So it begins. President Trump has launched the protectionist trade policies against China that he has long promised. Whether this will cause a maelstrom in the global economy through a tit-for-tat trade war will depend on the composure and trigger finger responses of policy makers on either side. That said, it does not look promising.

Cui Tiankai, Chinese Ambassador to the US stated: “We are not afraid of [a trade war] . . . We will certainly fight back and retaliate. If people want to play tough, we will play tough with them and see who will last longer.” Indeed, China has already announced $3 billion of import taxes on US products in response to Trump’s $50 billion of tariffs, and signalled that there is yet more to come. No doubt economists and commentators around the world will be kept occupied over the weeks and months ahead debating who will lose more from such a trade war. This piece does not seek to answer those questions; instead it seeks to offer an account of how we got to where we are today and where we might be heading in the future. It posits that the US might be able to reduce its current account deficit from these protectionist measures, but simultaneously it erodes its ability to lead the international economic system (IES).

Let’s start by acknowledging that there are huge imbalances in the IES. Indeed, large and persistent global capital and trade imbalances played an important role in causing the Great Financial Crisis[1]. Being at the centre of the IES, with the world’s reserve currency, the United States was forced to absorb global excess savings in what Bernanke (2005) described as a “savings glut”. This promoted excessive consumption in the US, which manifested itself, most vividly, in a housing market boom driven by credit and risky borrowers.

To understand the IES today, it is instructive to rewind over one hundred years when the United States first began to emerge at the centre of global trade and capital flows. At that time, the US was running a current account surplus and capital account deficit (i.e. it exported capital abroad)[2]. From the start of World War One until the 1960s, the world became capital constrained[3] and reliant on US capital exports to finance wars and then to rebuild nations after them. Yet, once nations had been rebuilt, there was less of a need for US capital exports and instead what nations wanted from the IES was additional demand through selling goods and services abroad. With its flexible financial markets, the US was able to reconceptualise its role at the heart of the international system and went from running current account surpluses to current account deficits, and from capital exporter to capital importer. Through buying goods from the world, the US provided nations with additional demand in a world that was savings abundant and demand deficient. We have lived in this savings abundant world since the 1960s, and the US, through absorbing the world’s excess savings and providing liquidity to facilitate global trade, has cemented the dollar’s role as the world’s reserve currency.

However, being the world’s reserve currency comes with its own risks, and leadership has a cost, the strains of which are clearly beginning to show. As John Maynard Keynes argued in the 1940s, and built on by Robert Triffin in the 1960s; to maintain its position as the world’s reserve currency the United States needs to willingly supply dollar assets, namely US treasuries, to global markets in order to facilitate global trade and provide the necessary liquidity for global economic growth. While running this large capital account surplus, the US must necessarily run a large current account deficit, accepting a build-up of debt[4] and appreciation pressure on its currency which reduces American competitiveness, especially in the tradable goods sector.

These forces have been exacerbated by the excessive hoarding of dollar assets, above and beyond what is required for precautionary purposes, particularly by Japan, Germany and most recently, China. These countries deliberately held their currencies at below fair value for the benefit of their tradable goods sectors; perpetuating global trade and capital imbalances. For a long time, the US absorbed the costs of leadership, partly for political reasons[5], partly for prestige but also to acquiesce to the lobbying power of a financial sector that thrived on a strong dollar. With the election of Donald Trump, the withdrawal from TPP and now the issuance of tariffs, the US has come to realize (albeit not explicitly) that dollar centrality is not an “exorbitant privilege” but instead, an “exorbitant burden” (Pettis, 2013).

The shortcomings of the existing IES are not just felt in the United States. The financial crisis has exposed inherent fragilities in the global monetary system as conflicts between the needs of the American economy and international economy became more apparent. As the United States tried to boost domestic demand, it created excess liquidity in global markets and increased volatility in emerging markets[6]. Moreover, if the US tries to ease inflationary pressures at home it may fail to meet the world’s demand for liquidity. As former People’s Bank of China Governor Zhou argued in a famous speech in 2009, “the costs of such a system to the world may have exceeded its benefits. The price is becoming increasingly higher, not only for the users, but also for the issuers of the reserve currencies”.

Historical experience tells us that systems with persistent imbalances risk collapse[7]. Collapse does ultimately bring reform – but the adjustment costs of moving to the new system are significant. With Trump’s introduction of tariffs and the increasing risk of a trade war, the probability of system collapse just became much greater. The tariffs are more than just a short-term tool to punish China; they symbolize the start of a process where the United States rejects its role at the heart of the IES. While Trump’s trade policies fit with his narrative of “America First”, and may well lower the current account deficit – they crucially undermine the US’ ability to lead the IES – most visibly through declining dollar centrality. That’s because, leadership in today’s IES necessitates high current account deficits. Through turning its back to that reality, the US is implicitly stepping away from the international economic system it has led since the end of World War One.

This is part one of a two-part series that discusses Trump’s tariffs, China’s response and global capital and trade flows. Part two will consider the notion that China can replace the US at the heart of the international economic system, as well as discussing responses to the tariffs and the design of a more sustainable international economic system based on multiple key stakeholders, as opposed to simply the US.

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[1] See, for example, Rajan (2010) and Pettis (2013)

[2] A current account surplus necessarily means a capital account deficit and vice-versa, so to ensure the balance of payments sums to zero.

[3] Most famously, in the 1950s when countries needed dollars to buy US goods, they were unable to do so due to a dollar shortage

[4] Such a build-up of debt does not need to be problematic if there exist productive investments in the US, but the financial crisis, excessive consumer debt and real estate boom might suggest the US is beyond this point.

[5] An argument can be made that the US accepted these costs for their geopolitical advantages. This was a key feature of the cold war period. A more contemporary example is TPP, where it was widely viewed as geopolitically more advantageous for the US as opposed to economically.

[6] For example, in India, the rupee fell by over 20% in 2013 during the US ‘taper tantrum’

[7] We can see this with gold standard post World War One