• Paul T. Rubens

Testing the Limits of Faustian Trade Relationships

In all Faustian agreements, it's critically important for each party to fully understand and fulfill their end of the agreed terms. This is clearly not happening today with the US and China on trade.

The concepts of free trade were conceived during the time of a gold standard, which provided a self-correcting mechanism to keep trade imbalances in check. Deficit countries parted with their gold in exchange for goods. Their currencies depreciated and became more competitive, leading eventually to an improved trade balance. As trade deficits grew in the 1960s-70s, the US chose to abandon its commitments to the gold standard, finally under the Bretton Woods agreement, rather than part with all of its gold reserves. The mechanism for determining the value of the dollar was handed over to the US Treasury and Fed. Free trade was upheld in theory, but a new the era of managed trade was born.

The US is turning to managed trade once again to guide US trade imbalances with China onto a more sustainable trajectory and move away from large, long-term, structural trade deficits. Tariffs are blunt force objects of choice, alongside efforts to further open China's market to US goods. Some question whether there is even a need to reduce large trade imbalances in today’s global economy. The US needs that liquidity to fund its persistent budget deficits, supported by an ever-rising debt ceiling. As we saw in the 2008 global financial crisis however, things tend to work and keep working until they just hit a wall and no longer work. How realistic is it to think dollar hegemony will last forever, or that the US will be able to borrow amount x at the rate of y, in perpetuity?

The US trade imbalance with China began to accelerate under the Presidency of George Bush with China’s ascension to the WTO in late 2001. In the early 1980’s, large trade imbalances with Japan were tolerable under a tacit agreement that surpluses would be re-invested in US treasuries and other assets, enabling US rates to stay lower and help finance structurally high budget deficits. A critical third part of this Faustian arrangement, in the form of the Plaza Accord of 1985, led the US Dollar meaningfully lower against the Yen and Deutschemark, effectively monetizing the new US debt. What would be the effects on China’s economy of a similar quantum appreciation in the RMB? Just half the level of appreciation the yen experienced would equate to the RMB moving from the current 6.3-level to below 5 against the dollar – levels undoubtedly viewed by Chinese negotiators as patently absurd and potentially destabilizing.

Global trade imbalances, particularly between the two largest economies, have grown to unsustainable levels. A US-led trade model has allowed trade deficits to persist and trade surplus countries to grow faster than they otherwise would have, while also helping facilitate U.S. budget deficits and necessitating continued increases in the U.S. debt ceiling. The Faustian arrangement, whereby investment flows are recycled back to the US to keep interest rates low and help fund structural budget deficits, while surplus countries appreciate their currencies against the dollar to effectively monetize new debt, is not mutually agreed upon by the U.S. and China at present. What does the sustainable path of global economic growth and cooperation look like? Finding a mutually acceptable framework requires a thorough understanding of how the relationship has evolved to date and an appreciation of mutual objectives of growth, peace and prosperity.