Tariffs and the Trade Deficit
By Pierre Lemieux
Michael Hicks, a professor of economics at Ball State University, tweeted on Monday:
For everyone who thinks trade policy (tariffs) will affect the trade deficit (instead of just slowing economic activity in general, as taxes without better public services tend to do, I offer Exhibit #1: US Trade Deficit Grows for months after Trump’s Tariffs.
Instead of reproducing the trade deficit chart used by Professor Hicks, my figure shows exports and imports separately. The increase in the trade deficit (the difference between the two curves) since June can be seen clearly.
Many people seem puzzled by the fact that the U.S. trade deficit does not necessarily decrease as tariffs are increased. But this is not surprising when you realize that the trade deficit is influenced by many other factors, including the value of the dollar, the net inflow of foreign investment, total domestic savings, and the federal budget deficit, to name the obvious suspects.
Consider the following propositions:
Ceteris paribus (other things being equal), a tariff will decrease the trade deficit (or increase the trade surplus).
Ceteris paribus, a higher U.S. trade deficit will push down the value of the dollar.
Ceteris paribus, a lower dollar will push down the trade deficit.
Ceteris paribus, the attractiveness of investment in the U.S. will push up the trade deficit.
Ceteris paribus, lower domestic savings will push up the trade deficit.
Ceteris paribus, a higher federal budget deficit will push up the trade deficit.
All of these are true, but only ceteris paribus. In the broader economy, the variables they represent influence each other. And variables such as the trade deficit, the exchange rate of the dollar, and foreign investment are determined simultaneously. The economy is a general equilibrium system, where all variables are determined like in a system of equations.
I previously discussed an analogous case: supply and demand–“A Frequent Confusion and the Yo-Yo Economic Model,” January 29, 2018. Quantity is determined by price and price is determined by quantity. These two propositions are not contradictory because price and quantity are determined simultaneously by two equations, one representing demand (quantity demanded as a function of price), the other one representing supply (quantity supplied as a function of price).
Back to the trade deficit. Consider for example propositions (2) and (3) above (in isolation from the other propositions). These two propositions are not contradictory because both the trade deficit and the price of the dollar are determined simultaneously, given other autonomous factors such as the attractiveness of the American economy. More generally, we can say that the trade deficit and the exchange rate are determined simultaneously with all other variables in the economy
What presumable happened over the past few months is the following. The federal government imposed new tariffs, which ceteris paribus would have pushed down the trade deficit and the dollar. But other factors exerted upward pressure on the currency. A trade war and deteriorating prospects for the world economy made the American economy relatively more attractive (the dollar is considered a refuge value). The increasing federal deficit attracted more savings to America. On balance, the dollar increased, pushing imports up (in conjunction with the brisk pace of the American economy), exports down (in conjunction with foreign retaliation), and the trade deficit up.
A fixation on the trade deficit (which has been typical of protectionists for centuries) as the source of all evils fails to consider the economy as a system. Tariffs don’t determine the trade deficit, except in a ceteris-paribus sense.