President Donald Trump has a logically coherent strategy for achieving the goal of reducing the US trade deficit, one of his stated priorities. The problem is that his strategy is based on totally wrong assumptions about trade deficits.
Two logical chains are leading the president and his team to erroneous conclusions. The first is based on the mistaken assumption that foreign barriers to US exports cause the US trade deficit. If that assumption were true, the strategy of trying to lower foreign barriers by threatening to raise US barriers would be defensible. But both theory and evidence demonstrate that barriers reduce exports and imports equally, with no lasting effect on trade balances. A higher tariff on imports reduces both imports and the demand for foreign currency to buy imports, which causes the domestic currency to rise against the foreign currency, making exports more expensive and imports cheaper. For example, a 10 percent import tariff would cause a country’s currency to appreciate by 5 percent. The appreciation offsets half of the price increase from the tariff for domestic consumers and imposes an equal price increase on foreign buyers of that country’s exports. Imports and exports decline equally.
My own work (see page 7 here) finds that tariff rates have no significant effects on trade balances. A comprehensive new study also finds no significant effect of tariffs on trade balances; the study finds that tariffs increase a country’s real exchange rate, as predicted by theory, and reduce income and employment at least temporarily. A tariff targeted at a single country may raise the bilateral trade balance with that country, but only at the cost of a lower bilateral trade balance with other countries.
To view the original posting of this article on Peterson’s website, click here.
Copyright © 2018 Peterson Institute for International Economics. All Rights Reserved.