International capital flows are the flip side of trade imbalances.
To fund its trade deficit, the United States relies on net capital inflows—foreigners purchasing US debt and equity—as well as foreign direct investment. In other words, the United States must attract savings from abroad because it does not save enough at home. In contrast, China and the European Union both have excess savings.
Domestic factors are the main reason for the widening of imbalances between these major economies. China’s consumption has been persistently weak. Households in China hold high precautionary savings because social safety nets are not well developed, and the property sector has been shaky. In the European Union, investment has been weak relative to savings because opportunities are less attractive, especially in high tech.
The opposite is true in the United States. Consumption and investment are high, fiscal deficits are large, and the savings rate is low. So the United States is running a trade deficit, and the biggest counterparts are the European Union and China.
Imbalances are not inherently bad—global capital flows are part of a well-functioning international trade and financial system. But risks accumulate when the imbalances grow unsustainably and the necessary adjustments do not take place.
Countries or regions with a trade surplus—in this case, China and the European Union—generally face little market pressure to adjust. Usually, most of the adjustment would be forced onto the country with a trade deficit—the United States. But because the US dollar is the global reserve currency, foreign investors have been willing to finance US spending. So imbalances persist.
Why do we care? Because we’ve seen it go wrong before. In the lead-up to the 2008–09 global financial crisis, imbalances built up as China ran large trade surpluses and the United States ran large trade deficits. The US subprime mortgage implosion was a product of flawed financial innovation and lax regulation. But the massive inflows of foreign capital to the United States made a local problem global—and they sparked the worst financial crisis since the Great Depression.
Global imbalances narrowed after the crisis, but they’ve started to grow again. Because of insufficient domestic savings, the US fiscal deficit must be funded in part by foreign investors, and they could become less enthusiastic about US assets. At the same time, US government debt is increasingly being purchased by non-bank financial intermediaries, particularly hedge funds using highly leveraged strategies. This is increasing leverage at the very core of the financial system. These are vulnerabilities.
And, no, US tariffs probably won’t fix global imbalances. Lower US imports from the rest of the world will likely come at the cost of lower US exports. As long as the United States is spending more than it’s producing, it needs to import more than it exports.
The shifts have global implications
These megatrends have global implications. And now new US tariffs combined with the unpredictability of US policy are increasing uncertainty, shifting relationships, weakening global demand and reducing the efficiency of global supply.
Countries around the world are adjusting their supply chains and seeking out new partners. China’s reach into emerging-market economies is increasing. New partnerships support China’s quest for a multipolar world, where the United States has less geopolitical weight. The European Union, too, is making changes—beyond simply diversifying trade—by tackling internal challenges that have hampered its competitiveness.
The global economic fallout from the US trade war has so far been milder than first predicted—both because US tariffs are not as high as initially feared and because retaliatory tariffs were limited. But the full impact has yet to be seen. Many US households remain cautious about spending, and US employment growth has slowed. In the euro zone, growth looks to be softening as US tariffs weaken exports. In China, export substitution to Asian markets has offset the worst effects of US tariffs so far. However, businesses are investing less, and growth is expected to slow.
What can governments around the world do? When the United States raised tariffs sharply in the 1930s with the Smoot-Hawley Tariff Act, most leading nations responded by erecting their own trade barriers. The combined impact was severe, contributing to the depth and persistence of the Great Depression. This time, countries have avoided an escalating global trade war. That’s good, but they could go further by strengthening trade ties where possible.
The era of open trade with the United States may be over, but the rest of us can still deepen trade with others. To do this, we will need our multilateral institutions—particularly the World Trade Organization and the International Monetary Fund (IMF)—to work together better to address the problems of unbalanced trade and the lack of adjustment.
Together, countries also need to be prepared for new financial stability risks. We need financial supervisors to strengthen surveillance of financial vulnerabilities—especially as hedge funds and other non-bank financial intermediaries play an increasingly important role in the financial system. Here the IMF and the Financial Stability Board need to work together to identify potential systemic risks.
For their part, businesses need to consider both geopolitical risks and the resilience of supply chains along with efficiency. More industrial policy means chief executive officers need to think about how their corporate strategies interact with national priorities. These national priorities may allow businesses to take more risks to fuel growth, but they should not be used to create monopolies.
Central banks also have a role to play, but it is limited. Monetary policy cannot undo the damage caused by tariffs. At best, monetary policy can smooth the path in the short term, supporting economic growth while ensuring inflation is well controlled.
What it all means for Canada
This brings me to the impact and implications here at home—in both the short term and the longer term.
The tariff shock is hurting economic growth and employment
First, the near term. Trade growth in Canada had slowed well before the re-election of President Trump: trade as a share of GDP stopped increasing in about 2000.
But Canadian exports have declined sharply since President Trump imposed new tariffs on Canada and created considerable uncertainty with tariff threats and reversals. The pain is falling primarily on a few key sectors: steel and aluminium and motor vehicles. Last month, tariffs were increased or extended to more goods, including copper and softwood lumber. High tariffs are also being imposed on exports that are not compliant with the Canada-US-Mexico Agreement (CUSMA). While most of Saskatchewan’s exports comply with CUSMA and are not affected by US tariffs—at least not directly—the hit from China’s tariffs on canola is significant.
The economic impact has been a whipsaw: Growth held up at the start of the year as exporters shipped all they could to get ahead of the tariffs. This reversed in the second quarter—exports dropped almost 27% and GDP contracted by 1.6%.
The sharp drop in exports is hurting the job market. The unemployment rate rose from 6.6% in February to 7.1% in August. Hiring and employment in trade-affected sectors are down sharply, and employment growth in the rest of the economy has slowed. Many businesses have also told us they have paused investment plans given elevated uncertainty about US trade policy.
Canada’s long-term prosperity requires change
In the longer term, increased trade friction with the United States means our economy will work less efficiently, with added costs and less income.
Chart 7 shows the Bank of Canada’s assessment of the growth path for the Canadian economy before US tariffs—the blue line—and with US tariffs based on trade policy as of the end of July—that’s the orange line. We can see that the orange line is permanently below the blue line. Monetary policy cannot undo the efficiency costs of US tariffs—it can’t bend the orange line back up to the blue no-tariff line. Nor can counter-cyclical fiscal stimulus.
But positive structural reform could.
Canada has a choice. We can live with the structural impact of a more protectionist United States—the lower path. Or we can improve our productivity and competitiveness and bend the orange line back up to, or even above, the blue line.
