Book review: Trade Wars are Class Wars

It's all connected.

I finally got a chance to read Matthew C. Klein and Michael Pettis’ book, Trade Wars Are Class Wars: How Rising Inequality Distorts the Global Economy and Threatens International Peace! And I have a fair amount to say about it.

These are two authors you should know. Pettis is a finance professor at Peking University in Beijing, generally regarded as China’s top university. For years, he has warned about capital misallocation in China; now, the real estate crash that started with Evergrande seems to have decisively proven him right. Klein is a finance writer who now writes a Substack called The Overshoot, and has long promoted an approach to macroeconomics similar to what Pettis uses (which we’ll get to later). The two make a very natural team, and I hope they write more together.

Trade Wars are Class Wars offers a provocative thesis — that what looks like economic competition between nations is actually just a manifestation of economic competition between classes within those nations. From the introduction:

Regular people everywhere are being deprived of purchasing power — and tricked by chauvinists and opportunists into believing that their interests are fundamentally at odds. A global conflict between economic classes within countries is being misinterpreted as a series of conflicts between countries with competing interests. (p. 2)

The authors present this as an optimistic idea. After all, if class wars are driving everything else, then we can solve the world’s economic imbalances by focusing on domestic redistribution instead of international conflict. Instead of shouting about China and voting for Donald Trump, Americans could shout about our own super-rich. Instead of getting mad at America, Chinese people could get mad about their own nexus of corrupt politicians and inefficient companies.

Personally, I’m not as sanguine. Even if Pettis and Klein are right, history is not exactly on our side here; class wars tend to be intractable things, and there are many examples of nations engaging in self-destructive wars to serve the interests of their ruling classes. World War 1 comes to mind.

But despite my pessimism on that score, the thesis is a provocative and important one. And on their way to making the promised argument, Pettis and Klein detour through a dizzying array of other topics — theories of trade, the reliability of trade statistics, the history of global growth, and the recent economic situations of China, the U.S., and Germany.

In fact, I should say up front that in my opinion, the book’s massive scope ends up being its main weakness. Most books of this type are too short — they’re essentially just two or three blog posts with a lot of padding, because our culture insists that books be accorded a greater intellectual gravitas than blog posts. But Trade Wars are Class Wars suffers from the opposite problem — in just 232 pages, it attempts to unify trade theory, business cycle theory, and growth theory, while also teaching a quick course on data interpretation and recapping tons of current events. This combination of sprawling ambition and low page count forces some sacrifices, as we’ll see.

Despite that, however, Trade Wars are Class Wars is an important book about the important but under-written topic of international macroeconomics. It deserves a place on the shelf next to books like Reinhart & Rogoff’s This Time is Different, Ahmed’s Lords of Finance, and Tooze’s Crashed. So let’s dig in a bit and go through what’s in this book.

Trade statistics and their discontents

The first chapter of the book starts with a whirlwind history of global trade, but quickly turns into a seminar on why commonly used trade numbers are wrong. This is a very important thing that few commentators know about (and even fewer, sadly, bother to take into account).

We usually hear a lot about the U.S.-China trade deficit. And it is really big. But it’s not as big as you think. Roughly, there are two huge things wrong with these numbers.

First, imports and exports don’t actually reflect the value added within a country. If Japan and Korea ship complex, expensive iPhone parts to China, and a Chinese worker slaps them together and ships them on to American consumers, the whole value of the iPhone gets counted as a Chinese export to the U.S. even though the amount of economic value added in China was miniscule. That can make Chinese exports to the U.S. look bigger than they are.

The second problem is profit-shifting. When corporations get taxes on their profits, they can game the system by using various accounting tricks to pretend that their production is taking place in a low tax country. Goldman Sachs issued a report about this back in 2017 (which I wrote about), which included the following chart:

These are both very useful things to know, for when read the newspaper or your favorite economic blog and think about trade numbers. It’s not clear how the section fits with the rest of the book (except to justify the authors’ use of current account numbers, which are less subject to these distortions). But to be honest I don’t really care — it’s interesting, and it’s informative, and I like reading about interesting and informative things.

A Grand Unified Theory of macroeconomics?

In the third chapter, Klein and Pettis lay out the theoretical framework that they use to think about everything else in the book. In other chapters, they use this framework to try to explain practically everything in the macroeconomy — growth and development, booms and recessions, imports and exports.

It’s a version of sectoral balances theory.

