Why Trump’s Tariffs Won’t Fix Global Trade

DAN KURTZ-PHELAN

Kim, thank you for doing this. I realize it’s been a dizzying few weeks for anyone who works on trade and international economic policy.

KIMBERLY CLAUSING

My pleasure to be here. Thanks for having me.

DAN KURTZ-PHELAN

Given how much can change on this front in a matter of hours, I should start by saying that we are recording on Monday, April 21 in the afternoon on the East Coast. But Kim, you have studied trade and international economic policy for much of your career and you were a senior Treasury Department official in the Biden administration, as well as serving on the Council of Economic Advisers in the Clinton administration, I believe, if I have that right.But I’m curious: I want to look at the diagnosis of the problem in the global economy as you understand it, before we get to trying to understand the consequences and logic of some of the tariff moves we’ve seen out of the Trump administration in recent weeks. How much overlap is there between your diagnosis of the state of the global economy and what it has meant for the United States and what you hear from the current administration? Everything we’ve seen in these last few weeks is driven by a sense that the global economy as it has developed in recent decades, in many ways driven by decisions made in Washington, has been quite bad for Americans and for America. And there’s certainly plenty of dissatisfaction that you hear from voters and others. Different members of this administration, the Trump administration, would focus on different specifics, but they all share that broad sense.Where is there truth in that? And to the extent that you think they get the specifics wrong, what would your alternative account be?

KIMBERLY CLAUSING

Yeah, so I think most international economists would join me in the view that their characterization of how the global economic system has harmed the United States is about 180 degrees wrong. In particular, the United States has really done well by the rules of the global system, and we spent seven decades trying to build those rules, in part because we thought a free and open trading system that was rules-based was really in the interest of the United States. And when you look at how the U.S. economy has done as a whole in recent decades, it has done really remarkably well.

So I don’t think the rules themselves disadvantage the United States. I would also disagree with the characterization of foreign trade policies as being particularly unfair. Of course, there are examples that we could point to of countries that have unfair trade policies, but this across-the-board conflation of unfair trade policies with bilateral trade deficits is puzzling and misleading, since most of the countries that we have bilateral trade deficits with have relatively fair trade policies.

So I think there’s a lot of disagreement between the international economic community and the Trump administration. I would say that there’s maybe a couple areas where there might be more agreement. One would be that the situation of typical American workers has fallen short of expectations. And I think that’s true and there’s multiple reasons for that, many of which lie far beyond trade, including technological change and the decline of unionization, rising market power of firms. But I think there is some consensus that there’s a reason why people in the lower half, say, of the U.S. income distribution might be dissatisfied. So I think the diagnosis might be somewhat correct, but the solutions that are proposed for that are incorrect.

And a second area of potential agreement, although I think the agreement might be more philosophical than practical, is that the government fiscal situation is unsustainable and we should do some things to reduce deficits. I think unfortunately, the Trump administration, together with Congress, is really posed to move in the opposite direction from addressing that problem, but some of their rhetoric fits the economic consensus that that itself is a problem.

DAN KURTZ-PHELAN

You were in the Biden administration a few years ago, and it has often been noted that that administration kept in place some of the tariffs that Trump put in place during his first term, especially on China. The administration was certainly not a champion of free trade and did not go back to the Trans-Pacific Partnership or negotiate new trade agreements. Why was that? Was that simply a matter of political constraints? Or was there some other policy theory that was animating those decisions?

KIMBERLY CLAUSING

So I think I wouldn’t be alone in characterizing the Biden administration’s position in this area as nuanced. I think that they were interested in addressing some of the problems with respect to competition with China, and they were reluctant to pull back entirely on the Chinese tariffs. I think there was some disagreement within the administration about how successful those tariffs were in achieving their policy aim. And there was, of course, late in the administration, some new tariffs that were put on, now just on $28 billion worth of goods, or—I forget the exact number—but a very small number of goods compared to, say, the Trumpian proposals, which involved tariffs on $3 trillion worth of goods, potentially all of the world.

So if you compare the two, I think they’re really incomparable. The Biden administration’s views, while one could critique them, are far more strategic, nuanced, and careful than this sort of slapshot, scattered approach of the Trump administration, which encompasses a lot of countries for which there is no strategic threat, where trade policies aren’t unfair. So I think those are really big differences.

I think you’re right that TPP is a lost opportunity. I think it’s really unfortunate that that didn’t get done during the Obama administration, that we don’t have that as a powerful tool. Because if you think about the best way for the United States to sort of build up its productive economic links with like-minded partners and allies, TPP is a perfect solution.

DAN KURTZ-PHELAN

Let’s turn to some of the Trump moves and we can, I think, return to some of these bigger questions as we get further along in the conversation. We’re having this a few weeks after some truly wild swings in U.S. trade policy and responses to it in the rest of the world. We had the announcement of reciprocal tariffs based on a somewhat idiosyncratic, to put it mildly, calculation of where those should be. And then with the retraction of those or the pause of those, and we’re in the midst of these negotiations with several dozen governments about where those should land. Still, a ten percent across-the-board tariff, as well as an escalating trade war with China. So I’m hoping you can, despite all that volatility, help us make sense of the long-term impact of some of these moves, even though we don’t know exactly where they’ll land.

