The origins of the US trade deficit and the futility of tariffs

The most persistent driver of America's unsustainably large trade deficit is foreign investment in the United States, not other countries' trade barriers. If President Donald Trump manages to shrink the US trade deficit, it will be because he drove away foreign investment and slowed US economic growth.

Trump's recent letters to foreign leaders state that higher US tariffs are needed to counteract unfair foreign trade practices and reduce US trade deficits. His mistaken assumption that tariffs and other trade barriers affect trade balances may well cause the largest trade war in world history, with immense economic costs on all sides.

The Trump administration's reckless fiscal deficits, chaotic trade policy, and anti-foreigner rhetoric appear to be scaring off foreign investors, which is weakening the dollar in a way that may shrink the trade deficit. But if foreign investors demand higher interest rates on their US loans, the United States will face higher costs in servicing its foreign debt, negating the benefits from a lower trade deficit.

The right approach to reducing the US trade deficit would start with shrinking America's fiscal deficit. This would be combined with efforts to increase US exports, manage a moderate depreciation of the dollar, and assure investors of the safety and soundness of their investments in the United States.

Our new working paper shows that the most important cause of the persistent US trade deficit is the attractiveness of US financial markets to foreign investors, which has kept the dollar strong and pulls in the foreign capital that finances the deficit. Multiple factors are at work, including the centrality of the dollar in international transactions, the large size of the US economy, the apparent safety of the US legal and regulatory environment, and the ability of US financial institutions to securitize capital into assets that appeal to investors.

The uniquely large and safe US financial system makes dollar assets the natural target for mercantilist foreign governments seeking to hold their currencies down in support of their exports. Dollar assets are also the primary outlet for excess saving in economies suffering from chronically deficient aggregate demand. Especially since the COVID-19 pandemic, these massive capital inflows have enabled the US government to run unprecedentedly large peacetime fiscal deficits without causing interest rates to soar.

As of December 2024, nearly 50 years of trade deficits had resulted in US net international liabilities reported at an astonishing 90 percent of GDP. We show that some of this net position likely reflects measurement error and that a more reasonable estimate is that net liabilities equal 67 percent of GDP. Even this lower value is close to the maximum that has been sustained by any advanced economy for more than a few years without a crisis or a notable reversal. Continuation of the trade deficit at its current level would push the United States into uncharted territory.

A key criterion for sustainability is that the net liability position should stabilize or even decline as a share of GDP.

• If the United States continues to be able to pay a relatively low rate of return on its liabilities, then the deficit needs to shrink by about 2 percent of GDP to stabilize the net liability position.
  • Other things being equal, that would require a dollar depreciation of around 15 to 20 percent.
• On the other hand, if the United States needs to pay rates of return equal to those it receives on its foreign assets, the deficit needs to shrink by 3.5 percent of GDP.
  • This requires a dollar depreciation of 25 to 30 percent.
  • Even this larger adjustment is not unprecedented and might occur smoothly over several years.

Despite Trump's fixation with eliminating the trade deficit, his policies are distinctly counterproductive.

• First, the continuation of massive fiscal deficits is keeping US spending and interest rates higher than they would otherwise be, drawing in both imports and foreign capital.
• Second, tariffs (indeed all trade barriers) are well known to have little permanent effect on trade balances, as documented in this recent IMF study. Instead, tariffs reduce productivity and growth by skewing US labor away from its most profitable uses.
• Third, scaring off investors by adopting irrational policies and demonizing foreigners will likely raise the rate of return we must pay on our liabilities.
  • As noted above, the sustainability benefit of any reduction in the trade deficit can be negated by an increase in the payments on our liabilities to foreigners.
  • Scaring off foreign investors raises the interest burden on all US borrowers, whether their debts are owed to foreigners or to other Americans.

A better set of policies would be nearly the opposite of those adopted by Trump.

• First, save tariffs for targeted measures based on bona fide national security concerns and distinguish clearly between friends and foes.
• Second, cut the fiscal deficit in a credible and non-regressive manner to a level equal to that in other advanced economies as a share of GDP over three to four years.
• Third, insist that other economies take credible and comparably sized steps to increase domestic demand to offset the decline in US spending.
• Fourth, work with other economies if possible, or alone if necessary, to encourage whatever dollar adjustment proves necessary to achieve a sustainable US trade balance over the medium term.
• Fifth, assure international investors of the safety of their investments in the United States both directly through a sound legal and regulatory framework and indirectly by the adoption of sensible growth-oriented policies.