Description
President Donald Trump would have more success in reducing the US trade deficit by reducing the fiscal deficit and pushing down the overvalued dollar than by raising tariffs.
A recent blog post shows that tariffs do not reduce trade deficits. In fact, countries with higher tariffs tend to have larger trade deficits, but there is probably no causal connection. Tariffs and deficits likely go together because both reflect a country's stage of economic development—that poorer countries frequently have higher tariffs and bigger trade deficits than advanced economies.
Meanwhile, existing research shows that, in a framework that allows for multiple factors influencing trade balances, fiscal policy and exchange rate policy are the most important drivers of trade imbalances. Panel a shows that trade balances are positively correlated with fiscal balances; the slope coefficient is 1.05 and is significant at the 1 percent level. Panel b shows that trade balances are positively correlated with currency intervention; the slope coefficient is 1.52 and is significant at the 1 percent level. In these cases, the correlations do reflect causation: Bigger fiscal surpluses (or smaller deficits) push down interest rates and cause a country's currency to depreciate. That, in turn, makes imports more expensive and exports cheaper to foreigners, shrinking a trade deficit or increasing a trade surplus. Purchases of foreign currency with domestic currency (currency intervention) also tend to depreciate a country's currency and raise its trade balance.
Data disclosure
The data underlying this analysis can be downloaded here [zip].
