July 27, 2018 | By Robert L. Thompson

Guest Commentary - The Trump-Navarro Tariffs: A Wrong-Headed Approach to the Wrong Problem

By Dr. Robert L. Thompson, Nonresident Senior Fellow, Chicago Council on Global Affairs
 
In 1930 Congress passed the Smoot-Hawley Tariff Act which raised US import tariffs with the objective of protecting American jobs that were being lost in the Great Depression. The Smoot-Hawley Act precipitated a trade war of escalating tariffs through retaliation and counter-retaliation which drove the Great Depression deeper and longer than would otherwise have occurred. The adverse consequences of this trade war were only ameliorated after World War II through a series of multilateral tariff reductions negotiated under the auspices of the General Agreement on Tariffs and Trade (GATT).
 
In economists’ discussions of tariff policy the names Smoot and Hawley live in infamy. The Trump-Navarro Tariffs are destined to have the same fate.
 
The stated rationale for imposing the Trump-Navarro Tariffs on imports into the United States is the existence of large imbalances in trade between the US and individual countries with which we trade. Trade imbalances are cited as symptomatic of unfair trade practices that cause the loss of American jobs. However, it is dynamic shifts in comparative advantage resulting from technological change that accounts for much of the shift in American jobs overseas. In the case of China, there is also a large problem of intellectual property theft.
 
Imposing tariffs on imports into the US is a wrong-headed approach to a misdiagnosed problem.
 
Bilateral balances of trade are meaningless. Think of it this way. A country's balance to trade is analogous to a household's balance of trade. Members of the household sell their services to their employers. This provides their income that in turn gets spent on a variety of goods and services. It makes no more sense to suggest that bilateral trade between individual nations should be balanced as to suggest that a household's payments with a supermarket or a barber should each be balanced.
 
The key issue is whether a household's purchases of goods and services from multiple sources in any given year are less than, equal to, or greater than its income, likely also from multiple sources. If the expenditures exceed receipts, the household must borrow to finance some of its purchases. Conversely, if its income exceeds purchases, the household is a net saver.
 
A country’s balance of payments is like a household’s. Revenue from selling goods and services to foreigners in various countries minus the value of their purchases of goods and services from us is known as the balance of the “current account.” Just as in a household, if the receipts from buying goods and services from foreigners exceeds the value of what they buy from us, the deficit is offset by borrowing from foreigners, known as the “capital account.” For payments to be balanced, a current account deficit must be offset by a capital account surplus, or vice versa.
 
In the case of a household, we think of a “payments deficit” caused by expenditures on goods and services exceeding income requiring net borrowing. However, in international payments, the causality can go in the opposite direction. The US is a low saving nation, and we are running large government deficits which Americans are not saving enough to finance. Therefore, a large volume of the bonds the US Government sells to finance its budget deficit is bought by foreigners.
 
The foreign buyers enter the foreign exchange market to buy the dollars with which to buy the US Government debt instruments. A foreign exchange market can be thought of just like a commodity market. Since payments between nations are composed of both trade in goods and services (the "current account") and international capital flows (the "capital account"), the market clearing condition (i.e. where supply of equals demand for foreign exchange) requires that the exchange rate (i.e. price of foreign exchange) adjust to ensure that any net capital inflow be offset by an equal current account deficit.
 
Foreigners buying more dollars in the foreign exchange market puts upward pressure on the dollar exchange rate. Larger net capital inflows require the dollar to appreciate sufficiently to squeeze down American exports and increase imports to the US by enough to generate the requisite current account deficit to offset the larger net capital inflow. The point is this. The President can levy all the tariffs on imports he wants, but as long as the dollar is allowed to float freely and we continue to run large Federal budget deficits, exchange rate adjustments will offset his tariffs. His tariffs cannot have the result he desires. The numbers simply do not work.
 
The problem of large US trade deficits (really current account deficits) is the result of large net capital inflows into the United States. In part, this reflects the fact that the United States has been seen as a very attractive place for foreigners to invest. However, looking to the future with projected US Government budget deficits exceeding a trillion dollars per year as far as the eye can see into the future, as long as Americans remain low savers, a substantial part of the budget deficit will be financed by borrowing from abroad (i.e. net capital inflows). As long as the dollar is allowed to float on foreign exchange markets, the exchange rate will adjust enough to generate the requisite current account deficit to offset the net capital inflow.
 
The trade deficit will not be eliminated as long as the Federal budget deficit requires borrowing from foreigners.  
 
The root of the loss of American jobs is technological change, and in the case of China, intellectual property theft. Tariffs are totally ill-suited to address these problems. To address the latter problem, what Trump needed to do was to solidify a working group of like-minded nations which would bring joint pressure on the Chinese Government. Instead, Trump has completely blown that approach by destroying whatever working relationship the US had with the G-7.
 
 

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