Last month, the Washington Post reported that former president Donald Trump plans to enact a 10 percent tariff on all imports if reelected. After facing sharp criticism, Trump defended his proposal in a letter to the Wall Street Journal. He argued that the trade deficit is a “loss” for the US economy and that his tariffs would be the “best way” to address the trade deficit and to encourage domestic manufacturing.
Trump continues to demonstrate his misunderstanding of how tariffs would impact trade and the US economy.
The former president’s reasoning starts with the observation that a tariff would raise the relative price of imported goods. If nothing else changed, consumers would demand fewer foreign goods and demand more domestically produced goods. From this, tariff supporters like Trump contend that the increased demand for US goods will reduce imports, shrink the trade deficit, and increase US output.
This, however, misses how other prices in the economy would adjust to a tariff. If consumers reduce their purchases of foreign goods in favor of US goods, this would result in foreign producers receiving fewer US dollars (USD). A reduction in the global supply of USD would raise its value relative to other currencies.
A stronger USD would do two things. First, the more valuable dollar would partially offset the tariff. While the tariff would push up the relative price of imports, the appreciation of the USD would make the pre-tax price of foreign goods cheaper, offsetting part of the tax increase. As a result, imports would not fall as much as the magnitude of the tariff suggests. Second, the stronger USD would make US exports more expensive for foreigners and reduce exports. In order to purchase US goods, foreigners need to exchange their local currency for USD. A stronger dollar makes that exchange more expensive.
The net result of Trump’s tariffs would, indeed, mean fewer imports, but also fewer exports, leaving the US with a trade deficit and lower economic output.
The trade deficit is ultimately driven by an imbalance in saving and investment. It is not necessarily a bad thing, but the US runs a trade deficit because domestic investment exceeds national saving, requiring the US to “borrow” from abroad. This borrowing shows up in the national accounts as net imports. Lawmakers could reduce the deficit by either reducing investment or increasing saving. Reducing investment would harm economic growth, so lawmakers should avoid that. But lawmakers could increase national saving by either encouraging private saving or reducing the federal budget deficit.
The critics are right: Tariffs are a bad idea.