Responding to critics of the administration’s proposed steel and aluminum tariffs, Commerce Secretary Wilbur Ross stated on CNBC: “I think this is scare tactics by the people who want the status quo, the people who have given away jobs in this country, who’ve left us with an enormous trade deficit and one that’s growing. [The trade deficit] grew again last year, and if we don’t do something, it will keep growing and keep destroying American jobs.”1
Though the forces determining our trade deficits have many moving parts, it is not that complicated to explain why everything in the above statement is wrong. In this article I explain why:
- Our trade deficits are caused more by U.S. government fiscal deficits than by the mercantilist export promotion policies of China, Japan and Germany;
- Mercantilist policies that subsidize exports and restrict imports do not cost American jobs but rather reallocate workers and capital to less productive jobs that lower our standard of living; and
- Challenging mercantilist policies using the tools and provisions of the WTO and other trade agreements better serves our long-run interests than unilaterally imposing tariffs and inciting trade wars.
To understand the relationship between our fiscal deficit and trade balance, it is essential to understand the macro level relationship of our trade deficit to the other broad categories of our national income and expenditures. The economy’s total domestic output, known as gross domestic product (GDP), can be broken into the broad components of our output/income that reflect how that income is spent. Starting with the components of expenditures:
GDP = C –M + I + G + X, or GDP = C + I + G + (X-M)
C = household consumption expenditures/personal consumption expenditures
I = gross private domestic investment
G = government consumption and gross investment expenditures
X = gross exports of goods and services
M = gross imports of goods and services
C-M is household consumption of domestically made goods and services, while M is household consumption of foreign made goods and services. If we subtract M from X (foreign expenditures on domestically made goods and services) we have the famous trade balance. When we buy more foreign goods and services than foreigners buy of our output, i.e., when X-M is negative, we have a trade deficit. As discussed further below, it is important to note that the trade balance (deficit or surplus) is between the U.S. and the rest of the world. Bilateral deficits or surpluses with individual countries are irrelevant.
But another way of breaking up total output (and thus income) is into how households allocate it:
GDP = C + T + S
T = household tax payments (personal and corporate income taxes plus sales taxes)
S = household saving
These two equations each provide definitions of the same quantity (GDP) and thus can be set equal to each other. This enables us to arrive at a useful formulation of the trade deficit:
C + I + G + (X-M) = C + T + S, or M-X = I-S + G-T;
The relationships in the identity can be described in several ways. Our fiscal deficit (G-T) must be financed by domestic net saving, i.e., a negative I-S, or by foreigners (M-X), i.e., a trade deficit or a mix of the two. Government finances its deficits by selling treasury securities domestically or abroad. If they are purchased domestically, residents must save more for that purpose or investors must borrow and invest less from existing saving. If a fiscal deficit does not crowd out private investment or increase private domestic saving (e.g., if I-S = 0) then it must be financed by foreigners who get the dollars with which to buy U.S. treasury securities by selling their goods and services to us in excess of what they buy from us, i.e., from a trade deficit.
The above relationships are derived from definitions. They are tautologies. If the government’s spending exceeds its tax revenue, it must borrow the difference from someone: a diversion of spending that would have financed investment (crowding out), a reduction in consumption (i.e., increase in saving), or an increase in the share of consumption spent abroad (increase in imports) giving foreigners the dollars they lend to the U.S. government. The interesting part – the underlying economics – is how markets bring about these results (usually a mix of all three).
When the government increases its need to borrow, other things equal, the increase in the supply of treasury securities relative to the existing demand for them increases the interest rate the government must pay. Higher interest rates generally encourage more saving and discourage investment. If we have no trade deficit (X-M = 0 so that G-T = S-T), the government’s deficit (G-T) must be financed by net saving (S-T). Depending on how much of the net saving comes from an increase in saving and how much from a decrease in investment, government deficits are bad for investment and economic growth in the long run (abstracting from countercyclical budget deficits and surpluses meant to offset cyclical swings in aggregate demand).