First, if we assume that wherever this goes, there will be a permanently higher tariff across-the-board, whether that’s ten percent or 15 percent, it will be many times higher than the overall tariff rate a year ago. It’s kind of amazing that everyone just kind of accepts that ten percent across the board is maybe not so bad, given where we were a couple years ago. What will the cost of this be for the American economy? What will the effects be?

KIMBERLY CLAUSING

Yeah, so what’s kind of astonishing to me is how little note has been really taken of how much of a tax increase a ten percent across-the-board tariff is. If a Democrat or a Republican were announcing the largest tax increase in more than a generation, it’s unlikely that they would do that in a Rose Garden ceremony to try to draw a lot of attention to it.

But these tariffs really are an enormous tax increase. And if you take sort of the set of tariffs that are in place today on April 21, they amount to the largest tax increase in more than a generation. They will cost American households thousands of dollars and increase costs for goods. And they risk sinking the economy into a recession because a lot of the goods that we import are really important parts of our supply chain and the pressures of retaliation will really hurt our export industries.

So I think it’s a surprisingly damaging set of policies, and that’s before you even get into the parts of it that aren’t that ten percent across-the-board tariff. I think the escalating situation with China is quite damaging. There are a lot of small businesses that rely on inputs from China that are now wondering whether they have to close their doors or completely reconfigure their business models. There’s a lot of investor uncertainty surrounding whether the tariffs stay at that high rate or come down eventually. And in the midst of this kind of uncertainty, the natural thing to do if you’re a business investor is to just wait and see what happens. But if many, many actors in the economy simultaneously wait to resolve these uncertainties, that also creates recessionary headwinds.

So even the set of policies as they are, which I think are less damaging than the ones that we had before the pullback of the so-called reciprocal tariffs, before those were pulled back, things looked even worse. But I don’t think the situation now is something we should be sanguine about. It’s going to impose enormous costs to both U.S. consumers and to the broader economy and to the world economy too. We just heard in the news over the past 24 hours that China has made some announcements that countries that do deals with the United States will themselves be retaliated against. So you can imagine the sort of escalating mini–trade wars that our initial trade war is causing throughout the world could risk a global recession and stagflationary pressures as prices go up due to the tariffs at the same time that all of these countries are facing reduced gains from trade. So this is a deeply distressing situation.

DAN KURTZ-PHELAN

Do you imagine that other countries will start working around the United States when it comes to trade deals and setting the rules of the road? You’ve seen China try to suggest that this will be the case in meetings with the South Koreans and Japanese and others, and Xi Jinping’s goodwill tour around southeast Asia last week. Do you see any sign that’s starting to happen? And if that does, in fact, occur in a real way, what will that mean for the U.S. economy and its global economic influence?

KIMBERLY CLAUSING

In a way, I think we should hope that other countries work around us because I think the alternative is even worse than that. We kind of want to have an adequately functioning rules-based world system should we want to join it again. And if everybody’s like, “Well, there are no rules because the United States is behaving badly, we should all behave badly,” then I think we end up, as a world, in a much worse starting point than if there is some working around us.

If you look at the first Trump administration as a possible mini version of this, we saw Europe close a lot of trade deals during those four years, in part to help insulate themselves from this perceived additional riskiness of the United States. I think the second Trump administration has tenfold increased that impression in a lot of our partner countries. If we think about the European Union and Canada and Japan and Korea, these are some of our most reliable friends and allies and all of them are probably wondering just how reliable the United States is and thinking hard about ways that they can build relationships with each other. And you see announcements on a daily basis of Canada and Australia getting together, Japan and Korea being more friendly.

So there’s a lot of working around the United States that’s happening right now. I think what that will do in the long run is put the United States in a less powerful position in the world economy, not just with respect to economic considerations, but also with this sort of amorphous concept of soft power, like the view of the United States as a potentially benevolent actor and leader in a host of global collective action problems. I think that view is diminishing at a much more rapid pace over the past 90 days than it’s ever diminished in my lifetime.

So I think that’s a big risk, it’s a big loss for the United States, but to be honest, I really do hope that the rest of the world does continue to address some of these global problems together and climate change leaps to mind, public health leaps to mind. We’ve got global pandemics that could happen around the corner. Tax competition leaps to mind. There have been important international strides and cooperation there. And I think it would be a much better world if countries do move ahead without us than if they simply give up on these efforts.

DAN KURTZ-PHELAN

The other anxiety that has arisen in the last few weeks is about the status of the dollar. What are you worried about when it comes to the dollar’s place? And what would the consequences be if there really is a change in the place of the dollar in the global economy?

KIMBERLY CLAUSING

Yeah, so I think the biggest consequence would be, as an American, that our lifestyles would get more expensive. There’s a lot of ways in which the centrality of the dollar helps typical Americans. So let me give you one example. Because the United States is considered a safe place and our government debt is considered a safe investment, historically, we’ve been able to borrow at very low interest rates. And this has enabled consumption in the United States to be higher than it would otherwise be, and it has made it easier to do things like run a six-percent-of-GDP budget deficit in a perfectly good economy, which is what we’ve been doing lately, without it imperiling U.S. investment or the standard of living of typical Americans.

