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President Trump just threatened Germany over trade. Here’s what you need to know.

- May 30, 2017

On Tuesday morning, President Trump wrote a tweet saying that the United States had a “MASSIVE trade deficit with Germany.” He further said that this was bad for the United States and (in what seemed to be a vague threat against Germany) said that this would change. This follows on Trump’s reported statement in a closed-door session with European officials a week ago that German trade policy was “bad, very bad.” What lies behind Trump’s complaints about Germany’s trade deficit? Here’s what you need to know.

We have a MASSIVE trade deficit with Germany, plus they pay FAR LESS than they should on NATO & military. Very bad for U.S. This will change

— Donald J. Trump (@realDonaldTrump) May 30, 2017

Trump doesn’t understand Germany’s trade relationships

The Trump administration seems to have some basic misunderstandings of Germany’s economic policy. Trump’s trade adviser, Peter Navarro, seems to think that Germany wants a weak euro. In fact, German officials have spoken out consistently against the European Central Bank’s quantitative easing policy that is helping hold down the euro’s value.

More broadly, the president seems to think of trade in terms of bilateral relationships between pairs of countries that bargain with one another to strike a deal. However, trade relations are much more complex and harder to trace — policy changes in one country can lead to indirect ripple effects that are difficult to trace, but very important.

Even if Trump’s criticism rests on dubious assumptions, the United States is not the only country worried about Germany’s economic policy, and some of the U.S. concerns are both reasonable and long-standing. Germany’s large current account surplus is now in its 15th year and exceeds 8 percent of German gross domestic product. However, neither the Trump nor the Obama administrations, nor, for that matter, other European officials, have convinced the Germans that this is a problem, let alone that they need to solve it.

Germany, too, misunderstands the sources of its own success

As I discuss in a recent paper for the Transatlantic Academy, Germany has responded to such concerns with two complementary rhetorical arguments. First, it says that its large surplus and other countries’ deficits are a simple product of differences in competitiveness. Second, German officials “normalize and apologize.” To do this, they start by stressing that Germany is just like any other advanced economy and that any state willing to do the right policy reforms could enjoy its competitive advantages. When they get pushback, they become apologists, articulating and defending Germany’s uniqueness and purported inability to change.

A better explanation, however, would move the focus away from competitiveness to capital flows — large financial flows between countries that reflect policy-driven changes in incomes, consumption, savings and investment. In Germany’s case, a host of labor market, pension, public investment and fiscal policy changes have helped lower the share of national income that goes to labor. This put far more money in the hands of those who save rather than spend. As a result, German domestic consumption has necessarily grown much more slowly than has national income, and lower consumption, by definition, has meant greater savings.

Practically, this means firm profits have soared ever higher, and, more recently, government debt has shrunk — both manifestations of these higher savings. Overall, German national savings grew from about 21 percent of German GDP to 28 percent during the period in which its current account went sharply into surplus (2003-2017). Meanwhile, German private investment stagnated, and public investment fell to among the lowest levels in the Organization for Economic Cooperation and Development. This means that of the three usual sources of economic growth — consumption, investment and trade — Germany has become disruptively reliant on trade since about 2003.

Thus, where German apologists claim that the trade surplus is simply the aggregate result of free consumer choices, it is, in fact, mostly the result of Germany’s capital outflows, which are a result of policy choices, especially those that shift national income from consumers to firms (as profits or capital subsidies) or to government (as budget surpluses). Global capital flows have their own logic and have now grown to dwarf trade flows.

This has policy implications

Why should it matter to other countries how much Germany saves? The answer is that national savings don’t just sit in banks. They often have large unanticipated knock-on effects elsewhere. It is an economic truism to say that global savings and investment must equal each other by definition. This means that savings increases in one place logically must be matched either with investment growth (there or somewhere else) or by savings declines somewhere else.

Broadly speaking, Germany is one of a number of countries, including China, Japan and South Korea, that are now saving far more than they are either consuming or investing (a country’s GDP is the sum of its consumption and investment. Because all GDP is income for the nation’s residents, another way to put this is that GDP is the sum of consumption and savings — the two things people can do with their income). This alone is complicated enough to make most elected officials’ heads hurt.

But it gets worse. What happens to those “extra” savings (e.g., in excess of the nation’s total investment)? According to macroeconomic theory and data, these savings are going to any country with a trade deficit. Indeed, another way to understand a country’s trade surplus is that it is (and must be) exactly equal in size to its investment deficit.

The academic literature on capital flows emphasizes the importance of this relationship and spells out its counterintuitive and often unwelcome results. For example, it is difficult for countries to deal with unwanted capital inflows when their current investment needs are largely covered, as is true in the United States today. Because savings must, again by definition, match investment, those inflows that aren’t invested must generate lower savings in the receiving country. Put differently, countries don’t simply get to choose their own savings rates because these are profoundly affected by the presence of foreign capital.

Thus, countries that persistently save more than they invest — even if for sensible reasons such as the aging of their society — can nevertheless cause trouble for other states. However, free capital flows in the euro zone and in the liberal international order more broadly mean that there are few ways of stopping inflows of capital.

The two main ways that a country like the United States reacts to inflows from Germany, China and elsewhere are through a consumption boom or an increase in unemployment. Both ultimately bring down U.S. savings rates to compensate for inflows. For example, consumption decreases savings by increasing debt, and the boom runs out when no more credit is extended; meanwhile, unemployment also causes savings to shrink because people have to live off past earnings. Unfortunately, however, this can persist for a very long time, especially when fresh supplies of foreign capital arrive every day.

Of course, German capital flows are not the only problem for the United States or countries in Southern Europe — but German commentators rarely acknowledge that they are a problem.

There are responses Germany could make

If the German government actually wanted to tackle this problem, there are steps it could take, such as reducing taxes on labor and consumption (Germany, like other E.U. member states, has a value-added tax that hits consumer spending), increase public spending, and either reduce national savings or improve the domestic investment climate for firms. Equally, there are steps that the United States could take, too. But vituperative disagreements about trade miss the point — trade relations are dwarfed in importance by capital flows.

At some point, the world will be unable to absorb the capital surpluses of Germany, China and others, leading to another painful correction that might undermine the liberal order. As a surplus country, Germany depends on that order, even if it is difficult for German and U.S. politicians to understand that.

Wade Jacoby is a professor of political science at Brigham Young University.