Trump is backing tariffs in the fight against America’s trade deficit

They can be thought of as a way of boosting local manufacturing – but with severe dangers

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Economists have typically looked askance at tariffs as a tool of economic policy. Their prevailing assumption is that free trade is best. And if there is a significant trade deficit, then the appropriate policy is not tariffs but a lower exchange rate. This is the equivalent of a uniform tariff on imports, plus a uniform subsidy on exports, thereby treating all sorts of trade interactions equally. So, why is Trump so keen on tariffs?
We need to go back to basics. Many people seem to believe that if a country runs a current account deficit – that is a trade deficit, plus various other international items that affect income, and not to be confused with the government’s budget deficit – that this is a country’s equivalent to a business making a loss. Similarly, when a country is running a surplus, then this is viewed as the equivalent of making a profit. Sometimes, it seems that Trump believes this.
Yet, this is complete bunkum. If surpluses amounted to profits and deficits to losses then international trade would bring no benefit at all since the total of the world’s surpluses is balanced by the total of its deficits, so the overall profit would be zero.
In fact, the benefits of trade come from exchanging exports for imports, which improves the allocation of resources and enables the realisation of economies of scale. In general, the larger the amount of trade, the greater the benefit, whether the balance is a surplus or a deficit. And it can sometimes be healthy for a country to run a deficit, especially when this facilitates higher real investment. This is especially relevant for rapidly developing, poor countries.
But the peculiar thing about the current situation is that one of the world’s richest countries, namely the United States, is running a deficit and some of the world’s poorest countries in Asia, including China, are running surpluses.
Meanwhile, many other countries that are not poor at all are running huge surpluses relative to their GDP, including Japan, Singapore, Switzerland, Norway and Germany. They are using overseas markets to generate demand for their own production.
You could argue that countries such as the US (and the UK) that are on the other side of this arrangement shouldn’t have a problem with it. After all, the surplus countries are providing us with goods and we are giving them pieces of paper in return. That doesn’t sound like such a bad exchange – until you contemplate what the build up of these pieces of paper implies.
Countries that are running a persistent deficit are worsening their international asset position. This amounts to negative investment. And often the pieces of paper that we transfer to foreigners are the ownership certificates of large parts of our industry and utilities.
There is a powerful counter-view to all this which holds that America’s central problem is that it simply doesn’t save enough. If it saved more, then its deficit would fall back. 
This is true but it misses an essential point. More saving, i.e. less spending, would weaken aggregate demand and reduce employment. To correct the trade deficit by this method alone would imply engineering a domestic slump.
So, if Americans could be persuaded to save more, then some other sort of demand would have to be higher to fill the demand gap. That is where the trade deficit comes in. America needs both increased domestic saving, a switch of spending from imports to domestic production and stronger external demand for American goods and services.
It isn’t that easy for America to address this situation by engineering a lower dollar. In any case, for Trump, tariffs have a distinct advantage precisely because they do not fall evenly across the board. They can be applied at different rates to different types of goods and at different rates to goods from different countries. Also, they do not normally apply to services.
Accordingly, they can have a distinct impact on the structure of production. In particular, the imposition of tariffs on imports of goods, especially from China, can be thought of as a way of boosting the demand for American manufacturers and increasing employment in manufacturing. Productivity growth is normally much higher in manufacturing than it is in the service sector.
So, if Trump were able to boost the size of America’s manufacturing sector, then that could be seen as helping the prospective growth of productivity – and hence the growth of the economy overall.
This is not to say that Trump’s embrace of widespread and swingeing tariffs is to be admired or recommended. Even if they do not encounter substantial retaliation, tariffs come with high potential costs and severe dangers. They increase inflation – just as when a country experiences a fall in the exchange rate. This is not only because of the direct impact on the cost of goods in the US, but also because increasing the demand for US output puts pressure on limited supply capacity.
Secondly, the very differentiation and flexibility about tariffs that Trump likes can lead to damaging distortions as the president-elect panders to domestic pressure for protection of particular industries.
Yet, many countries are currently using international trade to build up substantial overseas assets and seem to have no intention of making their trade relations reasonably reciprocal. If this is sustained for a long period – and it already has been – this puts severe pressure on both the finances and the real economies of deficit countries. This was a leading causative factor behind the global financial crisis (GFC) of 2007 to 2009.
After the GFC, the size of global imbalances, including America’s deficit and China’s surplus, shrank. But they have recently been rising again. 
This is a two-way street. Not all of the adjustment should fall on deficit countries. 
In the absence of any action from the surplus countries, we shouldn’t be surprised to see a reaction from Trump.
Roger Bootle is senior independent adviser to Capital Economics and a senior fellow at Policy Exchange. [email protected]
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