Three Ways to Reduce a Trade Deficit

November 6, 2017 11:30 AM
Photo Credit: 
REUTERS/Alexandria Sage

President Trump hates the US trade deficit, and he has made eliminating or reducing large bilateral trade deficits the centerpiece of his trade policies. He thinks that deficits mean the United States is "losing" in global markets because it is buying more goods and services from overseas than it is selling to foreign markets. This interpretation is misguided, but there are reasons to be concerned about the aggregate trade deficit. The main worry is that sustained deficits over an extended period will rack up debt that eventually must be repaid.

The United States runs a trade deficit, not because of bad trade deals, but because its citizens spend more than they earn and finance the difference with foreign credit. In 2016, the households, firms, and government in the United States earned $18.6 trillion but spent $19.1 trillion on goods and services, resulting in a disparity of $500 billion. 

Since the deficit is about production and consumption, the tools that will be most effective in reducing it are those that impact how much US citizens, businesses, and governments save.

Three ways to reduce the trade deficit are:

  1. Consume less and save more. If US households or the government reduce consumption (businesses save more than they spend), imports will drop and less borrowing from abroad will be needed to pay for consumption. This means that consumption taxes—like those that nearly all other countries in the world have—could help reduce the deficit, by discouraging consumption, increasing saving, and reducing the government deficit. In contrast, an unfunded tax cut, such as the one proposed by the administration, will expand the deficit because the government will be consuming more relative to its earnings.
  2. Depreciate the exchange rate. Trade deficit reversals are typically driven by a significant real exchange rate depreciation. A weaker dollar makes imports more expensive and exports cheaper and improves the trade balance. Given the dollar is the world's reserve currency, and still regarded as the safest for investors, it tends to run stronger than other currencies. But when foreign governments actively push the dollar up to maintain their surpluses, the United States could counteract intervention by selling dollars and buying foreign currencies. The administration could also encourage the adoption of other major currencies, such as the euro, yen, or renminbi, as alternative reserve currencies. A weaker dollar would be good for the US economy, but relinquishing the role as the dominant currency would reduce the power of the United States in global markets and the seigniorage (profit) earned.
  3. Tax capital inflows. One of the reasons that the United States runs a trade deficit is because borrowing from abroad is cheap and easy. If it were more expensive, US citizens and the government would borrow less. A tax on (non–foreign direct investment) capital inflows that rises with the size of the inflow could reduce excessive borrowing for consumption and help close the government imbalance. While some worry that capital controls could distort asset prices and reduce investment, they could also curb excessive speculative investment, such as happened before the financial crisis.

If the administration is serious about reducing the trade deficit, there are ways to do it. Trade policy, however, is not on the list. Although it seems intuitive that trade policy should be the appropriate instrument for a trade deficit—just as fiscal policy is the right tool for a fiscal deficit—the economics do not work that way. Higher tariffs on one country or product divert trade to other countries or products, distorting consumption but leaving the trade balance roughly unchanged. Higher tariffs on all countries will reduce imports, but they will also reduce exports, again leaving the trade balance roughly unchanged. The reason is that import tariffs reduce the demand for foreign currency and the dollar strengthens, thus the tariffs reduce both imports and exports and distort consumption and production. Overall, higher tariffs can be expected to reduce trade and income, but with a negligible impact on the trade deficit.

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Jeff Ferry


Hi Caroline,

You claim that: The reason is that import tariffs reduce the demand for foreign currency and the dollar strengthens. 

Can you cite any examples where the US took action to reduce its trade deficit and that led to the dollar strengthening? Or examples from any other country/currency? Otherwise this seems like one of those propositions that exist in theory but not in the real world. 

Regards, Jeff


Caroline Freund

Exchange rates are notoriously hard to predict and move in response to many factors, so it is difficult to find a clean example.  In addition, sharp tariff changes are rare and tend to be driven by forces that also affect the exchange rate. One potential example is Chile in the early 2000s.  The simple average tariff fell from 10 percent to less than 5 percent. Theory suggests that increased demand for imports in Chile should have led to greater demand for foreign currency and a real exchange rate depreciation. Indeed, the real exchange rate depreciated by 9 percent, and the current account balance actually improved somewhat.  There is stronger evidence found in cross-country data.  If tariffs lead to few imports without affecting exports, the correlation between tariffs and the trade balance should be positive.  In fact, if anything, the reverse is true:

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