Trade Deficits

Steve H. Hanke of the Johns Hopkins University explains trade deficits.

President Trump, and most in his administration, believe that the U.S. trade deficit is a “bad” thing caused by foreigners who engage in unfair trade practices. For them, the solution is U.S. imposed tariffs and other anti-trade measures. What a nostrum. Our trade deficit is made in the good, old U.S.A., not by foreigners engaging in “unfair” trade practices. Tariffs will not change the overall U.S. trade balance.

How could this be? In economics, identities play an important role. These identities are obtained by equating two different breakdowns of a single aggregate. Identities are interesting, and usually important, by definition. In national income accounting, the following identity can be derived. It is the key to understanding the trade deficit.

(Imports - Exports) ≡ (Investment - Savings) + (Government Spending - Taxes)

Given this identity, which must hold, the trade deficit is equal to the excess of private sector investment minus savings, plus government spending minus tax revenue. So, the counterpart of the trade deficit is the sum of the private sector deficit and the government deficit (federal + state and local). The U.S. trade deficit, therefore, is just the mirror image of what is happening in the U.S. domestic economy. If expenditures in the U.S. exceed the incomes produced, which they do, the excess expenditures will be met by an excess of imports over exports (read: a trade deficit).

So, if tariffs and other anti-trade measures don’t affect the overall U.S. trade balance, what do they do? They simply alter the playing field and the bilateral trade deficits that the U.S. runs with various countries. The total U.S. trade balance remains unaltered; however, the U.S. consumer is not unaltered. Shifting sources for U.S. imports means that U.S. purchasers will be forced to move away from their first choices to second best choices.

But, how can the U.S. continue to rack up big trade deficits year-after-year? The U.S. can do this by borrowing internationally to finance its trade deficit (read: the domestic savings deficiency). And, because the U.S. dollar is the world’s reserve currency, the U.S. can borrow at attractive rates. Indeed, the dollar’s reserve currency status gives the U.S. what the former French President Valéry Giscard d’Estaing described as an “exorbitant privilege.” This privilege is simple: the issuer of the world’s reserve currency and its citizens can borrow “cheap.” The privilege works like a charm as long as the reserve currency stays on top. But, kings can be toppled. Remember when the pound sterling was the world’s reserve currency? Well, when the pound was replaced by the greenback, the exorbitant privilege baton was passed from the United Kingdom to the United States.

So, while trade deficits have not proven to be a burden while the U.S. dollar is the world’s reserve currency, a burden might rear its ugly head if the greenback were to be knocked off its top spot.