The U.S.-China Trade War: Structural Imbalances and Global Economic Realignment

The persistent structural imbalances in the global economy, notably the significant current account deficits of the United States juxtaposed against surpluses in China and European creditor nations like Germany, have defined international economic dynamics for decades. These imbalances have resulted in the United States accumulating a large amount of debt to the rest of the world.

By 2024, the United States had a negative net international investment position (NIIP) amounting to approximately 24 percent of global GDP, indicating that foreign investors collectively held significantly more U.S. assets than U.S. investors held abroad. The NIIP measures the difference between U.S.-owned foreign assets and foreign-owned U.S. assets, not just “debt.” It includes equity, bonds, real estate, FDI, and other investments, not only what we typically think of as “creditor debt.”

Historically, the U.S. has maintained its deficits primarily through an inflow of foreign savings, which has sustained American fiscal deficits despite consistently low real interest. This dynamic can be understood through the lens of sectoral balance accounting, a framework rooted in national income accounting and advanced by Wynne Godley/Marc Lavoie and James Tobin. According to this framework, the sum of the financial balances of the private sector, the government sector, and the foreign sector must equal zero:

(Private Sector Balance) + (Government Balance) + (Foreign Sector Balance) = 0

When the U.S. runs a current account deficit, meaning the foreign sector is in surplus, this must be mirrored by a combined deficit in the domestic sectors. Since U.S. households and businesses have generally been net savers or in balance since the early 2000s, the counterpart to the foreign surplus has necessarily been persistent government budget deficits.

If real interest rates had been high, fiscal deficits might have been driving the chronic external deficits. But the opposite was true: real interest rates were either low or very low. The inflow of net foreign savings, shown in the capital account, made big fiscal deficits necessary because domestic demand in the U.S. would otherwise have been chronically.

Michael Pettis highlights that the imbalance is significantly rooted in China's unusually low household consumption, representing only 39 percent of its GDP, and excessively high savings rates. Such structural characteristics underpin China’s aggressive investment-driven growth model and the "Made in China 2025" initiative, which has strategically strengthened China’s manufacturing dominance and fostered advanced technological capabilities. Consequently, China’s rise has triggered apprehension among traditional industrial powers, particularly the U.S., setting the stage for escalating trade tensions.

The ongoing trade war between the U.S. and China thus symbolizes broader shifts in global economic structures and power dynamics. China's potential response to American protectionism, expanding domestic demand to compensate for lost U.S. market access, could decisively determine the trade war outcome. Despite skepticism regarding China's willingness and historical reluctance to significantly boost domestic demand, China's current economic circumstances might compel such a strategic shift to avoid economic stagnation and maintain social stability.

Historically, the global economic order established post-World War II was anchored in American economic hegemony and the dollar's central role, as articulated in Kindleberger’s theory of hegemonic stability. Initially, the U.S. maintained substantial current account surpluses, recycling them through international lending and supporting global economic stability. The breakdown of this system occurred in the early 1970s with the collapse of the Bretton Woods arrangement, leading to a global shift towards floating exchange rates and inflation targeting regimes. However, the sustainability of this model has been increasingly questioned following China’s economic ascendancy and the associated stresses placed on American economic capacities as a global borrower and spender of last resort.

Recent protectionist policies under the Trump administration, characterized by unpredictability and a transactional approach to international trade, reflect deeper structural shifts rather than mere political anomalies. While these measures may be criticized as economically inefficient, they indicate a broader erosion of the U.S.'s traditional role in the global economic order and reflect structural economic nationalism. The global economy, particularly major surplus countries such as China and Germany, faces the critical task of rethinking and restructuring international economic relationships and macroeconomic adjustments.

This evolving landscape demands significant economic adjustments from China and Europe, necessitating greater domestic consumption in surplus nations and more balanced trade relationships, in line with proposals for global rebalancing advocated by the IMF and various economic scholars. The effectiveness and willingness of China to recalibrate its economic model toward higher domestic consumption could significantly influence future global economic stability and the ultimate outcome of the trade war with the U.S.

Additionally, scholars emphasize the importance of institutional frameworks in managing global economic imbalances. Institutions such as the IMF, World Bank, and WTO have historically played pivotal roles in maintaining economic stability, facilitating international trade, and providing forums for resolving economic disputes. However, recent tensions, protectionist policies, and nationalist sentiments have challenged the efficacy and legitimacy of these institutions, prompting calls for institutional reform and adaptation to contemporary economic realities.

Moreover, emerging economic literature underscores the critical role of innovation and technological advancement in shifting comparative advantages and altering trade dynamics. China's deliberate and state-led investment in high-tech sectors, articulated in "Made in China 2025," demonstrates a strategic shift from low-value-added manufacturing towards high-tech innovation and intellectual property-intensive industries, reshaping competitive dynamics globally and intensifying geopolitical tensions.

In conclusion, the U.S.-China trade war encapsulates profound and multifaceted shifts within the global economic order. Structural imbalances, institutional pressures, technological competition, and evolving geopolitical considerations collectively demand a reassessment and recalibration of international economic strategies, policies, and institutions. The responses and adjustments made by key global players, especially China and the U.S., will critically shape the future landscape of international trade and global economic governance.