Sectoral balances start with account identities. These are definitions, which divide one number that we can measure (say, GDP) into other numbers we can measure. For example, the most famous accounting identity is the national income accounting identity:

GDP = Consumption + Investment + Government Spending + Net Exports

or in its simplified form:

Y = C + I + G + NX

There are other identities, such as the fact that savings equals investment (by definition), or the balance of payments identity that relates the current account to the capital account.

It’s very important to understand these identities, but by themselves they can’t give you a theory of how the economy works. They’re just definitions. As Paul Krugman wrote back when a lot of us were arguing about this stuff back in 2012:

[E]conomic explanations…have to [describe] how the actions of individuals…add up to interesting behavior at the aggregate level.

And the key point is that individuals in general neither know nor care about aggregate accounting identities…. [I]f you want to claim that a rise in savings translates directly into a fall in the trade deficit, without any depreciation of the currency, you have to tell me how that rise in savings induces domestic consumers to buy fewer foreign goods, or foreign consumers to buy more domestic goods. Don’t tell me about how the identity must hold, tell me about the mechanism that induces the individual decisions that make it hold…. [O]nce you do that, you realize that something else has to be happening — a slump in the economy, a depreciation of the real exchange rate, it depends on the circumstances, but it can’t be immaculate, with nothing moving to enforce the identity….

Accounting identities… inform your stories about how people behave, [they do] not act as a substitute for behavioral analysis.

Modern academic macroeconomics tries to analyze economic behavior using a whole bunch of (usually pretty dodgy) assumptions about how companies and consumers behave. Sectoral balances theory makes a different set of assumptions — it assumes that the components of accounting identities are autonomous, i.e. that they move around on their own. Instead of making assumptions about the people who invest and consume, sectoral balances makes assumptions about how various policies or economic changes affect investment, consumption, etc. directly.

That makes sectoral balances pretty simple. You can look at America’s debt binge in the 2000s and say “Americans had to borrow because other countries wanted to save.” But you can just as easily say “Americans wanted to borrow, so other countries decided to lend to them.” Those are two very different stories that both match the data. To know whether to expect a repeat of the 2000s in the future, though — or how to avoid a repeat — you need a deeper causal story.

That’s why I’ve always been a bit leery of sectoral balances thinking, despite the fact that most people in the private sector use it. Because the assumptions about the behavior of various economic aggregates seem tailored to each situation, it feels more like a vehicle for telling just-so stories than a tool that can be used to predict the result of a policy change or an economic shock.

Which is why I agree with Krugman that to really understand the economy you’ve got to add nuts and bolts about how the various pieces of the economy influence each other. You’ve got to think about things like prices — import and export prices, exchange rates, interest rates. You’ve also got to think about things like aggregate demand and aggregate supply. And so on.

Klein and Pettis are thinking about these things in the background. But because of the book’s extreme brevity, they don’t have much of a chance to talk about them. And so they end up writing things like:

When resources are abundant, however, trying to save by consuming less is wasteful and counterproductive. People who could be working are left idle even as desires remain unfulfilled. Fields lie fallow as the hungry starve. (p. 66)

They’re talking about the Paradox of Thrift. Excess demand for cash can produce a shortfall of aggregate demand, causing a recession (which is why we use fiscal stimulus to jog the economy out of a recession, because it prompts people to spend more). But the Paradox of Thrift doesn’t always hold. In a boom, when interest rates are well above the zero lower bound, people consuming less and saving more really could accelerate economic growth, by lowering interest rates and making capital cheaper for companies that want to borrow.

Because Klein and Pettis are being very brief, they just shorten this to “When resources are abundant”. Which probably leaves a lot of readers scratching their heads and asking “When are resources abundant?”

Here’s just one more example:

Trying to promote additional investment through higher saving is often counterproductive. The simplest way to raise the saving rate is to spend less on consumer goods and services. Unless investment immediately rises to offset the decline in consumption, however, the result is less total production[.] (p. 80)

This, as it’s written, is simply a tautology. Yes, obviously, if investment fails to rise, it will fail to rise! The real question — which Klein and Pettis are too rushed to go into — is why it wouldn’t rise. One possible answer, again, is that the economy is demand-constrained, so the Paradox of Thrift is in effect. Another possible answer is that there’s a breakdown in the financial system that prevents savings from financing productive investment. And so on. If we want to know when increasing savings rates will boost growth and when it won’t, we need to know more.

