Macroeconomic Identity Politics
Trade Policy is as Simple as A + B = C
Every now and then, I like to curl up with an economics textbook and pretend I can decipher the secret language social scientists use to communicate with each other. Even as I struggle to make sense of symbols that all look the muted horn from The Crying of Lot 49, I can’t help but enjoy how economists make their arguments. One delightful analytical tool beloved by economists of all stripes, from hardcore Marxists to softcore neoclassicists, is the mathematical identity—an equivalency that by the rules of logic must always be true.
Here’s an identity you might vaguely remember from algebra:
This formula is true for any numbers you choose for a and b. Try it yourself—if you happen to find two numbers that it doesn’t work for, you’ll have discovered a tear in the fabric of the laws of the universe and the problems I’m about to discuss will seem meaningless in comparison.
In economics and finance, accounting identities describe how all economic activity necessarily creates an equal and opposite response. Every dollar has to be, well, accounted for. If I spend a dollar, someone else gets a dollar. If a save a dollar, that’s a dollar I don’t spend. If the Joker burns a giant pile of cash, there’s a corresponding transaction on the balance sheet of the Federal Reserve. One number goes up somewhere, another has to go down somewhere else.
For no reason related to the news, this week I read Trade Wars Are Class Wars by Matthew Klein and Michael Pettis. The central argument of the book is that trade wars are not “a conflict between countries” but “a conflict between bankers and owners of financial assets on one side and ordinary households on the other—between the very rich and everyone else.” Yep, that sounds like the world.
Their book is not about tariffs, specifically, but Klein and Pettis’ use of deceptively simple accounting identities to illustrate their arguments inspired me to try to make sense of tariffs by playing around with the adjustable slider of macroeconomic identities, like an online auto loan calculator for the entire global economy.
First, a few basic statements that many of us never think about but, because they are logical equivalencies that are by definition always true, make intuitive sense.
Everything the economy produces—its output—must either get consumed or held as an asset or, if there’s extra output lying around in the back, exported. The resulting identity, the national income identity, looks like this:
Gross Domestic Product = Consumption + Investment + (Exports - Imports)
All of that production creates income—every expenditure has to be paid for—which must be divided, like so:
Income = Consumption + Savings
In other words, every penny earned is a penny saved or a penny spent—true for an individual, a country, and the entire world. Because production and income are two sides of the same transaction, we can combine the above two identities:
Consumption + Savings = Consumption + Investment + (Exports - Imports)
A little shuffling of variables brings us to the relevant identity for messing around with trade policy:
Imports - Exports = Investment - Savings
Okay, now we can get into specifics. On the left, we have our trade deficit: we import more than we export. Tariffs are an effort to lower that deficit. If the trade deficit narrows, the difference between investment and savings needs to shrink by the exact same degree. As a result, America would have to pay for more of its investment out of its own domestic savings. See, trade policy is a lot simpler than you thought.
We’ve been told that the purpose of the tariffs is to bring production back to the United States, which means that investment in productive assets—building factories, for example—will increase. In order to keep the two sides of the identity in balance, then, savings will also need to increase. According to the income identity—every dollar has to be either spent or saved—that means spending, i.e. consumption, will have to decrease.
What does that look like in practice? As more of our economic output is devoted to developing production capacity, more of our money will have to be diverted from buying stuff to investing in that development. We’re a nation of people who like to buy stuff, so reducing consumption is the short-term pain JD Vance is talking about, as opposed to the long-term pain JD Vance is.
Michael Pettis, for his part, has emerged as a defender of tariffs. I would never dare be inspired by an economist’s accounting identities and then disagree with him—grad students at the University of Chicago have been shanked for less—but I’m surprised, for reasons I’ll explain in a moment. First, this is what he wrote in Foreign Affairs:
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.
In other words, spending will just be a smaller piece of a bigger pie, so we’ll still be able to buy everything we want. The reason I’m surprised that Pettis is so optimistic about tariffs is because he and Klein persuasively argue in their book that in the higher-savings economies of China and Germany, the gains of production were not shared with households in the virtuous cycle he describes above. They write:
America’s openness to international trade and finance means the rich in Europe, China, and the other major surplus economies can squeeze their workers and retirees in the confidence that they can always sell their wares, earn their profits, and park their savings in safe assets.
The circumstances may not be identical but I doubt American economic elites would behave any better. Nothing that is happening in the United States right now (or maybe, ever) suggests that the gains of increased production would be shared with workers. Squeezing workers and retirees? Where can American billionaires sign up?!
It seems more likely to me that any gains from increased production would be hoarded by the rich, who’d park their earnings in financial assets, like Klein and Pettis show the economic elite in Europe and Asia have done, and domestic real estate, bidding up prices of housing so that it becomes even more unaffordable for everyone else. It’s also not a stretch to imagine that a lot of investment would be in productive assets that require fewer workers—a building boom in factories where robots manufacture other robots.
And what about the rest of the world? The same accounting identities that apply to a domestic economy apply to the entire global economy. In order for the United States to save more, the rest of the world has to save less. Here’s one final mashup of the accounting identities:
Savings = Production - Consumption
As far as I can tell, there are roughly four ways for the rest of the world to save less.
Produce the same amount, consume more. Presumably, this scenario is why Pettis is open to tariffs. Klein and Pettis argue that excessive saving in countries that overproduce are not a result of the trade deficit but the cause, as the United States has been forced to absorb their excess production so that the exporting countries can get their hands on dollars to buy financial assets, like United States Treasuries. A positive outcome of tariff-induced consumption reduction in the United States, then, would be the necessary balancing act of increased consumption in countries like China and Germany.
Produce more, consume a lot more. I’m not sure how this would work. If you’re an exporting country, you’re presumably producing more than can be consumed by domestic demand, and that’s before the United States started buying less from the rest of the world. I assume this scenario would require enormous demand stimulation, likely in the form of government spending.
Produce less, consume the same amount. This sounds like people continuing their spending habits in a shrinking economy, maybe with support of government stimulation, maybe by tapping into their savings—an awful lot like what happened during COVID. This scenario seems very inflationary—the same amount of money being spent on fewer goods and services—but I’m not an economist, my magician-like facility with extremely simple equations notwithstanding.
Produce a lot less, consume less. I think this is a depression?
I have no idea which of these outcomes we’ll see but even the best one, the first one, seems fraught. Reversing the trade-and-finance flywheel Klein and Pettis depict doesn’t seem painless: if foreign buyers have fewer dollars from trade, they’ll buy less—or even sell their huge pile of—dollar-denominated debt, which would in theory cause interest rates here to go up. That could depress both investment and consumption in the United States, which wouldn’t be good for anybody.
We also want other countries to have money. Not only because it’s insane to think you can “win” a trade war—we’ll finally get back at Japan for buying Rockefeller Center!—but because we ultimately need foreign markets for our own goods and services. Wasn’t that the idea behind the Marshall Plan? A devastated and impoverished Europe couldn’t afford to buy American soda and guns.
Sloppy protectionism shouldn’t turn us all into doctrinaire free-traders, but if Trade Wars Are Class Wars convinced me of one thing, it’s that trade policy on its own can’t make the economy more fair. My own politics are partial to pro-labor, fair trade policies, but building a bunch of factories in the United States is not an end in itself. The jobs at those factories have to pay their workers enough to be able to afford what they—and other workers—produce. If our national output increases but our consumption doesn’t, we’re no better off as a country. Where a factory is built matters a lot less than how much a country’s workers get paid.