The Pettis Paradigm and the Second China Shock

Wow, two China-related posts in two days! This one is going to be less dire and more wonkish than yesterday’s, because it’s about China’s economy and the international trade situation, instead of about war and conflict. (The two aren’t entirely unrelated, of course.)

China has a huge and growing trade surplus, as you can see in the chart above. That chart is via Brad Setser, who is really a one-man army in terms of tracking global trade and financial flows. Here’s a thread from Setser with a lot more detail on China’s surplus. Interestingly, China’s exports to the developing world are a lot bigger of a factor here than its exports to the U.S. and the EU, though the latter are up by a little bit.

This is the Second China Shock. Trade surpluses like this can’t be explained by the good old theory of comparative advantage — a Chinese trade surplus is just countries writing China IOUs in exchange for physical goods. Countries don’t really have a comparative advantage in writing IOUs.¹

Why trade surpluses and deficits do happen is an important and interesting and complex question, and my general impression from reading a bunch of economics papers on the topic is “No one really knows”. It probably has something to do with the fact that China’s government is directing its banks to loan vast amounts of money to manufacturers, and paying manufacturers tons of subsidies on top of that. But there also has to be some sort of financial factor involved that prevents China’s currency from appreciating and allowing Chinese people to buy more imports. This could be something the Chinese government is doing intentionally, or it could be a natural outgrowth of China’s economic difficulties. More on this later.

The question is what to do about the vast flood of Chinese exports. Overwhelmingly, from all sides of the commentariat, there has been one main policy proposal² for the world outside of China: tariffs on Chinese goods. The MAGA people, obviously, endorse this idea — tariffs are one of their big policy ideas.

In addition, some commentators suggest that China should shift its economic model toward promoting domestic consumption instead of yet more manufacturing. Many of the people suggesting this are private-sector macroeconomists who work for banks, writers, or other private-sector analysts. But notably, Paul Krugman has said similar things. Many commentators who don’t explicitly endorse tariffs will nevertheless say that if China doesn’t shift toward consuming more of what it produces, the world inevitably will put tariffs on Chinese goods.

The “other countries should put tariffs on China” idea and the “China should shift its economy toward domestic consumption” idea are unified in the worldview of Michael Pettis, who has advocated both things. He has been saying that China needs to increase the share of consumption in its domestic economy for well over a decade, and it seems to me that more than anyone, he is responsible for injecting this idea into the discourse. And in an article in Foreign Affairs in December, Pettis laid out a case for tariffs:

Today, [unlike in the 1930s], Americans consume far too large a share of what they produce, and so they must import the difference from abroad. In this case, tariffs (properly implemented) would have the opposite effect of [the] Smoot- Hawley [tariffs of the 1930s]. By taxing consumption to subsidize production, modern-day tariffs would redirect a portion of U.S. demand toward increasing the total amount of goods and services produced at home. That would lead U.S. GDP to rise, resulting in higher employment, higher wages, and less debt. American households would be able to consume more, even as consumption as a share of GDP declined…

Thanks to its relatively open trade account and even more open capital account, the American economy more or less automatically absorbs excess production from trade partners who have implemented beggar-my-neighbor policies. It is the global consumer of last resort. The purpose of tariffs for the United States should be to cancel this role, so that American producers would no longer have to adjust their production according to the needs of foreign producers. For that reason, such tariffs should be simple, transparent, and widely applied (perhaps excluding trade partners that commit to balancing trade domestically). The aim would not be to protect specific manufacturing sectors or national champions but to counter the United States' pro-consumption and antiproduction orientation.

Pettis’ views on trade policy, and his whole way of thinking about international economics, has drawn pushback from some economists. For example, in September 2023, Tyler Cowen questioned the focus on Chinese domestic consumption as a target for Chinese growth policy. As an alternative, he suggested that China should focus on improving certain dysfunctional service sectors like health care, which will increase both consumption and production.

