withdraw from TPP was widely seen as detrimental to the United States both because it would lead to a reduction in Washington’s influence globally and because the dramatic reversal of a policy pursued energetically by the past administrations, Republican and Democratic, would likely reduce American credibility among its allies.

Trading Economic Disadvantage for Political Advantage

While their near-term assessment of the geopolitical impact may be correct, the longer term impact may be less than many assume. It might even be positive, depending on whether it is primarily the relative strength of the US economy that determines Washington’s ability to influence global events or whether it is the complex of alliances, defense pacts, political relationships, precedents, and shared cultural and political values that are the key to US predominance. If it is the former, withdrawing from TPP and similar agreements may strengthen Washington’s hand over the longer term. If it is the latter, a very strong geopolitical case can be made against Trump’s decision.

Contrary to what we might first expect, however, those who oppose Trump’s decision on economic grounds (that restrictions on American trade deemed harmful for the US economy) and those who oppose it on geopolitical grounds (that these treaties expand US power and influence abroad) might not truly be allies except at the most superficial level. If foreigners accept Washington’s leadership in international affairs in exchange for participating in American trade agreements, it is usually because they believe that there are significant economic advantages to agreements that give them unfettered access to US markets. While it is perfectly possible that both parties gain economically from these trade agreements, the claim is too often merely asserted (and buttressed mainly by the repeated cheerful chirping of the phrase win-win).

In some cases, it is true that agreements are win-win and both parties gain. It would be dishonest, however, to deny that there are many cases—involving not just developing economies but also advanced ones—in which foreign counterparts have steadfastly refused to give American businesses the same access to their markets as their businesses have received from American markets. In these cases, in other words (and there are many of them), trade partners act as if it is contrary to their economic interests to grant to American and other foreign businesses the concessions that Washington is willing to grant them.

There can only be three explanations for this policy asymmetry: first, that foreign leaders are extraordinarily stupid or uninformed; second, that some fundamental (and as yet unexplained) structural difference between the United States and other economies cause these trade concessions to benefit the US economy and harm theirs; and third, while these concessions are indeed costly, Washington is nonetheless willing to grant one-way concessions for reasons of state.

Whether or not the third of these explanations is the correct one, there is a long American tradition—stretching back unambiguously at least as far as former US president Richard Nixon, and probably much earlier—in which Washington has accepted trade agreements which Commerce and Treasury officials privately argued were disadvantageous to American businesses and workers. But these agreements were nonetheless explicitly justified by foreign policy priorities, although publicly the administration usually justifies these concessions by claiming that the United States still gains economically by opening its own market, even if others don’t reciprocate.

Those who oppose Trump’s decision on geopolitical grounds, in other words, might agree with the economic arguments of those who support Trump’s decision on economic grounds, and disagree only with their relative assessment of the political advantage. But while there may be controversy over the benefits to the United States of the current global trading regime, much less controversial is that the benefits and costs within the country are asymmetrically distributed. While many sectors, especially financial institutions and businesses that are able to arbitrage global value chains, undoubtedly benefit from the continued asymmetrical opening up of US markets in goods and services to foreigners, and households benefit as consumers from lower prices for imported goods, the very uneven distribution of costs and benefits domestically penalizes those Americans most vulnerable to unemployment in the tradable goods sector and to burgeoning consumer debt.

These are also the sectors that may have most strongly supported Trump during the elections, but opposition to TPP is not limited to Trump’s supporters. Former Democratic presidential candidate Bernie Sanders, for example, also opposed TPP and the complex of trade agreements of which it is in part. An article was published in the Guardian a week after Trump’s November 21 announcement, for example, by former Sanders supporters and anti-trade activists, that extolled the death of TPP which, the authors argued, died not just because Donald Trump was elected but rather because “an unprecedented, international uprising of people from across the political spectrum took on some of the most powerful institutions in the world, and won.” The authors are Evan Greer, a transgender activist; Rage Against the Machine guitarist Tom Morello; and Canadian actress Evangeline Lilly, none of whom are likely to be typical Trump supporters.

