Does Trade Policy Affect Trade?

The claim that trade policy does not affect trade balances is one of those peculiar arguments believed by neither the layman nor the analyst, but widely embraced by ideologues desperate to justify a political project. Other examples include “stock buybacks are just efficient reallocations of capital” and “immigration doesn’t affect wages.” Common sense may say it’s wrong. Rigorous analysis may prove it’s wrong. But if enough people with enough power wish hard enough for it to be right, and repeat the claim often enough with the right combination of confidence and condescension, it can acquire sufficient legitimacy to steer public policy wildly off course.

The telltale hobgoblin is an absurd level of macroeconomic abstraction that disconnects the claim from any real-world experience of market forces and transactions. For instance, the stock-buybacks story holds that when a firm returns capital to shareholders by buying their holdings of its stock, the funds paid can then be put to better use. Perhaps. But there is no massive reservoir somewhere in Kansas with a sign reading “capital” into which firms pour their profits and from which others draw the funds to build new things.

No, a firm buying back its stock just gives money to whomever might want to sell the stock. Maybe the recipient will then invest the funds productively, buying new equipment or building a factory somewhere. Do you know anyone who has done that with money they received from selling shares of stock? I don’t. Maybe they will buy Bitcoin. Maybe they will buy a yacht. Maybe they will bet it on the New York Giants to win the Super Bowl. These stories are very different ones. Indeed, it’s strange that no one defending stock buybacks seems to have much interest in finding empirical evidence of how the funds are subsequently deployed. The abstract, implausible claim remains more appealing.

The latest example of the phenomenon comes from Maurice Obstfeld, senior fellow at the Peterson Institute for International Economics, who argues in a new policy brief that “Misconceptions about US Trade Deficits Muddy the Economic Policy Debate.” According to Obstfeld:

• “Identifying trade liberalization as a primary cause of the [trade] deficit is simply wrong. The deficit is the macroeconomic outcome of an economy’s collective decisions to save and invest.”

• “Tariffs and other trade barriers cannot affect the trade deficit unless they shift saving or investment.”

• “[T]rade partners’ commercial policies are an unlikely explanation for US trade deficits, the roots of which are primarily macroeconomic.”

The abstract economic claim here is that the U.S. economy’s total “investment” must be financed by some combination of domestic “savings” and foreign capital. If we want to invest, we must produce more than we consume. If we fail to do that, we must instead rely upon other countries producing more than they consume and sending some of that excess production to us. That excess production shows up as a trade deficit (“they sent us more than we sent them”) and, from this perspective, is nothing to lament—indeed, it would appear a necessary and beneficial feature of the global economic system that promotes growth. “An investment-driven deficit,” writes Obstfeld, “is likely positive for the economy.”

Paul Krugman makes the same point in a recent newsletter: “Trade deficit = net inflows of capital. So unless we reduce the amount of foreign capital flowing into the United States—the amount that foreign governments, companies and individuals are investing here—we can’t reduce the trade deficit.”

Accepting this premise, it follows that trade policy contributed to neither America’s enormous trade deficit nor its absurdly imbalanced economic relationship with China. China’s mercantilism doesn’t dictate how much we want to save or invest; if anything we should be grateful that Chinese producers provide so much at such low prices. Tariffs don’t dictate those things either, so imposing them would just frustrate our access to the foreign products our economy needs to close our own savings-investment gap. If the trade deficit concerns you—though perhaps it should not—come up with a plan to reduce investment in the U.S. (seems unwise) or boost domestic savings (good luck).

What’s wrong with this appealingly elegant and exculpatory story? The terms “savings” and “investment,” when used in these arguments by economists, are not what the vernacular would imply. We think of savings as money put into savings and brokerage accounts and investment as money used to build and expand businesses. In this story, banks and the stock market help to transform the former into the latter. But that’s not what economists mean, and that’s not what’s going on.

Translating Obstfeld and Krugman’s abstractions into the reality they imply, the story falls apart. Take the concrete example of two towns, one anchored by several booming factories and one suffering from deindustrialization. In one town, workers in the factories earn healthy wages, allowing them in turn to support myriad local businesses that themselves employ workers at healthy wages. The factories earn healthy profits, which they use to expand output and boost the productivity of their workers, whose wages increase, in turn boosting local businesses whose own workers can share in the rising prosperity. In the other town, the factories are gone. An increasing share of households become dependent on public programs to make ends meet. Many local businesses, and their workers, struggle as well.

The first town sent as much value out into the world from its factories as it received back in products from afar, and raised more in taxes than it consumed in public services. The second town produces few goods and services consumed elsewhere and raises little tax revenue, depending instead on government transfer payments into the community.

The citizens of both towns may be living paycheck to paycheck or even taking on consumer debt to keep up with the Joneses. But in macroeconomic terms, the first is saving much more than the second. Conversely, all those transfer payments flowing into the second community, funded by a federal government with an enormous budget deficit, qualify as investment: The Treasury sells bonds, using the proceeds to fund the transfers. Or, even more concretely, people around the country and the world send things to the community for which the community sends nothing back, and instead the federal government issues a piece of paper saying, “thank you, we will pay for this some day.” The second town’s depressed production and its need for resources represents an “investment” opportunity that, according to this macroeconomic theory, we ought to be grateful to China for filling.

