Rebalancing the world economy: Right idea but wrong approach

Treating a symptom rather than the primary cause, and with outdated medicine

To be certain, significant industrial and agricultural tariff and non-tariff barrier disparities persist, particularly between developed and major emerging economies. Failure to address these adequately was one of the principal reasons for the failure of the last multilateral round of trade negotiations, the Doha Round. The U.S. and other countries eventually gave up on these talks around 2017 because they concluded there was not a satisfactory balance of concessions in them, including with respect to this area.

Thus, at its core, the Trump “reciprocal” trade initiative identifies a long-standing and legitimate concern of U.S. trade policy,² but the administration has mistakenly conflated differences in tariffs and other trade practices with the larger, more macroeconomically driven phenomenon of the level and persistence of the country’s trade deficit. Unfair trade practices are a contributing factor, and the large general tariff increases will lead to some degree of import substitution. But undue reliance on this blunt instrument will lead at least as much to a diversion of imports from one trading partner to another and compression of demand due to the higher prices brought by import substitution and lower income resulting from lost exports due to foreign retaliation.

Trade policy countermeasures like tariffs and industrial subsidies like those enacted during the Biden administration in the CHIPS and Science and Inflation Reduction Acts are essentially microeconomic tools—most effective when targeting products or sectors in relation to specific practices abroad or defense production risks and strategic industrial development opportunities at home. The fundamental drivers of large and persistent trade deficits and currency misalignments remain principally misaligned fiscal and monetary policies, on the one hand, and structural and institutional aspects of domestic economic policy that influence the rate and composition of real economy private investment and household consumption, on the other.

By relying predominantly on the former to address the latter, the administration is effectively treating the superficial symptoms (bilateral trade deficits) of the underlying problem (macroeconomic imbalances) and doing so with an overprescription of an outmoded medicine (a 19th century-like tariff wall) that runs the risk of precipitating a cascading failure of the patient’s (the U.S. and world economy’s) vital functions. The defunct practice of bloodletting, which reportedly contributed to President George Washington’s death from a throat infection, comes to mind.

Just an opening gambit?

For this reason, speculation is rife over whether this latest trade broadside is just an opening salvo, an attempt to gain diplomatic leverage in a larger strategy yet to be announced that will try to induce a more fundamental and far-reaching macroeconomic rebalancing of the world economy. Some of the potential elements of such a grand bargain—e.g., intervention in currency markets, including through taxation and/or long-term lock-in of foreign holdings of U.S. Treasuries in return for relief from the new tariffs and maintenance of the U.S. security umbrella for allies—were outlined in a paper published before the administration took office. Often referred to as a potential “Mar-a-Lago Accord,” these ideas have been greeted with general skepticism, although some respected economists are sympathetic, at least with respect to their strategic direction if not detail.

There are indeed serious unresolved issues in the international monetary system that merit attention. More than fifty years since the world abandoned fixed exchange rates, it is clear that the system is not sufficiently self-regulating. Not infrequently, large current account imbalances and currency misalignments have arisen and persisted, affecting rich and poor countries alike. John Maynard Keynes’ concerns³ during preparations for the 1944 Bretton Woods conference about the asymmetrical burden of adjustment borne by deficit countries continue to echo across the ages. The U.S. dollar’s role as the world’s de facto reserve currency complicates the adjustment process further by tending to boost the dollar’s value and constrain international liquidity.

The last time major global economic imbalances were successfully addressed through an explicit exercise or “deal” in macroeconomic cooperation was in the 1980s. In the 1985 Plaza and 1987 Louvre Accords, the Group of Five (G5)—the United States, Japan, West Germany, France, and the United Kingdom—markedly depreciated and then stabilized a grossly overvalued and deindustrializing U.S. dollar through concerted intervention in currency markets. However, the strategy succeeded in large part because U.S. fiscal policy was by then pushing in the same direction, creating additional space for the Federal Reserve to reduce interest rates. The Gramm-Rudman-Hollings Deficit Reduction Acts of 1985 and 1987 had the effect of reducing annual growth in federal spending from an average of 10% between 1980 and 1985 to 4.6% in 1986 and 1.2% in 1987, contributing to a reduction in the fiscal deficit from 4.9% to 2.7% of GDP between 1985 and 1989.⁴ U.S. interest rates and the dollar’s value followed suit, each declining by about a third from peak to trough between 1985 and 1987.⁵

