President Donald Trump has a logically coherent strategy for achieving the goal of reducing the US trade deficit, one of his stated priorities. The problem is that his strategy is based on totally wrong assumptions about trade deficits.
Two logical chains are leading the president and his team to erroneous conclusions. The first is based on the mistaken assumption that foreign barriers to US exports cause the US trade deficit. If that assumption were true, the strategy of trying to lower foreign barriers by threatening to raise US barriers would be defensible. But both theory and evidence demonstrate that barriers reduce exports and imports equally, with no lasting effect on trade balances. A higher tariff on imports reduces both imports and the demand for foreign currency to buy imports, which causes the domestic currency to rise against the foreign currency, making exports more expensive and imports cheaper. For example, a 10 percent import tariff would cause a country’s currency to appreciate by 5 percent. The appreciation offsets half of the price increase from the tariff for domestic consumers and imposes an equal price increase on foreign buyers of that country’s exports. Imports and exports decline equally.
My own work (see page 7 here) finds that tariff rates have no significant effects on trade balances. A comprehensive new study also finds no significant effect of tariffs on trade balances; the study finds that tariffs increase a country’s real exchange rate, as predicted by theory, and reduce income and employment at least temporarily. A tariff targeted at a single country may raise the bilateral trade balance with that country, but only at the cost of a lower bilateral trade balance with other countries.
The second logical chain starts with the assumption that tariffs inflict more pain on foreigners than on domestic residents. If that were true, the United States would easily win a trade war fought entirely with tariffs because it has more imports on which to levy tariffs than exports on which foreign governments can levy tariffs. Presidential trade advisor Peter Navarro made this point very clearly on Fox News earlier this year.
But longstanding economic theory says that both the home country and the foreign country roughly equally bear the cost of tariffs. Tariffs raise costs for consumers and producers in the importing country. Moreover, there is no reason why the war must be fought only through tariffs. US businesses have considerably more direct investment in Chinese operations than Chinese firms have in US operations. On that front, the United States has more to lose from commercial conflict than China.
Higher tariffs will surely benefit some Americans at the expense of others. But, judged on its goal of narrowing the overall trade deficit, the Trump administration’s trade policy is already failing. Thanks to the administration’s massive fiscal stimulus program, imports are soaring and the trade deficit is widening. As former Treasury and White House adviser Brad Setser points out, when it comes to the trade deficit, macroeconomic policies trump microeconomic (tariff) policies.
1. In the case of a fixed exchange rate, domestic prices rise by 5 percent, leading to the same outcome.
2. In this context, “win” means getting the other country to change its policies in the requested direction. It does not mean the overall trade balance will change.