Can Beijing Take Up the Challenge?

But while opposition to the system of which TPP had become the symbol is not new and is supported across the political spectrum, Trump’s announcement nonetheless came across internationally as a bombshell. The most widely articulated concern was that Trump’s rejection of TPP would exacerbate the geopolitical repercussions of an aggressive Beijing displacing an inward-looking Washington as leader and guarantor of global trade. Typical of this view is a statement by Deborah Elms, executive director of the Asian Trade Center, in reaction to Trump’s November 21 announcement that he would immediately issue a notification of intent to withdraw from TPP: “This is very depressing news. It means the end of US leadership on trade and the passing of the baton to Asia. At a time of slowing economic growth, the world can ill-afford watching the largest economies turn inward.”

That baton, Fortune warned the next day, “would be gleefully received by China.” China was not invited to become a TPP signatory presumably because it did not meet the standards written into TPP membership. Beijing had proposed a rival trade pact with less stringent conditions that had largely agglomerated existing trade agreements, known as the Regional Comprehensive Economic Partnership (RCEP). It excludes the United States but includes Australia, New Zealand, Japan and twelve other Asian countries.

It seemed to many that if TPP—an agreement designed largely by Washington and with the US economy at its heart—withers away, its signatories would formally or informally withdraw in favor of a more active Beijing-led RCEP, an agreement designed with the Chinese economy at its heart. The leadership of the global trade and capital regime, in that case, would shift from Washington to Beijing, and this concern seemed confirmed by statements coming out of China. For example, Tu Xinquan, an economist who has advised Beijing on trade issues, told reporters that “if the US gives up its leadership here, of course, China will take the role.” Meanwhile, during his APEC speech in Peru, Chinese President Xi Jinping pointedly championed globalization and took pains to present China as a bulwark against a rising protectionist tide around the world.

There were, even more, extreme reactions. Chinese exports are certainly no longer subsidized to nearly the extent that they were a decade ago—especially since 2012, when the greatest of these subsidies, highly repressed interest rates, began to disappear—but it is still hyperbolic to proclaim that Beijing, in the words of one excited American journalist, is “free trade’s new champion.” China’s massive trade surplus is not as much the result of explicitly mercantilist policies implemented by a cynical Beijing as many critics insist, but it isn’t the “natural” outcome of Chinese efficiency and hard work either.

China Relies on Trade Surpluses

Like nearly all persisting trade surpluses, China’s trade and current account surpluses are the results of domestic demand distortions.[1] These distortions, in China’s case, are ones Beijing has been trying to address at least since a famous March 2007 speech by former premier Wen Jiabao. It hasn’t done so largely because of powerful opposition from what the Beijing press excoriates as the “vested interests.” As a result of these distortions, Chinese households retain the lowest share of GDP perhaps ever recorded for a large, diversified economy and, with it, the lowest household consumption share. The obverse of its extraordinarily low consumption share is its extraordinarily high savings rate, which has fueled what will one day probably be seen as the largest investment misallocation spree in history.

This demand distortion is key. China’s trade surplus is a residual effect of a domestic growth model that has systematically forced up savings and which Beijing is finding extremely difficult to reverse. That is why despite all the concern, the structure of China’s economy makes nearly impossible a great shift from the world whose trading system is dominated by the United States to one in which China dominates. Even China’s official voice, the People’s Daily, had to point out that same day Trump’s video was released how unlikely it was that China could “overtake [the] US to lead the world.”

What prevents this shift is the role of China’s trade surplus within the structure of the global trading system. Because China’s trade surplus is a residual effect of its growth model, it plays an important part in resolving domestic demand imbalances. Until these imbalances are resolved, high and rising trade surpluses are necessary to manage the stark tradeoff Beijing currently faces between rising debt and rising unemployment.

