Hopeless game of trade whack-a-mole

Set aside the fact that President Trump’s trade agenda is ill-conceived and that his plan for bringing it about is inchoate at best. It is also doomed to failure, even if Trump’s plan is evaluated by his own, idiosyncratic standards.

Most of his — and our — attention has been focused on Trump’s threats to erect tax and tariff barriers in order to suppress the flow of imports into the United States. So far, it’s been instructive, in a way. For example, what apparently was an off-the-cuff remark about how Mexico could be forced into paying for a wall generated some useful commentary about how a Destination-Based Cash Flow Tax works, and on the extent to which exchange rate adjustments would offset whatever effects a DBCFT would have on net exports. This may or may not become policy — who can tell? — but at least the episode wasn’t a complete waste of time.

But none of this is likely to matter when you think about why the U.S. is running a large current account deficit in the first place, and in particular, the role of international capital flows. (The current account includes both the trade balance and the net flow of income generated by foreign investments.) According to the balance of payments accounting rules, a debit created by the purchase of an imported good or service must be offset by a credit: a sale of a good or of an asset. If a country is running a current account deficit, then the net negative outflow of goods must be balanced by a net positive inflow of investment.

So saying that you’re alarmed about a trade deficit is the same thing as saying that you’re alarmed by foreign investment. Foreign investment is not always a bad thing: it can accelerate growth in developing countries. In the absence of government controls, you’d expect capital to “flow downhill” from rich countries (where savings are abundant) to poor countries (where savings are scarce). The better way to pose the puzzle is not in terms of trade balances but in terms of capital flows: why is so rich a country as the U.S. on the receiving end of such a large inflow of capital?

To answer this, you have to go back to the budget deficits of Reagan administration. Former vice-president Dick Cheney once said that “Reagan proved that deficits don’t matter,” and to the extent that the U.S. government has always been able to find buyers for its debt, he wasn’t wrong. But Reagan did not prove that balance of payments accounting rules don’t matter. Since the increase in the U.S. deficit was largely financed by foreign investors — U.S. domestic savings were too weak to absorb the extra supply of U.S. government debt — this inflow of foreign savings showed up as a current account deficit.

When you look at capital flows, it’s hard to see what the problem is the United States has with Mexico. While it is true that it has a trade surplus with the U.S., Mexico is running a current account deficit with the world as a whole — just as you’d expect. Mexico is an example of an emerging market that is importing the capital it needs to develop and is doing so by playing by market-friendly rules.

China is — or rather, was — another story. It’s pretty clear that during the 2000s, the Chinese government used capital controls to suppress its exchange rate in order to promote exports and run a large current account surplus — and ended up accumulating enormous reserves of U.S. debt in the process. It never made much economic sense for a country as poor as China to send its savings to the U.S., and U.S. would have been well within its rights to name China as a currency manipulator during that period.

China’s weak yuan policy wasn’t sustainable, and it appears to have been abandoned: the Chinese current account balance has fallen sharply in recent years. There’s little point in a U.S. attack on China’s exchange rate policy at this point.

Which brings us back to the U.S. government deficit. It’s probably not a coincidence that the only periods during the last 30 years when the U.S. current account narrowed occurred when the budget deficit fell.

And that’s the real problem with Trump’s plan to cut taxes, increase spending and simultaneously reduce the U.S. current account deficit. Unless his administration can figure out a way to drastically increase domestic savings (how?), or unless his government is willing to tolerate a sharp reduction in business investment (why?), then Trump’s plan to increase the pace of U.S. government borrowing will move the U.S. current account even further into deficit. The takers for that new debt will be mainly non-U.S. investors, and the increased capital inflow will manifest itself as an even larger U.S. current account deficit. Just like it did under Reagan’s administration.

The new U.S. administration has committed itself to reducing the U.S. current account deficit, but the remorseless logic of national accounting rules means that his fiscal policy plans will only increase it. President Trump has condemned himself — and the rest of us — to a never-ending and increasingly frantic game of trade policy Whack-a-Mole that he will never win.