American Tariff Threats & Foreign Retaliation: No escape from macroeconomic reality

Economists are working through the implications of threats to raise U.S. import tariffs on Chinese goods by 60% and by 10-20% on goods sourced elsewhere. Some economists prefer to simulate the consequences of these tariff moves—but this cuts no ice with policymakers uninterested in economic models or those that reckon analysts aren’t using the correct model in the first place.

Harder to ignore are fundamental macroeconomic relationships that must apply in any economy which engages in international trade. Recently, my IMD colleague Richard Baldwin and the Financial Times’ Martin Wolf reminded their readers of this long-established point: The absence of a widely recognised credible link between import tariffs and a nation’s net savings position means that raising import taxes will not affect the size of a nation’s current account, of which the trade balance is integral.[1] I used similar arguments in Briefing #48 to show that any reduction in the U.S. trade deficit in goods brought about by higher import tariffs must be offset by a reduction in the U.S. trade surplus in services. The abrupt break in growth of the latter witnessed during 2018 and 2019 (the start of the first U.S.-China Trade War) is evidence of the type of reshuffling that is inevitable once the reality of a fixed net saving position is acknowledged.

In this briefing I draw out other implications of the following three considerations, two of which are facts:

·        U.S. exports cannot fall below zero,

·        the U.S. has a large current account deficit,

·        American net saving behaviour does not change in response to either changes in U.S. import tariffs or any foreign trade retaliation.

The combination of these factors yields simple, yet powerful policy insights.

Here I will spare readers the mathematics (the details can be found in the Box at the end of this briefing.) Those constraints imply that:

1.      A nation’s net saving position alone determines the size of its current account.

2.      The massive prevailing U.S. current account deficit, plus the fact that the total value of U.S. exports cannot be negative, limits the degree to which foreigners lose sales in the American market as U.S. import tariffs are ratcheted up.

3.      When tariffs—U.S. or foreign—affect only goods trade, they must decrease U.S. imports by the same U.S. Dollar value as they reduce U.S. exports.

To establish the relevance of these relationships for the current discussion of future U.S. trade policy, I use 2023 official U.S. data to make a series of back-of-the-envelope calculations. These calculations help scale potential trade outcomes and the policy choices linked to them.

According to the U.S. Bureau of Economic Analysis, in 2023 the U.S. current account deficit was $818.8 billion. Of that, the trade balance was in deficit by a total of $784.9 billion. The U.S. goods trade deficit of $1,063 billion was partly offset by services trade surplus of $278 billion.

A current account deficit means that U.S. firms, state and federal governments, and households collectively spend more than they earn—or save less than they invest. In the absence of a convincing link between the level of import tariffs and their spending/saving decisions, this excess spending will remain should tariff hikes occur.

Now let’s consider the four elements of the current account in turn. It is difficult to see a direct link between the net transfers the United States makes abroad and the net factor income the U.S. earns to trade policy choice—so trade policy changes must affect goods or services trade.

Moreover, purely for the sake of exposition (I relax this assumption later), suppose the trade surplus in services is unaffected by import tariffs as well. Several policy implications follow.

First, given the U.S. imported $3,108 billion of goods in 2023, no matter what happens during any near-term trade war, U.S. goods imports cannot fall below $1,063 billion, the size of the goods trade deficit in 2023. Hence the fall in U.S. goods imports cannot exceed 66%. As a point of historical reference, after the U.S. imposed the Smoot Hawley tariffs, U.S. goods imports fell 70%.

Second, given the U.S. net saving position is unaffected by higher tariffs, it follows that the percentage reduction of U.S. imports that keeps the value of the current account unchanged must be less than the percentage reduction in U.S. exports. Figure 1 plots the required percentage reductions in U.S. goods imports that are associated with incremental 10% reductions in U.S. goods exports, that could follow from different degrees of foreign retaliation. For example, foreign retaliation that cuts U.S. goods exports in half requires a fall in U.S. goods imports of just under 33%. Measured in terms of percent hit to the other side’s exports, the optics of a global trade war do not favour the United States.

Figure 1: More foreign retaliation results in lower U.S. goods imports—but the U.S. net saving position limits the percentage fall in U.S. imports.

