Where next on tariffs?

Trump is right that America is being 'ripped off', but tariffs are no panacea

For the reasons detailed in a previous Pimlico Journal newsletter, Trump’s April tariff agenda — ‘Liberation Day’ and after — can hardly be described as the pinnacle of economic statecraft. It eventually resulted in a decoupling of the inverse relationship between bonds and equities, leading to a rare Trump retreat, pulling America back from what could have been the financial abyss. But, even aside from the immediate financial consequences, by allowing big firms to carve out exemptions for imports of their products, the current system is on track to actually penalise the domestic manufacture of more complex goods; a suspension of tariffs on most countries for the purpose of ‘negotiation’ rapidly undid a lot of the ‘Liberation Day’ programme; and, to get negotiations started in Switzerland, even those levied on China have now been placed at remarkably generous levels.

Yet I must disagree with the editorial team’s more general criticisms of Trump’s attitude to international trade. The fact remains that Trump’s tariffs were attempting, at least in part, to confront a very real structural problem in the American economy. America does not produce a large proportion of the durable goods which it consumes, such that its gross trade deficit with the rest of the world now consistently exceeds one trillion dollars. There are a number of obvious reasons why this is bad, including some which have recently become far more politically salient: a domestic industrial base is more resilient to instability in international supply chains; it provides stable jobs outside large cities; and it can be repurposed to produce weapons in the case of war. But the deficit is also symptomatic of larger imbalances which lead to excessive borrowing, financial instability, and asset price bubbles. The link between America’s trade deficit and its other woes, especially those which led to Trump’s election, goes far beyond cliché images of shuttered factories in provincial towns: it encapsulates an entire ecosystem of finance-orientated globalisation which has been draining the life out of Middle America. Trump is right in thinking it needs to change.

The fundamentals of this argument are no longer even particularly controversial. While it has long been a neoclassical shibboleth that free trade is basically the closest thing you can get to a free lunch, growing geopolitical tensions and the sheer scale of international imbalances have made such a belief increasingly untenable. The turning of the tide is visible in more than just Financial Times columns and interviews with academics. There is now a growing literature on trade imbalances which makes two key points:

1. America’s role in accommodating the excess savings of other countries is a major (though not the sole) cause of its very large trade deficit.

2. The glut of excess savings entering America’s economy from abroad is, to a substantial extent, the result of years of conscious economic policy on the part of the governments of surplus countries.

This new consensus can be traced back to before even the Great Recession, with Federal Reserve chair Ben Bernanke giving a speech in 2005 on the connection between other countries’ excess savings and the American trade deficit. Around this time, there was also a renewed interest in the role that excess savings played in running up demand for debt: without foreign, especially European, countries’ demand for safe American assets, there would have been much less demand for mortgage-backed securities; indeed, Chinese investors held so many that preserving ties with the country was one reason the American government declined to impose losses on Fannie Mae and Freddie Mac bondholders. All this and more is discussed in Michael Pettis and Matthew Klein’s 2020 book Trade Wars Are Class Wars, which provides the most expansive and lucid formulation of the argument yet. Pettis and Klein are, granted, somewhat controversial among the economic policy establishment. Yet even the very mainstream Maurice Obstfeld, an IMF economist who worked with Douglas Irwin (of anti-tariff pamphlet Free Trade Under Fire), has to concede in his Brookings Institution paper that the view of excess savings affecting the balance of payments is fundamentally ‘right’, even if other factors also remain important.

The explanation of why this is ‘right’ is simple. While classical economics presupposes that the purpose of selling exports is to gain currency to buy imports, for various reasons, which themselves can be debated, many modern economic actors simply do not behave in this way, usually due to deliberate economic distortions created by foreign governments. As a result, certain countries consistently, year after year, export far more than they import, and so accumulate excess savings. Due to the magic of international finance, instead of using this currency to increase domestic consumption (including through imports), these countries invest their excess savings abroad. In doing so, they help finance increased consumption in the deficit countries, ensuring that the demand for their exports remains steady, rather than the deficit country having to make adjustments. By holding their excess savings abroad, their own currency is devalued; ceteris paribus, this makes their exports more competitive, and any imports less competitive. The cycle can therefore continue for an extraordinarily long time with no adjustment required on either side of the equation.

Critics of Trump’s tariffs, such as Harvard economist Jeffrey Sachs, have said that America’s deficit is simply the result of fiscal irresponsibility. By way of analogy, he notes that most customers at a supermarket would run a ‘trade deficit’ with the business. How could it be the fault of the business if a customer goes into debt shopping there? But the problem with such an analogy is that while individuals tend to have fairly strict capital controls (in that they usually take on debt on a wholly discretionary basis), America’s economy has free and open capital markets.

A more apt analogy than that of a supermarket and its customers would be as follows. Countries are not shopping at a supermarket, but are different traders at a market. One market trader is willing to buy the wares of other traders, but many other traders have decided to stop buying as much from him, preferring to accumulate large amounts of his credit notes and IOUs. This market trader, who has used debt to finance many profitable ventures in the past, is fairly committed to the idea of freely borrowing, and does not draw a clear line between borrowing to invest in his business and borrowing to consume. At any rate, he stops making many of his own products, as they have few buyers, and he can buy replacements for the ones that he wants with IOUs. Some of his sons, who were learning his craft, have nothing to do. A few can still produce products for the market, speculate on the IOUs, or do things for the rest of the family. But others are basically idle. Much of their inheritance now belongs to the other market traders. As a result, they are beginning to lose faith in the market altogether. While we can certainly still criticise the market trader for all sorts of reasons, it is obvious that this story is far more complicated than Sachs’ easy analogy of the supermarket.

