Commentary Type

The Debate on Trade Deficits Is Littered with Misconceptions


Misconception No. 1: Trade Deficits Are for Losers

Trade deficits and surpluses are nothing more nor less than borrowing and lending between countries. Borrowing to buy a home or run a business is not for losers only, and neither are trade deficits. What matters are the terms of the loan and the use to which it is put.

America is uniquely positioned to borrow cheaply from the rest of the world by virtue of its large economy, strong military, sound policies and the dollar's historical role in international trade and finance. As long as we use foreign loans to help our economy grow, a trade deficit can leave us better off.

A trade deficit can also be a helpful safety valve for an economy that is overheating. Strong growth and high employment tend to pull in more imports, creating a large trade deficit. Without the deficit, inflation and interest rates would be higher, choking off investments that support long-run growth and cut the expansion short. 

Misconception No. 2: Trade deficits are harmless

Economies with trade deficits should have higher rates of business and housing investment than economies with trade surpluses, but the opposite is true among the advanced economies today. America is borrowing to finance its large federal fiscal deficit, not to build the factories and infrastructure of the future.

Our net debt to the rest of the world is growing faster than our economy. The sooner we reverse this unsustainable trend, the better off we will be. 

Just as a trade deficit may be a useful safety valve for an overheating economy, a trade surplus may be a lifeline for an economy in recession. However, policymakers in many economies, especially in Asia, increasingly view trade surpluses as attractive sources of economic growth in all circumstances.

To achieve these surpluses, they invest public funds in foreign assets, which pushes up the values of foreign currencies relative to their own, making their exports more competitive in global markets.

Former Federal Reserve Chairman Ben Bernanke argued in 2011 that China's currency policy in particular was holding back the US economic recovery because it was preventing the US trade deficit from shrinking further.

Misconception No. 3: Tariffs reduce trade deficits 

President Trump and Commerce Secretary Wilbur Ross blame the US trade deficit on foreign tariffs and other trade barriers. They believe raising US tariffs will shrink the deficit. But the evidence shows that tariffs and other trade barriers have essentially no effect on trade deficits.

Countries with the lowest trade barriers (Singapore, Switzerland) have some of the biggest trade surpluses, while countries with high trade barriers (Brazil, India) have trade deficits.

It may seem obvious that raising tariffs reduces imports and thus increases a country's balance of trade. However, this inference ignores the exchange rate. When America buys less foreign steel, foreigners have fewer dollars to buy our exports.

The resulting dollar scarcity pushes up the dollar exchange rate, making other imports cheaper and US exports more expensive. To the extent that the stronger dollar discourages foreign investment in America, there may be some reduction in the trade deficit.

But the international experience shows that almost all of the response to a tariff increase takes the form of lower exports and higher imports in categories that are not affected by the tariff, leaving the trade balance basically unchanged.

Tariffs targeted at specific countries can reduce bilateral deficits with those countries, but they tend to increase deficits with other countries, leaving the overall deficit little changed. Tariffs that hit all countries reduce both imports and exports, hurting productivity and raising inflation. A global tariff war would make all countries poorer. No one would "win."

Misconception No. 4: Americans don't produce exports that foreigners want to buy

Many big-name American consumer products—from Apple to Ford to Coca-Cola—are produced overseas and thus not exported in large amounts. Meanwhile, major American exports—grain, internet switches, excavators—are often inputs or machinery for foreign businesses and thus get ignored by the general public.

In addition, many people do not realize that foreign royalties on Hollywood movies and foreign student tuition at American universities are also US exports. The upshot is a widespread misconception that Americans are unable to produce things the world wants to buy. 

In fact, America is the world's No. 2 exporter, with exports of goods and services worth $2.3 trillion in 2017, only slightly below China's exports of $2.4 trillion. A 10-percent increase in exports and a 10-percent reduction in imports would be more than sufficient to balance US trade.

Misconception No. 5: America cannot shrink its trade deficit without starting a trade war

Governments have several tools to influence trade balances that are allowed under international law. These include fiscal policy, foreign exchange intervention, and taxes and controls on foreign capital.

Countries with the largest trade surpluses (in proportion to their economies) tend to have large budget surpluses and massive foreign exchange intervention (Norway, Singapore).

The large US fiscal deficit was already a major factor supporting our trade deficit last year. The new tax cut and spending increases taking effect this year will widen both deficits further.

However, the US trade deficit has been larger and more persistent than can be explained by US fiscal policy alone. To some extent, this reflects the attractiveness of US financial markets, but it also reflects mercantilist policies in some of our trading partners.

Given the ongoing fiscal expansion, now is not the best time to launch policies aimed at weakening the dollar and boosting exports, as they would tend to increase the economic overheating already under way.

Moreover, the Trump administration may have effectively engaged in a weak-dollar policy already, as foreign investors appear to have less appetite for US assets. The congressional debate on tighter rules for foreign direct investment may have contributed to this loss of appetite.

The best course of action for sustainable US and global economic expansion with relatively balanced trade is for America to reverse its imprudent fiscal binge while standing ready to counteract any renewed burst of dollar strength with appropriate currency policies such as foreign exchange intervention or taxation of foreign capital.

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