So this has been a privilege, this ability to borrow at a low rate; it’s not a burden. I think the Trump administration might characterize this as, “Oh, this is a big global imbalance that’s being foisted on us by other countries and that we have to somehow respond to this, we have to right this international system.” But I think that what they risk doing is sort of making the U.S. assets more risky.

And it’s not just this sort of completely shambolic and distressing set of trade policies; it’s an assault on the independence of the central bank. It’s a reduction in the sense that the United States government will adhere to the rule of law in any number of areas, including in their tussle with Harvard, in their exchanges with the Supreme Court about due process and the like. And then at the same time, we’ve got Republicans in Congress suggesting that we adopt a new budget rule that would effectively make $4 trillion worth of future deficits utterly disappear. So you don’t even have the legislative branch acting as a responsible counterweight to what the executive branch is doing.

So all of this means that when the U.S.goes out to borrow in world markets, the interest rates that we’re going to pay are going to be higher. That makes U.S. debt less sustainable. That means U.S. taxpayers will get less government services per dollar of tax paid because more and more is going to go to interest. And it means that you and I, if we go out and take a mortgage on our houses or accrue credit card debt, even debts like that are going to face higher interest rates in a world where the United States isn’t considered a safe location to invest in. So this, I think, is a deeply troubling erosion in the confidence that international markets have in the U.S. dollar.

DAN KURTZ-PHELAN

And do you see signs that the place of the dollar is in fact changing in irreversible ways right now? What should we be looking for as we try to consider whether that’s happening?

KIMBERLY CLAUSING

Yeah, I see two signs that I consider troubling. One is what’s kind of happening in bond markets. You’ve seen interest rates and bond prices respond to some of these recent announcements and moments in an adverse way, in an unexpectedly concerning way. And in fact, news reporting suggested that the bond market reaction to the so-called reciprocal tariffs was part of why they were paused, is that it was recognized as a very scary sign.

A second sign is what’s happening to the U.S.dollar when we look at both the tax cuts that have been proposed by Congress and the tariffs that have been proposed by the administration, arguably in an excessive use of authority that they don’t truly have. Both of those normally would cause dollar appreciation. The tariffs because there’d be an excess demand for U.S. goods, which would increase the value of the dollar. And the fiscal expansion because it would tend to raise equilibrium interest rates, which would make U.S.assets look, in theory, more attractive and also raise the value of the dollar.

What we’ve seen in contrast is dollar depreciation accompanying both these budget announcements and these trade tussles. And that suggests that we’re in a regime where the confidence risk premia–type things that I was talking about earlier are dominating these underlying economic forces. And that’s a regime that international economists will recognize from situations like Greece during the euro crisis or Argentina, off and on. There’s plenty of countries that have that experience, but it hasn’t been a U.S.experience in my lifetime.

DAN KURTZ-PHELAN

And you mentioned the tax cuts that the administration and Congress would like to push through. The president often says that tariffs will pay for those tax cuts. Is there any truth to that? Or how should we respond to that argument?

KIMBERLY CLAUSING

Yes, so there’s a couple of interesting facets of this. One I just alluded to, which is that you might wonder, can the president basically do tax policy by himself? Doesn’t he need Congress? It seems like Article I of the Constitution gives Congress the authority to lay taxes and that includes tariffs. That they have some exceptions for emergencies and national security, and President Trump is relying on those. But I think most international trade lawyers would tell you that exceptions such as those don’t really meet the moment. So there’s the legal question.

But I think the economic question is even more interesting here. I think tariffs, of course, will bring in revenue. I think that the claims that the Trump administration is making for them are often a multiple of the true revenue that they would bring in. Because when you levy a tariff, that raises the price of imports, as we know, and that’s going to reduce demand for those imports, and so the tax base will start to shrink for those reasons. And there are also recessionary headwinds that get caused by the tariffs, and that can reduce taxes elsewhere in the tax system, too. So if people are laid off because their small business can’t get access to the inputs they need, that means they’re going to stop paying payroll taxes and income taxes. So the tariffs can also hurt the income tax through that mechanism as well.

But there’s a more underlying, kind of fundamental math problem with their notion, which is that if you look at the tax base for tariffs, it’s really about $3 trillion worth of goods imports. If you look at the tax base for the income tax, it’s closer to $20 trillion. So you really have to get tariffs up to a really crazy high level to get serious amounts of revenue out of them. And by the time you’re at such a high level, you’re really strangling the economy. So it’s not considered by really any decent economist a good source of revenue.

So I think the income tax is here to stay. How broken the income tax is will be determined in part by the actions of Congress over the coming year, how much they cut taxes and reduce the fiscal solvency of the United States. But I’m also concerned about the big cuts to the IRS because that’s also going to reduce tax morale and tax compliance, because small businesses that have perceived discretion about what they’re reporting in terms of income and expenses will feel that the probability of an audit has gone down quite a lot too. So we’ve got this sort of multifaceted attack on the streams of income that we would normally use to finance the state, and we’re suggesting this very regressive, distortionary tax policy tool to replace it, and I think it’s just a deeply misguided and problematic approach.

