MW Trump is attacking the wrong deficit if he hopes to right the economy
By Steven B. Kamin
The federal budget deficit is a more dangerous threat to Americans' wealth than the trade deficit
Trump needs to pivot from an ill-fated bid to reduce the trade deficit to a much more promising effort to reduce the budget deficit.
President-elect Donald Trump's threats to impose tariffs on Mexico, Canada and China are mainly about wielding political clout. But his eagerness to use tariffs reflects a deep-seated skepticism of trade in general and trade deficits in particular. In Trump's own words, "Trade deficits hurt the economy very badly."
But that view is deeply misguided. The trade deficit is not a threat to U.S. growth and prosperity, and we don't need more tariffs to try to reduce it. Conversely, the federal budget deficit is a threat to U.S. growth and prosperity - and that's what Trump needs to cut.
If the U.S. economy were in recession, Trump's antipathy to trade deficits might be more on point. A trade deficit means that domestic residents are spending more on goods from abroad than they sell. In principle, trade deficits could depress domestic spending, economic activity and employment.
But this is manifestly not a problem for Americans. The U.S. economy has been growing briskly, at close to a 3% pace over the past year. And despite trade deficits of around 3% of GDP, the unemployment rate is just 4.2%, well below its historical average.
In fact, rather than a drag on America's economy, the trade deficit is a reflection of the strength of U.S. spending - if that spending weren't allowed to spill over to foreigners in the form of higher imports, it would show up as economic overheating and higher prices.
This brings us to a second possible objection to trade deficits: They reflect that as a country, the U.S. is spending more than it's earning, and must borrow from foreigners to finance the difference. As the U.S. debt to foreigners grows over time, paying the interest and principal on that debt could become increasingly burdensome. If the debt grew too large to repay, it could lead to default and financial crisis.
This is an ominous scenario, but it leaves out an important fact. The trade deficits the U.S. has been racking up are not the result of any profligacy on the part of the private sector. U.S. households and businesses earn more in aggregate than they consume and invest - they lend the remainder, amounting to about 3% of GDP in 2023, to the rest of the economy. This flow of funding is soaked up entirely by the U.S. government, which ran a budget deficit of 6.3% of GDP last year. With those funding needs amounting to more than double the flow of financing from the U.S. private sector, the rest of the funding had to come from abroad. In consequence, the broadest measure of the U.S. balance of trade, the current account balance, showed a deficit of 3.3% of GDP in 2023.
So it's clear that the federal-budget deficit primary driver of both the trade deficit and our rising debt to foreigners. The budget deficit and debt are pernicious in their own right. Most importantly, when the government runs a deficit, it competes for financing with private firms, raising interest rates and squeezing resources that could be used for productive investment.
Analysis by the U.S. Congressional Budget Office $(CBO.AU)$ indicates that for every rise of one percentage point in the ratio of federal debt to GDP, long-term interest rates rise two to three basis points (hundredths of a percentage point). Although this seems like a small effect, considering that the federal debt already amounts to nearly 100% of GDP, it is likely already exerting a material boost to interest rates.
Even more worrisome is the future trajectory of the federal debt if our budget deficits go on uncorrected. The CBO's long-run projections have the debt skyrocketing to 172% of GDP by 2054. This would boost interest rates an additional 11/2 to 2 percentage points, not only further depressing business investment, but also, combined with the higher debt levels, boosting federal interest payments on the debt by upwards of four percentage points. These higher interest payments would cut into the resources available for other public expenditures - including Medicare, Social Security and military defense.
The pressure on the budget from rising interest payments could call into question the government's ability to sustain ever-higher debt levels without resorting to either default or inflationary money-printing. And that, in turn, could lead to further rises in interest rates in a vicious cycle -well-known to developing economies such as Argentina but heretofore unobserved in the United States.
Obviously, the prospect of the U.S. government experiencing an Argentina-style debt crisis seems remote right now. But to keep it that way, the federal budget deficit must shrink from current levels, projected this year to be 7% of GDP, to something closer to its long-term average of 3.7%. There is no way this can be achieved just by cutting "waste, fraud and abuse." It cannot even be achieved by cutting non-defense discretionary spending - including health, education and veterans' benefits - which totals only about 3% of GDP. It will require a serious combination of cuts to defense and mandatory programs like Social Security and Medicare and/or hikes to taxes.
Trump's plans to extend his 2017 tax cuts, along with further reductions in corporate and capital gains taxes, are expected to substantially enlarge, not reduce, the federal budget deficit.
So far, however, almost every policy initiative Trump has floated is slated to bring Americans' day of fiscal reckoning closer. Trump's plans to extend his 2017 tax cuts, along with further reductions in corporate and capital gains taxes, are expected to substantially enlarge, not reduce, the federal budget deficit. And Trump's plans to boost tariff barriers to U.S. imports will raise costs and trigger foreign retaliation, thereby slowing economic growth and making it even harder to balance the budget. Trump needs to pivot from an ill-fated bid to reduce the trade deficit to a much more promising effort to reduce the budget deficit.
Steven B. Kamin is a senior fellow at the American Enterprise Institute $(AEI)$, where he studies international macroeconomic and financial issues.
More: Traders aren't taking Trump's tariff threats seriously. This Wall Street bank says they should.
Plus: Trump's tariffs are the opening rounds of Trade War II
-Steven B. Kamin
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December 21, 2024 11:53 ET (16:53 GMT)
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