The reason for this very difficult tradeoff is that economic activity in China has become during the past two decades overly reliant on unsustainably large increases in debt and any moderation in credit growth will very rapidly cause unemployment to surge. Like all the countries that have followed similar growth models, China has required accelerating credit expansion to maintain current levels of growth in the country’s economic activity. Today, Chinese debt is at least 250–260 percent of GDP. China has managed to meet the GDP growth target of 6.7 percent, the level of economic activity presumably needed to keep unemployment from rising, only by increasing total debt by a frightening amount equal to a 40–45 percentage points of GDP.

Debt capacity limits are the major constraint on China’s adjustment. With each percentage point of the country’s trade or current account surplus substituting for perhaps 10–15 percentage points of debt, China’s trade surplus provides the country’s leaders with crucial breathing space as Beijing maneuvers the necessary changes that will allow China to eliminate its reliance on debt. This reliance, however, is significant. Without the rise in the debt burden, if the debt were permitted to grow no faster than the corresponding growth in real wealth, or in debt-servicing capacity (which is much the same thing), China’s GDP growth would quickly fall to 3 percent or lower.[2]

The following five points summarize in simplified form the sequence of conditions that drive the need for China to retain large surpluses on its trade and current accounts:

Chinese debt levels are extremely high and growing too rapidly largely because the growth in Chinese investment is greater than the economy’s ability to absorb it productively. To rein in credit growth, Beijing must force a sharp deceleration in investment growth, which, because investment growth is a substantial source of economic activity, means laying off a large number of workers employed in investment-related activity. But to prevent a potentially destabilizing surge in unemployment, Beijing must also implement policies that increase the growth rate of consumption by enough to absorb these workers. China’s household consumption rate is among the lowest ever recorded in history because Chinese households retain a share of GDP that is also among the lowest ever recorded in history. Consumption growth is constrained by the growth in household income, and an investment deceleration puts downward pressure on the growth in household income by raising unemployment levels. The only way for Beijing to speed up household income growth sufficiently is through wealth transfers from local governments to Chinese households equal to at least 1–2 percent of GDP every year, a policy to which there is substantial opposition from those to whom the Chinese press refer as the “vested interests.” This transfer is a five­-year to ten-year process at best. The amount of time Beijing has in which to arrange the transfers depends on China’s debt capacity, the limits to which may be reached in as little as two years, depending on a number of variables, including of course the rate at which debt is growing. It currently takes an increase in debt every year equal to an alarming 40–45 percentage points of GDP to generate Beijing’s targeted GDP growth rate of 6.7 percent. If we assume that China’s current account surplus is 2 percent of GDP, a current account surplus set at zero it would require an increase in debt every year equal to 60–75 percentage points of GDP to generate Beijing’s targeted GDP growth rate, and an increase in debt every year equal only to 15–20 percentage points of GDP if it were double.

Might Doesn't Make Right

China, in other words, must maintain large surpluses as a crucially important debt-management tool. But this need for surpluses makes it incompatible under current global conditions with the leadership of a global trading regime. To see why, we must consider how the United States, after decades in which it had the world’s largest economy along with a nonetheless negligible governance role, finally came to dominate global trade. The United States became the world’s largest economy by the early 1870s, but for the next forty years the political strength of the silver constituency in the country undermined Washington’s perceived commitment to the gold standard and it's chaotic and crisis-prone banking system undermined its financial credibility. By the end of the nineteenth century, the country had been running large trade surpluses and had transformed itself from a major net importer of foreign savings to a fairly large net exporter,[3] but it continued to play a negligible role in global governance.

There is, by the way, a widespread misunderstanding that often crops up in discussions about the rise to major reserve-currency status of the renminbi and that also sheds light on the implications of Trump’s decision on TPP. While there are many useful points of comparison between the US economy in the 1920s and the Chinese economy in the 1990s and 2000s, there are also some fairly inept ones. Many commentators have noted for example that between 1914 and 1918, the United States was transformed from the world’s largest debtor nation to the world’s largest creditor. It was also during this period, according to these commentators, that as a consequence of the change in US creditor status, the US dollar was transformed into the world’s dominant reserve currency. By analogy, given China’s status as a leading creditor nation, the renminbi must soon become either the leading or one of the two leading reserve currencies.

