Rethinking the Trade Deficit
President Biden’s success depends on working-class prosperity which means lowering the trade deficit. But technically viable policy tools are not on the public radar, as Biden’s predecessor proved. The best approach is reducing the trade deficit’s unneeded financing by eliminating esoteric tax breaks granted exclusively to foreigners. Doing so will challenge some of the most sacred doctrines of mainstream economics and the naked self-interest of Wall Street — and allow the president to govern with the aid of a strong and balanced economy.
For almost 30 years, policy makers have fetishized “the strong dollar” even though they know it overprices American goods abroad and underprices foreign goods here at home. However, the strong dollar story of U.S. trade deficits is misleading. The underlying problem is the inflow of unneeded foreign saving into our financial system. They are the first link in a chain of causality that has ravaged American manufacturing.
As individuals, we borrow to buy more than we can currently afford. If we do not want to borrow, we are not obligated to do so. Unfortunately, it does not work that way for the U.S. economy. America serves as the world’s banker because foreigners can lend to us just by buying U.S. bonds or stocks or depositing money in U.S. banks. America passively accepts their choice.
This process bids up the dollar’s price and the price-competitiveness of American goods falls until our trade deficit equals what the rest of the world lends. The dollar’s value is only a middle link in the chain of causality; the chain runs from an inflow of foreign financing and ends with a trade deficit of equal dollar value. If we neither lent to nor borrowed from the rest of the world, the trade deficit would be zero.
The money comes here because other countries do not need or want it because the surplus cash destabilizes their financial systems and slows their economies. Sending it here transfers the problems and avoids economic reforms in the countries of origin. German banks are actively encouraging customers to take their deposits elsewhere. Many oil-exporting and East Asian government directly buy U.S. financial assets to maintain their trade surplus. China’s government can direct its banks to do the same.
Inevitably, these unwanted funds spill over to America which does not need and cannot absorb them. Rather than financing job-creating investment, the money generally finances more consumer debt. The money that came in 2004-2007 flooded into poorly underwritten mortgages and other financial chicanery, leading to the 2008 Financial Crisis.
The “twin-deficits hypothesis” holds that the federal budget deficit forces America to borrow abroad and causes the trade deficit. This explanation can be true in some times and places. However, some countries with large budget deficits have trade surpluses (like Japan). When the U.S. budget was in surplus between mid-1996 and mid-2000, the trade deficit ballooned. In 2000, the extra money sloshing around financed the trade deficit and helped inflate the dot.com bubble. Since then, the economy has grown slowly in spite of repeated rounds of fiscal stimulus to offset the drag of the trade deficit. In the U.S. case, the twin-deficits hypothesis is backwards: trade deficits cause budget deficits.
Trump desperately wanted to eliminate trade deficits but failed because he relied on “trade deals” and tariffs. Those policies add two more intermediate links in the chain of causality between financial inflows and the trade deficit, but do not change the endpoints. Tariffs can protect a particular industry, but as long as the incoming cash keeps financing the trade deficit, tariffs just cause an offsetting increase in the dollar’s value.
The Biden administration’s only effective choice to reduce the trade deficit is to slow the unwanted financial inflows: the mechanics of the balance of payments will defeat anything else.
The president should begin by revoking, or even reversing, the special privileges extended to foreign residents on their U.S. financial assets. The income foreigners receive on those assets is often either granted special tax exemptions under 26 U.S.C §871(h)(1) or shielded from their home tax authorities. Foreign residents are not merely protected from double taxation, but any taxation, a better deal than Americans get. Tax incentives are even extended to foreign governments who buy U.S. Treasury bonds to promote their exports by keeping their currencies from appreciating versus the dollar.
There will be political pushback. For ideological reasons, many economists oppose any restrictions on financial flows, no matter how large or destabilizing. Money-center banks generate huge fees moving this money around and it is a cheap source of financing for their operations. Their cut comes regardless of whether or not the money is productively used, and they will fight to keep it.
However, some progressive think-tanks, heartland manufacturing lobbies, and economic conservatives hold opposing views. A bill to tax financial inflows was introduced into the last Congress by Senators Tammy Baldwin (D-WI) and Josh Hawley (R-MO). Treasury Secretary Janet Yellen and Council of Economic Advisors member Jared Bernstein, Biden’s long-time advisor, have previously expressed concern about the dollar and trade deficit. On the right, the late Nobel laureate and supply-sider Robert Mundell suggested the dollar’s current role as world reserve currency and liquidity source is ill-advised and should be replaced by a new system of fixed exchange rates and an international currency to settle trade accounts.
The public may not understand arcane economic policies issues, but politicians should remember that re-elections do not depend on popular economic policies, they depend on popular economic outcomes. Lifting the economic burden created by excess foreign financial inflows requires breaking the barriers of narrow, ideological conformity. All else is spitting into the wind.
Kenneth Austin recently retired after 27 years as an economist at the U.S. Department of the Treasury. He is currently an adjunct professor at the University of Maryland Global Campus.
