President Trump’s protectionist policies have been widely criticised and rightly so. What is more surprising is the lack of analysis as to why America has a long-standing trade deficit, and the contradictory and self-defeating nature of President Trump’s overall economic strategy.
Much has been written lately about the consequences of a trade war as President Trump announces punitive increases in tariff protection, and other countries are then provoked into tit for tat increases in their own tariffs. Understandably, the reaction by many commentators has been to refer back to the damage done by such ‘beggar thy neighbour” policies adopted during the Great Depression. Not only was international trade supressed then, but so was economic recovery.
What I find surprising, however, is the relative absence of discussion about why the US trade deficit is so large in the first place. Indeed, this is especially curious, as President Trump seems to define the existence of a US trade deficit with another country as conclusive evidence that this other country is somehow cheating and engaging in unfair trade. The implication seems to be that only when the trade between the US and say China is balanced, with the value of exports and imports between the two countries approximately equal, and only then, will Trump consider that the two countries have a fair trading relationship. But of course, this myopic view of trade ignores the whole point of the multi-lateral trading system, where countries specialise in what they do best. This specialisation is why, for example, the US can have a trade deficit with China, while enjoying a surplus with Australia; although luckily for us that US surplus with Australia has been interpreted as indicating we are “fair” traders and so we have not thus far been subject to higher US tariffs.
The critical point, however, is why does the US have an overall trade deficit? Trump seems to believe that the US trade deficit is the net result of other countries’ unfair trading practices. But even a first-year undergraduate studying economics would be expected to know that in the National Accounts, a country’s current account deficit is by definition equal to the difference between that country’s domestic saving and investment. Or to put the same point in perhaps less technical terms, a country’s current account deficit is equal to the extent that that country is spending more than it earns – which can of course be equally thought of as the extent to which that country is living beyond its means.
Nevertheless, there may be reasons why a country with, for example, very strong investment possibilities will want to borrow from overseas to help develop these possibilities and would thus be running a current account deficit on its balance of payments. However, no-one has made this case for the US, which in any case has a relatively low investment rate – about 6 percentage points lower than Australia relative to GDP.
In any event, an increase in protection across the globe will not necessarily reduce the US deficit. In fact, it is more likely that the consequent collapse in world trade will result in lower incomes and expenditure everywhere. However, if – as is quite possible – the decline in US incomes is greater than the decline in US expenditures, then the US trade deficit will get even worse.
Furthermore, even if other countries do not retaliate fully to an increase in US protection, this protection increase will not reduce the total US trade deficit so long as US expenditures continue to exceed US earnings. Instead the increased protection directed against China, for example, would then lead to either US trade being diverted to other trading partners that the US has not targeted for higher protection and/or the US exchange rate increasing. An increase in the exchange rate would of course tend to offset the increase in protection, and in this way market forces will likely move to nullify that increased protection so long as US demand exceeds its potential production. Thus the increase in US tariffs cannot make the US more competitive: their impact is likely to be offset by a counter-active increase in the US exchange rate. The reason why the US real exchange rate is likely to be higher in these circumstances is because it is the price relative that responds to maintain the equality which must always exist between the balance of payments deficit on the one hand, and the difference between that country’s domestic expenditure and income on the other hand.
As part of that adjustment interest rates in the borrowing country may also be higher in order to attract the necessary capital inflows to cover the trade deficit. These higher interest rates can be expected to modify expenditures but probably at some cost to economic activity, although the net effect on the trade balance depends upon whether domestic expenditure or production is more impacted by the higher interest rates.
In sum, Trump’s protectionist policies are most unlikely to achieve their desired result of reducing the US trade imbalance. Instead, already market forces have resulted in a US exchange rate that is far too high relative to the purchasing power of the US $ rendering it therefore uncompetitive. But Trump’s policies will lead to considerable trade distortion, and even worse, an overall decline in global economic activity.
The reality is that Trump needs to constrain US expenditures so that the US can live within its means if he wants to reduce the trade deficit. By reducing its budget deficit, the US could achieve lower interest rates and a lower exchange rate. Economic activity could be maintained as the US would then be able to export more and import less.
Unfortunately, however, Trump’s fiscal policy is the opposite of what is needed. Trump is cutting taxes for the rich, on the promise that benefits of these tax cuts will trickle down, and so stimulate economic activity that the tax cuts will pay for themselves. Some of us will remember that similar tax cuts favouring the rich were introduced by Presidents Reagan and Bush (junior), using a similar logic based on trickle-down economics. In both cases, economic activity did not improve much and the budget deficit blew out alarmingly. It was left to Clinton to clean up Reagan’s mess, and Bush’s incompetence led directly to the Global Financial Crisis. But now history is repeating itself and we have yet another Republican President proposing an even worse version of the same failed strategy, and this time there is no spare economic capacity.
Furthermore, to the limited extent that America is prepared to try and put its own house in order, expenditure savings are mainly targeted at health, education and welfare spending. But leaving aside the questionable ethics of these policies, savings in these areas will only weaken the American economy further, as this reduction in investment in human capital reduces employment participation and productivity.
In sum, President Trump can only be described as an economic ignoramus. His contradictory policies will not work but do risk great damage to his own country and the world. Furthermore, there seem to be no ‘adults’ among his advisors, or if there are, they don’t have the moral fibre to tell the President when he has no clothes.
Michael Keating is a former secretary of the Department of Prime Minister & Cabinet.