DAN KURTZ-PHELAN

One of the animating factors behind the Trump international economic policy has to do with manufacturing, and I think this is one that was in some ways shared by members of the Biden administration and has a kind of deeper hold in much of our political debate, even if the responses to it are quite different. You noted in a piece you wrote for us in 2019, called “The Progressive Case [Against Protectionism],” which drew on your fantastic book, which was called Open, I believe—you noted in that piece that the share of Americans working in manufacturing has been declining steadily since 1950. This does not all start with the post–Cold War free trade agreements, it goes much further.As you look at the proper role of manufacturing and the concern about it in our political discourse and our policy more broadly, what do you make of it? Is there any validity to this concern with manufacturing beyond a few critical industries that are especially important to national security? Is it just kind of a nostalgic throwback? And either way, is there really any policy that can reverse what has been that many-decade decline?

KIMBERLY CLAUSING

So let me first be generous to the view and then express some concerns. So I think one motivator that I think drives both the Biden types who were concerned with manufacturing employment and some of the Trump types who are concerned with that is that there’s a sense that there are regions and pockets of this country that feel left behind. So if you’re in Ohio or you’re in West Virginia, they may look back to an earlier era where there were more plentiful jobs available, in particular for non–college educated men, but also more broadly. And I think this story of left-behind places is a real story with empirical truth behind it.

So I think there’s a reason to care about this issue, but I also think there’ are many solutions beyond fetishizing manufacturing jobs per se, and I think there are dangers associated with fetishizing manufacturing jobs. You may end up encouraging an economy that’s a pretty advanced economy to go back to making things that are really better made in other countries. So if you poll Americans and you say, “Should there be more manufacturing jobs?” most of them are like, “Sure, yes.” But if you ask them, “Would you like to work in a manufacturing job?” most of them are like, “No, I would really rather not.” I think it’s much more fun to design the next Nike shoe and to market it and to finance it and to do the R & D and the advertising for it than it is to sew it up and kind of make the shoe physically. So I’m not sure why we would be putting tariffs on footwear, which we are for many countries in the world, and apparel, when most people don’t want to make footwear and apparel. And if we do that, we’re just driving up costs for consumers and we’re pulling resources away from other sectors where we’re really good at making things.

So an example would be the Boeing 787 Dreamliner plane. We’re very good at making that plane and other Boeing planes. And in theory, that creates a lot of great jobs in places like South Carolina and the state of Washington. But when other countries say, “Just send the airplanes back,” we lose jobs in that export sector. And to make more shoes and clothing, we’d have to pull resources out of other sectors in the economy where we might be usefully making stuff.

So one of the dangers of protectionism as a response to this lost manufacturing sector is it’s actually kind of shrinking the sectors that we're good at and expanding sectors where I don’t think we’re really well-suited to production. So that doesn’t mean that left-behind communities aren’t important; it just means that there’ are probably better ways to do that, ight?

One other little tiny thing I would add here is that, of course, there are some sectors that are of strategic importance, right? But when you identify a strategic sector and you want to have more of it, I think the best way to do that is to just put your money where your mouth is and subsidize the sector. I think if you put up tariffs and just hope that the homegrown sector rises to the occasion, you’ll end up with a sector that never really can meet the test of world markets, as we’ve seen in our steel sector, right? Somehow every year, for what feels like decades, there’s pressure to protect the steel sector. It’s not really meeting the test of world markets or we wouldn’t need tariffs over and over and over again for it, Right?

DAN KURTZ-PHELAN

And meeting the test of world markets means we just cannot produce it in a competitive way no matter how much we tariff it?

KIMBERLY CLAUSING

Yeah, that appears to be the case. And you could say, “Well, some of this is because of unfair trading practices in China.” And I think if that’s the problem, then it behooves us to deal with that problem. How would you do that? I think the best way you could do that is to work with partners like Canada and Australia and Japan and Korea and Europe and together pressure China on specific things. Like, “We think you have too much capacity in the steel sector, we want to work in a rules-based way to address that.” But I think slapping up a lot of tariffs and starting a trade war that involves 125 percent tariffs, I think that’s a very clumsy and foolish way to deal with the underlying problem.

DAN KURTZ-PHELAN

Can you imagine, assuming there are people who, in an attempt to kind of discern some logic in the series of moves by Trump that are presumably driven by whims and reaction for the most part, at least pointing to an objective that doesn’t sound that different from what you just described: that we will have used this kind of shock of our other trading partners and allies to get them to deals with us while we punish China and create this slightly, in a shambolic way, to use your word, but we do end up with this kind of coalition to defend against some of the trade practices? Do you see any possibility of that outcome in the series of moves we’re witnessing right now?

KIMBERLY CLAUSING

In my conversations with people from other countries, I’ve seen zero evidence that this approach is bringing people to the table or winning an argument for the United States relative to China. I think on the contrary, it’s weakening our arguments to have us kind of lashing out. Look at how we started this with this Groundhog Day proposal to put enormous tariffs on Canada and Mexico and targeting Europe really early on. It’s really a set of steps that have deeply angered and frustrated our closest friends, who we might normally work with on this.So I think it’s just plain wrong to say that that’s a great starting point for bringing together the community of nations to counter the challenge of China. I don’t think that’s what this looks like. To me, this looks like a very foolish lashing out of everybody at once.

