Why a War on Trade Deficits Won't Reindustrialize America

President Donald Trump and his team are out to reindustrialize America. Our steelworkers and auto workers, the president says, have “watched in anguish” as “foreign cheaters have ransacked our factories.” But they know the way out: a tariff-led war on the trade deficit.

It seems simple: If we make imports more expensive, people will buy fewer of them. If imports decrease, the trade deficit shrinks. If we smelt our own steel, build our own cars, and stitch our own track shoes, we make America great again.

Unfortunately, this notion is as fantastical as Ron Vara, the character White House trade guru Peter Navarro represented in some of his books as a real China commentator.  The connections among the many moving parts of the economy are such that pulling the tariff lever to cut imports is more likely to hinder reindustrialization than to help it. This commentary explains why, with special attention to the linkages among trade deficits, budget deficits, investment and saving.

It all starts with the national income accounts

The national income accounts make a good starting point for understanding how various parts of the economy relate to one another.[1] The two most important numbers in the accounts are national product, a measure of a country’s total economic output, and national income, the total income that all participants in the economy earn from their contributions to production of that output. Since national income and national product both arise from the same set of productive activities, we can treat them as equal for purposes of analysis.[2]

National product can be broken down into major components as follows:

Eq. 1: National Product = Consumption + Investment + Government purchases  +  (Exports  – Imports), or more briefly, Y = C + I + G + (Ex-Im)

Here, the term (Ex-Im) represents the trade balance – a deficit if imports exceed exports or a surplus if exports exceed imports.[3] The term I includes investment in means of production and accumulation of inventories. The term G includes purchase of goods and services by government for both current use and investment purposes.

National income can be broken down according to the purposes for which it is used:

Eq. 2: National Income = Consumption + Saving + Net taxes, or Y = C + S + T

Saving, as used in this context, refers to private saving. It is defined as the part of private income that is not devoted to consumption or payment of taxes. It includes household saving plus saving by private businesses in the form of retained earnings. Net taxes means taxes paid to the government minus transfer payments received from the government.  

Since national product and national income are equal, we can combine Equation 1 and Equation 2 and simplify them by dropping the consumption component, which appears in both equations, and moving imports to the right-hand side. Doing so gives us the following useful accounting identity:

Eq. 3: I + G + Ex = S + T + Im

The role of international financial flows

So far, we have discussed only movements among countries of goods and services. For a fuller understanding of issues raised by trade policy, we also need to consider international financial flows (also sometimes called capital flows), which represent changes in the ownership of assets.

For a simplified example of the relation of international trade in goods to financial flows, consider a two-country world in which Americans import cell phones from China. How do Americans pay for the imports? In the first instance, they pay with cash in the form of dollar-denominated bank transfers. The Chinese sellers of the phones could, if they wanted, use the dollars thus earned to buy American soybeans or take vacations in Las Vegas. If so, trade in goods between the two countries would be balanced. But suppose instead that the Chinese are big savers (which they are) and don’t want to spend their earnings on American goods or services. Instead, they choose to invest them in American assets, such as stocks in American companies or condos in Miami. In that case the result will be a financial inflow to the United States that is the exact mirror image of a U.S. trade deficit in goods. Meanwhile China has a financial outflow and a trade surplus.

This example suggests that whether a country has a trade deficit balanced by a financial inflow or a trade surplus balanced by a financial outflow depends on whether foreigners have a stronger appetite for the goods and services it produces or for the investment opportunities it provides. And that is just what we see in the real world.

Over time, the United States has been sometimes on one end of this dynamic and sometimes the other. As Brian Reinbold and Yi Wen document in a paper for the St. Louis Fed, the United States had a trade deficit and net financial inflows in almost every year from 1800 to 1870, due, among other things, to a torrent of capital flowing in from Europe to finance construction of railways. Then, from about 1870 to about 1970, increasingly wealthy U.S. capitalists began investing heavily abroad. In almost every year of that entire century, America ran a trade surplus. Finally, since about 1970, the direction of financial flows has flipped again, with foreign savers acquiring American assets and the U.S. trade balance showing persistent deficits. Figure 1 shows the whole picture:

Note that from this perspective, trade deficits don’t need to be seen as anything especially negative. In fact, it seems more reasonable to look on them as a badge of honor, an indicator of a country’s ability to create investment opportunities.

Two inconvenient truths

With these basics in mind, it is time to come back to the current realities of American trade policy. To set the stage, it will be useful to rewrite our key identity once again. We group domestic private saving and financial inflows from abroad — which, recall, are equal to imports minus exports — on the left-hand side. We now see that these are the sources of funds for private investment and financing the government deficit, expressed as government spending minus taxes:

                Eq. 4: S + (Im-Ex) = I + (G-T)

Figure 2 shows these sources and uses of funds in two stacked charts. Figure 2a places government borrowing on top of private investment to show total uses of funds. Figure 2b  places financial inflows on top of domestic saving to show total sources. Since they represent the two sides of the same equation, the top-line profile of the upper and lower charts is identical.

