Trump is wrong: Raising tariffs won’t fix the trade deficit

President-elect Donald Trump’s obsession with tariffs reflects a deep-seated antipathy toward trade and trade deficits — in his own words, “trade deficits hurt the economy very badly.”

Whether the trade deficit is really a problem for the American economy is debatable. But either way, most economists oppose using tariffs to address the issue, arguing that higher tariffs will boost inflation, lower real wages, kill jobs, disrupt the global economy and weaken relationships with our allies. And on top of all that, nobody even knows how much of a dent in the trade deficit would be made by higher tariffs, if any at all.

There is a far better way to narrow the trade deficit while addressing the country’s economic challenges: Cut the federal budget deficit.

A tariff is nothing more than a tax on imports brought into the U.S. It is paid by the importer, and, unless the importer absorbs the additional cost in the form of lower profit margins, the cost gets passed on to the final purchaser. (Trump’s claim that foreign exporters will lower their prices in response to our tariffs has been thoroughly debunked.) This, in turn, motivates households and businesses to switch from purchasing imported goods to purchasing domestic goods. In consequence, imports fall, domestic production rises and the trade balance (exports minus imports) becomes less negative. Sounds good! What could go wrong?

For starters, the discussion above assumes that tariffs are raised against all of our trading partners, as with the 10 to 20 percent tariff Trump promised on the campaign trail. But he also has a hit list of individual trading partners — Mexico, Canada and China — that have incurred his wrath. A tariff on China alone (or any other country) can be evaded by routing exports through third countries; this would reduce our bilateral trade deficit against China, but increase it against other countries, leaving our overall trade balance little changed. Or, even without this tariff evasion, other countries could pick up the market share lost by China.

Second, by raising domestic prices, the tariffs would encourage the Federal Reserve to keep interest rates higher, making the dollar more attractive to foreign investors and boosting its value against other currencies. This would make our imports cheaper and our exports more expensive, thus reversing some of the narrowing of the deficit caused by the tariffs. Nobody knows how much the dollar would rise — I was once in charge of forecasting exchange rates at the Fed, and I doubt we ever beat a random walk. But some increase is likely.

Third, imports may be less responsive than generally assumed. There are many products that will remain cost-effective to import even after tariff hikes, either because of very low wages abroad (toys and clothes), differences in natural supply (bananas) or accumulated specialized expertise and infrastructure (semiconductors).

Finally, tariffs hikes would likely put a damper on American exports, and not only because of the rise in the dollar. The higher prices of imported inputs stemming from tariffs would raise production costs for many firms, reducing their competitiveness in foreign markets. And, of course, hikes in tariffs here invite retaliation via tariff hikes abroad on our exported goods, further weighing on U.S. exports.

In sum, the effects of higher tariffs on the trade balance are complex and hard to predict, but most likely would reduce the trade deficit by less than might be expected at first blush. Indeed, nearly all of the factors offsetting tariffs described above were apparent after Trump’s 2018-2019 hikes, which left the trade deficit entirely unchanged. This is just one episode, of course, but analysis by IMF researchers of 151 economies over several decades confirms that tariff hikes have little effect on the trade balance.

Is there a way to reduce the trade deficit that is both effective and promotes the country’s long-term economic prospects? Yes: shrinking the federal budget deficit.

At present, the budget deficit amounts to some 7 percent of GDP, an extraordinary figure during a time of economic expansion. Reflecting borrowing to finance budget deficits, the federal debt is at nearly 100 percent of GDP and on track to reach 150 percent by the middle of the century. This is clearly unsustainable, and the sooner that steps are taken to reduce the budget deficit, the smaller the disruptions to the economy will be and the more resources will be available for private-sector investment.

But shrinking the budget deficit will also raise the level of national saving, and insofar as the trade deficit reflects our nation’s spending in excess of our income, budget cutting will lead to trade-deficit cutting as well. If Trump were serious about restoring balance to our economy, he would forget about tariffs and focus on getting our fiscal house in order.

Steven Kamin is a senior fellow at the American Enterprise Institute, where he studies international macroeconomic and financial issues.