DAN KURTZ-PHELAN

If you were to set about creating that coalition in the right way and you were to set about addressing the weaknesses and shortcomings in the international economic system as you’ve seen them, what would your strategy look like? What would a better path to reform be?

KIMBERLY CLAUSING

Yeah, so I think a better path to reform would be to recognize that of course the WTO isn’t perfect, and to roll up your sleeves and work in a legitimate way with partners and friends to make the WTO more responsive to some of the concerns the United States, Europe, and others have had about the WTO. I think throwing out the rule book isn’t the answer, but I can imagine a round of reforms is necessary, and it probably does need to be led by a coalition of willing leaders who can come to the table and say, “Here’s a way we could do this.”

DAN KURTZ-PHELAN

I want to close by going back to that fantastic essay you wrote in 2019. You wrote about a “new Washington consensus” that was taking hold. Describing that consensus, you wrote that it held that “decades of growing economic openness have hurt American workers, increased inequality, and gutted the middle class, and new restrictions on trade and immigration can work to reverse the damage.”. Senior members of the Biden administration picked up the language about the new Washington consensus. I’m not sure that came from you, but that was a term they would use. They would use it in a positive sense to describe a new approach that involved industrial policy and subsidies, as well as trade skepticism. What in this new consensus do you see as welcome and positive, and what would you change if you could refashion that consensus?

KIMBERLY CLAUSING

I think focusing on making sure that economic growth is really benefiting the broad swath of American experience is a really valid and useful goal. So I welcome that part of the consensus. It’s not just about GDP growth, or even GDP per capita growth. It’s really about making sure that all segments of society benefit from U.S.economic growth. And I think we’ve had a mixed record on that front.

Where I would challenge the so-called post-neoliberal view is that I don’t think they’re blaming the right root causes here. I think there’s no evidence that trade is the dominant factor. Trade has created a lot of jobs, and of course, it’ has destroyed some jobs too, and we should be sensitive to the harms that happen in the economy. But robots destroy jobs too. Big companies displacing little companies destroy jobs. Capitalism itself constantly creates and destroys jobs.

So I think this tendency to try to blame outsiders for things that are really not the outsiders’ problem is harmful and actually risks hurting the very people you’re trying to help.

I think in the case of trade restrictions, you’re not just putting on a regressive tax, which is what a tariff is—it’s a tax that disproportionately hurts those that are poor because they’re spending all of their income, whereas those that are richer can save some and avoid the tariff. So it’s not just that you’re hitting them with this new tax; you’re also creating brand new shocks, right? You’re hurting those Boeing workers, you’re hurting the small business that relied on Chinese inputs to produce their product, right? So you’re introducing new disruption. It’s not going back in time. We can’t go back in time.

So I worry very much that the solution, this post-neoliberal solution, is worse than the disease, and it’d be better to do nothing at all than do that. But I do think there are also things that we can do. So I’m not saying that we should be complacent. I think a more progressive tax system, a stronger safety net, more investments in community college and infrastructure, all of these things can help left-behind people and communities and can make that growth inclusive. But trade barriers and immigration barriers are just plain wrong.

DAN KURTZ-PHELAN

Kim, thank you so much. We will pick up that conversation as we see how those further disruptions play out, but we’ll also, I’m sure, come back to you as we see what happens with trade policy over the coming weeks and months. So thank you so much for joining me, and we’ll look forward to more soon.

KIMBERLY CLAUSING

Thanks for having me. I really enjoyed the conversation.

DAN KURTZ-PHELAN

Michael, thank you so much for joining me, especially given that it’s late at night for you in Beijing.

MICHAEL PETTIS

My pleasure.

DAN KURTZ-PHELAN

Given how much can change on this front in a matter of hours, I should start by saying that we are having these conversations on Monday, April 21. But Michael, the reason I was so interested in speaking to you this week is that while you have had your share of critical things to say about the Trump tariffs and trade policy, you also diverge from what you might call consensus critique in economic policy circles in some interesting ways.For one, your diagnosis of the problem with an imbalanced global economy is in some ways similar to the diagnosis driving the Trump approach. As you write in a piece published this week in Foreign Affairs, “A dramatic change of some kind was necessary to address imbalances in the global economy that have been decades in the making. Current trade tensions are the result of a disconnect between the needs of individual economies and the needs of the global system..”So let’s start with that. How would you describe the problem? What ails the global economy? And where does that overlap and diverge from the Trump diagnosis as you understand it?

MICHAEL PETTIS

Well, the first thing that I would say is that my view of these imbalances is not particularly new. It’s only new in the context of American academic economists who seem to have forgotten a lot about what we used to know. In effect, I’m reviving arguments made by John Maynard Keynes, Joan Robinson, Ragnar Nurkse, and a whole bunch of economists from the 1920s and 1930s that had to deal with these imbalances and the consequences of the imbalances.And the basic argument is to remind people something that every economist should know, even if they don’t understand the implications, and that is that first of all, for every country, the internal imbalances must be perfectly aligned with the external imbalances. And then, of course, for every country, its external imbalances must be aligned with the external imbalances of the rest of the world. The balance of payments balance.

