WHY TRADE WAR IS VERY LIKELY TO BREAK OUT THIS YEAR / THE FINANCIAL TIMES COMMENTARY & ANALYSIS ( HIGHLY RECOMMENDED READING )

Why trade war is very likely to break out this year

By Michael Pettis

Published: January 26 2010 20:20

For two years some commentators have been arguing that the contraction in global demand set off by the 2008 crisis would lead almost inevitably to a trade war, following much the same path that the world took in the 1930s. With anger already being expressed over disordered currency markets by several leaders before the meeting of the Group of Seven wealthy nations in Iqaluit, Canada, next month, it is beginning to look as if 2010 will be the year that proves them right.

This should cause alarm. A breakdown in trade will slow the global recovery and create hostility and mistrust between major economies, making a resolution of important global problems, including the environment, terrorism and nuclear proliferation, unlikely. If trade issues are to be resolved optimally, policymakers in the leading economies must begin by understanding how difficult the problems are for their counterparts.

Like the US before the 1930s Great Depression, China has benefited from a decade of surging productivity growth and an undervalued currency to claim an outsize share of global manufacturing and a relatively small share of global consumption, which requires it to export the surplus abroad.

As long as global demand surged, this was not a problem. But the global financial crisis set off a contraction in debt and of excess demand in overconsuming countries. China, like the US in 1930, has done everything it can to maintain its ability to export excess production, but Asian trade rivals and western importers, like Europe in 1930, are having none of it. The result is that trade is increasingly the centre of conflict, as it was after 1930.

Since, as in 1930, each side has misunderstood or underestimated the others’ problems, it is hard to imagine trade disputes being resolved optimally. Escalating tensions, aggressive actions and reactions and a slower global recovery are more likely.

China’s problem is that it cannot change its reliance on foreign net demand quickly enough. Rebalancing the economy away from overproduction and towards domestic consumption is a long and difficult process. The historical precedents are clear.

But it is also politically unacceptable for trade-deficit countries, especially in the developed west, to accept the high unemployment consistent with leakage of demand to trade-surplus countries. With 10 per cent US unemployment – and higher in some European countries – few will see the benefits of permitting domestic demand to be absorbed abroad to maintain employment in China.

Beijing needs to understand that the world cannot continue indefinitely accepting policies, such as an undervalued exchange rate and excessively low financing costs, that force China’s consumers to subsidise its exporters. Washington and Brussels must understand that China cannot possibly rebalance quickly without causing massive disruptions to its own economy. Unless they expect Beijing willingly to engineer a transition that causes domestic manufacturing to collapse and unemployment to surge, the west cannot expect a quick resolution.

Things will get worse before they get better. The massive monetary expansion engineered by the world’s major economies to protect themselves from the effects of the financial crisis has temporarily reduced the economic pain, but perhaps only at the cost of exacerbating the underlying imbalances. The US and European governments have postponed the necessary rise in savings. China has pumped money into increased production or into economically unviable infrastructure investment, which, since it must be paid for by China’s long-suffering consumers, will continue to inhibit consumption growth.

As a result the trade imbalances are more necessary than ever to justify increased investment in surplus countries, but rising unemployment makes them politically and economically unacceptable in deficit countries. Rising savings in the US will collide with stubbornly high savings in China.

Unless a long-term solution is jointly worked out immediately, trade conflict will worsen and it will become increasingly hard to reverse offensive policies. Most importantly, if deficit countries demand structural change faster than surplus countries can manage, we will almost certainly finish with a nasty trade dispute that will slow the global recovery and poison relationships for years. Our new decade should not start out so badly.

The writer is a finance professor at Peking University and an associate with the Carnegie Endowment

Copyright The Financial Times Limited 2010.