In November, Pettis vented his frustration with the academic economics establishment in an X thread:

If you want to understand the effects of trade intervention, its ok to ask economic historians, but never ask economists. That's because their answer will almost certainly reflect little more than their ideological position…It was direct and indirect tariffs that in 10 years transformed China's EV production from being well behind that of the US and the EU to becoming the largest and most efficient in the world…Tariffs may not be an especially efficient way for industrial policy to force this rebalancing from consumption to production, but it has a long history of doing so, and it is either very ignorant or very dishonest of economists not to recognize the ways in which they work…To oppose all tariffs on principle shows just how ideologically hysterical the discussion of trade is among mainstream economists.

Tyler responded ascerbically:

I am usually loathe to turn [Marginal Revolution] space over to negative attacks on others, but every now and then I feel there is a real contribution to be made. I have been saying for years that Michael Pettis flat out does not understand international economics, and yet somehow he is treated as an authority in the serious financial press. Here is his recent tweet storm. It is wrong.

As you know, any time there’s an economist food fight, especially over macroeconomics, I am here for it! I wish Tyler had elaborated on his criticisms of Pettis’ paradigm, and I also think Pettis is being unfair in his blanket accusations of ideological bias.

But in any case, I think I have four points to make on this topic.

International economics is really, really hard

The first point is that as far as I can tell, nobody really understands international economics. It’s basically macroeconomics on steroids. There are a huge number of factors that make issues of tariffs, trade surpluses, and the effect of trade on consumption vs. investment very complex. Some of these factors are:

• There are many countries in the world, not just two. Although we tend to think about bilateral trade deficits, in fact third parties matter a lot, and there are a lot of them. For example, if China’s trade surplus with America goes down, it might be because China is exporting more components to Vietnam for cheap final assembly, to be shipped onward to American consumers.

• Business cycles matter a lot. If countries are in a depression-style situation where interest rates are at the zero lower bound (a “liquidity trap”), a number of standard results about the effects of trade policies — and results about how monetary and fiscal policy affect trade — go out the window. Right now, there are signs that China is in that situation, but the rest of the world is not.

• Tariffs interact with monetary and fiscal policy. For example, if the U.S. puts tariffs on China, China might try to cancel those tariffs out by printing a bunch of money, which would make the yuan cheaper. These sorts of interaction depend on understanding how monetary and fiscal policy work (which we don’t really), and also on understanding how policymakers in countries around the world make decisions about monetary and fiscal policy (which we definitely don’t understand).

• Exactly why international trade happens in the first place isn’t well understood. There’s the classic theory of comparative advantage. There are theories based on capital-intensive countries investing in labor-intensive countries. There’s Krugman’s “New Trade Theory”, which focuses more on differentiation and variety as the motivation for trade. And so on. The most empirically successful models of trade are just very simple equations called gravity models, which are agnostic on why trade happens, and could arise from a variety of different processes. This means we don’t really know the baseline of what trade between the U.S., China, and other countries would look like without Chinese industrial policies or currency market intervention.

• There are all kinds of wrinkles and complications that affect trade, called “frictions”. These include things like home bias in both consumption and financial investing, sovereign default, currency market frictions, and so on. Economists argue back and forth about which of these frictions cause the various “puzzles” in international trade — disconnects between theory and evidence — or whether that’s just how trade works in the first place.

• Competition (also called “market structure”) can throw a wrench into all of this. Trade is carried out by companies, and whether Chinese companies and American companies end up making profits on their exports and their domestic sales will affect how they behave. Domestic competitive environments and international competitive environments both matter, and neither one is particularly well-understood.

In graduate school, I took a class in international finance. The professor who taught that class was known for using advanced mathematical methods borrowed from engineering to make models in which two different frictions interacted to affect international trade. That was a big improvement over the standard theories that could only handle one friction. But what if you have seven? It’s hopeless.

I think that one reason no one has come up with an alternative to Michael Pettis’ ultra-simple way of analyzing international economics is that anything more complex that that quickly balloons into an absolute nightmare. Making big sweeping assumptions about how tariffs will affect production and consumption isn’t exactly the most rigorous or empirically testable way to think about trade and industrial policy, but if the alternative is a blizzard of unworkable math that probably still makes way too many simplifying assumptions, maybe you just go with the simple thing.

Also, Pettis’ paradigm isn’t that different from some of the heuristic ideas that orthodox economists have used to analyze trade policy. For example, Ben Bernanke’s