The jury remains out on whether U.S. fiscal policy will take a similarly reinforcing posture in the years to come. History counsels skepticism. It is not just the recent track record of President Trump’s first term and the Biden administration in running huge deficits during times of full employment that augurs poorly. The two prior Republican presidential tenures (counting those of Reagan and Bush Sr. as one) coincided with large increases in fiscal deficits. The two following Democratic ones spent much of their time and political capital climbing out of the fiscal holes left by their Republican predecessors, which Sen. Daniel Patrick Moynihan memorably described as pre-meditated efforts to “starve the beast.”⁶

Under President Clinton, the deficit declined from 4.7% of GDP in FY 1992 to a surplus in FY 2001. However, he took no joy in the process, at one point grousing to his advisors: “You mean to tell me that the success of the program and my re-election hinges on the Federal Reserve and a bunch of ‘bleeping’ bond traders?”⁷ Similarly, President Obama managed to reduce the fiscal deficit he inherited due to the Bush tax cuts, Iraq War and the Great Financial Crisis from 9.75% of GDP in FY 2009 to 2.4% by FY 2015.⁸ The weight of the contemporary (and much real-time) expert opinion is that this was too much too soon and indeed contributed importantly to the conditions giving rise to President Trump’s victory in 2016.

A similar outbreak of U.S. fiscal rectitude appears unlikely in the next few years, notwithstanding the sound and fury of the Department of Government Efficiency. Those cuts are sensational purely in the journalistic sense of the term thus far. For all of their wanton disregard for worker rights and Congressional authority, the savings are marginal from a macroeconomic perspective. Although the House of Representatives has passed a budget resolution calling for up to $2 trillion in budget cuts over the next ten years, non-partisan analysis suggests that it would actually increase the fiscal deficit to an estimated 6.5% to 6.9% of GDP by 2034, chiefly because of a $4.5 billion extension and expansion of the first Trump administration tax cuts that the measure also includes as well as the use of overly optimistic economic assumptions.⁹ The recent Senate counterpart to this legislation is also problematic in this respect. As Boccia and Lett have written, it provides for “$3.8 trillion in tax cuts that will be magically waived away by using a current policy [as opposed to current law] baseline—roughly the equivalent of pretending it doesn’t cost anything to extend a streaming subscription because you’ve been paying for it for a few months already.” While the administration has indicated that part of its motivation in imposing the new tariffs is to help fund these tax cuts, these revenues are not likely to be officially scored and integrated into the budget negotiations. Their level and duration are uncertain—likely to be subject to complex, rolling negotiations—and their impact is expected to diminish over time, since the tariffs are expressly intended to sharply reduce the volume of imports on which such duties would be imposed.

A more effective and less risky approach to rebalancing is available, for which there is historical precedent

In short, U.S. trade and macroeconomic policies appear likely to row in opposite directions for the foreseeable future, condemning the project of global economic rebalancing to continued circling. Or worse. Sharply and coercively increasing tariffs and capital controls in this environment runs the risk of further destabilizing investor expectations and consumer confidence. These have already been shaken. If the administration is not careful, imbalances could resolve in the worst of ways, through a further fall in confidence and asset prices and contraction in demand that ripple across the world economy.

Nevertheless, the aim of rebalancing the world economy and modernizing its cooperative architecture remains a valid one, and the incoherence and incompleteness of U.S. policy in the face of it across multiple U.S. administrations of both parties runs even deeper than the considerations outlined above. The world economy has changed—geopolitically, technologically, environmentally, and most of all in terms of the distribution of industrial production and middle-class purchasing power—such that the time has come to think more seriously beyond existing international economic arrangements that were formed in response to 20th-century circumstances and challenges.

The Trump administration’s norm-busting actions are a wake-up call that the contradictions and tensions in the system are unsustainable, extending well beyond trade rules. A Plaza/Louvre Accord or Bretton Woods-like moment appears to be approaching one way or the other, most likely during this or the next U.S. administration and quite possibly later this year. This raises a number of critical questions beyond the United States: Will this system update be a constructive one that ends up relieving bilateral tensions and improving the long-term functioning of the world economy, or will it be a rancorous and destructive affair that erodes trust and hastens the descent into a mercantilistic law of the jungle in which all sides eventually lose? In a related sense, will it be organized proactively through cooperative diplomacy and statesmanship or cobbled together reactively and chaotically in the heat of a financial crisis? Indeed, will it end up being led and shaped by the U.S. as it expects, or rather imposed upon it by events of its own careless making, leaving it in a weaker and lonelier position?

President Trump’s and former President Biden’s breaks with neoliberal trade policy in terms of tariffs and industrial subsidies, respectively, have given the U.S. new leverage to bring other parties to the table. But whether the preparatory process and subsequent accord take the high or low road is not a matter for the U.S. to determine alone. Nor should it be, given the current administration’s disavowal of international norms and institutions that have succeeded for generations in drawing a line under the worst beggar-thy-neighbor, negative sum game practices of the past.