So what that means is that if you have a globalized system in which most countries agree, most major economies agree to give up control of their domestic economies in favor of a more globalized system—what Dani Rodrik called more global integration.e have one kind of globalization. But if we live in a very different system in which some countries agree to give up control of their domestic economies in favor of more global integration, but other countries major economies, insist on controlling their domestic economies, then you have a very different type of globalization in which policies in one country, countries that control their external accounts, effectively become policies in other countries.

And the problem with that, as Keynes pointed out, is that it makes sense for countries to do things individually that doesn’t make sense collectively for the system. In my piece in Foreign Affairs, I refer to that as the Michael Kolesky paradox. And Kolesky argued that in an economy, you want rising wages because rising wages drives demand, which drives business investment, and particularly investment in increasing the productivity of individual workers. And that’s how you get rich. But individual businesses benefit from suppressing wage growth relative to productivity growth. And that was the paradox: what makes sense for each individual business doesn’t make sense collectively. And that’s the type of globalization that we’re in. What makes sense for individual countries, which is to suppress wages in order to grow exports more rapidly and expand your manufacturing sector, is bad for the overall economy. So the point of the paper is to argue that we’ve locked ourselves into the kind of globalization that people like Keynes thought was a real problem and we need to break out of it.

DAN KURTZ-PHELAN

Could I ask you to quickly be a little bit more concrete about how that explains the place of the U.S. economy and the world at this point and how that, to your view, is stoking some of the tensions both between the United States and China, but also more broadly that have brought us to the place we’re at now?

MICHAEL PETTIS

Well, one thing I would say is that although the conflict between the United States and China gets all of the attention in the press, that’s a mistake. In fact, global tensions are rising everywhere. We’re seeing a huge number of countries, for example, put in WTO complaints against China, and it’s spreading very rapidly, and against each other. We’re going to see more and more of this. But the United States plays a very special role in the global imbalances, basically since we went off the Bretton Woods system in the early 1970s. And the role of the United States, and, to a lesser extent, of the United Kingdom and Canada, is as the great absorber of excess savings in the rest of the world. So if you’re a country that puts into place policies that are aimed at expanding manufacturing exports at the cost of domestic consumption, which basically means you subsidize manufacturing at the expense of the household sector, then you’re going to grow more quickly, but you’re going to require trade surpluses to balance the gap between your domestic production and your domestic consumption. And in order to run trade surpluses, you have to acquire foreign assets. If you export more than you import, then you have to get paid in the form of the acquisition of foreign assets.

And there are basically only a few countries that are really willing and able to absorb these deficits by exporting claims on domestic assets, and that’s the United States and the other anglophone economies. The U.S. accounts for roughly half of all of the deficits in the world, which is another way of saying that roughly half of the excess savings in the surplus countries are balanced by the acquisition of U.S. assets. And if you include England and Canada, you account for roughly three quarters. And what these economies have in common is not just that they all speak English, but rather that they all have very deep flexible financial markets, very good corporate governance, a strong reputation for safe assets. So if you are going to acquire assets abroad, these are the countries in which you prefer to acquire these assets.

But while that is very good for the financial system of these countries, and British and American banks dominate globally, it comes at an enormous cost. And the cost is an overvaluation of the U.S.dollar and a contraction in U.S. manufacturing in favor of an expansion in U.S. consumption, which means that basically the U.S.has to balance the surpluses of the rest of the world, either with rising unemployment, which is what Joan Robinson argued back in the 1930s, or, since the breakup of Bretton Woods, with rising household debt or rising fiscal deficits.

And as Joan Robinson argued, that only goes up to a point. At some point the cost becomes so great that countries begin to retaliate. And once that retaliation begins, we will see a rise in global tensions, a contraction in global trade, and all the things we are worried about.

The point is that this was inevitable. It didn’t take Trump or Biden to do it, it was going to happen one way or another.

DAN KURTZ-PHELAN

Trump, of course, fixates on trade deficits, even if he doesn’t exactly understand the drivers beneath them. Is that in some ways a reasonable proxy for addressing the imbalances that you’re identifying in the global economy?

MICHAEL PETTIS

Absolutely. In fact, what Keynes argued is that you don’t really focus on specific things like tariffs or interest rates or wages because they’re all summarized in the trade balance. If a country runs large persistent surpluses, that means that one way or another, it’s subsidizing exports at the expense of domestic demand, so you should focus on surpluses and deficits. The problem is you should never focus on bilateral surpluses and deficits. They’re quite meaningless. What really matters is systemic surpluses and deficits.

DAN KURTZ-PHELAN

And Trump, of course, is obsessed with that bilateral deficit—

MICHAEL PETTIS

Exactly.

DAN KURTZ-PHELAN

—which is not exactly the right measure, but it’s at least gesturing in that direction. Let’s bring tariffs into it. You wrote a piece in December for Foreign Affairs arguing that given the current U.S.and global economic situation, "Tariffs could increase employment and wages in the United States, raising living standards and growing the economy." So if, let’s say, Michael Pettis, rather than Peter Navarro, were White House trade czar and you were the one deploying tariffs at this point, what would you be doing? And how does that differ from what the administration is doing thus far?