China is by far the worst of these ‘market traders’. Chinese domestic consumption has been notoriously low for decades, as most of its workers are paid far less than the value of what they produce, and save a good portion even of what they are paid. This latter fact is, in turn, because many of them are categorically excluded from the welfare system where they live due to their hukou status (i.e., their official household registration location does not match where they actually work), and the only legal trade unions are controlled by the state. Suppressing domestic consumption in this way has been the backbone of China’s development model for a long time. Low spending provides a big stock of savings to finance investment, and thus development. How else are you going to pay for all those high-speed rail lines? However, since the early noughties, much of this capital has been exported by state-owned banks. This is because allowing this glut of savings to enter the domestic economy could lead to inflation and economic instability. This also suits China’s government for other reasons: an appreciating Renminbi could make exports less competitive, and rebalancing the domestic economy to utilise this capital for consumption would require disruptive and politically unpalatable reforms. As such, China’s export surplus has simply grown and grown.

Furthermore, China’s industrial policy has long aggressively focused on production, to the point where it is simply impossible for even the enormous Chinese home market to absorb its own output. Through cheap capital from state-owned banks, efforts on the part of state-owned enterprises to reduce the prices of key industrial inputs, and intense competition between local governments to meet centrally-set goals, manufacturing capacity has exploded far beyond total domestic market demand. The exact degree to which China’s government wants Chinese businesses export so much can certainly be debated; indeed, there has been a growing awareness in China of the importance of domestic demand and problems of the distortions created by its insufficiency. The ‘Dual Circulation’ policy announced in 2020 is one of many measures aimed at addressing at least somewhat this imbalance. But while China’s government does not want to be reliant on foreign countries to absorb its exports, they can insure against the risks attendant on this if foreign countries are themselves reliant on Chinese goods. Moreover, despite the shift in rhetoric, major reforms to push consumption higher, such as a rebalancing of state spending away from investment and and towards welfare, are still yet to be seen.

Of course, it isn’t just China: other surplus countries still play a key role. South Korea, Taiwan, Singapore, and Japan all either run large surpluses or have in the past; and in Europe, Germany and the Netherlands have also historically generated huge imbalances. All of them, at least to some extent, have suppressed domestic demand in order to achieve this, though the Europeans have usually done so more for reasons of autistic fiscal prudence than developmentalism (let alone cynical geopolitical manoeuvres). It is worth reiterating that Europeans played a major role in driving demand for American spending in the run-up to the 2007 financial crash. Desirability of dollar-denominated financial assets and the continued dynamism of certain critical sectors of the American economy (as best represented by the ‘Magnificent 7’) has meant that the whole world has parked much of their excess wealth in American assets.

All of this broadly vindicates Trump’s assertion that America is, at least in some important sense, being ‘ripped off’ by the rest of the world. America’s economic woes, from deindustrialisation to house price bubbles, are substantially the result of the economic policy of other countries. And, even if he may not understand the exact mechanisms, there are members of his team who do. Stephen Miran adeptly outlined several of the arguments against maintaining America’s current role in the global trading system in a paper published last year through his investment management company Hudson Bay Capital. Robert Lighthizer, an advisor in Trump’s first term, has also discussed the same issues in his popular book No Trade Is Free. But as the mess that came with the ‘Liberation Day’ tariffs showed, there are other actors within the Trump Administration who are pushing things in a less productive direction.

In order to deliver on the task he has been given a clear mandate to achieve, Trump needs to diversify beyond tariffs, and focus on nurturing specific industries through a mixture of protection against imports as well as targeted industrial policy. Tariffs can help to offset the issues associated with absorbing excess savings, forcing that capital to circulate domestically, but they are also disruptive and can be evaded. Levying them on countries without large surpluses, or on goods America has little interest in manufacturing (let alone on raw materials unavailable at home), or on immediate neighbours, is unlikely to help solve anything. Controls on capital entering the country, while largely unprecedented, should be explored and then judiciously implemented. There are already rumors that Trump has mentioned restricting sales of US Treasuries to China in talks; a more comprehensive programme would be needed, but it at least shows they are considering movement in that direction. Finally, despite all we have said above, America’s deficit is not purely the fault of external factors. As the aforementioned Obstfeld notes, America’s commitment to relaxed borrowing constraints and low taxes was also a key factor in the debt and housing bubbles. Washington and Wall Street, as well as Beijing, are also to blame.

Another goal should be building free trade links with Western countries who do not abuse the system by building up large surpluses. Britain’s negative net international investment position is the world’s second largest after the United States. In the British context, deindustrialisation is substantially a deliberate government policy, and macroeconomic factors are not by any means the biggest drivers. But as other countries reindustrialise, it will present opportunities to change course in Britain, too. As stated earlier, current imbalances in the global economy are led primarily by China. Building a broader coalition of trading partners to cut down on trade with the country will be necessary not just to close gaps in any tariff regime, but also to ensure that the many real fruits of free trade can be enjoyed among countries willing to play by the rules. The current system of international trade and capital flows took decades of international cooperation to build. Changing it, even to make it more nationalist, will still require plenty of time and cooperation.

Trump, ever the master of political intuition, is thus completely correct to suggest that America is being sucked dry. But as the last month has made abundantly clear, tariffs are no panacea. The Right needs now to settle in for the long fight; pushing beyond tariffs, and beyond America’s immediate borders. Outdated ideological commitments to free trade need to be updated; but so too do facile critiques of the current system. Only then will there be a real chance at success.

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Image credits: Public domain

This article was written by an anonymous Pimlico Journal contributor. Have a pitch? Send it to pimlicojournal@substack.com.

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