Trade Deficit And Tariffs: It Is Complicated

Originally published on March 8, 2018

President Donald Trump's announcement that he is instituting tariffs on imported steel and aluminum came as a surprise to some, although reducing the trade deficit was one of his campaign promises. Dealing with the trade deficit issue is a complicated one, since no one factor impacts trade. What is complicating a necessary discussion at the moment is the vitriol with which President Trump's tariff proposal is being discussed. For example, the media repeated commentary that the market would collapse once President Trump signed the tariff executive order; yet, the S&P 500 Index closed almost .50% higher today.

Some believe the trade deficit is harmful, while others think it is not problematic. Today's economy is a global one, and "free" trade is likely to be a policy that results in the strongest rate of global growth. However, free trade needs to be "fair" trade as well. Today, Tesla's Elon Musk replied to one of President Trump's tweets that raises the issue of "free" versus "fair" trade.

In order to deal effectively with the trade deficit, one needs to know what causes the deficit - and there is no single factor. Everything from exchange rates, budget deficits, personal savings rates and private investment has an influence on the trade deficit. From an economic perspective, though, the trade deficit is an issue for a number of reasons, but a key one is the negative impact the trade deficit has on GDP.

GDP is commonly defined as:

• GDP = C + I + G + (X - M)

Where

• C = private consumption
• I = gross investment
• G = government spending
• (X - M) = exports - imports

In the above equation, then, if imports exceed exports, this becomes a deduction from the GDP calculation.

The trade deficit for the U.S is certainly one that seemingly is getting larger. On Wednesday, the monthly deficit figure was reported at -$56.6 billion and was larger than the high end of the consensus estimate. The below chart of the annual trade deficit puts the deficit into clearer focus.

As the U.S economy continues to grow, though, looking at the deficit as a percentage of GDP is important. Since the end of the financial crisis in 2009, as a percentage of GDP, the trade deficit has remained mostly around -3%.

On a big picture basis, in a paper by James McBride titled "The U.S. Trade Deficit: How Much Does It Matter?" he notes, "the fundamental cause of a trade deficit is an imbalance between a country's savings and investment rates. As Harvard's Martin Feldstein explains, the reason for the deficit can be boiled down to the United States as a whole spending more money than it makes, which results in a current account deficit." This means the country borrows from foreign governments to fund the shortfall, and this foreign source of credit will end at some point.

As noted in the McBride paper:

• More government spending, if it leads to a larger federal budget deficit, reduces the national savings rate and raises the trade deficit. A portion of the budget deficit is effectively financed through a rise in the total amount Americans borrow from abroad.

• A stronger dollar makes U.S. exports more expensive. The net effect is a widening of the trade deficit. And if the U.S. economy is strengthening, consumers have more income to use to buy more imported goods, again increasing the trade deficit.

Trade tariffs under a President Trump are not a new type of policy. According to an article by Marcus Nunes titled "Don Trump: Meek Inheritor of the Forgotten Reagan Protectionist Legacy?" Nunes notes that under President Reagan:

• "The share of U.S. imports subject to some form of trade restraint increased from 12% in 1980 to 23% in 1988."

• "President Reagan slapped a 100% tariff on Japanese consumer electronics. And a 50% tariff on Japanese heavy motorcycles, as a favor to Harley Davidson, hog-makers. Forgotten today, Harley was about to go under. Reagan rode to the rescue, and Harley Davidson survives to this day. I guess if you like American-built huge motorcycles, protectionism has its merits."

• "Reagan was such a ferocious protectionist that Milton Friedman wrote that the one-time actor was 'making Smoot-Hawley look positively benign.'"

The economy during the Reagan years seemed pretty good with average GDP growth of 3% during his term.

Tariffs are not new, and when they have been used in the past, each occurrence has not resulted in Armageddon. Having a conversation or evaluation of trade practices could lead to positive outcomes. Many once-vibrant manufacturing oriented cities in the Midwest have business districts that have become near ghost towns. And certainly all manufacturing is not coming back to the U.S., and some may have moved overseas for good reasons; however, reviewing trade practices and their potentially negative impact on U.S. companies seems like a worthwhile endeavor. The steel industry is another example. The U.S steel industry's woes seem somewhat self-inflicted, and tariffs may simply delay the inevitable.

Importantly, though, the U.S. trade deficit is sufficient enough in size that it does warrant evaluating the causes and potential solutions. The Elon Musk reference above certainly seems to raise a valid issue - that of free trade versus fair trade. What seems to be clear, at a minimum, is the fact that there are some trade issues that might need to be dealt with on a targeted basis.