Third, so long as the U:S. net saving position is unchanged, every $1 billion of U.S. imports cut by higher U.S. import tariffs must be offset by an equal reduction in U.S. exports, be it in services or in goods. Claims that U.S. import tariff hikes will reduce the U.S. goods trade deficit mislead as they ignore the implied hit to U.S. service exports.

Fourth, the more U.S. exports fall due to foreign retaliation, the more the fall in U.S. imports. In fact, in order to preserve the current account, every $1 billion fall in U.S. goods exports must be offset by a $1 billion fall in U.S. imports. The upshot: While each trading partner of the United States makes their own retaliation decision—collectively those decisions boomerang and reduce the very sales to the United States that foreign governments say they are keen to protect.

But what about services trade? The U.S. surplus in services trade may be a tempting target for retaliation by trading partners. It turns out that, combined with hefty retaliation against U.S. goods exports, hitting U.S. services exports could bring about Smoot Hawley levels of trade contraction.

The three-dimension surface in Figure 2 ^[2] is colour coded using a traffic light system plus I added black cells to indicate a 70% or greater reduction in U.S. goods imports. Only in the extreme case when foreign governments essentially ban all U.S. exports of goods and services (worth some $3 trillion) would U.S. imports fall by percentages witnessed during the 1930s. But again the current account deficit ensures the fall is less than 100%.

Figure 2: Only in extreme retaliation scenarios can the Smoot Hawley reduction in U.S. imports (70%) occur.

Note: vertical axis shows the reduction in U.S. imports.

In this first term in office, President Trump argued that “trade wars are good, and easy to win” against nations which the United States has trade deficits with. In fact, the huge size of the United States’ current account deficit limits the extent to which U.S. imports can fall. For sure, higher U.S. import tariffs would do a lot of damage and could reduce trade flows significantly, but until American firms, governments, and households collectively bring their spending closer into line with their incomes, then together they will continue to import vast amounts of goods and services.

For foreign governments there is no escaping the fact that the cumulative effect of any retaliation against higher U.S. import tariffs will be to reduce the total value of their own exporters’ sales in the United States. What some may deem as “smart” individual retaliation moves are in fact collectively counterproductive. As they plan for next U.S. Administration, officials should keep these macroeconomic constraints in mind.

Box: Macroeconomic relationships central to the extent of goods market access to the United States.

First, I introduce notation:

Current Account balance: CA

Trade balance in goods: TBG

Trade balance in services: TBS

Net factor income: NFI

Net transfers: NT

Total value of national goods (services) exports: XG (XS)

Total value of national goods (services) imports: MG (MS)

Net national savings: NS

Total value of national savings (investment): S (I)

Primary fiscal deficit: PFD

Total value of national taxes collected (government spending on goods and services): T (E)

Second, I state accepted macroeconomic relationships:

CA = TBG + TBS + NFI + NT

TBG = (XG - MG)

PFS = (T – E)

NS = (S – I) + PFS

CA = NS

Third, the current account formula can now be written out:

CA = TBG + TBS + (NFI + NT) = (XG - MG) + (TBS + NFI + NT)   (equation 1)

A formula for the total value of U.S. imports can therefore be derived:

MG  = (XG – CA) + (TBS + NFI + NT)      (equation 2)

Fourth, I make standard assumptions about the (non-)impact of import tariffs:

A1. Import tariffs do not affect NS and, therefore, do not affect CA.

A2. Import tariffs do not affect NFI and NT.

Assume for the moment that TBS is unaffected by import tariffs on goods. Foreign retaliation against US exports reduces XG, which in turn reduces MG one-for-one: Δ MG = Δ XG   

Changes in TBS also affect MG one-for-one. This implies that foreign retaliation that targets the United States’ trade surplus in services will also reduce the total value of goods imports into the United States.

Simon J. Evenett, an international trade economist, is Professor of Geopolitics & Strategy at IMD Business School, Switzerland. He is also Founder of the St. Gallen Endowment for Prosperity Through Trade, home of the independent monitoring initiatives Global Trade Alert, Digital Policy Alert and the New Industrial Policy Observatory and Co-Chair of the World Economic Forum’s Global Futures Council on Trade & Investment.