This sort of condensed writing can make Trade Wars are Class Wars feel at times like a T.S. Eliot poem — the kind of thing you’ll only understand if you’re already in the know and can catch all the references.

And I think this ultimately makes the book’s theory chapter of questionable value. Sectoral balances thinking seems intuitively easy, because the math is all just addition and subtraction. But in fact, it’s really hard to use it effectively — you have to know a lot about the institutional context of each situation, and it really helps to understand underlying economic mechanisms like prices (which Trade War are Class Wars very rarely talks about). My guess is that it would take a 500-page book to teach readers how to apply sectoral balances thinking effectively. But Klein and Pettis only have time to give readers a whirlwind tour.

The chimera of Chimerica

Trade Wars are Class Wars recovers its footing when it goes back to narrative history, especially of the U.S. and China in the 2000s and 2010s. This is where the combination of Klein’s knowledge of U.S. economic history and Pettis’ understanding of China’s economic system really complement each other.

The basic story that Klein and Pettis tell about the last two decades is a familiar one by now. China’s desire to pump up exports, along with a desire to avoid any repeat of the 1997 Asian Financial Crisis, caused it to buy a lot of U.S. bonds. This meant lending a lot of money to the U.S., which Americans eventually borrowed to buy houses that — because of rising inequality — they couldn’t afford. After the financial crisis and the Great Recession upset that apple cart, China switched to building a ton of (sometimes useless) buildings, while the U.S. got its cheap money from Europeans who wanted a safe place to stash their cash.

This is where the “class wars” come in. America’s rich people were perfectly happy to see America lose factory jobs to China as long as their stock and real estate portfolios went up, thanks to the influx of cheap money. And China’s well-connected corporate overlords were happy to see more resources funneled their way. The trade imbalances between the U.S. and China enriched the rich and powerful on both sides of the Pacific, so they saw fit to let the situation continue.

Klein and Pettis also rightfully point the finger at the dollar’s status as the “reserve currency”. This isn’t any sort of official or legal status — it just means that central banks around the world like to hold their reserves in dollars. This creates an “exorbitant privilege” for Americans who want to borrow cheaply, but it also pushes up the dollar’s value relative to other currencies, but an “exorbitant burden” for the working-class Americans hurt by trade imbalances.

Of course, the only way to end the dollar’s reserve currency status is to get other countries — China, Europe, etc. — not to want to hold so many dollar-denominated reserves. It’s not clear how that would be accomplished. But so far, middle-class and working-class Americans don’t even realize that it’s in their class interests to do it at all. People probably think of a “strong dollar” as somehow indicating American strength, rather than simply meaning that U.S. exports are overpriced.

It would be good, in other words, if more people heeded Klein and Pettis’ call to rebalance the international reserve system away from over-reliance on the dollar.

So…are trade wars class wars?

And so here we get to the book’s primary thesis. The authors only return to it in the conclusion, having reached it by a circuitous route that took them through history, data, theory, and more history.

The conclusion they ultimately draw is more nuanced than the one initially promised (and that’s a good thing, since nuance is good). In Klein and Pettis’ telling, global imbalances feed inequality in the U.S., but the fundamental cause isn’t inequality. In fact, they freely admit that it’s a bit of a mystery why transferring more of the country’s income to the rich — who consume far less of what they earn — hasn’t reduced consumption.

The real force hurting America, in this story, is the dollar’s reserve currency status — which is all about other countries’ financial choices. Economic redistribution in the U.S. would ameliorate the harm from those imbalances, but it wouldn’t discourage other countries from buying dollars.

As for China (and Germany), the story is more straightforward — mercantilism is being driven by the class interests of rich industrialists. In these countries, perhaps, economic redistribution would put a stop to the problem, by transferring resources to the consumption-hungry middle classes and poor.

But in China’s case, I wonder. What if there was another reason for the country to engage in mercantilist policy and pump up investment at the expense of consumption? Over the last year, we’ve seen Xi Jinping try to reshape China’s economy in ways specifically designed to increase national power vis-a-vis the country’s rivals. That includes a heavy emphasis on manufacturing.

What if China’s persistent current account surpluses aren’t just a sop to well-connected industrialists, but also a strategy to build its manufacturing base at the expense of America’s? And what if the purpose of that, at least in the minds of the country’s top leaders, is to be able to overmatch America in a grander version of the bloody struggle we now see playing out on the plains of Ukraine?

In other words, what if some trade wars are just…wars?

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