MICHAEL PETTIS

Well, the purpose of that paper was not to support tariffs. The purpose is that under certain conditions, tariffs can be expansionary and under other conditions they can be contractionary. So the paper was really about the Smoot-Hawley tariffs, which were implemented at a time when the U.S.had a problem of weak domestic demand and very strong exports. So tariffs did exactly the opposite of what the U.S.needed. The U.S.needed to boost domestic demand, and tariffs did the opposite because by raising the price of imports, it actually reduces real domestic demand. So that was the point.

I think there are much more efficient ways of addressing the U.S.deficit. One way, as I argue in the most recent piece, would be a new global trade agreement along the lines that Keynes proposed. If that isn’t possible, then the next best way is for the U.S.to interrupt the ability of countries with excess savings to balance those by acquiring U.S.assets, so some sort of capital controls, taxes on inflows, et cetera.If you’re going to use tariffs, which are probably the least effective way of doing so—and the most contentious, by the way—then probably what you would want is tariffs across the board on all imports, because the purpose of the tariffs would be to change the savings investment imbalances in the rest of the world. And of course, bilateral tariffs simply do not do that.

DAN KURTZ-PHELAN

How do you assess China’s response so far to Trump’s first moves in what seems to be a new trade war? And what do you think Beijing’s strategy will look like going forward? It would seem to me that part of what will determine their options is Xi Jinping’s assessment of how much pain the Chinese economy and Chinese people can take, as well as what other weapons—economic weapons—Beijing still has to deploy to put pressure on the United States beyond the moves it has made thus far. But how do you read what they’ve done thus far? And how do you see the upcoming moves given where we are right now?

MICHAEL PETTIS

Well, China’s in a tough position because we know from the historical precedents and also from the logic of imbalances that countries that run surpluses do so because they have very weak domestic demand. They’re forced to run surpluses in order to resolve the high production domestically. Without surpluses, they would have to reduce production, which means closing down factories and firing workers and doing all the things that nobody wants to do.So if the U.S.is successful in reducing its deficit, and it’s not clear that the Trump tariffs will do that, but if the U.S.is successful in doing that, that puts enormous pressure on China to reduce its surpluses. And there are basically two ways it can reduce its surplus. One way is to produce less stuff, fire workers. The other way is to increase domestic demand. But the problem with increasing domestic demand is that the whole economy is sort of structured around weak domestic demand because the household sector gets a very low share of everything that’s produced in China, among the lowest shares in the world.

So the sustainable way to increase domestic demand is a redistribution of domestic income. That is really hard to do. Now, there is a way you can do it quickly, and that’s helicopter money. You can basically have the central government borrow money and deliver that, directly or indirectly, to the household sector in order to boost domestic consumption. You can do that for short periods of time, but given the enormous debt levels in China and the rapid growth in debt, there’s a limit to how long they can do that. But I suspect that this year that’s what they’ll do. We’ll see more of a fiscal deficit oriented towards supporting the demand side of the economy rather than the supply side, which is what they traditionally do. It’s just not sustainable.

DAN KURTZ-PHELAN

Do you expect further escalation in response to the United States? Or do you think that they will be eagerly looking for a deal, knowing that they’re in a precarious position?

MICHAEL PETTIS

I think they will be looking for a deal, but I also think they cannot afford to be seen as folding to U.S.pressure, which puts them in a tough position. The article that you mentioned late last year, the whole point of the article was that the reason the U.S.made a huge mistake with Smoot-Hawley is because as the leading surplus country of the world, it couldn’t tolerate an increase in trade tensions and in trade conflict. China now occupies that position. It’s the country that is most vulnerable to an increase in trade tensions because of its very weak domestic demand.

DAN KURTZ-PHELAN

So let me turn attention back to U.S. policy, back to Washington. In attempting to make sense of the tariff strategy that we’ve seen over the last few weeks from the Trump administration, some people have pointed to a paper written by the Chair of the Council of Economic Advisers Stephen Miran. This was published before he joined the administration, but seems to have something to do with thinking in at least parts of the administration.In that paper, he lays out a vision for what has been called the Mar-a-Lago Accord, in which the gradual imposition of tariffs would play a role in transitioning the global economy away from dollar hegemony, which would be part of addressing these imbalances. Leaving aside the question of whether this has anything to do with what’s driving Trump himself, do you see any logic to this? Do you think that’s part of what’s unfolding here? And would that be a reasonable response to some of the problems that you’re focused on?

MICHAEL PETTIS

My reading of Miran is that he’s broadly right. He recognizes that it’s really the capital side of the equation that drives the U.S. trade imbalances, that drives the contraction in U.S. manufacturing, et cetera, et cetera. He’s very concerned by the fact that if countries mostly resolve their savings imbalances by buying U.S. assets, they’re going to drive up the value of the dollar. And by driving up the value of the dollar—a currency appreciation is basically a tax on production and a subsidy for consumption, because a higher currency reduces the cost of imports, of consumer imports, and it makes it more difficult for producers to compete globally.