So which way does the causation run? Would trade policy that encourages the departure of the factories lead to a decline in savings and the need for an influx of lending to fill the gap? Or, as the macroeconomists seem to claim, did a decision by the townspeople to stop saving and start borrowing somehow prompt the factories to leave?

Translating the abstract macroeconomic concepts into behaviors in the domestic market makes clear that trade policy has an enormous effect on savings and investment—indeed, to a significant extent, the economy-wide balance between savings and investment will be dictated by trade balances rather than vice versa. With different trade policy and different incentives for locating production, the supply of savings and the demand for investment changes too. If firms find it most economically attractive to serve rising consumer demand with domestic production, doing so will in turn generate the savings and investment conditions in which large trade deficits are neither warranted nor necessary nor likely to emerge. If firms find offshoring to China more profitable, doing so will produce the macroeconomic conditions in which a trade deficit comes to seem inevitable. In formal terms, saving and investment are endogenous to trade policy, not some exogenous factor to be held constant in assessing the effects of that policy.

Note also that the extra foreign “investment” flowing into the domestic economy is not needed to build new productive capacity, nor does it in practice do so. To the contrary, the domestic economy has more than enough capital to fund real investment and the corporate sector has in fact become a net source of capital back into financial markets in recent years. A miniscule fraction, generally less than 5%, of “foreign direct investment” actually establishes or expands economic activity rather than merely acquiring existing assets. What would America do without so much foreign “investment” simultaneously de-industrializing the economy while fueling housing and other asset bubbles and an exploding federal budget deficit? It might be nice to find out.

In the abstract formulation, Obstfeld can suggest modestly that it is “unclear that freer trade will raise investment more than saving, which it must in order to widen the deficit.” But if “attracting investment by selling more treasury bonds to fund direct payments to depressed communities” is an instance of investment rising more than savings, then freer trade that makes rapid offshoring attractive to multinational corporations can quite clearly have that effect.

Much like the effect of immigration on wages, the effect of trade policy on trade balances and domestic industrial development was entirely uncontroversial until the political imperative to deny it emerged in recent decades. Even Paul Samuelson’s industry-defining economics textbook, Economics (1948), which made an aggressive case for policymakers to adopt free-trade policies, acknowledges that protectionist policies would alter the trade balance. Under the heading, “Beggar-Thy-Neighbor Policies,” Samuelson considered the ways a policymaker might “set about to create a favorable balance of trade,” listing such options as “protective tariffs,” “low import quotas,” “comprehensive exchange control,” and “devaluation of the dollar.”

“Any intelligent person who agrees that the United States must play an important role in the postwar international world will strongly oppose the above policies,” he wrote, not because they would be ineffective, but rather because they would indeed work and “attempt to snatch prosperity for ourselves at the expense of the rest of the world.” Further, because the policies would work, other countries would retaliate, leaving everyone worse off.

The issue of retaliation is an important one, but only underscores the folly of the claim that trade policy does not affect trade balances in the first place. If it doesn’t, then why retaliate? Indeed, more broadly, why does any nation pursue any trade policies? And why, throughout history, have those policies appeared to have precisely the effects common sense would suggest?

The United States built up its own industrial base behind high protective walls. Other nations, especially in Asia, used both tariffs and aggressive industrial policy to drive their own export-led growth. China, obviously, has bet on its ability to establish itself as the hub of global manufacturing with a range of policy interventions. And then, as the United States dropped its own trade barriers and welcomed China into the World Trade Organization, U.S. manufacturing collapsed (moving, in particular, to China), and its trade deficit exploded.

To believe the free traders, one would have to accept that all this—the economic history of the United States and the global development of the past half century—is just a misleading coincidence. The U.S. in its early centuries “was well situated for both extensive and intensive growth, regardless of the trade policy it chose,” insists economic historian Doug Irwin. “Protectionism is merely what held it back from being even more awesome,” chimes in George Mason economics professor Vincent Geloso. Some even argue that China would be doing better had it eschewed industrial policy and just opened its markets.

Thus, against the straightforward story that blind embrace of free trade with an aggressively mercantilist China yielded a deeply damaging deindustrialization in the United States, Obstfeld concludes:

Low US interest rates and especially the easing of other US financial conditions allowed a big increase in home prices as well as in equity prices and consumption spending, accompanied by a weaker dollar. Higher consumption spilled over into imports and nontraded US products, drawing resources from the manufacturing export sector and raising the net export deficit at the same time. Despite a higher overall level of US consumption spending, a demand switch from import-competing goods toward cheaper Chinese imports helps explain the China shock—and this switch would have occurred even if the US trade deficit had been smaller.

The straightforward case that trade policy affects trade seems the stronger one.