Waiting for Trump to shrink the trade deficit? Don't hold your breath

Waiting for Trump to shrink the trade deficit? Don't hold your breath
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The Trump administration’s trade policy suffers from the most basic of contradictions that dooms it to failure.

Purportedly, the administration wants to impose increased import restrictions on our trade partners to help eliminate the US trade deficit. Yet, the administration follows policies that will both increase the U.S. budget deficit and that will have the unintended consequence of strengthening the U.S. dollar.

That combination of an increased budget deficit and a stronger dollar is bound to cause the U.S. trade deficit to widen rather than to narrow.

As the International Monetary Fund will be the first to tell you, any country that wishes to eliminate its trade deficit while still maintaining full employment logically needs to do two things:

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First, it needs to reduce the level of the country’s domestic expenditure to make room for the increase in exports and the reduction in imports needed to reduce the trade deficit. Second, it needs to weaken its currency so that exporters are incentivized to export, and importers are discouraged from importing.

 

Seemingly oblivious to that logic, the Trump administration is pursuing policies exactly the opposite of those necessary to reduce the trade deficit.

For a start, rather than attempting to reduce the country’s domestic expenditures and to raise its savings level, it is choosing to pursue an expansive fiscal policy at this very late stage in the economic cycle that is sure to increase the budget deficit.

This policy has included the introduction of the unfunded Trump tax cut that will increase the U.S. public debt by around $1.5 trillion over the next decade. It has also included going along with a $300 billion congressional increase in public spending over the next two years.

At the same time, it is pursuing a reckless fiscal policy, the administration is also following policies that are bound to cause a strengthening rather than a weakening in the U.S. dollar.

By pursuing an expansive fiscal policy at this late stage in the economic cycle, the administration is forcing the Federal Reserve to be more aggressive in raising U.S. interest rates to avert inflation than would otherwise be the case.

The administration is forcing the Fed to do so at a time that both the European Central Bank and the Bank of Japan are still engaged in quantitative easing and in maintaining ultra-low interest rates.

With the Federal Reserve in a monetary policy tightening mode and with Europe and Japan still in a loosening mode, it is little wonder that the dollar has strengthened by around 5 percent over the past three months.

Further putting upward pressure on the U.S. dollar are President TrumpDonald John TrumpLawmakers release defense bill with parental leave-for-Space-Force deal House Democrats expected to unveil articles of impeachment Tuesday Houston police chief excoriates McConnell, Cornyn and Cruz on gun violence MORE’s threats to intensify import protection against China and Europe. Those economies are very much more export-dependent than the United States and are likely to be more damaged than the United States by a trade war.

Those economies also are having to cope with uncertainty from Italy in the case of Europe and the deflating of a credit bubble in the case of China. At such a time of domestic economic vulnerability, the threat of further import tariffs on these economies is bound to cause these economies to weaken.

That in turn will require monetary policy responses from those economies that will further weaken their currencies against the dollar by making those countries’ monetary policies even more out of phase with that of the United States.

All of this raises the risk that when the U.S. trade deficit does not get eliminated but rather widens, the Trump administration will double down on its policy of intensifying import restrictions.

More troublingly yet, for both the U.S. and the global economies, that in turn would heighten the risk of a full-scale trade war as the U.S. trade partners felt obliged to retaliate to increased U.S. protectionism.

Hopefully, these fears will prove to be ill founded, and the Trump administration will come up with a more coherent policy approach to remedying the country’s trade deficit. However, with all the clues pointing in the opposite direction, I am not holding my breath for this to happen.

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.