warwick mckibbin directs the Center for Applied Macroeconomic Analysis in the Crawford School of Public Policy at Australian National University. A version of this article appeared in the Financial Review of Australia.
Published on March 9, 2018
First, it was washing machines from South Korea. Then, it was steel and aluminum from the whole world.
Donald Trump has been promising to slap tariffs on countries allegedly responsible for driving the U.S. trade deficit to around $2 billion a day since the early days of his presidential campaign, and now he’s done it. But before considering the consequences if, as widely expected, America’s trade partners respond in kind, it is instructive to go through some basic — and rather unintuitive — economics of what determines a country’s trade balance.
The “current account” is a more comprehensive indicator of a country’s balance of commerce with the rest of the world than the trade deficit. It is, as a matter of accounting, identical to the difference between how much the country saves and how much it invests at home. A country that invests more than it saves can only manage the feat by attracting financial capital from overseas. This capital inflow appreciates the currency, reducing exports and raising imports.
The U.S. current account deficit is thus the flip side of net inflows of capital. Protectionist measures like tariffs change the mix of both exports and imports, but unless they change the overall balance of savings and investment, they cannot reduce the trade deficit.
Why the mini-lesson in financial economics? Because the trade-capital linkage expands the ways in which aggrieved countries might respond to protectionism.
As much as countries are tempted to raise tariffs to counter the trade aggression of the Trump administration, they will be reluctant because the consequences would range from unfortunate to catastrophic.
In recent research Andy Stoeckel and I analyzed the potential impact of Trump administration economic policies, including a trade war scenario. We found that a minor global trade war in which average tariffs rose 10 percent would reduce the GDP of most countries between 1 and 4.5 percent, with the U.S. at the low end (1.3 percent) and China at the high end (4.3 percent). A nastier escalation — to a 40 percent change in tariffs — would cause a deep global recession. So as much as countries are tempted to raise tariffs to counter the trade aggression of the Trump administration, they will be reluctant because the consequences would range from unfortunate to catastrophic.
But there are still alternatives to turning the other cheek. An indirect response, which might even have unintended positive consequences in the long term for the world outside the U.S., is rooted in the reality that the force driving the United States’ external deficit is its unquenchable demand for foreign capital to bridge the gap between domestic savings and investment.
Over the past few decades, trillions of dollars’ worth of foreign savings in excess of investment back home has been parked in U.S. Treasury securities issued to cover federal budget deficits. This foreign appetite for Treasury securities reduces the borrowing costs of the U.S. government relative to what it would pay if it just had access to U.S. domestic savings. And the implicit subsidy of U.S. spending has come at the expense of investment that could have been made in other countries, increasing their GDP. So if creditor countries that are victims of U.S. protectionism left their tariff rates unchanged and instead decided to sell some of their U.S. government securities and invest the proceeds in other countries, the United States would be forced to confront the lock-step relationship between trade deficits and the savings-investment gap.
The mechanics underlying the adjustment process would look like this. Cashing in dollar securities in favor of other currencies would reduce the exchange value of the dollar and raise long-term interest rates (rates not directly controlled by the Federal Reserve). This, in turn, would stimulate domestic U.S. savings and reduce domestic investment. Meanwhile, thanks to the depreciated dollar, U.S. exports would rise and imports would fall until the gap that had previously been filled by foreign purchases of Treasury securities had been commensurately narrowed. Thus in this low- (or no-) trade deficit world that Trump apparently wants to build, the United States would have to learn to live within its means.
Think of the advantages over a trade war. Responding to American protectionism this way would not violate the hard-won rules of the World Trade Organization. And it would enable market forces to adjust the U.S. current account — an initiative that policymakers have, off and on, proclaimed has been needed for decades. It would also nip in the bud the real (if hard to measure) risk to the stability of the global financial system posed by large and ever-growing U.S. current account deficits. And it might stimulate flows of capital to emerging market countries as the vast pool of foreign-held dollar debt diminished.
I doubt that any of this has escaped the leaders of the major countries who understand the forces driving international trade and investment flows. And I’ll acknowledge that they have reasons (beyond inertia) to avoid deployment of what might be dubbed the Trump reality check. For one thing, a disorderly decline in the exchange value of the dollar could devastate foreign firms dependent on American sales and might well also trigger a global recession. For another, it would exacerbate the problem faced by governments and multinational corporations in finding a safe harbor in which to store trillions of dollars’ worth of liquid assets.
But, at a minimum, the scenario offers insight into the tangled web created by protectionist impulses and the difficulty of responding in ways that aren’t mutually destructive. President Trump may believe “trade wars are good and easy to win,” presumably because he believes that the side with the big trade deficits has little to lose. How wrong he is.