Donald Trump is deluded if he thinks that raising tariffs will reduce the US trade deficit. That deficit represents the fact that the US is spending more than it earns. Unless this fact is altered – and Trump has increased the fiscal deficit – the increase in US tariffs will automatically be offset by an appreciation of the exchange rate. Back in the 1980s Australian farmers and miners understood this elementary fact, and that is why they successfully lobbied to reduce tariff protection of Australian manufacturing.
The US exports about $130 bn of goods to China each year currently, while importing $530 bn, resulting in an annual trade deficit of around $400 bn. According to President Trump’s simplistic analysis this evident trade imbalance proves that China is cheating in some way. Instead, according to the doctrine of Trump, fair trade must be balanced everywhere and anywhere, otherwise it is unfair and one of the trading parties must be cheating.
While Trump’s ignorance has never been a hindrance as far as he is concerned, the reality is that his “theory of international trade” is contradicted by the basic “laws” of economics. In fact, in the system of national accounts, used by the UN and all member countries, the current account balance is identically equal to the difference between what a country earns and what it spends.
A country with an unacceptable trade deficit must therefore spend less or produce more if it wants to return to a sustainable balance. Attempts to intervene to either restrain imports or subsidise exports are likely to be offset by an appreciation of the real exchange rate – either because the nominal rate floats upwards in response to market pressures, or because the rate of price increases will rise relative to other countries, which effectively results in the same appreciation of the real exchange rate.
As Australians can contest, however, a current account deficit is not necessarily a problem for a country. Its exchange rate is unlikely to come under pressure, provided that its current account balance is readily matched by capital flows, with no significant change in the country’s international reserves.
Of course, some countries are net capital importers and some are net capital exporters. However, that is not evidence of exchange manipulation, so long as the returns on the equilibrating capital flows are consistent with market conditions; it just means that the returns on investment in a net capital importing country are on average higher than would be obtained by more investment in the countries that are net capital exporters.
In addition, of course, trade does not need to be balanced between individual countries. For example, part of America’s large trade deficit with China is offset by its surplus with Australia, which in turn has a surplus with China. That is why trade generates winners all round, and why it makes no sense for Trump to pick on America’s trade deficit with individual countries, and to pressure them to take action.
In sum, if a country’s trading partners are not intervening to impose restrictions on imports or subsidise exports, or to impede capital flows, then if that country feels it has an unsustainable trade deficit, the only viable solution would be to reduce its own domestic demand or to improve its productive potential relative to that domestic demand. For example, whacking higher tariffs on trading partners, as Trump is doing, will not work – it will just divert trade to other sources of imports, and/or will achieve a new balance by reducing domestic expenditure as prices rise in response to the tariffs and other trade restrictions.
Consistent with this view, ‘Recent IMF research finds that bilateral trade balances are mostly determined by macroeconomic conditions’, … [and] that, unless China significantly boosts demand, the increase in imports from the US will likely be offset by a decrease in imports from the rest of the world’. Furthermore, the IMF went on to point out that ‘Even if China cut the bilateral trade gap in half by importing an additional $200 bn per year of [favoured] products from the US, the current volume of these [US] imports would need to increase by 400 per cent, which seems unlikely in the near term’.
In fairness, there was a time a decade or more ago, when China did have an excessive current account surplus; equivalent to 10 per cent of GDP in 2007 just before the Global Financial Crisis (GFC), and which helped create that crisis. As explained above, this Chinese current account surplus reflected a huge domestic savings surplus, which could be sustained by exporting those excessive Chinese savings to prop up the American bond market. In effect, the US was encouraged to continue living beyond its means, by going into debt, which was financed in large part from Chinese savings. The reward for China was that they substituted American demand for Chinese exports for inadequate consumption demand in China. But this system of financial transfers was bound to prove unsustainable, and that is part of why we got the GFC.
Today, however, the situation is very different. In 2018 China’s current account surplus is now down to 0.4% of GDP in 2018 from its peak of 10 per cent a decade earlier. According to the IMF, this decline reflects ‘strong investment growth, real exchange rate appreciation, weak demand in major advanced economies, technological upgrades in manufacturing, and a widening of the services deficit’.
The IMF in its recent annual assessment of China (published 9 August) concludes that China’s ‘external position in 2018 was broadly in line with medium-term fundamentals and desirable policies’. The IMF found no evidence of currency manipulation by China – contrary to Donald Trump’s assertions – and ‘in line with continued rebalancing [of China’s policies] the Chinese current account surplus is expected to gradually decline further over the next few years’.
But then why did the Chinese currency depreciate immediately following Trump’s announcement of tariff increases on Chinese goods, which perhaps understandably Trump is now claiming as evidence of Chinese currency manipulation. Frankly the answer is simple. As explained above, if there is no change in domestic demand relative to production, then tariff increases are almost bound to be offset by an increase in the exchange rate of the importing country and a depreciation of the country whose exports have been restrained.
All that Trump has achieved with his tariff blitz on China is to create enormous uncertainty in the world economy, which is likely to prove damaging. But he has done nothing to improve the US balance of payments, nor to protect jobs in America.
Source: All citations are from the IMF Review of the Economic Outlook for China, published August 9, 2019.
Michael Keating is a former Head of the Departments of Prime Minister & Cabinet, Finance, and Employment & Industrial Relations. He is presently a Visiting Fellow at the Australian National University.