US imagines a new Weapon of Mass Destruction: Trade Deficit

A persistent trade deficit continues to this day, without in any way meaningfully undermining the US economy.

US President Donald Trump didn’t disappoint his supporters on April 2. The reciprocal tariffs do declare a trade war on the world, with a country-wise breakdown showing that China’s manufacturing investments in third countries such as Vietnam being picked for special attention. This is largely on lines of his election campaign; there are no surprises here.

The current global trading order, represented by the baseline framework followed by member-nations of the World Trade Organization, is largely a creation of the US. Trump has just blown it up. It begs the question; why would the US wreck an order that it has created?

Both during the election campaign and in the memoranda that Trump’s office released over the last two months, the economic symptom that is his focal point is the US trade deficit. It has been represented as a sign of weakness which has been exploited by “unfair” trade practices by other countries. This, therefore, has adverse implications on economic and national security.

Donald Trump is plain wrong in his interpretation. He has launched a trade war based on misrepresentation of economic data.

A history of US fiscal deficit

World Bank data shows that US current account as a percentage of GDP was in deficit for 44 of the last 50 years. The US recorded a decisive victory in the Cold War while running large and persistent current account deficits. During the Soviet Union’s twilight years in the 1980s, the US ran current account deficits as a percentage of GDP that were larger than what the country has recorded in the recent past.

Linking national security to trade deficit for a country whose domestic currency is the world’s reserve currency misrepresents reality.

Moreover, a persistent trade deficit cannot be simplistically linked to lack of reciprocity in trade partners. Trade balances are closely linked to domestic savings and investment. In other words, underlying causes of trade balances may be primarily on account of domestic factors.

US personal saving rate as a proportion of GDP has fallen from above 10 percent in 1960-80 period to below 5 percent now. But US investment rate hasn’t changed much, a factor which has played an important role in a persistent trade deficit.

Trump’s being disingenuous in accusing others of lacking reciprocity

WTO is the primary platform to set the baseline for trade architecture, including tariffs. After the end of the Cold War, US, the ideological victor, played the key role in creating a new world trade order. To make it acceptable to everyone the grand bargain in the 1990s was that WTO members would change laws to make it compatible with US standards (intellectual property law changes being of special relevance to India), while differential tariff reductions were allowed to accommodate the stage of development of WTO members.

Consequently, developed countries would lower tariff rates faster than developing countries. Every country had a ceiling tariff rate (WTO’s bound rate). The US, of course, to use sports parlance, had “home ground” advantage on account of WTO rules and norms being compatible with its domestic structure.

One of the most important developments of the advent of WTO was the creation of a dispute settlement mechanism, which allowed the poorest countries to contest policies of the richest countries. This mechanism has played a critical role in preventing trade wars as an alternative was made available.

When Trump talks of unfair practices by trade partners, it’s important to keep in mind that WTO’s dispute settlement mechanism has been made dysfunctional today. The culprit here is the US, which since 2017 has blocked new appointments to the body.

Will the Plaza Accord outcome repeat itself?

Trump is not the first US President to highlight trade deficits and link it to unfair practices by partners. However, the scale of his response is unprecedented and tantamount to carpet bombing.

Looking back at US anxiety over the dollar appreciation and trade deficits in the 1980s during the Ronald Reagan years, the Plaza Accord comes to mind.

The Plaza Accord of 1985 was reached among US, France, Germany, Japan and the U.K. Its aim was to devalue the USD against the Deutschmark and Yen. This devaluation by design was seen as a necessary pre-condition to correct trade imbalances. The US, on its part, was to cut budget deficits and Germany and Japan were to boost demand through tax cuts.

The USD did depreciate by about 26 percent over the next two years. However, that did not help it meet its initial objectives of compressing the trade deficit. By 1987, the Plaza Accord members had to enter into the Louvre Accord, which was designed to stop the continuing decline of the dollar and stabilise exchange rates.

A persistent trade deficit continues to this day, without in any way meaningfully undermining the US economy. It remains the world’s largest economy, the USD has no competitors as an international anchor currency and America continues to be at the frontier of technological innovation. Arguably, it’s Japan that lost its way after Plaza Accord. Currency manipulation, however, didn’t change the pattern of US trade deficits.

It’s hard to say how Trump’s trade war will unfold and anticipate the long-term consequences. But for Trump supporters in the US and elsewhere, an idiom should suffice: Be careful what you wish for.