Trump’s trade war is poised for a Pyrrhic victory

The flip side of the Trump administration’s drive to reduce the U.S. foreign trade deficit is that it will leave the rest of the world with fewer dollars to finance its budget deficit. President Trump could cut spending drastically or persuade the Federal Reserve to buy more bonds, but neither seems likely.

Chinese steelworker directs crane to pick up coils of wire in Yichang city, Hubei province cut spending drastically
The Trump administration can slap tariffs on Chinese steel, but then it must figure out who buys the Treasuries to finance its growing budget deficit and public debt. © dpa

In a nutshell

  • To reduce its trade deficit, the U.S. must trim its fiscal deficit or find new bond buyers
  • Drastic spending cuts or more quantitative easing from the Fed is quite unlikely
  • If domestic investors don’t buy more Treasuries, the trade deficit will widen again

In January 2018, President Donald Trump’s administration introduced new import tariffs on solar panels and washing machines. This month, it was the turn of steel and aluminum imports. Next to be targeted may not be industries but countries that enjoy a trade surplus with the United States, especially China.

Of course, President Trump is right to complain about countries that use trade barriers against American exports – including Canada, China and the members of the European Union. Likewise, he is probably right to argue that many U.S. partners have failed to live up to their commitments. Frequent examples mentioned by the American president are Mexico’s ineffective efforts to fight drug trafficking and low military spending by NATO members. Mr. Trump also has a point when he claims that international bodies such as the World Trade Organization lack the means and possibly the political willpower to enforce the rules of the game.

Yet, President Trump is wrong to use trade policy and global muscle flexing as a way to pursue domestic political goals. The attempt to make America great again could simply turn the U.S. into an international bully, which would ultimately backfire. Creating new conflicts is not always the best way to solve old problems.

Seeking dollars

Much ink has been spilled describing the dark side of protectionism and President Trump’s habit of running roughshod over sensitive global issues. Rather than showing why the president’s views on international trade and domestic job creation are wrongheaded, however, this report takes the Trump administration’s approach as a given. Instead, it seeks to identify the options it leaves open to policymakers and some possible consequences – both for the U.S. and the rest of the world.

Accountancy and common sense tell us that if the Americans want the rest of the world to keep financing their budget deficit and public debt – equivalent to about 3.5 percent and 105 percent of the U.S. gross domestic product, respectively – they must allow the rest of the world to obtain the dollars required to buy U.S. Treasuries. Even more is needed if President Trump hopes to persuade foreign investors to finance or provide equity to American companies.

If the U.S. wants to reduce its trade deficit, it must first cut the budget deficit or find creative ways to refinance debt.

Foreigners can obtain the dollars Mr. Trump would like to see invested in the U.S. in two ways: by asking central banks to give away the dollar-denominated cash held in their vaults (which is limited) and/or by running a current account surplus (in the simplest terms, by exporting more goods and services than they import). Not surprisingly, China has a large trade surplus with the U.S., and is the largest holder of U.S. government debt, together with Japan. Each of these two countries owns about 5.5 percent of the outstanding American debt, with the rest of the world accounting for another 20 percent. The remainder is held by American households, banks and institutional investors.

Ways to trim

If the U.S. administration wants to reduce its trade deficit vis-a-vis the rest of the world, it must cut the budget deficit or find creative ways to refinance its maturing debt. Four possibilities come to mind.

The first and simplest is to reduce or eliminate the budget deficit. This is a rather tough nut to crack, especially if one considers the consequences of the recent fiscal reforms, which implies lower tax revenue and roughly constant public expenditure.

A second possibility would be to ask the Fed to monetize part of the debt, by printing new dollars and buying Treasuries. This would increase the money supply and stoke inflationary pressure, which would run against the monetary authorities’ prudent approach to policy. This especially applies with annual inflation running at 2.2 percent, slightly above the Fed’s 2 percent target.

The third option would be to persuade American retail and institutional investors to buy a larger share of government debt, thus reducing the role of foreign buyers.

President Donald Trump and Fed Chairman Jerome Powell
President Donald Trump is unlikely to get his new appointee as Federal Reserve chairman, Jerome Powell (R), to keep the dollar from strengthening by a new cycle of monetary extravagance. © dpa

The fourth possibility is to do nothing and let the market take care of the problem. In this case, the smaller trade surplus run by other countries would reduce foreign demand for U.S. debt securities, leading to lower prices of these assets and a rise in domestic bond yields.

This last scenario would make debt servicing more expensive for the U.S. Treasury. But it would also make Treasury papers more attractive, encouraging foreign investors to dump non-dollar denominated assets and buy large quantities of the American public debt. How would they get the funds to do so? By buying more dollars on the international currency markets.

Bound to backfire

More appetite for dollars raises two possibilities. Either the Fed meets this additional demand by printing new greenbacks, or they let the dollar strengthen on the currency markets. As pointed out earlier, the Fed’s current strategy makes the first scenario unlikely. And as we’ve seen, a stronger dollar will make American exports less competitive and imports cheaper. So back to square one, with a widening trade deficit.

Unless the Fed is willing to engage in a new cycle of monetary extravagance, President Trump’s protectionist move must backfire if the budget deficit is not reined in by Americans buying more Treasuries. U.S. economic growth does not look ready to accelerate much, especially since annual productivity growth has averaged less than 1 percent over the past three years. That means the relative size of the federal budget – the budget-to-GDP ratio – will not shrink much.

The worst scenario would see Mr. Trump basking in his mercantilist drive while the dollar appreciates.

Can the Trump administration persuade Americans to finance their country’s debt? This is certainly possible, because interest rates will be rising, and Mr. Trump would not think twice about exhorting U.S. banks and institutional investors to “buy American” as a way to protect the country’s financial independence.

Certainly, the worst scenario would see Mr. Trump basking in his mercantilist drive, while the dollar appreciates and the current account reverts to its former deficit. By starting a trade war, the president would alter the rules of a free-market economy, giving short-term protection to some interest groups while making the world at large shiver.

Great leap back

One wonders whether President Trump realizes whose doubtful footsteps he is following. One predecessor who comes to mind is Jean-Baptiste Colbert, who introduced a kind of central planning for foreign trade in 17th century France. Another is Franklin D. Roosevelt, who torpedoed the 1933 London Economic Conference in the first year of his first presidential term, unleashing the protectionist wave that swamped the world economy until World War II.

The consequences of Donald Trump’s swashbuckling mercantilism also depend on the reactions of America’s major trading partners. A generalized trade war seems unlikely. Too many companies worldwide have too much to lose, and most policymakers (even within the U.S.) are only too aware of the possible consequences of a leap back into the economics of the 1930s.

However, retaliatory measures against the U.S. cannot be ruled out, and one senses that America would get the short end of the stick, both economically and politically. The business community wants a stable institutional setting and shies away from environments and counterparties subject to shifting rules and abrupt changes in the political climate, depending on the ruler’s whims.

Mr. Trump’s approach will discourage world entrepreneurs from establishing long-lasting business relationships with Americans. Instead, they will redirect their efforts and talents to other parts of the world. East Asia under the Chinese umbrella is a prime candidate to replace the U.S. as an economic and trading partner. If that happens, America loses on all fronts, even as it achieves its mercantilist goals.

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