Tariffs, Deficits, and Debt

Scott Sumner recently had a post discussing a potential relationship between trade deficits and government debt.  To sum up, since debt must come from savings, if domestic savings are too low relative to domestic investment, then foreign savings must come in and make up the difference; the United States imports foreign savings.  When the government incurs deficits and decides to fund those deficits by incurring debt, the savings used to pay for that debt can come from domestic sources or foreign sources.  In the US, much comes from foreign sources, being a partial amount of the trade deficit.

Some protectionists have used this relationship between trade deficits and government debt to argue that classical liberals (like myself) and others concerned about government debt should support tariffs to reduce the trade deficit.  Reducing the amount of foreign savings coming into the US would increase interest rates and thus make government borrowing more costly.  The government would consequently reduce deficit spending.  That argument is specious, however, for two reasons.

First: interest rates would likely rise, but it is not obvious that will reduce government deficit spending.  The people making spending and budgetary decisions do not face the full costs of their decisions.  Neither do voters (indeed, the costs are spread out across all taxpayers).  Consequently, we end up in a situation that James Buchanan and Richard Wagner call “Democracy in Deficit”: politicians prefer easy choices over hard, and will generally support higher spending and lower taxes. 

Voters face similar incentives.  Indeed, the absolute amount of resources used to produce the same amount of spending will increase if tariffs are used to try and tackle government debt (assuming the same amount of deficit spending occurs, it will be financed at a higher interest rate than would have occurred with larger trade deficits.  Thus, the amount needed to pay back the debt would be higher than otherwise).  No one in the political process faces the incentive to cut deficit spending even with a higher interest rate because “the government” is not a monolithic chooser such as the individual in the marketplace.  Rather, it is a collective made up of many independent choosers, each acting in accordance with their own will and self-interest.

Second: Tariffs are a blunt instrument.  Even assuming (contrary to evidence) that tariffs can reduce the trade deficit, there is no promise that the reduction in debt will come from a reduction in government deficit spending.  It could (and perhaps would, given public choice constraints discussed just above) come at the expense of private investment.  Domestic firm managers would find it harder to expand, to hire, to acquire, and to produce.  Since domestic firm managers do face the full costs of their actions, managers would feel the impact of higher interest rates more acutely than the government choosers.  Using tariffs to reduce government deficits is like burning down a house to kill a spider: sure the spider may be dead, but the collateral damage is far worse.

Ultimately, using tariffs to reduce the trade deficit in the hopes that it reduces government deficit spending is confusing the symptom for the cause of the disease.  Trade deficits may signal excessive government spending, but if that is the case, then the goal should be to actually reduce government spending.  Of course, that is a much more difficult problem for the reasons mentioned above.  But just because it is difficult does not mean one should choose an easier, but probably more harmful, option.

Many economists, from Adam Smith to modern day, dismiss trade deficits as “absurd” and argue their presence causes more confusion than clarity.  The linkage between trade deficits and government debt support their conclusion.

 


Jon Murphy is an assistant professor of economics at Nicholls State University.

READER COMMENTS

Richard W Fulmer
Jul 5 2024 at 11:47am

Data point: Interest rates have risen so much that interest on the debt is now a larger budget item than is defense spending (or it would be if we had, you know, a budget). Federal spending increases haven’t noticeably slowed in response.

Craig
Jul 5 2024 at 2:18pm

“First: interest rates would likely rise, but it is not obvious that will reduce government deficit spending. ”

I agree if foreigners stopped buying treasuries to finance the deficit the government would have to offer better rates and if foreigners began to sell off their treasuries the price of bonds would fall and yields would rise. Indeed I agree the government will try to kick the can down the road some more because for my life its what they do, but I would suggest if foreigners ‘dump’ on the treasuries the deficit and the debt will quickly become untenable and there will have to be some kind of fiscal reckoning. That likely entails less spending, more taxes or inflation or some combination of the three.

SK
Jul 7 2024 at 12:47pm

Would be tough  to see how reduction how reduction of trade deficit would affect gov deficits given two of the largest components of the fiscal deficit are Soc Sec and Medicare.  SS payments are past incurrences and will not be cut so those payments to be made regardless of any tariffs; and lots of health care expenditures that Medicare pays for are domestically sourced.  Add in payments to defense contractors which are US based companies for the most part and to me it seems silly for anyone  to think when breaking down the major components of US gov budget that trade deficit affects it to any extent.

Jon Murphy
Jul 8 2024 at 7:04pm

You are right that it wouldn’t affect mandatory spending much. The idea behind the argument is government would be more careful about borrowing to fund discretionary spending.

Thomas L Hutcheson
Jul 10 2024 at 5:15pm

This seems to have the causation backwards.  Fiscal deficits, given a Fed inflation target means higher interest rates.  These in turn attract foreign capital and overvalue the dollaree.  This makes imports cheaper in elation to domestic non-tradables and makes exporting less profitable.  Ergo, trade deficits.

vince
Jul 8 2024 at 2:08pm

 

Many economists, from Adam Smith to modern day, dismiss trade deficits as “absurd” and argue their presence causes more confusion than clarity.

 

Many other economists claim that large trade deficits are a problem.  And there’s an example of a general problem with economics:  it’s too ideological.

 

As for Adam Smith, trade deficit imbalances were checked by the gold standard.

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