Comments

[Lawrence J. Kramer]

It is the privilege and burden of the world's only superpower to issue the world's reserve currency. The benefits are that we get cheap goods and we pay for them in our currency, which means the dollars stay here (because dollars only exist in US banks) and are invested here, usually in Treasuries, lowering interest rates for everyone here. (A trading partner that wishes to repatriate US proceeds has to sell its US dollar accounts to its central bank, which then owns a US bank deposit, or bonds, as the case may be.)

The downside of issuing the reserve currency is that the issuer must run a trade deficit to provide the currency, and the downside of running a trade deficit is that the country must run a fiscal deficit to absorb the trade dollars (or else foreigners buy up real assets or, even worse, bogus assets - aka liars' loans), and the country's producers don't get to produce as much product as they might if cheap imports were not supplanting them.

In Ricardian terms, the more powerful a nation becomes, the more its comparative advantage - the thing that drives international trade - shifts from production to consumption, i.e., the thing it can do most cheaply is simply BE the best place on earth to sell things. Just as the comparative advantage of a tourist mecca is its physical climate, the comparative advantage of a superpower is its political and economic climate, most notably the stability of its money. This advantage is exploited by industries that serve it, i.e., advertising, financing, and distribution of other people's goods. (After all, what do tourist destinations "make" for their customers?)

But with a comparative advantage in supporting imports, we don't get to make exports, and we have not yet figured out how to prosper, how to share the benefits, of that advantage. Rather, it accumulates in the hands of the owners of businesses that cater to consumers. (See Amazon and Wal-Mart). This is what makes populists believe that bringing back the dinosauurs, selling things in which we do not have a comparative advantage but from which we do know how to distribute the winnings, is a better policy than exploiting our comparative advantage in stability and distribution. Thus, trade deals that encourage a trade deficit are labeled "unfair" to the US, when, in fact, they are only unfair to US citizens who can't enjoy their benefits to the US in the aggregate (because Jeff and Sam et al. are enjoying them).

These are challenging problems, because, as Upton Sinclair observed, the most difficult thing in the world is to get someone to understand something when his salary depends on his not understanding it, e.g., that coal and steel are not where our bread will ever again be buttered. And yet, such is the case, or would be if we could figure out how to share the fruits of our success at nation-building. Instead, we are unbuilding ourselves, electing fools, and making ourselves NOT the world's remaining superpower. Soon, we won't be burdened with issuing the world's reserve currency, we will pay for things in Yuan and Euros and Yen, our prices and interest rates will rise, and our industries will return (although they will be staffed by robots owned by capitalists, defeating the whole "pupose" of the purposeless fall from power), but, at least trade will be "fair."

Whoopee.

[labradoodle]

Lawrence,
I respectfully disagree. The US should be the worlds' biggest steel exporter. Here's why:

1.)Most steel exporting countries must import both their met coal and iron ore from as much as a third of the way across the world, and then move the finished product as much as HALF WAY across the world to the US. We in the US have those things virtually and sometimes literally right next to our steel plants and we have therefore, much cheaper sources of raw materials.

2.)Most overseas steel producers have power prices that are much higher than here in the US. For example, natural gas prices are less than one half that of Europe and the far east and NG prices are ONE THIRD the world price in Pittsburgh due to the Utica shale right under that city.

3.) The US takes the second fewest man hour to create a ton of steel in the world.

4.) The US steel worker has seen stagnate wages for thirty years and has seen their purchasing power nearly halved. The far east and Europe, by comparison, have seen steel wages go up and will continue to go up for the forseeable future.

5.) Overseas competitors are often directly subsidized and even owned by their governments, whereas ours are not. Our tariffs on steel are very low versus those overseas. We are not even allowed access to sell in most markets. Just like cars, we in the US have the most competitive market in the world and we can compete with anyone if only the world had a FAIR playing field.

6.) The US has some of the largest iron ore and coal reserves in the world. Logically, industry moves to the source of its raw material to have the cheapest raw material prices available. Witness the meat packing industry that moved to the High Plains region where all of the feedlots went in order to access the cheapest grain and cattle in the country. Same with oil refineries going to the GOM, steel plants going to the source of cheapest coal(it takes several tons of coal to process one ton of iron ore), etc. Ideally, steel prices, like all items, should price higher the farther away from its sources of raw material are. Labor costs, currency differentials, and tariff and non-tariff barriers really distort the natural free market that should exist.

Your thinking is flawed by believing that steel production is a low tech industry only worthy of low tech countries.

[Lawrence J. Kramer]

"Your thinking is flawed by believing that steel production is a low tech industry only worthy of low tech countries."

We don't have a comparative advantage in steel. When I was lawyering, I could type faster than my secretary. But she still did the typing, because I could lawyer better than I could type, and she could type better than she could lawyer. You are making an absolute advantage argument, but international trade is a comparative advantage thing. It makes no difference whether we can make steel more cheaply than China; it matters whether we can produce customers and the world's best money more cheaply than we can produce steel.

