I’m talking an awful lot about Trade Deficits, aren’t I?
It’s just that Mr. Trump has vocalized so many controversial economic policy prescriptions for reducing the US Trade Deficit which he considers symbolic of all the jobs America has lost to foreigners, that I (and many others who have a background in economics) feel compelled to talk about Trade Deficits and the common misconceptions and untruths that plague this subject.
In my last post, What the "Value-Added" Trade Deficit means for US Trade Policy with China, I talked about some of the problems that the US would encounter if as Trump has promised, tariffs are imposed on all Chinese imports. Here is an excerpt below:
1) Around 55 cents of every dollar spent by American consumers on products “Made in China”, go to American producers, mostly service providers. This means that if Trump imposes tariffs on Chinese imports, these will end up hurting American businesses and American workers will end up losing jobs.
2) China won’t remain passive if America imposes tariffs on its exports. It will impose taxes on American imports as well. Hence, the supposed gain in output from reduced competition from Chinese imports might be counter-balanced or more than reversed by the loss of exports to China.
3) Finally, this won’t impact just final goods i.e. final exports or imports. There are many American products that source components from/are assembled in China, the iPhone being a popular example. In case tariffs are levied on Chinese imports, goods such as the iPhone will become much more expensive. Their sales will suffer which will ultimately harm American producers and workers.
In this post, I will explain the underlying theory behind what really happens when a large, open economy such as the US imposes tariffs on imports, and whether this actually reduces the Trade Deficit.
The Theory: What happens when an economy imposes Tariffs on Imports
We know that for any open economy (one that trades with other nations) lets say economy “A”, Savings (S) - Investment (I) = Net Exports (NX). I’ve explained why in detail in my post, Why are the Net Exports of a Country = its Net Capital Outflow?.
This equality is preserved through movements in the Real Exchange Rate (e). Let’s see how this happens. (Look at the chart below)
When a Country imposes Tariffs on Imports, the Real Exchange Rate rises; Net Exports remain unchanged
Let’s assume that economy “A” is at equilibrium at E1. The real exchange rate is = e1 and S - I = NX1. Now let’s assume that country A imposes a 45% tariff on all imports from the ROW. What happens now?
The Net Exports curve NX1, moves rightward to NX2. This is because at every real exchange rate, the tariff causes imports to fall, which automatically raises the value of Net Exports.
At the original exchange rate e1, Net Exports are now greater than S - I, or the Net Capital Outflow from country A (the gap between Savings and Investment in a country gives us the net capital that flows out of that country to others). Since Net Exports raise demand for country A’s currency (because foreigners need A’s currency to pay for these) and net capital outflows from country A increase the supply of A’s currency, when NX > Net Capital Outflows (S - I), demand for A’s currency will be greater than supply, which will cause A’s currency to appreciate. This will cause the real exchange rate to rise, reducing A’s net exports.
(Note: When country A’s currency appreciates i.e. it becomes more expensive vis-à-vis other foreign currencies, A’s exports become more expensive for foreigners. Imports on the other hand, become cheaper. Overall, A’s net exports fall.)
A’s real exchange rate with rise and net exports (NX2) will fall, until S - I is once again = net exports at E2. This happens when the real exchange rate has risen to e2.
The important thing to notice is here is that at the new equilibrium E2, while the real exchange rate is higher, Net Exports are the same as they were at the initial equilibrium E1, before the tariff was levied.
What has happened after the levying of the import tariff is that along with imports, exports have fallen as well (with the rise in the real exchange rate), so that the value of the Net Exports of country A is the still same as it was before the tariff was levied.
Has country A gained anything? No. Infact, it has actually lost. While the value of net exports is the same, the volume of imports and well as exports has fallen. A’s trade with the ROW the world has reduced. Reduced trade means lower output which means lesser jobs.
Bottom-line: The import tariff has actually hurt country A’s growth and caused job losses for its labour force.
Trump’s proposed Tariffs are a Bad Idea
The theoretical framework described above shows that if Trump is elected President and imposes tariffs on imported goods from China and other countries, he will end up hurting American workers, while doing nothing towards reducing the American Trade Deficit. Infact, he could actually make it worse if China imposes counter tariffs - which they most definitely will.
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