There is a great deal that is misleading or simply wrong about this narrative, but the relevant point is the mistaken attribution of the rise of the US dollar to the emergence of the United States as a net exporter of capital. In fact, the country had been exporting capital for nearly two decades, and the US transformation from the world’s largest debtor to its largest creditor is far less significant than it seems. The Great War simply accelerated an already existing trend, transforming in four years the net asset position of the United States that might have otherwise taken a decade or more.

A Century of Dominance

So does this mean that American net capital exports were irrelevant to the emergence of the United States and the US dollar to global centrality? No, but they seemed irrelevant before the war because during this time the world’s major economies confronted, as they do today, capital abundance driven by high levels of income inequality.[4]

This will become clearer as we examine more closely the 100-year period during which the US dollar took center stage and the US economy became the center around which the global trading system was organized—even though by well before the middle of the nineteenth century foreign trade had become, and remained, a relatively small share of the US economy. This timeframe really consists of two different periods of conveniently equal time spans that represent two very different stages in the process.

The first stage ran for roughly five decades beginning with World War I (1914–18) and included World War II (1939–45). Not surprisingly, these two highly destructive wars dominated this stage, and the extent of their destruction left nearly all of the world’s major economies acutely short of the savings needed to fund the investment for their reconstruction. The great exception was, of course, the United States, which began that period as the world’s largest surplus nation and its main exporter of savings.

This put the United States at the center of the emerging economic order. During the two-decade period of relative savings abundance before 1914, US trade surpluses and capital exports gave Washington little leverage in world governance. The Great War accelerated US economic growth, along with the excess of American savings over investment, so that it began the 1920s with a huge savings imbalance, like that of China today. Unlike today, however, this savings imbalance existed in a world in which the war had caused income and savings in most major economies to collapse, while simultaneously creating enormous investment needs. The American ability to export large amounts of savings almost immediately put it at the center of global trade and capital, although during the 1930s it became clear that once trade contracted sharply, American demand imbalances could create the same kinds of problems for the US economy as the ones China faces today.

Whatever partial rebuilding occurred during the interwar period, however, was more than reversed by wars during much of the 1930s and the first half of the 1940s, so that global capital scarcity continued for at least another decade or two. This ensured that massive American capital exports, which were not enough even to prevent the famous dollar shortage of the 1950s, were of vital importance to the world’s major economies. The ability to export excess American savings kept Washington at the center of governance in a global system in which Europe and Japan rapidly rebuilt their economies.

By the late 1960s, conditions were different. The advanced economies had been rebuilt, global savings was abundant, and other forms of demand determined growth rates for most economies. Rather than access to scarce capital, they wanted from global trade the ability to expand demand by increasing exports of tradable goods while constraining imports or, put differently, to export capital. With its flexible financial system and the gradual elimination by the 1970s of all capital restrictions, the United States was able quickly to adapt, and began running large trade deficits whose costs, in the form of unemployment and consumer debt, it was willing to absorb for geopolitical advantage, the importance of which soared during the Cold War.

We are now living, in other words, in a global environment of savings abundance, in which the surpluses most economies want to run are on the trade account, not the capital account. This is the key reason China cannot replace the United States. Participants in a trading system whose dominant member, like the United States, runs large, persistent deficits, are able to grow faster because of the net exports they are able to run—the counterpart to US trade deficits—that add demand to their economies on average equal to about 1.5 percent of GDP every year.