Europe can and must step up, as France’s Valery Giscard d’Estaing and Germany’s Helmut Schmidt did in preparing and convening the first-of-its-kind Group of Six (G6) Rambouillet Summit in 1975, and the U.K. did when Gordon Brown rallied the Group of Twenty (G20) behind a wide-ranging agenda of macroeconomic stimulus and financial regulatory reform at its 2009 London Summit. Yes, Europe currently has its hands full developing a new defense strategy and helping to reach a responsible and durable resolution of the Russia-Ukraine war. But its defense-related fiscal spending plans give it a strategic, first-mover advantage in an international macroeconomic coordination negotiation aimed at reducing economic imbalances. In particular, Germany’s long overdue relaxation of its debt brake has given Europe crucial new table stakes, reversing decades of history in which Germany’s fiscal posture prevented Europe from playing a leadership role in such settings.

Thus, the time is ripe for a new “deal” to be struck among the major economic powers aimed at strengthening the growth and stability of the world economy, an outcome that would be greatly in the national interest of each. The U.S. is eager and brandishing a big stick in the form of its new “reciprocal” tariff initiative; Europe is already preparing to do its part, albeit for unrelated reasons; and China appears to have finally convinced itself that, after wave upon wave of decreasingly effective supply-side investment-cum-export stimulus measures, it has no choice but to boost domestic consumption in order to maintain sufficient growth in output and employment.

However, to be fully effective the bargain must be a truly grand one, firing on all of the cylinders of international economic cooperation. It will need to include major initiatives in fiscal, monetary, development, and trade policy in order to yield demonstrable net benefits for each of the main protagonists as well as the international community as a whole. It must embrace a much higher degree of ambition in all of these domains than has been displayed in decades, arguably since the Bretton Woods conference itself.

A four-part US-Europe-China (G3) accord

First part: Fiscal policy

With respect to fiscal policy, China would need to agree in concrete terms to implement reforms sufficient to raise domestic consumption as a proportion of GDP to a level commensurate with its share of responsibility for maintaining the global economy’s momentum and stability, for example, by 10 percentage points of GDP over the next decade. Its final consumption expenditure relative to GDP is about 56%, which is well below that of other industrializing economies (e.g., 71% in India, 72% in Malaysia, and 82% in Brazil) and the global average (76%). As a result of its overemphasis on investment to drive economic growth, China’s household consumption as a share of GDP is 15 percentage points below that of the OECD average, a metric that has not improved in thirty years despite substantial increases in absolute terms (investment has grown faster), and its cash and in-kind social transfers also lag well behind by this measure and are roughly offset by required contributions.

At the same time, Germany and the rest of Europe would need to commit not to offset the fiscal impact of their reflationary defense-related spending increases (an estimated additional 1% of GDP over the next few years); and the U.S. would need to agree on a target for the orderly reduction of its fiscal deficit to a more sustainable and cyclically appropriate level, for example from the current 6%+ to about 2.5% of GDP over the next four years, not far below the 3% of GDP target Secretary of the Treasury Bessent has advocated.

All three parties already have stated their intention to move in this direction, but such a coordinated fiscal rebalancing among them would be unprecedented. Given the recent track record, the markets and media are likely to be skeptical. An international summit presided over by leaders resulting in an accord signed in their presence by Finance Ministers and incorporating a follow-up peer review process facilitated and analytically supported by the IMF would help to inspire the necessary confidence.

Second part: Monetary policy

With respect to monetary policy, all three partners should signal a contingent willingness to undertake coordinated intervention in foreign exchange markets to support a limited and orderly (e.g., 10% to 15%) depreciation of the dollar to levels more consistent with the progressive and symmetrical adjustment of global economic imbalances, reinforcing the expected effects of the fiscal policy measures outlined above, if required. In addition, they should request the IMF to calculate and publish independently (i.e., not subject to prior Board approval) estimates of exchange rate reference ranges on a semi-annual basis that it deems consistent with this immediate objective and the larger, ongoing one of avoiding large and persistent global economic imbalances.¹⁰

Third part: Development policy

With respect to promoting global growth and development more widely, the three parties should agree to support full and accelerated implementation of the “Better, Bolder and Bigger” MDB reforms outlined by the 2023 recommendations¹¹ of the G20’s independent expert group created for this purpose. This would triple annual sustainable lending levels to $390 billion per year by 2030 for the benefit of poor countries, which tend to have vast labor underutilization and thus substantial additional potential to grow and add momentum to the world economy (and U.S. exports). Similarly, the parties to the accord should declare their support for regular issuances of Special Drawing Rights (SDR) by the IMF—e.g., the SDR equivalent of $500 billion every four or five years—combined with modifications in the rules governing their accounting and use for the following specific and limited purposes: Developing country debt relief and restructuring; acute climate change mitigation and adaptation priorities such as accelerated coal plant retirement and replacement and methane abatement; and pandemic prevention and response.

