I spent a bit of time this morning catching up with a couple of unread Michael Pettis posts ( here and here are the links). Lots of good stuff and some particularly fascinating thoughts on trade surpluses, trade wars and the future impact of trade on country specific economic growth.

In his New Years Day post Pettis, not for the first time, expresses his fear that 2010 is likely to usher in an ugly trade war:

I am not sure Chinese policymakers fully understand how vulnerable China is to trade war.  This is perhaps because the “success” of the stimulus package has convinced them that they are less vulnerable to external demand than they originally thought.  But this would be a serious misreading.  The stimulus package has postponed the effect of declining net foreign demand on Chinese unemployment, but has actually increased its vulnerability by increasing the future gap between what China produces and what it consumes.  China needs foreign demand to keep absorbing its excess capacity for several more years while it engineers the difficult transition to domestic consumption-led growth, but I don’t see either China taking the necessary steps to force the transition or foreigners looking very eager to help China through the process.

As if to confirm my pessimistic trade expectations, the US on Tuesday announced that it would impose tariffs on Chinese steel grating.  According to press reports this is a pretty tiny market, so it won’t seem to matter too much to the overall economy, but even though US trade measures against China have generally been so far much milder than Asian or European measures, US measures have far more symbolic meaning and will affect behavior elsewhere.  Here is what the South China Morning Post had to say about it:

The US Commerce Department said overnight on Tuesday it has set preliminary anti-dumping duties of up to 145.18 per cent on steel grating imported from mainland to offset unfairly low prices.

The United States imported about US$91 million worth of the product from mainland last year. Steel grating is used in industrial floors, docks, ramps, drainage covers, staircases and other applications. The trade case is one of about a dozen brought by US companies this year against goods made in mainland, saying they have benefited from government subsidies or are being sold in the United States at less than fair value.

Worse yet, the very influential Paul Krugman has been focusing more than ever on China’s role in the imbalances, and he is clearly arguing that Chinese trade interference (via industrial policies and the currency regime) must be met with US protection.  His most recent piece in the New York Times makes the case that the supposed costs of protection are fictional.

China has become a major financial and trade power. But it doesn’t act like other big economies. Instead, it follows a mercantilist policy, keeping its trade surplus artificially high. And in today’s depressed world, that policy is, to put it bluntly, predatory.

Krugman has an enormous amount of influence in the US and Europe, so his arguments should be worrying a lot of people.

OK, admittedly this isn’t new news and as I said, Pettis has been warning for some time of the probability of protectionism breaking out all over. The push back to this for the last few months has been that it won’t make all that much difference as China and other Asian economies were developing trading blocs that would  make the West an afterthought. In his second post, Pettis has some pretty insightful thoughts about this meme:

This (reduced consumption in the US) is almost certainly good news for the US in the medium term, but if true, needless to say, it seriously undermines hopes that US net demand will revive enough to justify the overcapacity issues exacerbated by China’s fiscal and credit expansion.  There has been some hope that boosting trade with developing countries, and especially with developing Asia, will result in a new source of net demand.  James Kynge said something like this in the Financial Times earlier this week:

Popular narratives sometimes overshoot. One of the latest to outlast its veracity is the conventional wisdom that China’s export engines have been spiked by subsiding consumer demand in the US. This, so the argument goes, leaves Beijing with no option but to spur domestic demand to compensate for lost export revenues.

This became an über-narrative last year. Its snowballing popular appeal was powered by two unassailable charms: it made sense and seemed largely true – but not any longer. Its potency appears set to wane in coming months not so much because of a challenge to its central plot, but by other things happening off stage.

The telling off-stage action is the recent upsurge in trade with south-east Asia and the “newly-rising economies” of Brazil, Africa and India. Although Chinese trade with these places has historically been limited, it has grown so fast in the past five years that a robust performance in 2010 may be enough to offset any moderate weakness in China’s trade with the US.

A friend wrote to me to ask what I thought of this possibility, citing Kynge’s article, and my response (with some editing) was:

The idea that net demand from developing countries can replace net demand form the US is alarmingly widespread, both in China and abroad, and mainly indicates to me a lack of familiarity with the history of developing countries.  The developing world excluding China is roughly the same size as the US, so if you want them to replace the US you need the developing world to run trade deficits of roughly equal to 7% of their GDPs.

Leave aside the huge problem that most developing countries also want trade surpluses and have a stubbornly tough time understanding why they should run deficits in order to help Chinese employment, the historical evidence suggests that just a few years of trade deficits of 2% of GDP will lead to external debt crisis.  For example it took the Asian Tigers just a few years of deficits after 1993-94 to run into the Asian crisis.  Do Malaysia, Indonesia, Vietnam and so on really want to go through that again?  Developing country demand cannot replace the US.  Even Europe cannot replace the US.  This is an unrealistic hope.

No, I think the rapid growth of US consumption relative to (very healthy) US GDP over the past 30 years or longer may have been a special historical circumstance whose life, if not over, is coming to a close.  Except for small countries whose trade surplus can easily be accommodated, I think the days of rapid growth driven by trade-surplus policies may be over.

If Pettis is right, and I happen to think that he is, then the salad days for China might be coming to an end much sooner than many would forecast. Right now their response to the economic downturn has been a vast stimulus program that has added enormously to their productive capacity (and also created a real estate bubble of historic proportions). That there might well not be enough demand to warrant the added capacity seems to not be an alternative that has been considered.

I continue to believe that the Chinese economy is painting itself into a corner from which escape is going to be difficult. They should have used this downturn as the time to pivot aggressively towards a policy that stimulated domestic demand. Instead, they believed like the governments of the West that the solution was to be found in a return to the status quo. It seems increasingly clear that wherever we end up, it isn’t going to be back from whence we came.