President Donald Trump’s trade policy suffers from the most basic of contradictions that doom it to failure.
Purportedly, the administration wants to impose increased import restrictions on trade partners to help eliminate the US trade deficit. Yet, the administration is following policies that will increase the US budget deficit and that will have the unintended consequence of strengthening the dollar. That combination is certain to cause the US trade deficit to widen, rather than to narrow.
Any country that wishes to eliminate its trade deficit while maintaining full employment must do two things. First, it must lessen its domestic expenditure to make room for the increase in exports and reduction in imports needed to cut the trade deficit. Second, it must weaken its currency so that exporters are incentivised to export and importers are discouraged from importing. The Trump administration is seemingly oblivious to this logic.
Rather than trying to reduce the country’s domestic expenditures and raise its savings level, Washington is pursuing an expansive fiscal policy that is sure to raise the budget deficit. This has included the introduction of the unfunded Trump tax cut that will increase the US public debt by around $1.5tn over the next decade, in addition to a $300bn Congressional increase in public spending over the next two years.
By pursuing an expansive policy at this late stage in the economic cycle, the administration is forcing the Federal Reserve to be more aggressive in raising interest rates to avert inflation, while at the same time the European Central Bank and Bank of Japan remain engaged in quantitative easing and in maintaining ultra-low interest rates. It is little wonder that the dollar has strengthened by around 5% over the past three months.
Trump’s threats to intensify import protection against China and Europe place further upward pressure on the dollar. Those economies are likely to be more damaged by a trade war, since they are more export dependent than the US. They are also having to cope with uncertainty from Italy in the case of Europe and the deflating of a credit bubble in the case of China. At a time of domestic vulnerability, the threat of further import tariffs is bound to cause these economies to weaken. That, in turn, will require monetary policy responses that will further weaken those economies’ currencies against the dollar.
All of this raises the risk that, when the US trade deficit is not eliminated but rather widens, the Trump administration will double down on its policy of intensifying import restrictions. This would heighten the risk of a full-scale trade war as US trade partners felt obliged to retaliate to increased protectionism from Washington.
Hopefully, these fears will prove to be ill founded and the Trump administration will come up with a more coherent policy approach to remedying the country’s trade deficit. However, with all the clues pointing in the opposite direction.
Desmond Lachman is a Resident Fellow at the American Enterprise Institute. He was formerly a Deputy Director in the International Monetary Fund’s Policy Development and Review Department and the Chief Emerging Market Economic Strategist at Salomon Smith Barney.