Larry Kudlow, the new director of the US National Economic Council, and I go back many moons. We collaborated countless times during President Reagan’s first term. Kudlow was the associate director for economics and planning at the Office of Management and Budget, and I was a senior economist at the Council of Economic Advisers.
Kudlow was always informed and effective, so when I read Yale management professor Jeffrey Sonnenfeld’s assessment of his suitability for his new role, I was in agreement. The title of Sonnenfeld’s interview with Patrick Gorman in Chief Executive magazine says it all: Sonnenfeld: Larry Kudlow A ‘Perfect Fit’ For NEC Chairman.
That said, Kudlow will have his work cut out for him, particularly when it comes to the Trump administration’s views on international trade. The White House’s new economic czar favours free trade. President Trump, his cabinet and his trade experts all favour protectionism, or as they euphemistically refer to it, ‘managed trade’. Indeed, the Trump administration’s most recent salvo was aimed at China. Trump’s anti-China measures include tariffs on up to $60bn worth of annual imports. The president has also stated that he wants China to slash its bilateral trade surplus with the US by $100bn.
Trump, like most businessmen, fails to understand the most fundamental points about international trade and what causes overall trade deficits and surpluses. On international trade, Kudlow has a huge problem — one he never had with Reagan. After all, Reagan was, at least rhetorically, a free trader.
Kudlow’s first tutorial with Trump will be the key. If Kudlow fails, he will fail on trade and trade wars will ensue. When that happens, regime uncertainty will increase and confidence will plunge. Game over.
The first lesson on trade Kudlow must deliver should be titled: The overall US trade balance is made in the USA, not by ‘unfair’ foreign trade practices. The economic identity that forms the foundation for this lesson in international trade is:
(Imports – exports) = (private investment – private savings) + (government spending – taxes)
Accordingly, the trade deficit is equal to the excess of private sector investment over savings, plus the excess of government spending over tax revenue. The counterpart of the trade deficit is the sum of the private sector deficit and the government deficit (federal + state and local). The US trade deficit is therefore just the mirror image of what is happening in the domestic economy. If expenditures in the US exceed the incomes produced in the US, which they do, the excess expenditures will be met by an excess of imports over exports (read: a trade deficit).
The cumulative trade deficit the US has racked up since 1975 is about $11.15tn, and the total investment minus savings deficit is about $10.44tn.
So US trade deficits are not caused by ‘unfair’ trade practices. They are made in the good old USA.
Kudlow should make it clear that the imposition of anti-China tariffs or the brow-beating of Chairman Xi might reduce the US bilateral trade deficit with China, but it will not alter the overall US trade deficit. Indeed, if China is forced to reduce its bilateral trade surplus with the US, then others will supply what US consumers and investors demand. Yes, others will accommodate the US overall trade deficit that is dictated by the trade identity.
The only effective way for Trump to exorcise his demon (read: the overall US trade deficit) would be for him to reduce the fiscal deficit. But ironically, Trump’s policies are projected to increase the fiscal deficit, which will result in a larger trade deficit.
Steve Hanke is Professor of Applied Economics at Johns Hopkins University and Member of the OMFIF Advisory Board.