[labradoodle]

Lawrence,
And what happens when, not if, the dollar fails? Then we can only borrow and import goods to the degree that we can generate value by exports and producing value added goods, like everyone else. Shouldn't we be prudent and retain a pool of talent and industrial base against that inevitability?

[Sayitwithlyrics2]

The trade deficit exists because business decides it is in their best interest to create someplace else and sell here (US), and not to create here and sell elsewhere.

There are a host of factors that contribute to each business' decision -- labor costs, material costs, logistics costs, regulatory costs, taxes, access to necessary skills / infrastructure, patent / IP protection, etc.

Compelling business to do what it doesn't want to do otherwise may be a viable negotiating tool (and I think how Trump is using tariffs), but is not a good long-term solution. The only long-term solution is to make the US the preferred place to create for as many businesses as possible based on creating the best mix of the factors that drive their decision making process.

[TechVet]

@goifls,
“The only long-term solution is to make the US the preferred place to create for as many businesses as possible based on creating the best mix of the factors that drive their decision making process.”

And the tariffs on Steel and Aluminum basically undo the corporate tax cut favorability by increasing material costs for manufacturing businesses that consume the raw steel and aluminum products. One doesn’t require a tariff in order to negotiate trade issues. It appears from his first year in office that the only negotiating tactics that Trump knows is threats and hostage taking. Neither are very effective tools that advance deal making.

[Sayitwithlyrics2]

TechVet,

Trump's style is his style. I'm not here to bicker whether it is good or bad, just to report the facts. His style is to take a very strong position, then give a little ground. He blusters a lot, and every now and then you have to live up to the bluster or it loses all credibility.

Seems to me like that is what he did here, but I could be dead wrong. Time will tell. I'll leave the political banter to you. Enjoy.

[TechVet]

Giofls
I don’t see anything that Trump has actually made any great deals or even given any ground on. It appears he has been all bluster and no substance and no deals.

[Maxander10]

America's widening Trade deficit is a strong reason for shorting US stocks including Tech stocks.

[Just Some Guy]

Anybody who tries to rattle the status quo causes a certain type to have nervous breakdowns. Will the tariffs cause trouble? Yes. Are they needed? Yes. Will they have benefits to the US? Yes. Will they cause retaliation? Yes. Did Smoot-Hawley cause the Great Depression? No. Does Ricardo's "comparative advantage" mean the US should never increase tariffs? No. Will the sun rise in the east tomorrow? Yes.

[Ben Gee]

The sun will rise tomorrow is the only statement is true.
Tariffs will NOT benefit the US.

[johndoe1400]

Will the sun rise in the east tomorrow. NO !

Depending on the axis of the earth, it can rise anywhere from between ENE and ESE i.e. between the Tropic of Cancer and the Tropic of Capricorn.

[TechVet]

@Just Some Guy,

“Will they(tariffs) have benefits to the US?”

Of course, the response is far from a simple yes or no answer. Like any government decision or program there will be winners and losers. Maybe the better question is will there be more winners than losers because of the metal tariffs?
There are about 142,000 workers in the steel industry and about 161,000 workers in the Aluminum industry. There are over 6.5 M workers in manufacturing industries that consume these metals to produce their products.
So, basically the tariffs are being used to protect about 300,000 jobs but increasing prices for many producers and putting over 6.5 Million plus jobs at risk.
An example:
Steel Keg manufacturer Scott Bentley uses American steel which currently costs more and puts him at a competitive disadvantage to foreign manufactured kegs or US manufactured kegs that use imported steel. An increase in his steel material will make his business unsustainable as foreign manufactured Kegs will use cheaper steel and not be impacted by the steel tariffs. Now, his company only employs 20 people, but imagine the domino effect of manufacturing businesses that will have layoffs because of less demand for their increased costly products or worse, those that move manufacturing offshore in order to access lower cost metals. This lower demand and offshoring is estimated to cost 5 manufacturing jobs lost for every one gained.
http://bit.ly/2G94r6n

So, the answer to you question is really that the US will be hurt much more than it benefits from the tariffs and this not even considering the effects on sectors of the US economy targeted by foreign countries in retaliation.

“Did Smoot-Hawley cause the Great Depression? No.”
Of course, this question is a red herring since at the time Smoot-Harley was signed the US was already entering a recession and no person with any reasonable level of knowledge would attempt to blame a single event for the Great Depression. It is commonly acknowledged that Smoot-Harley did play a major roll in the trade wars that resulted and was partially responsible for the Great Depression lasting as long as it did.