Basic economic principles undermine Trump's trade goals

Basic economic principles undermine Trump's trade goals
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If there is one consistent theme in President TrumpDonald John TrumpDems make history, and other takeaways from Tuesday's primaries Pawlenty loses comeback bid in Minnesota Establishment-backed Vukmir wins Wisconsin GOP Senate primary MORE’s economic philosophy, it is that trade deficits are bad for the country and must be eliminated. This is the principal motivation for his recent imposition of punitive steel and aluminum import tariffs.

It also explains his insistence on renegotiating the North American Free Trade Agreement (NAFTA) and his charges that other countries are manipulating their currencies to the detriment of the United States.

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In pursuing his trade agenda, the president seems to be overlooking two basic points of economics that might suggest an alternative trade policy approach. The first is that being allowed by the rest of the world to consistently run external deficits, the United States is enabled to consume and invest more than the country produces.

 

It does so to the tune of around 2.5 percent of GDP a year. Former French President Valery Giscard d’Estaing referred to this as the United States’ exorbitant privilege of having the U.S. dollar as the world’s international reserve currency.

This means that the president should be careful about getting what he wishes for in terms of trade deficit reduction. If somehow the U.S. external deficit were to be eliminated, the U.S. would need to tighten its belt and live within its means.

In particular, U.S. monetary and fiscal policy would need to be tightened so as to reduce U.S. domestic demand by around 2.5 percent of GDP if the U.S. was to avoid the domestic economy from overheating and inflation from resurfacing.

This would mean very much higher interest rates than the Federal Reserve is currently planning and a very much more restrictive budget policy than the Trump administration has proposed.

The second basic point of economics being overlooked by the Trump administration is that a country’s trade deficit is basically the difference between its savings and investment rates. If a country invests more than it saves, it will run a trade deficit. If it saves more than invests, it will run a trade surplus.

This proposition is derived as a matter of straightforward math by rearranging the basic GDP identity in the national accounts equation. It remains true irrespective of the country’s level of trade protection or of the value of its currency.

This point reveals a basic contradiction in the Trump administration’s approach to economic policy. If the administration were really intent on eliminating the trade deficit, it would not have pushed for an unfunded tax cut that is estimated by the Congressional Budget Office to increase the budget deficit by $1.5 trillion over the next decade.

Nor would it have gone along with Congress’ recent proposal to increase public spending by $300 billion over the next three years.

By reducing public saving through tax cuts and public spending increases at a time when U.S. household saving is at an abysmally low level, increasing the budget deficit heightens the prospect that the U.S. trade deficit will widen. In effect, we will be revisiting the twin-deficit problem of the 1980s.

All of this does not bode well for the maintenance of an open global trading system that would be in the country’s long-term economic interest.

It is all too likely that when the U.S. trade deficit widens along with the U.S. budget deficit, the administration will double down on its recent resort to arbitrary import restrictions in a futile effort to reduce the trade deficit.

In so doing, it is almost certain to invite retaliation from our trade partners. That in turn risks leading us down the path to an international trade war that will be destructive of both domestic and global prosperity.    

Desmond Lachman is a resident fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund's Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.