The first inconvenient truth, seen clearly in the chart, is that U.S. domestic private saving is almost never enough to fully meet the needs of both private investment and government borrowing. There has been just one calendar quarter since 1980 (Q3 1981) when saving was enough to fully fund both private investment and the budget deficit, and even then, the excess was less than 1 percent of national income. In some years, including 1997 to 1991 and 2004 to 2008, domestic private saving has not been enough to cover even the needs of private investment. That leaves a sizable gap, averaging a little over 3 percent of national income per year, to be covered by financial inflows from abroad. By definition, every dollar of financial inflow means a dollar of deficit on the foreign trade account.

Why the addiction to financial inflows? One reason is that American households are not, by international standards, big savers. The U.S. household saving rate, at 4.6% of disposable income, ranks 26^th among 34 countries reported by Trading Economics and is less than a third of the average for the Eurozone. China’s personal saving rate has approached 40 percent in some years. Household saving is supplemented to some extent by business saving in the form of profits that firms retain to cover their own net investment needs, but those average only about half of household saving.

People have offered numerous explanations for low U.S. saving rates. Some blame a culture that emphasizes current pleasures over future security – a tendency to favor a peppermint mocha latte on the way to work more highly than an extra $7 in one’s 401k. Some observers emphasize easy access to credit – why save when you can tap your home equity in case of need? Some emphasize inequality – many households struggle to afford basic necessities, leaving home ownership or retirement savings out of reach. Tax changes, more generous income support for those with low income, and perhaps better financial education might raise saving rates, but there are no easy fixes,

Another way to trim the need for financial inflows would be to cut the fiscal deficit, but that raises our second inconvenient truth: Although politicians of all parties have given lip service to balancing the federal budget, those efforts succeeded only once, in the late 1990s. Ironically, those years of low fiscal deficits did little to limit the need for financial inflows, since they coincided with a collapse in private saving. In fact, the very boom that helped close the federal budget gap may have undermined saving, since rising stock market and home prices made it seem like the good times would never end.

The current administration, like many before it, has promised to reduce the budget deficit. Unfortunately, it is far from clear that it has any realistic plans for doing so. On the spending side, it has made headline-grabbing cuts to the federal workforce, but salaries make up only about 5 percent of federal spending. Meanwhile, the budget team is determined to extend expiring elements of the 2017 tax cuts, perhaps adding tax-free tips, overtime, and Social Security. More than half of all spending, including Medicare, Social Security, Veterans’ benefits, and defense, is off the table. Tariffs themselves could provide some new revenue, but independent estimates, such as this one from the Tax Foundation, say that tariff revenue would not be enough even to compensate for tax-cut extensions, let alone to narrow the already-large fiscal deficit.

What lies ahead?

We are at a moment of great uncertainty. We could soon be in a recession – or not. Tariff rates are changing from hour-to-hour. It is pointless to speculate. But there is one thing we can be sure America will not see any time in the near future. That is a combination of disappearing trade deficits and massive reindustrialization.

Setting aside any doubts over whether reindustrialization itself is a sensible goal, it is certain that accomplishing it would require massive investment. It would require more than just building new plants for assembling cars and stitching shoes. Beyond that, it would require other new industrial plants, mines, and smelters to reshore production of the inputs that the assembly workers and shoe stitchers would need. Not to mention massive investments in energy and transportation infrastructure.

The only things that would make a reindustrialization boom mathematically possible without large trade deficits would be a large federal budget surplus (not just a reduction of the deficit) and/or a leap in private saving to European, or even to Chinese levels. No one in Washington is even talking about either of those, let alone doing anything to make them come about.

So, if the combination of reindustrialization plus tariff-driven cuts in imports is unrealistic, what would be a more reasonable set of policy objectives? Certainly, fiscal responsibility, (meaning rules-based fiscal policy, not a chainsaw), should be part of the package. But the optimal rules-based budget balance, as I have explained elsewhere, would probably be a modest annual deficit, not a surplus. Improving the environment for private investment through reforms that increased government efficiency would also be welcome. (Some good ideas here, for example, but again, no chainsaws, please.)

And if we are to maintain strong investment together with a somewhat smaller, but still non-zero, government deficit, where are the funds to come from? The bottom line is that we should welcome a continued trade deficit, not view it as a reason to declare tariff war on our closest friends and allies.

Originally published by Niskanen Center, reposted by permission.

---

[1] In the United States, the national income accounts are compiled by the Bureau of Economic Analysis (BEA), a part of the Department of Commerce. The following discussion is based on a somewhat simplified version of the accounts. Among other points, it glosses over the distinction between national and domestic income and product, the difference between gross and net measures For full details, see A Guide to the National Income and Product Accounts of the United States from the BEA. For a shorter overview, see these posted versions of Chapter 5 and Chapter 6 of my textbook, Introduction to Economics (BVT Publishing).

[2] In practice, the BEA compiles its measures of national income and product from different sets of data that do not exactly agree. That results in a small difference, or statistical discrepancy, between the measured values of income and product.

[3] The terms trade deficit, trade surplus, or balance of trade, as used here, include both goods and services. Confusingly, some less careful discussions use the same term to mean the balance of trade for goods only, excluding services. That was the case, for example, in a memo released by the Office of the US Trade Representative to explain the calculations behind President Trump’s April 2 announcement of reciprocal tariffs. More precise discussions prefer the term current account deficit, a concept that includes trade in both goods and services, with adjustments for certain other types of international payments. For details, see, for example, this explanation from Investopedia.