Why Trump’s Trade War Will Cause Chaos

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Should Donald Trump be taken literally or seriously? Selena Zito presented these alternatives in an Atlantic column published in September 2016. Today, before a second term in office, Trump should be taken more seriously. And More literal than last time. This is evidenced by his nominations, notably Robert F. Kennedy Jr. in Health, Pat Hegseth in Defense, Tulsi Gabbard in National Intelligence, and Matt Gaetz in Justice. These people show that Trump will be far more radical. Moreover, trade policy has long been an area where it should be taken both seriously and literally. Conservationism is not just a long-held personal belief, but a belief he had already committed to last time.

Unfortunately, the fact that Trump needs to be taken literally and seriously doesn’t mean he (or those around him) understand the economics of trade. If he’s willing to buy Kennedy’s “anti-vaxer” nonsense, why should he care what economists think about it? He makes two major mistakes: First, he has no idea of ​​comparative advantage. Second, and worse, he does not recognize that trade balance is determined by aggregate supply and demand, not by the sum of bilateral balances. So his tariff war will not reduce the US trade deficit. On the contrary, especially in the current context, it is more likely to lead to inflation, a clash with the Federal Reserve and a loss of confidence in the dollar.

If someone wants to produce more — import substitutes, for example, as Trump wants — the resources have to come from somewhere. The questions are “From where?” And “how?” The answer may be “from exports through a stronger dollar,” since tariffs reduce the demand for foreign currency, with which imports can be purchased. Thus a tax on imports ends up being a tax on exports. The trade balance will not improve.

Basically, macroeconomics always wins, as Richard Baldwin of the IMD in Lausanne reminds us in a note from the Peterson Institute for International Economics. The balance of trade is the difference between aggregate income and expenditure (or saving and investment). As long as this does not change, the trade balance will also remain unchanged. America has spent more than its income for a long time. This is reflected in the steady net inflow of foreign savings between 2021 and the second quarter of 2024, averaging 3.9 percent of GDP. Therefore, the domestic sector is running an overall counterparty deficit. In fact, savings over investment in the household sector averaged 2.3 percent of GDP and the corporate sector 0.5 percent. Overall, only the government ran a deficit, averaging 6.7 percent of GDP. If one wants to eliminate the external deficit, the domestic sectors have to adjust in the opposite direction to a larger savings surplus, with the largest adjustment of course coming from these large fiscal deficits.

Still, as Oliver Blanchard notes in another paper for the Peterson Institute, Trump has promised to extend the tax cuts enacted in 2017. In addition, he has proposed making Social Security benefits and tips completely tax-free, increasing state and local tax deductions, and lowering the corporate tax rate, which in 2017 was 35 percent. was reduced to 21%, to be reduced further. 15 percent for manufacturing firms. He has also proposed the mass deportation of some 11 million undocumented immigrants.

In short, he intends to reduce supply and stimulate demand. This will worsen the trade balance, not improve it. Moreover, it will also create inflationary pressure, which the Fed will have to suppress. Meanwhile, the federal debt will continue on its explosive path, possibly threatening confidence in the dollar itself.

Overall, Trump’s proposed policies are unlikely to reduce the overall trade deficit. Reducing the bilateral deficit with China will only increase the deficit with others. This is inevitable given the continuing macroeconomic pressures. Additionally, its discriminatory trade policies with tariffs of 60 percent on China and 10-20 percent on others are bound to spread. Trump and his supporters will see exports from other countries displacing exports from China through transshipment, assembly in other countries or outright competition. The answer will either be the implementation of the “rule of origin” with all the red tape, or a tariff increase of up to 60 percent on all manufacturers’ imports. Meanwhile, no doubt, there will be retaliation.

Such a spread of high tariffs in the US and around the world is likely to lead to a sharp decline in world trade and production. Britain’s National Institute of Economic and Social Research forecasts: “Overall, U.S. real GDP could be as much as 4 percent lower than it would have been without the tariffs.” My guess is that’s too optimistic, given the uncertainty of what will end. Even so, America’s external deficit may not shrink. It will depend on whether costs have fallen more than production. If this happens, the trade balance will improve. But it would also mean a deeper recession.

Last week, I pointed out that trade policy is most unlikely to reverse the long-term decline in the share of US manufacturing jobs. This week, I add that tariffs unsupported by reductions in aggregate spending relative to output will not eliminate the external deficit. Tariffs alone, especially discriminatory tariffs on one country, will only lead to an economic and political mess, as they spread like weeds throughout the world.

When King Canute of England supposedly sat before the incoming tide, he did so to prove that he could not command the sea. Donald Trump believes he can. He will be disappointed. So, sorry, we will.

martin.wolf@ft.com

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