So what he wants to see is a reversal of that process, and one of the ways of reversing that process would be to engineer a decline in the value of the dollar. The problem with a repeat of the Plaza Accord is that tariffs and currency appreciation or depreciation are ways of intervening in trade, but there are many, many different ways of intervening in trade. So for example—

DAN KURTZ-PHELAN

And just to clarify for listeners, the Plaza Accord [was] the attempt to force a change in the value of the dollar during the Reagan administration, is that right?

MICHAEL PETTIS

Exactly right, in 1985. So under the Plaza Accord, Japan and Germany above all, but also France and England and one or two other countries, agreed to appreciate their currencies against the dollar. And in most of those countries, we did see a rebalancing of trade, but not in Japan. In Japan, we saw a rebalancing for about a year or so, and then the Japanese trade surplus surged again. So Japan ended up with as big a surplus as ever, as big as an imbalance as ever.And that’s the problem. There are many, many ways you can intervene in trade, and my concern is that if they agree on a change in the value of the currency, so for example, if we come to a new Plaza Accord where countries like China and Germany agree to appreciate their currencies against the dollar, that still leaves many other avenues open for them to reverse that appreciation.

Keynes, for that reason, argued that if you cheat on trade, to use a strong word, it will show up in the form of a trade surplus. So the only thing you should focus on is the trade surplus, not on tariffs, not on the value of the currency, not on interest rates, not on wages, but on the collective result of all of those things. And I would prefer a revival of Keynes’ proposal in 1944 at Bretton Woods than a new Plaza Accords. But one way or another, I think his approach is correct. He recognizes the relationship between the capital account and the trade account.

DAN KURTZ-PHELAN

You explore in your new piece for Foreign Affairs what an updating of the Keynes approach might look like. If you were able to deploy that at this moment in U.S.economic policy, what would you be trying to do? And what would the resulting system, if it’s a success, look like for the global economy?

MICHAEL PETTIS

Well, I think basically we want a system where countries can pursue whatever economic development policies they prefer, as long as they don’t externalize the cost of those policies. And the way you externalize them is through imbalances in your internal account that then reflect imbalances in your capital account.So for example, if I run policies that result in a persistent trade surplus on my part, and you have an open capital account, you have no choice but to run the corresponding trade deficit. And what Keynes argued is that countries shouldn’t be able to do that. So you and I can do whatever we like as long as we don’t have persistent imbalances on the internal accounts that are translated through the capital accounts, which is a long way of saying that if you run a persistent trade surplus, you should be penalized.

So what I would argue is a new trade agreement among countries—and here could be an exception for developing countries, for small economies, for special cases—but generally the agreement is that you manage your internal imbalances in such a way that you don’t export them to your trade partners. If you do, you get penalized. And in that case, we would once again have a balanced trading system in which the main reason for increasing your exports would be to increase domestic welfare by increasing your imports. That’s the kind of system Keynes proposed, and that’s what I would support.

DAN KURTZ-PHELAN

So if that’s a relatively good outcome from the current moment of uncertainty and stability, what is a scenario that worries you as you look at where we are now?

MICHAEL PETTIS

Well, the problem, as Joan Robinson said, is that inevitably we’re going to see a rise in retaliation if these imbalances aren’t resolved. So a worst-case scenario would be that the imbalances continue for several more years and get worse, in which case the reaction will be that much more violent, that much more problematic. This is something we should have addressed ten or 15 years ago. The longer it takes us to address it, the worse the likely outcome is going to be.

DAN KURTZ-PHELAN

Let me close by returning to a similar topic that we started on. You are a heterodox thinker when it comes to questions of trade generally and tariffs specifically. What, in your view, do most economists miss on these questions? Why are you somewhat outside the mainstream of economic thinking here? And how much do you think the fact that you’ve been sitting in China and teaching in China for the last couple of decades has shaped your view? Obviously, you would argue that it’s more accurate than the one you might get if you were sitting in an American university.

MICHAEL PETTIS

Well, I don’t really think of myself as a heterodox economist. I think of myself as an economist that’s reviving the sort of pre-1970s understanding of economics. I’m very unhappy with what happened in academic economics in sort of the post-1970s period, because it seemed to me economists became less interested in the country, in economies or in countries, and much more interested in internally consistent models. And for a model to be consistent, you have to make assumptions that simplify the models, but these assumptions are so unrealistic that they no longer reflect the economy.So we have very strong models in economics. For example, the Lerner symmetry theorem that argues that countries that see increases in exports see equivalent increases in imports, and that’s simply not true. You only have to look at China to see exports are rising and imports are declining. But most academic economists in the U.S., I would argue, sort of ignore China. It isn’t as real as the models.

I think when you’re outside of China, and most of my career has been in Latin America, Asia, outside of the U.S., I think there’s a much more realistic view of the relationship between economic theory and economic practice and actuality. So what I’m hoping is, just as in the 1930s there was a major change in the global balance of trade and payments and a major change in the way we thought about economics, and that happened again in the 1970s, I hope we’re undergoing a new change in the way we think about economics that’s a bit more realistic and a bit more meaningful to people in Wall Street or in government.

DAN KURTZ-PHELAN

That is much of what you get at in your new piece. It’s called “The Global Trading System Was Already Broken.” Michael, thanks so much for writing that and for joining me today.

MICHAEL PETTIS

Thank you.