Trade economics is a complex subject, especially when you bring in the capital flows side of things. Reflecting on his recent visit to China, David Cameron said that he believed strongly in free trade but that it was essential to deal with imbalances. He wants to put pressure on China to deal with imbalances from its side and suggested that he was dealing with the problem already from the perspective of the UK.

Trade is all about imbalances, of course. If there are only two goods (spinach and blackcurrants) and only two households (mine and my next door neighbour) and I grow only spinach and they grow only blackcurrants, there is an imblance. Trade resolves that imbalance and we can both eat fruit and vegetables rather than just one or the other.

Cameron, though, was talking about imbalances in total trade – that is a surplus in China’s current account being an imbalance compared with our deficit. In fact, these imbalances are balanced by respective positions on the capital accounts. Let’s ignore the government for the moment. This position could only arise if British people are short of goods because consumers want to consume more than they produce today (or consumption plus investing is greater than output) and Chinese people have too many goods because consumers want to save and consume less of what they produce today. In this situation, we trade goods today (we import televisions and teddy bears from China) for claims on goods tomorrow (the Chinese buy British investments). This is all perfectly rational and involves people expressing genuinely held preferences for goods today versus goods tomorrow. It should be added that there are complex channels that facilitate all this involving interest rate and currency adjustments.

So, what would happen if we all “rebalanced”? Interest rates would rise here as the Chinese saved less and people who genuinely wanted to buy goods from the Chinese and were willing to pay the rate of interest at which the Chinese were willing to lend would be disappointed. The Chinese who wished to lend to the British at British interest rates would be disappointed too. They would probably end up with an extraordinarily inefficient capital stock as the private sector there struggled to cope with the wall of savings – just like Japan did in the 1970s and 1980s when its capital markets were not very liberal.

So, as Nigel Lawson said in the 1980s, as long as deficits are driven by private decisions, we should not worry.

Enter the government…

It could be argued that our preference for goods today is partly driven by the welfare state and government borrowing. The first of these causes individuals to save less than they would really like to if decisions were undistorted and the second literally involves forced negative saving. Cameron argued that he was doing his best to rebalance the British economy. It is fair to say that he is dealing with the second issue – perhaps not the first to the same extent, but we will give him the benefit of the doubt.

But, Cameron also wants the Chinese to rebalance their economy too. This would probably mean less government saving, liberalisation of markets to encourage consumption and (some argue) a welfare state so that the Chinese have the same incentives as the British to not bother to save for the future. It could also be argued that a further complex feature of this already complex picture is the way in which the Chinese currency is managed (probably at an artificially low level and in an opaque manner).

Ignoring the issue of the welfare state the introduction of which would reduce Chinese saving for “bad” reasons, these are problems but they are bigger problems for the Chinese than for the British – much bigger. David Cameron should resolve the problems he has at home safe in the knowledge that he need not busy himself with things that are of secondary importance. If the consumer goods markets are not liberalised in China, it means that the Chinese have fewer television sets today than they would prefer to buy – and they have more claims on future television sets as a result of saving. Sure, the UK has less demand for its exports, but it has a capital inflow instead, thus helping to finance investment courtesy of the “oversaving” Chinese: again, this is all facilitated by exchange rate and interest rate movements with UK interest rates being lower than they otherwise would be. If China does not liberalise its currency arrangements, it will eventually end up with a bubble and/or domestic inflation and thus the domestic price level will rise instead of the currency rising (thus leading to the same effect). The fallout from this will be much nastier for the Chinese than for the UK.

As ever, good domestic policy is the key. Bad domestic policy tends to harm the countries that pursue it. Externalities in government policy – just like externalities in private affairs – are a good excuse for politicians becoming busier than they really need to be. Mr Cameron should focus his efforts on free trade.

Philip Booth

Philip Booth is Senior Academic Fellow at the Institute of Economic Affairs. He is also Director of the Vinson Centre and Professor of Economics at the University of Buckingham and Professor of Finance, Public Policy and Ethics at St. Mary’s University, Twickenham. He also holds the position of (interim) Director of Catholic Mission at St. Mary’s having previously been Director of Research and Public Engagement and Dean of the Faculty of Education, Humanities and Social Sciences. From 2002-2016, Philip was Academic and Research Director (previously, Editorial and Programme Director) at the IEA. From 2002-2015 he was Professor of Insurance and Risk Management at Cass Business School. He is a Senior Research Fellow in the Centre for Federal Studies at the University of Kent and Adjunct Professor in the School of Law, University of Notre Dame, Australia. Previously, Philip Booth worked for the Bank of England as an adviser on financial stability issues and he was also Associate Dean of Cass Business School and held various other academic positions at City University. He has written widely, including a number of books, on investment, finance, social insurance and pensions as well as on the relationship between Catholic social teaching and economics. He is Deputy Editor of Economic Affairs. Philip is a Fellow of the Royal Statistical Society, a Fellow of the Institute of Actuaries and an honorary member of the Society of Actuaries of Poland. He has previously worked in the investment department of Axa Equity and Law and was been involved in a number of projects to help develop actuarial professions and actuarial, finance and investment professional teaching programmes in Central and Eastern Europe. Philip has a BA in Economics from the University of Durham and a PhD from City University.