Created in Bretton Woods, New Hampshire, in 1945, the post-war world trading system involved foreign countries holding U.S. dollars as a reserve asset and using U.S. dollars to conduct global trade. With the U.S. dollar as the world’s reserve currency, the United States has provided the world with dollars by running a trade deficit, while the rest of the world has provided the United States with dollar support and cheap financing.
America First versus Bretton Woods
In the context of an increasing risk that the United States instigates a trade war, I would suggest that the United States can choose an America First trade policy with balanced trade and balanced capital flows, or the United States can choose to maintain trade deficits and import capital to fund its national savings deficit. It cannot do both. Mathematically, the United States cannot pursue a balanced trade deficit and also import capital to fund its increasing level of borrowing; after all, the balance of payments must – by definition – balance. Furthermore, if the United States ceases running a trade deficit, it cannot also provide the world with dollars with which to conduct trade.
In order to allow for U.S. exports to balance U.S. imports, everything has to change.
In recent months, U.S. Trade Representative Robert Lighthizer discussed the Trump administration’s willingness, if necessary, to dispose of those institutions that have facilitated global trade since World War II in order to reduce the U.S. trade deficit with China:
The sheer scale of their [China’s] coordinated efforts to develop their economy, to subsidize, to create national champions, to force technology transfer, and to distort markets in China and throughout the world is a threat to the world trading system that is unprecedented. Unfortunately, the World Trade Organization is not equipped to deal with this problem. The WTO and its predecessor, the General Agreement on Tariffs and Trade, were not designed to successfully manage mercantilism on this scale. We must find other ways to defend our companies, workers, farmers, and indeed our economic system. We must find new ways to ensure that a market based economy prevails.
Demise of the Bretton Woods Trading System?
Paul Krugman raised the problem with balancing trade under the Bretton Woods system in 2013 when he suggested that U.S. protectionist policies, once implemented, would “break up the whole world trading system we’ve spent almost 80 years building.” That world trading system includes those supranational institutions such as the International Monetary Fund (IMF), the World Bank, and the World Trade Organization (WTO) which were created at Bretton Woods and have supported the growth of global trade and global capital flows since then.
It is difficult to imagine these institutions surviving an era where the United States is no longer willing to work through them to resolve trade disputes. Supporting Lighthizer’s views, in January 2018, U.S. Secretary of Commerce Wilbur Ross participated in a panel at the World Economic Forum in Davos, Switzerland and agreed that it is finally time to break up the world trading system created at Bretton Woods in the aftermath of World War II:
Let me give you my version of post-World War II history… It was deliberate U.S. policy to help Europe and Asia recover from the ravages of the war… It was good policy globally and, at the time, all the way until the 1970s, we had trade surpluses every single year, so it was an affordable policy decision (for the U.S. to reduce trade barriers). I think one of the ways they went wrong was not time limiting it… Concessions that were totally appropriate to Europe or China or Japan in 1945 are singularly inappropriate as we sit here this year (2018)… Now we’re left with the cumulative effect of it, and we are trying to deal with it in a very short time period.
The video can be found below, with Wilbur Ross speaking beginning at 19:00.
With the support of global institutions like the WTO, the largest U.S. export has been U.S. Treasuries for the past several decades, and those U.S. Treasuries have been purchased and held by export-driven economies like China, Japan, and South Korea. In December, 2001, China was finally admitted into the WTO, and the People’s Bank of China went on a dollar buying spree immediately thereafter which continued up until 2013. China’s aggressive investments in U.S. Treasuries at a fixed exchange rate suppressed the exchange traded valued of the Yuan, but it also provided structural support for the dollar and financed U.S. deficits.
Transition Risks
Of course, no trading system lasts forever, and the current trading system certainly has its flaws. However, if the Trump administration follows through on its rhetoric to, in Dr. Krugman’s words, “break up the whole world trading system we’ve spent almost 80 years building,” without working with other countries to gradually transition towards a new system, the economic, geopolitical, and financial risks are significant and of an entirely different character than the risks represented by the 1930 enactment of Smoot-Hawley.
Following the logic of where this might end, I have arrived at an important question.
If the United States manages to successfully eliminate its trade deficit, balance of payments math suggests that net capital inflows into the United States would have to cease. If net capital inflows cease, with a record projected budget deficit (per the CBO), where does U.S. deficit funding come from?
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