A US trade deficit is not a sign of a weak economy but rather a magnet for investments

Mr Trump's fight against a trade deficit may be misguided

Mr Trump should consider rolling back the protectionist measures that he has installed, as they actually harm the US economy. Reuters

One of US President Donald Trump’s campaign promises was reducing the country's trade deficit with the rest of the world, and many of his trade policies have been efforts at realising that goal, most notably, the large tariffs imposed upon Chinese exports. However, by the end of 2018, the trade deficit reached its highest level in 10 years at $621 billion.

Why are Mr Trump’s policies seemingly failing?

Ironically, the biggest reason for the ineffectiveness of the president’s trade policies has been the effectiveness of his domestic economic policies. Mr Trump's predecessor, Barrack Obama, handed over a growing and robust economy, and it has continued to improve under him, both in terms of the growth of output, and in terms of unemployment, which is at levels not seen since the 1960s.

Why does an improving economy hurt the trade deficit? There are three main channels for this phenomenon.

First, the economy’s growth is partially the result of improved consumer sentiment and spending, which is in turn due to Mr Trump’s tax reforms. When consumers feel confident and spend more, some of that extra spending typically goes on imports, especially luxury imports such as Prada handbags and Porsche cars. At the same time, there is no direct boost to exports. The result is a widening trade deficit. The fact that other big economies, such as the European Union and China, are struggling relative to the US accentuates this channel, as it means that global consumers are not spending more on US exports to offset the increased spending by consumers in America on imports.

Second, the improved performance of the US economy compared with the rest of the world means an appreciating dollar, as global investors shift their assets there. The flow of financial assets to the US is accentuated by the fact that the Federal Reserve has been increasing interest rates in an attempt to relieve inflationary pressure. This causes the trade deficit to widen, because when the dollar is worth more, US exports become more expensive for the rest of the world, meaning decreased exports; and imports become cheaper for American consumers, meaning increased imports.

Third, as confidence in the US economy grows, when it imports goods and releases dollars into the international financial system, rather than using it to purchase exports that balance the trade equation, they end up being used to invest in the country. In fact, much of the trade deficit that the US has experienced since the global financial crisis of 2008 should be interpreted as a capital account surplus – a net positive flow of capital from the rest of the world to the US due to its superior economic performance.

Mr Trump has basically set himself up for conflicting goals: with the global economy doing so badly, improvements in the US economy can only come at the cost of a widening deficit; or, a shrinking trade deficit can only come at the cost of a deteriorating US economy.

Fortunately for Americans, Mr Trump apparently chose to prioritise the economy, because in practice, in most situations, a trade deficit is a non-issue, and attempting to shrink it does not serve the economic interests of the citizenry – a point recently made bluntly by former Federal Reserve chairwoman, Janet Yellen, as part of a broad set of criticisms of  Mr Trump’s competence as an economic policymaker.

So, why is a trade deficit benign?

The irrelevance of a trade deficit is evident in one of the few situations where it is damaging: when a country runs a fixed exchange rate, as the US did from the 1950s to the 1970s as part of the Bretton-Woods agreement. A sustained deficit means that a country will run out of the foreign currency necessary to maintain its fixed exchange rate, possibly precipitating a damaging currency attack by speculators. However, since president Richard Nixon withdrew from the Bretton-Woods system, the US has had a floating exchange rate.

When a currency’s value is free to vary, then in the long-run, trade deficits should eliminate itself, as deficits cause a decline in the value of the currency, which boosts exports and decreases imports and vice versa in the case of a trade surplus. The exception is when an economy is attractive as an investment destination for a sustained period of time, as capital flows continuously into the economy, automatically creating a trade deficit. This is the situation the US is facing since the long-term economic boom that started during the early 1990s under president Bill Clinton. In these circumstances, a trade deficit is an indicator of success.

So, what should Mr Trump do? For the most part, nothing, because the deficit reflects the robustness of the US economy. In fact, he should consider rolling back the protectionist measures, as they actually harm the economy, in addition to worsening diplomatic relations with some of its closest economic partners.

Omar Al Ubaydli is a researcher at Derasat, Bahrain. Follow him on Twitter @omareconomics