Do trade deficits matter?
President Donald Trump certainly thinks they do. Since his campaign, he has tweeted frequently about his unhappiness with America’s trade deficit, and last week he announced tariffs on imported steel and aluminium.
Trump once observed that the problem was that there were a lot of Mercedes-Benz in New York and not many Chevrolets in European cities. But is that due to unfair trade barriers which can be addressed through imposing tariffs, or to what consumers in America and Europe demand?
Economists since the days of Adam Smith have pointed to the latter. Of course, trade barriers do exist, and the international trading system is not an entirely level playing field. But, on balance, a country’s trade position is a reflection of its economic strengths and weaknesses.
Trump’s planned tariffs on all aluminium imports has led the very industry that is supposed to benefit to ask the President to think again. The Aluminium Association, representing 114 aluminium producers, has warned the tariff will likely do more harm than good. A tax will raise the cost of traded aluminium, hurting their industry and their supply chain partners in Europe and elsewhere.
The same can be said be said for a lot of trade barriers. If one barrier distorts markets, adding another is likely to increase the distortions and harm the industry that it intends to protect.
Instead, something more targeted could potentially work better, if the grievance can be established as falling within the rules of the World Trade Organisation (for example, national security issues or anti-dumping breaches).
But the more important factors that determine a country’s trade position are not tariffs, but what it produces. This was understood in David Ricardo’s day, when Britain repealed the Corn Laws in the nineteenth century, which were a protectionist measure favoured by landowners that raised the cost of imported grain.
Ricardo is known as the father of international trade, and his model demonstrated that a country’s comparative advantage determined what it produced, and thus traded.
If a country produced goods that were highly demanded by consumers everywhere, it would sell that good abroad. To improve the trade balance, a country should focus on how to increase productivity and production of highly demanded goods and services. Because of specialisation, a country would produce less of other products and import those while focusing on what it was good at.
Looking at America today, its long-standing trade deficit is due to a number of factors. Given that the US economy is largely based on services, the lack of liberalisation of the global market for services in contrast to manufacturing has hindered its exports. The US is still the largest exporter of services in the world, and tends to run a surplus in this sector. Remedying the overall deficit would entail promoting the liberalisation of service sectors in markets around the world, which was a part of the abandoned US-EU free trade agreement, TTIP.
Once investment flows are taken into account in the broadest measure of the external deficit, America still runs a current account deficit, but it is because foreign companies and investors put their money into the US. Since the dollar is the global reserve currency, there is high demand for US investments, debt, and assets. So, there are “imports” of investment funds, due to the attractiveness of the US economy.
America’s trading position with the rest of the world thus reflects a range of economic considerations that explain why it has a long-standing current account deficit.
Trade deficits only matter if they reflect an underlying weakness of an economy. For the US, that’s not likely to be the case, making the imposition tariffs a completely ineffective “solution” to a problem that doesn’t exist.