On the other hand, in a trading system whose dominant member must run large and growing trade surpluses, like China, participants must absorb the net imports that are the counterpart to China’s trade surpluses. These net imports subtract demand from their economies equal to a little under 1 percent of GDP every year, and so they must accept lower growth as the price of membership. To switch from a US-centered system to a China-centered system, in other words, represents a reduction in demand currently equal to between 2.0 percent and 2.5 percent of GDP every year (although in some years it would have been as high as 3.5–4.0 percent of GDP). The only countries for whom membership—with its attendant demand squeeze of 2.0–2.5 percent of GDP—does not entail lower growth are undeveloped economies that urgently need capital to fund domestic investment. These will willingly join the latter system if it ensures their capital imports, but of course, there are likely to be limits on Beijing’s willingness to invest in these low-credibility economies.[5]

In this global environment of capital abundance, we may have reached an inflection point in which savings abundance continues to characterize the global economy but the willingness and ability of the United States to absorb excess savings is at an end. For the first three decades of this second stage (from the late 1960s to the present), Americans ran deficits willingly, but more recently over the past two decades, with the US share of global GDP much lower than it was fifty years ago, with income inequality higher, and with the Cold War over, the costs have become much harder to bear and the geopolitical benefits less pressing for an increasingly isolationist American public, especially as these costs tend to be higher in periods of slow global growth when countries replaced faltering productivity with mercantilist policies.

Leadership Has a Cost

And there is no longer any question for some Americans that mercantilism has indeed been a policy response by many of its trade partners to slow growth. While China is usually singled out for its policies, other countries have behaved more irresponsibly, most notably rich Germany, whose surpluses, the largest in history, were built primarily on an undervalued currency, after the creation of the euro, and on weak wage growth, after the 2003–05 labor reforms.

Growing opposition to trade, particularly among Americans most vulnerable to unemployment and consumer debt, was probably inevitable, and for the reasons listed in the Guardian article referred to above. But if an American retreat really is about to take place, rather than reorganize under Beijing’s leadership and around the surpluses China requires, it is far more likely that the world’s economies would be forced into domestic adjustments of various levels of difficulty, and respond with a mélange of industrial and trade policies aimed at easing the adjustment. To the extent that these policies force adjustment costs abroad, other economies will be forced to respond, and over time global trade will become unstable and increasingly contentious—and especially difficult for today’s surplus countries—in a way that is, in fact, closer to the historical norm than the anomalous stability of the four decades before 1914 and the six decades after 1945.

A US retreat from trade, in other words, will be damaging to global prospects. Many economists argue that it will also necessarily damage US prospects, but they are almost certainly wrong. While there is no doubt that clumsily designed and implemented policy interventions can be disruptive for the US economy, there is historical evidence that intervention can easily benefit diversified economies with large, persistent trade deficits, especially when these deficits are driven at least partly by distortions abroad. The case that most resembles that of the United States today is probably Britain in the 1920s when its trade account was adversely affected by large foreign purchases of sterling for reserve and investment purposes. The British economy significantly underperformed that of both the United States and its continental rivals, with nearly a decade of unemployment in excess of 1 million insured workers.

This changed dramatically after London succumbed to strong protectionist pressures, took sterling off gold in September 1931, and imposed the General Tariff in 1932 (with additional tariffs before and after in 1931, 1934, and 1935). As Barry Eichengreen writes of the British economy, “Its performance compares less favorably with Europe’s in the ‘twenties, when it persistently lagged its Continental rivals, than in the ‘thirties, when it closed much of the gap that had opened up in that earlier decade.”

The strongest argument against trade intervention is that it tends to raise consumption costs for all households by increasing the costs of the imported component of consumption. This might be a classic fallacy of composition, however. Inflation is a structural issue and depends on variables that affect the amount and velocity of money. For there to be inflation, demand for all goods must rise relative to supply, and demand for consumer goods and services is a function of household income. If trade intervention leads to higher prices on imported goods and services, and there is no other effect, higher prices for imported goods and services will reduce the income available to pay for non-imported goods and services, and this will put downward pressure on their prices. The two will balance out. Trade intervention is only inflationary, in other words, if it causes total household income to rise—perhaps by putting unemployed workers back to work or by putting upward pressure on wages—in which case households are still better off.

