Econ 101 predicted Trump would widen the trade deficit

Econ 101 predicted Trump would widen the trade deficit
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It would be a gross understatement to say that President TrumpDonald John TrumpDems want tougher language on election security in defense bill Five aides to Van Drew resign ahead of his formal switch to GOP The myth of the conservative bestseller MORE has failed in delivering on his campaign promise to close the U.S. trade deficit with a view to promoting manufacturing jobs at home.

Indeed, under his watch, not only has the U.S. trade deficit steadily widened over the past two years. It has now reached an all-time high, running at an annual rate of close to a staggering $1 trillion.

Sadly, with his administration’s budget and trade policies, there is every prospect that the trade deficit will continue to widen during the remainder of his first term in office.

While the unwelcome widening of the U.S. trade deficit might have come as a surprise to President Trump and his economic team, it should have come as no surprise to anyone who had bothered to take an introductory course in international economics. 

Such a course would have taught that the main determinant of trade deficits is not so much the level of a country’s import tariffs but it is rather a question of whether the country saves enough to finance its investment.

If a country reduces its savings and increases its investment level, its trade deficit will necessarily widen. That has proved once again to have been the case for the U.S. over the past two years. 

A basic economic course would also have taught that the level of the dollar is an important determinant of both exports and imports. A strengthening dollar makes it more difficult to export and cheaper to import.

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Yet another lesson from an Economics 101 class is that with a floating exchange rate, an increase in a country’s capital account surplus will necessarily be matched by a widening in its current account deficit.

Looking ahead, there is every reason to expect that over the next two years, the U.S. trade deficit will rise to well over $1 trillion a year.

Among the main reasons for expecting this to happen is the Trump administration’s budget policy, which holds out the prospect of a major decline in the country’s savings level.

That policy includes an unfunded tax cut which is estimated by the Congressional Budget Office to increase the U.S. public debt by a mind-boggling $1.5 trillion over the next 10 years. It also includes support of a Congress-approved $300 billion increase in public spending over the next two years.

As a result of the administration’s expansive budget policy at this late stage in the economic cycle, it is widely expected that over the next two years, the U.S. budget deficit will rise to a peace-time high of over $1 trillion.

This makes it all too likely that we will be revisiting the famous twin-deficit problem of the Reagan presidency when we had both an outsized budget deficit and an outsized trade deficit.

Yet another reason to fear that the U.S. trade deficit will widen in the year ahead is that a strengthening dollar will discourage exports and incentivize imports. Already, over the past year, the U.S. dollar has appreciated by around 10 percent.

That strengthening is all too likely to continue in the period ahead as U.S. monetary policy becomes increasingly out of synch with that of our major trade partners.

Indeed, at a time that an expansive budget policy is forcing the Federal Reserve to keep raising interest rates to prevent economic overheating, the European Central Bank and the Bank of Japan are keeping their foot on the pedal to provide support to their lackluster economies. In the process, they are increasing the relative attractiveness of U.S. financial assets.

Another factor likely to contribute to a further strengthening of the U.S. dollar is the current global financial market turmoil that is being caused in part by the uncertainty engendered by President Trump’s "America First" trade policy.

As has happened so often in the past in times of global turmoil, too much capital is likely to be repatriated to the United States in search of a safe haven for investment. As a matter of arithmetic, under a floating exchange rate regime, as the U.S. capital account surplus strengthens, its external current account and trade account deficits must be expected to widen.

Judging by his past behavior, it would be too much to expect that President Trump will assume responsibility for the country’s disappointing trade behavior under his watch. However, if he is wanting to assign blame, a good place to start might be with his economic team.

After all, they all took Economics 101 classes, and they should have learned that an unfunded tax cut coupled with public spending increases runs the all-too-real risk of having the country revisit the twin deficit problem of the 1980s.

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.