However, much of our fiscal deficits have been financed by foreigners (predominantly China and Germany) through their trade surpluses and our trade deficits. The market produces this result because the higher interest rates on U.S. treasury securities (and until now their perceived low risk of default) attracts foreign investors. The foreign demand for dollars in order to buy these treasury securities increases (appreciates) the exchange rate of the dollar for other currencies. An appreciated dollar makes American exports more expensive to foreigners and foreign imports cheaper for Americans. The resulting increase in imports and reduction in exports increases the trade deficit, which then finances our fiscal deficit.
If you have made it this far, you will be better able to understand the errors of Secretary Ross’s statement above: “if we don’t do something, it [the trade deficit] will keep growing and keep destroying American jobs.” If the United States government wants to reduce its trade deficit, it should reduce, rather than further increase, its fiscal deficit.
As noted above, however, our trade deficits reflect many moving parts. In the above example, foreigners want to increase their holdings of U.S. dollars (and dollar assets) in part because the dollar is a widely used international reserve asset. Our trade deficit is the primary way in which we supply our dollars to the rest of the world (and its central banks). However, what if our trading partners were manipulating their exchange rates in order to produce trade surpluses for themselves?
In the past, China followed such a mercantilist policy of promoting its exports over imports as part of its economic development strategy. In that case, our trade deficit would result in foreign investments in the U.S. with the net dollars accumulated abroad even without U.S. fiscal deficits. If they are not soaked up financing government debt they will be invested in private securities or other assets (such as Trump Hotels).
Tariffs do not violate the above national income identities. Rather they potentially change the allocation of resources toward or away from traded goods. The tariffs proposed by President Trump on steel and aluminum imports were meant to prop up inefficient American steel and aluminum firms by increasing the cost of their imported competition. As such, they would reallocate our workers and capital to activities that are less productive than they would otherwise be used for (i.e., to the increased production of steel and aluminum). Once all of the adjustments were made, we would be poorer, though still fully employed.2
It turns out, however, that Trump’s tariff threats were probably a negotiating ploy (as he has temporarily exempted Canada and Mexico from the tariffs and is making deals with other suppliers in exchange for suspending the tariff). China is already paying special tariffs on these products to counter Chinese government subsidies and only sells the U.S. 2 percent of its steel imports. Thus, the tariff is largely irrelevant for China. The net short-term effect of Trump’s ploy may well result in almost no tariff revenue and no protection for U.S. steel and aluminum producers and some improvements in other trade deals with our trading partners or at least what the president considers improvements. In short, Trump’s tariff threat could turn out to be helpful. However, given Trump’s generally negative and/or ill-informed views on trade, this may be an overly generous interpretation.
As The Economist magazine put it: “If this were the extent of Mr. Trump’s protectionism, it would simply be an act of senseless self-harm. In fact, it is a potential disaster – both for America and for the world economy.”3
Why? Even if the tariffs are waved sufficiently to avoid the retaliatory trade war Europe and others are threatening, Trump’s use of the national security justification for his steel and aluminum tariffs cannot be taken seriously. “That excuse is self-evidently spurious. Most of America’s imports of steel come from Canada, the European Union, Mexico and South Korea, America’s allies.” [The Economist, ibid.]
Trump’s national security justification bypassed the World Trade Organization’s normal trade abuse remedy mechanisms and thus potentially weakening the WTO’s effectiveness in promoting the trade from which the world has benefited so enormously. Trump’s renegotiation of NAFTA and his foolish withdrawal from the Trans-Pacific Partnership (TPP) further demonstrate his lack of appreciate of the benefits to the U.S. and its trading partners of freer trade. The WTO has helped develop the international standards that have contributed so much to lifting the standard of living around the world. Despite its many weaknesses and shortcomings, our interests are better serviced by strengthening the WTO rather than weakening it.4
When China was admitted to the WTO in 2001 we expected that it would continue to liberalize and privatize its economy in accordance with the requirements of the WTO’s rules. The expectation was that China’s membership in the WTO would draw it into the liberal international rule-based trading system. Unfortunately, China’s liberalization has gone into reverse in recent years.
