The current administration claims that the U.S. trade deficit is proof that most of the world is ripping off the U.S. through bad trade deals or unfair trading practices. Swindlers are easily flagged: any country running a trade surplus with the U.S.
The last year the U.S. ran a trade surplus – which, the administration insists, should not be interpreted as proof that the U.S. is ripping off most of the world – was 1975. The fact rankles the administration bigly. To settle accounts, it is turning to its favorite blunt instrument: tariffs.
The choice is unsound. Imposing tariffs to reduce a trade deficit is like taking a shot of turpentine twice a day to get rid of freckles. Turpentine is poison, ingesting it won’t get rid of your freckles, and there’s nothing wrong with freckles, anyway.
Economists have long known that tariffs do not affect a country’s trade balance. Several were on to this in the latter 1600s. These economists noticed something peculiar. When a country placed tariffs on imported goods, imports fell, but so did exports, and the trade balance didn’t change. A country’s trade balance seemed to be determined by larger, more fundamental factors. In the mid-1900s, economists identified them: domestic saving and investment.
The idea is this. A country’s trade balance is determined by the difference between domestic saving and investment. If domestic saving exceeds investment, the country will run a trade surplus. If investment exceeds domestic saving, the country will run a trade deficit.
Let’s clarify the terms. Domestic saving is private saving – that of households and businesses – plus public saving – that of federal, state and local governments. A government has positive saving if it has a budget surplus, negative saving if it has a budget deficit. Investment consists of businesses’ purchases of capital goods, change in inventories and residential investment. Exports and imports are of goods and services.
The relationship between saving and investment is crucial. To finance investment, businesses must draw from retained earnings, issue bonds or stock, or borrow from banks. Whichever way, the funds to finance investment come from domestic saving – and, if necessary, foreign saving.
Here’s how it works. The U.S. routinely posts a low household saving rate, large federal budget deficits, and sizeable investment. Exceptions are few. Consequently, domestic saving is routinely less than investment. That is, domestic saving is routinely insufficient to finance investment. Routinely, with respect to domestic saving and investment, translates to the past 49 years.
When domestic saving is insufficient to finance investment, businesses must offer greater returns on financial assets to attract funds. Foreign savers jump.
To buy U.S. financial assets, foreigners must first buy U.S. dollars on the foreign exchange market. That drives the foreign exchange value of the dollar up, which in turn makes U.S. goods more expensive for foreign buyers and foreign goods cheaper for U.S. buyers. U.S. exports fall and U.S. imports increase, leaving exports less than imports. That’s a U.S. trade deficit, and it’s equal to the difference between domestic saving and investment.
What if the U.S. imposes a tariff on imports? Prices of imports increase; U.S. buyers purchase fewer imports. Fewer import purchases means fewer U.S. dollars supplied to the foreign exchange market. The dollar appreciates; U.S. goods become more expensive for foreigners, foreign goods become cheaper for Americans. U.S. imports fall, U.S. exports fall. No change in the difference between saving and investment; no change in the trade deficit. Tariffs harm the country that imposes them, they won’t change a country’s trade deficit, and there’s nothing wrong with a trade deficit, anyway.
Reg Murphy Center