Trump’s policies are increasing, not decreasing, the trade deficit

There has been a lot of recent discussion of how new trade deals with Mexico, Canada and China will affect the U.S. trade deficit. Some pundits claim the deals will reduce the deficit. Here’s the reality of the situation: The trade deficit is growing larger, and that has little to do with trade policy. That’s because trade policy is not the cause of trade imbalances.

Between the first quarter of 2018 and the third quarter of 2019, the U.S. tariffs on Chinese goods did manage to reduce the bilateral deficit with China. But a trade balance between just two countries doesn’t matter — it is the overall U.S. trade deficit that matters. This has still been increasing, because the U.S. trade imbalance with the rest of the world has been growing much faster than the deficit with China has been declining. 

Part of the problem is that many Chinese exports are being redirected through third countries such as Vietnam in order to avoid U.S. tariffs. But there’s a much deeper problem: the mercantilists who are advising Trump on trade issues do not seem to have a good grasp of what causes trade deficits. They see a problem of “unfair” trade practices, whereas the problem we should be focusing on is insufficient domestic saving.

The most comprehensive measure of our trade balance is called the “current account,” which includes all trade in goods and services. By definition, the current account balance equals domestic saving minus domestic investment. Thus “deficit” countries such as the United States invest more than they save, while “surplus” countries such as Germany and Japan save more than they invest.

Here’s how the current account captures the relationship between trade and capital flows: When people in the United States buy goods from another country without sending back any exports, we pay with financial assets such as stocks and bonds. Essentially, the people we purchase from have then invested in the U.S economy, and this represents an inflow of foreign saving. A significant portion of domestic investment in the United States (both business and residential) is financed by this type of foreign saving from Northern Europe and East Asia. As a result, they run trade surpluses while we run trade deficits.

The only way to improve the current account balance is by some combination of less investment in the American economy and higher levels of domestic saving. Trump administration policies have done the exact opposite. The corporate tax cut made the United States a more attractive place to invest, drawing in foreign saving and appreciating the U.S. dollar. More importantly, the large increase in the U.S. budget deficit since 2016 has reduced domestic saving. Government borrowing represents negative saving, and this reduces total domestic saving. Studies suggest that each extra dollar of budget deficit adds 52 cents to the current account deficit. 

Remember that current account deficits are a macroeconomic phenomenon, and cannot be understood with a narrow focus on trade policies. This is why tariff policies don’t work — they do not address the underlying imbalance between saving and investment. Tariffs merely push the dollar higher in the foreign exchange markets, which offsets the competitive advantage provided by a tax on imports.

If the United States is serious about reducing the trade deficit, it needs to either discourage domestic investment or encourage domestic saving. Because domestic investment generates economic growth, the latter approach is far more desirable. This can be achieved by reducing the budget deficit and making changes in the tax code that encourage saving. The recent Secure Act, which removed age limits for 401k retirement contributions, was a modest first step.

Scott Sumner is an emeritus professor of economics at Bentley University and the Ralph G. Hawtrey chair of monetary policy at the Mercatus Center at George Mason University.