China’s behavior has been a disappointment. From its accession into the WTO, China began flooding the world with its “cheap” exports while continuing to restrict its imports from the rest of the world. The normal market reaction and adjustment to the inflow of dollars to China from its resulting trade surplus would be an appreciation of the Chinese currency, which would increase the cost of China’s exports to the rest of the world (and lower the cost of its foreign import). However, China intervened in foreign currency markets to prevent its currency from appreciating and as a result China accumulated huge foreign exchange reserves, peaking at US$4 trillion in 2014. Not only did China intervene to prevent the nominal appreciation of its currency, but it also sterilized the domestic increase in its money supply that would normally result from the currency intervention, thus preventing the domestic inflation that would also have increased the cost of its exports to the rest of the world.
China’s currency manipulation was not seriously challenged at that time. Economic conditions in China have more recently changed and since 2014 market forces have tended to depreciate the renminbi, which China resisted by drawing down its large FX reserves (all the way to US$3 trillion by the end of 2016 – they have risen modestly since then). China is no longer a currency manipulator as part of an export promotion (mercantilist) policy.
But China does continue to violate other WTO rules with many state subsidies to export industries and limits and conditions for imports and foreign investment, such as requiring U.S. companies to share their patents as a condition for investing in or operating in China. A government subsidy of exports distorts resource allocation and thus lowers overall output in the same way but in the opposite direction as do tariffs. Both reduce the benefits and economic gains from trade and are to be resisted. The WTO exists to help remove such barriers and distortions in mutually agreed, rule-based ways. A tariff that balances a state subsidy helps restore the efficient allocation of resources upon which maximum economic growth depends. These are allowed by WTO rules when it is established that a country’s exports violate WTO rules. President Trump is considering such targeted tariffs (his steel and aluminum are certainly not an example of this type of tariff) and hopefully they will conform to WTO requirements.
“Whatever the WTO’s problems, it would be a tragedy to undermine it. If America pursues a mercantilist trade policy in defiance of the global trading system, other countries are bound to follow. That might not lead to an immediate collapse of the WTO, but it would gradually erode one of the foundations of the globalized economy. Everyone would suffer.” [The Economist, ibid.]
As an aside, the U.S.’s bilateral trade deficits (e.g. with China) and surpluses (e.g., with Canada) are totally irrelevant and any policy designed to achieve trade balance country by country would damage the extent and efficiency of our international trade and thus lower our standard of living.5
“Even though trade policies are unlikely to change the long-run trade balance, they are not unimportant. Americans will be better off if the United States can use trade negotiations to open foreign markets for its exports, not because more exports will increase the U.S. trade surplus, but rather because U.S. incomes will be higher if more U.S. workers can be employed in the most efficient U.S. firms that pay high wages, and if those firms can sell more exports at higher prices. Similarly, U.S. living standards will be higher if the United States reduces its trade barriers at home because this will give consumers access to cheaper imports and make the economy more efficient. Ultimately, therefore, the goal of U.S. trade policies should not be focused on trade balances but instead on eliminating trade barriers at home and abroad.” This is quoted from the excellent and more detailed discussion of many of these issues in “Five reasons why the focus on trade deficits is misleading.”6
There is another, very important negative byproduct of Trump’s transactional, confrontational, zero sum approach to getting better trade agreements. Mutually beneficial trade relations strengthen political and security relations and cooperation. These have been important non-economic benefits, for example, of NAFTA. Trump’s confrontational approach undermines these benefits. Pew Research Center surveys in 37 countries found that: “In the closing years of the Obama presidency, a median of 64 percent had a positive view of the U.S. Today, just 49 percent are favorably inclined toward America. Again, some of the steepest declines in U.S. image are found among long-standing allies.”
We have traditionally referred to those we trade with as trading partners. We need to return to that way of thinking.
This article was condensed from https://wcoats.blog/2018/03/17/econ-101-trade-deficits/, which contains additional text and links to additional material.
- Ted Mann, Bob Tita and Maureen Farrell, Wall Street Journal, March 9, 2018
- For a further elaboration, see: https://wcoats.blog/2018/03/03/econ-101-trade-in-very-simple-terms/.
- The rules-based system is in grave danger, The Economist, March 8, 2018
- See my earlier discussion of this issue in https://wcoats.blog/2017/07/23/the-balance-of-trade/