At any rate, inflation is unlikely to be a problem in a world suffering from disinflationary pressures, and would be even less of a problem in an overconsuming economy like that of the United States than it would be in economies—like those of Germany, China, and Japan—whose consumption levels are held down by hard-to-reverse distortions in income distribution. Certainly, the empirical evidence does not suggest that mercantilist policies are inflationary, or that counter-mercantilist policies that allow foreigners easier access to one’s market are disinflationary. Japan in the 1980s did not suffer higher inflation than did the United States, nor did Germany after the 2003–05 Hartz reforms suffer higher inflation than did Spain, Italy, France, and Portugal. In both cases, in fact, it was the reverse: mercantilist policies seemed to be associated with lower inflation.

Some economists argue that even if there are short-term benefits to American producers and workers, over the longer-term trade intervention is harmful for US productivity growth. This argument, which seems more ideological than empirical, is based on standard trade theory in which there is an implicit assumption that any intervention will drive trade performance away from its optimum, so that the United States always gains from the further opening up of its own market, even if trade partners don’t reciprocate. There are at least two problems with this argument. First, it doesn’t seem to conform to historical precedents, most especially American historical precedents, that suggest trade intervention has indeed been a successful part of many countries’ growth strategies. In fact, with the exception of a few, small trading entrepôts whose needs are radically different from those of larger economies, it is hard to think of a single advanced economy whose period of most rapid growth has not benefitted from, or at least coincided with, trade and industrial policies.

Second, the idea that any US intervention necessarily pushes the US economy from an optimum in which productivity is maximized simply does not make sense. It is easy to design models that show how mercantilist policies in one country, whether intended to be mercantilist or not, can push another country away from its previous equilibrium, so that if the second equilibrium is closer than the first to the optimum, trade policies can clearly improve productivity. And if the second equilibrium is not closer, trade policies just as clearly can improve productivity if they force a return to the first equilibrium. This is just logic. The claim that trade intervention is always value-destroying or always value-enhancing cannot be other than ideological. We must develop a framework in trade theory that recognizes the conditions under which specific interventionist policies can enhance or undermine long-term growth prospects, after which we must apply that framework to current circumstances.

Can We Redefine Global Governance?

If Washington does retreat from its global leadership role in trade, the world does not necessarily have to face a return to the contentious and unstable trade environment that characterized, for example, the interwar period. If a Trump administration were to fulfill another of his promises, although not one listed among the promised executive actions in his video announcement, and were to implement a major infrastructure rebuilding program in the United States, the extent of the increase in productive investment might substantially rebalance global savings with higher global investment, resulting in higher growth, and not with lower global consumption, resulting in lower growth.

But even if the United States does embark on a major infrastructure investment program, this is only a temporary measure that does not address the root problem, which is the decreasing ability of the United States to maintain large deficits that balance the desire of its trading partners to run surpluses. One way or another, either Washington implements specific interventionist policies that reverse the US deficit, or eroding US credibility will eventually accomplish the same purpose.

In that case, the only way of preserving the benefits of stable global trade is if well before then Washington were to convene a meeting of major trading nations, as it did in 1944 at Bretton Woods, to design a new regime that is harder to game and that allocates costs sustainably. It is probably too much to expect that the world will be convinced of the necessity of re-ordering global trade until after many difficult years have finally convinced all the major players. But an alternative may be for a much smaller group of major economies with similarly aligned incentives to take the lead and establish a new framework which is less dependent on the ability of the United States to absorb deficits and on the use of the US dollar as the main reserve currency. Advanced economies with persistent external deficits such as the UK or Australia might be natural candidates for membership. Advanced economies like Germany and Japan would strongly resist because while they refuse to recognize that they have any responsibility for creating the global imbalances, paradoxically they understand that they have benefitted tremendously from their abilities to amass US dollar investments, and would resist any constraints. This is why voluntary constraints probably cannot work. To pressure compliance, Washington should not rely on trade-directed policies but rather should make it difficult for countries to purchase unlimited amounts of dollar assets.[6]

This group would gradually admit new members as their financial and legal institutions became consistent with those of the original members so that the share of total trade that would be managed according to the rules of this new trade regime would grow eventually to encompass most of the world’s economies. Some will argue that this is exactly what TPP proposed, but TPP may have been undermined only partly because of what it actually accomplished in liberalizing trade. What may have killed it was the perception that it was an extension of a trading system that many Americans opposed, and certainly it was widely perceived to be as much an instrument of US geopolitical ambitions as a trade agreement.

