US trade deficits only matter if the economy is weak

Tariffs are only one part of the story, says LBS economist Linda Yueh

Donald Trump’s focus on trade deficits is misguided, according to Linda Yueh, Adjunct Professor of Economics at London Business School and author of The Great Economists: How Their Ideas Can Help Us Today.  

“Trade deficits only matter if they reflect an underlying weakness of an economy. For the US, that’s not likely to be the case,” she said in City AM. 

The US president has tweeted frequently about his unhappiness with America’s trade deficit since taking office in January 2017. During his campaign he observed that there were a lot of Mercedes-Benz cars in New York but few Chevrolets in European cities. He caused a dip in German car companies’ share prices by stating he would impose a border tax of 35% on vehicles imported to the US. His latest move is to impose tariffs of 25% on imported steel and 10% on aluminium. 

Once investment flows are taken into account in the broadest measure of the external deficit, however, America still runs a current account deficit but it is because foreign companies and investors invest in the US. “Since the dollar is the global reserve currency, there is high demand for US investments, debt and assets,” said Yueh. 

So there are ‘imports’ of investment funds, due to the attractiveness of the US economy. “Its deficit with the rest of the world thus reflects a range of economic considerations that explains why it has a long-standing current account deficit, of which tariffs are but a small part,” said Yueh.

She suggested that consumer demand is the reason for the lack of American cars on the streets of Paris and Berlin, as opposed to unfair trade barriers. “Economists since the days of Adam Smith and David Ricardo have pointed to this. Of course there are trade barriers and aspects of the international trading system that are not a level playing field. But, on balance, a country’s trade position is a reflection of its economic strengths and weaknesses.” 

The Aluminium Association that represents 114 aluminium producers has warned Trump that his tariff will likely do more harm than good. A tax that will raise the cost of traded aluminium will hurt the industry as well as supply-chain partners in Europe and elsewhere. 

“There is a more important factor that determines a country’s trade position and that’s what a country produces,” said Yueh. “This was understood in David Ricardo’s day [the mid-19th century], when Britain repealed the Corn Laws, which raised the cost of imported grain and was favoured as a protectionist measure by landowners.”

Ricardo, who is known as the father of international trade, demonstrated that a country’s comparative advantage determined what it produced and traded. If a country was producing goods and services that were in high demand, it would sell them abroad. To improve the trade balance, in his view, a country should focus on how to increase productivity and production of these goods and services. 

The US’s long-standing trade deficit is due to a number of factors, according to Yueh: “The US economy is largely based on services, so its exports have been hindered by the lack of liberalisation of the global market for services in contrast to manufacturing. The US is still the largest exporter of services in the world and tends to run a surplus in this sector. 

“The US trade deficit rose to 2.9% of GDP due to an increase in its goods deficit and a decrease in its surplus in services exports. To remedy this would entail promoting the opening up of the services sector in markets around the world, which was part of the abandoned US-EU free trade agreement [TTIP],” she explained