I think this is worth quoting in full:
To summarize, and to make the sequence clearer using nothing more than explicit assumptions and accounting identities, let me suggest schematically the list of factors that require either much greater flexibility on the part of surplus nations or much greater deficits on the part of the US:
1. I assume that for the foreseeable future the major trade deficit countries in Europe are going to find it very difficult to attract net new financing. At best they will be able, through official help, to refinance part of their existing liabilities.
2. If these countries cannot attract net new capital inflows, their currency account deficits, currently equal to two-thirds that of the US, must automatically contract.
3. If European trade deficits contact, there must be one or both of two automatic consequences. Either the trade surpluses of Germany and other European surplus countries – larger than that of China and just a little larger in sum than the European deficits – must contract by the same amount, or Europe’s overall surplus must expand by the same amount.
4. We will probably get a combination of the two, but a much weaker euro – combined with credit contraction, rising unemployment, and German reluctance to reverse policies that constrain domestic consumption – will mean that a very large share of the adjustment will be forced abroad via an expanding European current account surplus.
5. If Europe’s current account surplus grows, there must be one or both of two automatic consequences. Either the current account surplus of surplus countries like China and Japan must contract by the same amount, or the current account deficits of deficit countries like the US must grow by that amount, or some combination of the two.
6. If the Chinas and Japans of the world lower interest rates, slow credit contraction, and otherwise try to maintain their exports – let alone try to grow them – most of the adjustment burden will be shifted onto countries that do not intervene in trade directly. The most obvious are current account deficit countries like the US.
7. The only way for this not to happen is for the deficit countries to intervene in trade themselves. Since the US cannot use interest rate and wage policies, or currency intervention, to interfere in trade, it must use tariffs.
Tariffs in the US, Asia and probably in Latin America and Europe will rise. These are big numbers and the risk is that the adjustments are likely to occur rapidly. This means the rest of the world will also have to adjust just as rapidly.
I don’t really see how the numbers are going to work…