Opinion of Michael Pettis on China's comparative advantage argument

"China denied generating overcapacity and accuses the EU of protectionism. Xi Jinping reiterated that position in talks with Macron, saying there is no capacity issue viewed from the perspective of comparative advantage or global market demand."

Xi is right to argue that overcapacity in any particular industry can simply be an expression of comparative advantage. In a well-functioning global trade environment, countries will indeed "overproduce" those products in which they have a comparative production advantage in order to exchange them for products in which they have a comparative production disadvantage. That causes total global production to rise, and is the main benefit of international trade.

But, as argued in a twitter thread posted five days ago, there are two important points that must be part of the trade discussion. These two points are often conflated, even though they are very separate.

In response to a question on Chinese overcapacity at a press conference, the Foreign Ministry's Lin Jian responded: "The “China overcapacity” accusation may look like an economic discussion, but the truth is, the accusation is built on false logic and ignores more than 200 years of the basic concept of comparative advantage in Western economics. All countries produce and export products of their comparative advantage and this is the nature of international trade." "If a country," he continues, "should be accused of overcapacity and asked to cut capacity whenever it produces more than its domestic demand, then what would countries trade with?" He's partly right. Trade should be based on comparative advantage, which means that countries must indeed produce more than they need of goods in which they have a comparative production advantage in order to exchange them for goods in which they don't. But this argument misses two important points. The first, and most obvious, is that comparative advantage can only be expressed in the exchange of goods. It would matter much less to the world if China were using its export revenues to import from the rest of the world. But it's not. China's competitiveness (very different from comparative advantage) is based on transfers from the household sector that leave Chinese demand too weak to absorb Chinese production. The purpose of China's trade surplus is to shift this weak demand abroad. The second point is that natural or permanent comparative advantage is very rare. In reality countries implement trade and industrial policies in order to create comparative advantage. There's nothing wrong with that. Its the whole point of trade and industrial policies. But this also means that if a country implements trade and industrial policies that create comparative advantage in a strategically important industry, other countries can regain comparative advantage in that industry by implementing their own trade and industrial policies. Lin Jian is right to say that "all countries produce and export products of their comparative advantage and this is the nature of international trade," but this doesn't mean comparative advantage is consistent with running permanent surpluses to resolve weak domestic demand, nor does it mean that other countries cannot implement trade and industrial policies designed to regain comparative advantage in those same industries. Comparative advantage is constantly fought over. That's almost the definition of economic development.

First, comparative advantage is almost always driven by trade and industrial policies designed to help a country dominate strategically important industries. This means it is a dynamic process, and there is no reason why, once it has been achieved by one country, other countries may not also implement similar trade and industrial policies to regain comparative advantage if they too believe the industry is strategically important. That is the whole point of trade and industrial policy.

Second, comparative advantage is expressed in the exchange of goods, and not in their production. Exporting goods without importing isn't an expression of comparative advantage. It is just how countries export excess savings and externalize the costs of weak domestic demand.

Yesterday Ursula von der Leyen said "For trade to be fair, access to each other’s market also needs to be reciprocal." If there weren't the problem of excess savings, access to each other's market would indeed be part of any resolution of trade disputes.

But the overall problem for China's trade partners isn't lack of access. It is China's persistent excess savings, driven by distortions in domestic income distribution. This is what China's trade partners must absorb.

The information is firstly posted by Michael Pettis at X.