Capital Drives Trade

One weakness is that within the rules of TPP there were no substantial provisions to address the deepest distortions that force the United States to run large deficits. There was almost no focus on capital account restrictions or on rules limiting foreign central banks from amassing US dollar reserves, or on other mechanisms that allow the United States to protect itself from massive net capital inflows. Capital account restrictions were neglected even though for several decades it has been pretty obvious that the persistent US surplus on the capital account has become the main driver of the deficit on the current account, and not the other way around.

This relationship between capital and trade flows is an extremely important one that is yet widely misunderstood. The necessary reforms in the design of a sustainable global system of trade and capital regime must deal with reforming the governance of capital flows as much as trade flows. I discuss the relationship between capital and trade flows in chapters seven and eight of my 2013 book, The Great Rebalancing, as well as in various other writings. Others who have written extensively about the topic include Jared Bernstein, a former economic adviser to Vice President Joe Biden, and Kenneth Austin, a monetary economist at the US Treasury.

Using various related frameworks, we show in our work how two aspects of the capital account that are widely considered to be evidence of US economic strength—the dollar’s dominant reserve currency status and the global “insurance” role of US assets created by the safe-haven status of the US economy—have in fact undermined through the trade account the ability of the US economy to grow without debt ever since the global savings shortage was resolved and reversed, sometime beginning in the late 1960s. This aspect of the balance-of-payments logic creates in the dollar not the exorbitant privilege of French, Russian, and Chinese nightmares, but rather an exorbitant burden for the US economy.

Although it has only been in recent years that a much wider public is beginning to recognize the complexity of a relationship that is often dismissed as “merely” an accounting identity, we are not the first to note a causal relationship that seems to bewilder many economists.[7] This relationship underlay the vigorous debate in the 1920s between Jacques Rueff and John Maynard Keynes on how the shift in central bank reserve accumulation from gold to sterling would adversely affect British trade and unemployment, which Keynes had argued his 1913 book, Indian Currency, and Finance was a matter of “comparative indifference.”

The abysmal British economy of the 1920s, however, caused Keynes eventually to reverse his position and by the 1940s he clashed with Harry Dexter White over his determination to embed the US dollar within the global regime that would emerge from the 1944 Bretton Woods conference. Except for a period in the early 1960s, when Robert Triffin explored what became known as the Triffin Dilemma, in which foreign hoarding of US dollars was linked to persistent US trade deficits, the relationship between the capital and current accounts seems since then to have mystified most economists, including those specializing in trade, even as US trade deficits and foreign capital inflows soared, and as the growth in international capital flows, once consisting largely of trade finance, exploded relative to trade flows and relegated trade finance to minor importance.

Without an understanding of this relationship, however, it will be impossible to design a global trading system whose structure cannot be distorted or gamed, and it was probably a failure of the 1944 Bretton Woods Conference that Keynes was unable to convince White about the risks. Until the roles of variables that affect both the capital account and the current account (which includes the trade account) are fully recognized within the trading regime—with the latter probably taking primacy during periods of savings scarcity and the former during periods of savings abundance—a new global trading system, whether or not it is centered on China, will be even less sustainable and more easily disrupted by imbalances than the current system.

This is probably the greatest weakness of TPP, and why even if for geopolitical advantage Washington had continued its support, an underlying opposition would continue to grow anyway. But rejecting TPP should not mean the rejection altogether by Washington of the very idea of a stable, rules-based trading system. The world is better off with such a regime, and we must remember that the animating spirit behind the 1944 Bretton Woods conference was the determination never to return to a world like that of the 1920s and 1930s, in which international trade was a zero-sum game of beggar thy neighbor. The sooner a new global trading regime is established with clear rules and stronger incentives for all members to behave responsibly, the better it will be for the United States, the better, even more, it will be for the world, and the better most of all for today’s surplus countries.

