Why tariffs won't fix the trade deficit

Protectionists argue that taxing imports will close the trade deficit and bring American industry back to its former strength. The argument runs into a basic accounting identity, which anyone who has sat through an economics course should recognise. A country's trade balance equals the gap between what it saves and what it invests at home.

The question is live again. Donald Trump, the presumptive Republican nominee, has floated a universal tariff on all imports and far steeper duties on Chinese goods, while the Biden administration in May raised duties on Chinese electric vehicles to 100 per cent. Both parties now treat import taxes as a respectable tool of industrial policy. The goods deficit they say they want to shrink ran to about $1.06 trillion last year.

Savings decide the balance

As long as the United States runs big federal budget deficits and households save little, the country must attract capital from abroad, and that inflow comes with a matching deficit in goods trade. Tariffs tend to push the dollar up, which hurts American exporters and diverts imports through countries that face no tariff. Trade gets rerouted. The accounting stays the same.

The identity is worth spelling out, because it is where most tariff arguments go wrong. Every dollar the federal government borrows beyond what Americans save has to come from somewhere, and when it comes from abroad, foreigners must first earn the dollars they lend. They earn them by selling Americans more than they buy. A tariff changes the price of an imported washing machine, but it does nothing to the gap between national saving and national investment, so the deficit reappears in another product line or another country.

How the dollar undoes the duty

The mechanism runs through the currency market. When Americans buy fewer imports, they sell fewer dollars for foreign currency, and the dollar tends to rise. Foreign exporters can also let their own currencies slide to keep their goods competitive. A stronger dollar makes American soybeans, aircraft and machinery dearer abroad, so exports shrink alongside imports and the balance barely moves.

Rerouting does the rest. After Washington imposed duties on hundreds of billions of dollars of Chinese goods in 2018 and 2019, China's share of American imports fell, but imports from Vietnam, Mexico and other countries rose to take its place. Some of that reflected factories genuinely moving; some was Chinese components assembled a border or two away. The bilateral deficit with China narrowed while the overall goods deficit did not.

What the last round showed

The first Trump tariffs are the cleanest test available. The overall goods deficit widened in 2018, the year the biggest duties began, because a large tax cut boosted demand and federal borrowing rose. Beijing retaliated against American soybeans and other farm exports, and the government ended up paying farmers billions of dollars in compensation. Most academic studies of the episode found that American importers and consumers bore nearly all of the cost of the duties, rather than foreign suppliers.

The currency channel showed up as well. The yuan weakened past 7 per dollar in August 2019, the month the Treasury labelled China a currency manipulator, which handed Chinese exporters back part of what the tariffs had taken. Washington collected the duties; American buyers paid them; the trade gap carried on.

The case for duties, fairly put

Defenders of tariffs have a better argument than the trade balance. Duties can protect industries judged strategically vital, such as chipmaking or steel, and can buy time for domestic producers to reach scale. They also raise revenue, which, other things equal, narrows the budget deficit and so nudges national saving up. That last channel is real but small, since the sums raised by duties are modest next to federal borrowing and are paid largely by American households, who may save less as a result.

A national-security case can justify a tariff on its own terms. It should be judged on those terms, including the higher prices and the retaliation it invites, rather than sold as a cure for a trade gap it cannot reach.

Who gains and who pays

The winners from a broad tariff are the protected producers and the countries that replace China as assemblers of last resort. The losers are easier to name: exporters facing a dearer dollar and foreign retaliation, manufacturers that rely on imported parts, and lower-income households, which spend a larger share of their budgets on traded goods. Farm states, which absorbed the brunt of Chinese retaliation last time, would be first in line again.

What would actually shrink the gap

History offers two routes, neither attractive. The first is a sharp fall in the dollar, as after the Plaza Accord of 1985, when governments agreed to push the currency down; the deficit did narrow, but only years later. The second is a recession, which cuts investment and imports together, and the deficit shrank markedly in 2009 for exactly that reason. Neither is what tariff advocates have in mind.

The late 1990s show the identity working in the other direction. Washington ran budget surpluses from 1998 to 2001, and the trade deficit still widened because an investment boom outran domestic saving. A lasting improvement requires the federal government to borrow less, households to save more or businesses to invest less at home, and only the first sits within easy reach of policy.

The numbers to watch are therefore not the tariff schedules but the Congressional Budget Office's deficit projections and the household saving rate, which has fallen well below its pandemic peak. Neither points towards a smaller gap, whichever candidate wins in November.

Trying to close the trade deficit with tariffs ignores basic arithmetic. As long as Washington borrows heavily and households save little, the deficit will probably persist whatever duties are imposed, and exporters will pay for the stronger dollar. A broad tariff imposed next year would most likely leave the goods deficit close to a trillion dollars, shifted towards Mexico and South-East Asia, with American farmers and exporters paying the first instalment.