These two financing initiatives would go far in alleviating a lack of financial resources in developing countries in areas that most matter for growth and development, on the one hand, and human security of the entire planet’s population, on the other. They have the potential to triple ODA-related external flows to more than 100 poor countries for most of the next decade—an additional $2 trillion.¹² The balance sheets and other capabilities of multilateral development banks (MDBs) and extraordinary liquidity issuance authority of the IMF remain underutilized assets in a world experiencing severe fiscal space constraints in many poor countries, shrinking foreign aid budgets in many rich ones and rising threats to the prosperity of younger and future generations everywhere from unchecked climate change. Much more effective deployment of them is constrained mainly by a lack of imagination and leadership of G20 governments rather than an absence of investable capital in the world economy or the institutions’ mandates.

Fourth part: International trade policy

Finally, regarding international trade policy, the three preceding components of this global accord would make possible the wider “balance of concessions”—i.e., positive-sum game political outcome—that was missing in the Doha Round and continues to frustrate attempts to update the WTO’s norms and dispute settlement system. The institution has been in a state of semi-suspended animation since the first Trump administration, and the Biden administration did little to breathe new life into it. The carrot of a large and sustained increase in development financing, as outlined above, and the stick of potential unilateral adjustments in U.S. tariffs could help to create the conditions necessary for a constructive, negotiated reset of the institution and multilateral trade system.

By now, it should be abundantly clear to the world that there is a durable bipartisan consensus in the U.S. that the country no longer enjoys the enormous advantage in economic size and technological leadership which led it to take a generally non-reciprocal, foreign-policy-first, and short-term-shareholder-return-first approach to trade policy in the latter half of the 20th century. In addition, market-based growth and development, or capitalism, has evolved into many shades of “mixed economy.”¹³ Thus, a one-time negotiated rebalancing of tariff schedules combined with modernization of rules and procedures to take better account of the changing nature of trade¹⁴ and industrial policy as well as corresponding reform of the dispute settlement system, paired with a big sustained push on development and climate finance and refocusing of trade preferences on low-income countries, might provide the political basis for a new modus operandi for the WTO, especially if it takes place in the context of a process of macroeconomic rebalancing among the largest players. To enhance the prospects for success of all of this, the U.S. should express a willingness as part of the overall accord to discuss its tariff rebalancing objectives vis-à-vis the countries with which it has the most legitimate concerns (based on their actual practices rather than bilateral balances) on a best-efforts and time-limited basis, employing the procedures authorized by the organization’s charter for this purpose.¹⁵

In sum, such a four-part international economic accord would be far more likely to spur major and enduring adjustment of global economic imbalances than the blunt and risky instrument the Trump administration has deployed. It would be a tonic for both global growth and climate action, each of which clearly needs a shot in the arm judging from the latest, deteriorating projections.¹⁶ And it would help to avert or at least limit damage from the accumulating trainwreck of the West’s diplomatic relations with developing countries as a result of the Russia-Ukraine and Israel-Gaza wars, the Trump administration’s trade, development, and other policies, and the EU’s impending implementation of its Carbon Border Adjustment Mechanism.

In an earlier era, the U.S. government could be counted upon from time to time to conceive and marshal support behind strategic initiatives that advanced its national interest through a simultaneous strengthening of the international system. The U.S. would arguably be the biggest beneficiary of a 21st-century project to update multilateral norms and institutions that were established in its image during the last century. Judging from recent pronouncements, there appears to be little prospect of it acting along these lines at present. For the time being, the responsibility falls to Europe, which has greater agency to lead the international community in this direction than it may imagine.

Particularly if financial market volatility and fears of a recession in the real economy persist as a result of the trade policy shock, the current administration may begin looking for a way out that would still enable it to claim partial credit for having revived global and U.S. economic growth prospects as well as modernized international economic relations and institutions. The proposed G3 accord offers such an opportunity. Indeed, the three partners should consider it their responsibility to tackle these fundamental drivers of the world economy’s dysregulation at this time. If they fail to do so, they will just be passing the buck to their successors.