Tariffs and the Trade Balance (Wonkish)

So today’s Chautauqua is about how protectionism, Trump style, will affect the trade deficit.

Actually, start with proposals for something like a U.S. VAT, which would include taxes on imports and rebates on exports. There is widespread confusion about what a VAT does to trade. No, it isn’t like a combination of an import tariff and an export subsidy; it’s like a sales tax, and to a first approximation it doesn’t affect trade at all.

To see why, think about competition between domestically-produced and foreign-produced goods in two markets: at home and abroad. How does the VAT or VAT-like tax affect competition in each market?

Not at all. In the foreign market, domestic firms pay no tax on their sales, because the VAT is rebated; neither do foreign firms. In the domestic market, foreign firms pay the VAT-rate tariff, and domestic firms pay the VAT. So the playing field is level in the domestic markets as well.

In short, a VAT isn’t a protectionist policy; it shouldn’t even lead to a change in the exchange rate.

What about straight tariffs? Here things get a bit more complicated.

The starting point for a simple analysis of trade balances is the accounting identity,

Current account + Capital account = 0

where the current account is the trade balance broadly defined to include services and income from investments. The standard story then runs as follows: the capital account is determined by international differences in savings and investment opportunities, with capital inflows to countries that offer good returns. The real exchange rate then adjusts to ensure that the trade balance offsets these desired capital flows.

In this simple story, a tariff shouldn’t lead to a lower trade deficit, as long as capital still wants to come here; it will just lead to a stronger dollar, making U.S. products less competitive. Imports will still be lower, but so will exports: you end up with the same trade balance, but with less trade.

But this story is a bit too simple, because reduced openness to trade should also inhibit capital flows.

To see why, first consider a reductio ad absurdum. Imagine that we discover a civilization on Alpha Centauri, too far away for any trade in physical goods or meaningful services. Would terrestrial investors nonetheless want to buy Centauri assets? No – even if they earned a return, how would they bring it back to Earth?

Clearly, then, capital flows do depend on the potential for trade in goods and services. But how does this work when we’re talking about restricted openness, not complete autarky?

Think of it this way: when investors put funds into a country, they do so in the expectation that somebody will eventually extract real goods and services from that country and send them abroad. Put another way, trade deficits are always a temporary phenomenon, to be followed eventually by surpluses, and vice versa.

Consider the case of Japan, which used to run large trade surpluses. It still runs a surplus on current account, thanks to income on its overseas investments, but these days it runs a significant deficit on goods trade (shown in the figure as a percentage of GDP).



But how does a country make its eventual transition from trade deficit to trade surplus? Other things equal, via a depreciation in its real exchange rate. And this eventual depreciation reduces the return to foreign investors who buy domestic assets.

The question then becomes, how big a depreciation is necessary? And the answer to that question depends on how open the economy is. If the trade balance needs to increase by, say, 5 percent of GDP, this will take a much bigger depreciation if initial exports are only 5 percent of GDP than if they start at 40 percent of GDP.

So protectionism should inhibit capital flows. It reduces trade flows; this means that larger real exchange rate movements are necessary to accommodate swings in the capital account; and these exchange rate movements themselves reduce the return to international investment.

By the way, this argument applies a fortiori to temporary trade policies. A Trump tariff that people expect to see rescinded by a future sane president would drive the dollar up temporarily, but the prospect of future depreciation would inhibit investments in the U.S..

Now, all of this is a subtler channel than the crude notion that foreigners are taking advantage by selling more to us than they buy, and tariffs will fix that. Dollar appreciation would undermine some of the effects of unilateral tariffs, and definitely hurt exports. But a more protectionist world would in general have lower capital flows as well as less trade; and the U.S., as a recipient of capital inflows, would therefore end up with a lower trade deficit.

An update (which nobody will read, but what the heck): I knew that something like my figure was out there in the literature; I tracked it down to Dornbusch 1975. Rudi’s version was more elaborate (with the axes reversed :



What I did can be interpreted as the special case with a linear PPF. And if you have no idea what I’m talking about, congratulations.



About Uy Do

Banking System Analyst, former NTT data Global Marketing Dept Senior Analyst, Banking System Risk Specialist, HR Specialist
This entry was posted in economists, Uncategorized, US economic, US economy and tagged . Bookmark the permalink.

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