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I would like to thank Guy de Jonquières and Kenneth Austin for reading early drafts of this essay and for providing comments.

Notes

[1] As I explained in a June 2015 book review of The Leaderless Economy, by Peter Temin and David Vines, large and persistent trade surpluses are nearly always the result of policies that have distorted domestic demand, usually policies that force down the household share of GDP. This is most obvious in countries with the largest surpluses today: Germany, China, and Japan. The only exceptions historically have been the persistent trade surpluses run by advanced economies that export savings to developing economies, like England during much of the nineteenth century when British savings were absorbed by the tremendous investment needs of the United States. Of course German, Chinese, and Japanese capital exports to the United States contradict the historical precedents.

[2] There is no way of calculating China’s sustainable GDP growth rate—i.e. the growth rate at which the country’s debt-servicing capacity grows at least as rapidly as the debt itself—but since 2010 and earlier I have been unable arithmetically to get the numbers to work at much above 3–4 percent annual GDP growth, except by assuming implausibly large wealth transfers from local governments to ordinary households. What is more, although mainstream economic models implicitly—and often explicitly—assume that rising debt burdens have minimal effects on overall GDP growth prospects, in fact I would argue that corporate finance theory makes clear that once debt burdens exceed some threshold (one that necessarily varies—contrary to claims made by Carmen Reinhart and Kenneth Rogoff—according to the specific conditions, institutions, and debt structures of each country), increases in the debt burden must necessarily put increasingly severe downward pressure on economic growth, a claim more than amply supported by an enormous amount of historical data. If so, then to the extent that my original estimate in 2010 that China’s sustainable growth rate was 3–4 percent, it must be lower today and will continue to drop until Beijing can rein in the growth in debt.

[3] A significant share of this export of savings took place in the form of workers’ remittances and interest and dividend payments on foreign investment, which are usually listed in the standard accounting classification as current account outflows, not as capital account outflows. For our purposes, it is more useful to think of them as capital account outflows to make explicit their relationship to the gap between US savings and US investment.

[4] It is not a coincidence that this is the period that saw the emergence of the insights of British economist John Hobson and his American counterpart Charles Arthur Conant on underconsumption, the consequences of excess savings, and the role of capital exports in late nineteenth-century imperialism.

[5] In this case, it is clearly win-win if China can export capital to these low-credibility countries if there were some way of assuring repayment. China would benefit from running the corresponding trade surpluses, and they would benefit from the badly-needed capital with which they would build infrastructure.

[6] One way of distinguishing “good” inflows from “bad inflows might be to take a leaf from the Chilean playbook of the 1980s. In 1991, Santiago imposed unremunerated reserve requirements in which a portion of any capital inflow had to be deposited at the central bank for a specified period, at no interest. The effect was to impose an asymmetric Tobin tax whose value varied according to the term of the investment—it could be prohibitive for short-term investments but negligible for long-term investments. Taxes can also be set according to the nature of the investment, with FDI receiving favorable treatment, and short-term portfolio flows receiving unfavorable treatment. Economists will complain fairly automatically that taxes on inflows distort the most efficient global capital allocation and so will reduce total global output, but it is hard to argue that capital flows today are driven largely by the efficient allocation of capital from less productive investments to more productive investments when capital flight, speculative currency plays, and reserve accumulation seem to play so large a role, or when among the largest capital flows are those from less developed economies to the United States, which violates even simple notions of efficient allocation. It is also hard to argue that the allocation of capital in the United States has been far more efficient after the elimination of capital restrictions in the late 1960s and 1970s than it was before.

[7] A country’s current account (which for our purposes can be thought of as the trade account) must balance its capital account. This accounting identity, however, does not establish the direction of causality, which must be inferred in other ways (causality in any case usually runs both ways). It is probably safe to say however that trade had primacy for much of history, and the capital account usually adjusted to balance trade. This is almost certainly no longer true, although much trade theory implicitly assumes it still is.