In my last article I used a proven accounting identity to show that the end result of President Trump’s trade tariffs would be to increase the trade deficit, assuming there is no change in the savings rate. The savings rate is important, because if it does not change, then the budget deficit must be financed by any combination of three variables: monetary inflation, the expansion of bank credit, or capital inflows. This is captured in that equation, where the trade balance is the balance of payments, thereby including capital flows as well as goods and services:
(Imports – Exports) = (Investment - Savings) + (Government Spending – Taxes)
It assumes the economy is working normally, and as we shall see, there is no major economic contraction or systemic crisis.
This article explores the implications of the relationship between the twin deficits in the context of the current situation for the United States, which may or may not be on the edge of a significant economic retrenchment. It looks at the detail of how trade tariffs act on the economy at the current stage of its credit cycle and the implications for the economic outlook and for monetary policy. It examines the problem through the lens of sound economic theory, but empirical evidence is invoked as well for confirmation.
(Imports – Exports) = (Investment - Savings) + (Government Spending – Taxes)
It assumes the economy is working normally, and as we shall see, there is no major economic contraction or systemic crisis.
This article explores the implications of the relationship between the twin deficits in the context of the current situation for the United States, which may or may not be on the edge of a significant economic retrenchment. It looks at the detail of how trade tariffs act on the economy at the current stage of its credit cycle and the implications for the economic outlook and for monetary policy. It examines the problem through the lens of sound economic theory, but empirical evidence is invoked as well for confirmation.
The empirical evidence
Looking at history, we find that the effect of tariff increases has depended on the stage of the credit cycle. The best clearest examples are the tariffs introduced after the First World War (the Fordney-McCumber tariffs of 1922) early in the credit cycle, and the Smoot-Hawley Tariff Act of 1930 at the end of it. On the face of it, Fordney-McCumber had little effect, while Smoot-Hawley, it is generally agreed, had a significant effect. Of course, this is in the context of a US-centric viewpoint.
The Fordney-McCumber tariffs were introduced early in the US’s credit cycle. At that time, the US economy still had the legacy of wartime production, whereby imported goods and agricultural products were minimal, having been virtually eliminated by wartime economic planning. The impact of tariffs on the US’s domestic economy was therefore barely relevant to the economic situation. Consequently, unlike the European economies which had been ravaged by war, US agricultural and industrial production were both higher in 1920 than they had been in 1913, the year before the outbreak of war. The effect on Europe was another matter.
European economies found themselves needing dollars to pay reparations (in Germany’s case) and to repay war debt in the case of the Allies. US Tariffs made it extremely difficult for the Europeans to earn those dollars. A number of European economies collapsed into hyperinflation as governments continued the wartime practice of money-printing to finance themselves and service wartime obligations.
Another factor affecting America was the collapse of agricultural prices from inflated wartime levels. By 1921, wheat had collapsed from $2.58 a bushel to 92 cents and hogs from 19 cents per pound to under 7 cents. Tariffs did not help farmers, because at that time, they depended on export markets to a significant degree. And when other countries introduced or increased their tariffs against agricultural products as a response to US tariffs, they proved to be wholly counterproductive for US farmers.
Of course, tariffs were not the sole problem for America’s farmers. Rapid mechanisation increased Canada’s wheat yields, the Argentine was increasing beef production and Cuba exporting large quantities of sugar. Consumers were benefiting from catastrophically lower prices despite tariffs. Other than the pain faced by producers, pain which in free markets is only alleviated by redeploying economic resources away from overcapacity in agriculture, the overall economic effect of the Fordney-McCumber tariffs on America was not significant.
Smoot-Hawley was different. Congress voted in favour of it on 31 October 1929, and the stockmarket clearly saw it coming. The Wall Street Crash commenced on Black Thursday, 24 October, when the market fell 11% that day, before recovering most of the fall. Black Monday followed, when the market fell 13%. By the close on Tuesday 29 October the market had lost over 34% in just fifteen calendar days.
At today’s stock prices, that would be a loss of over 8,000 Dow points. The stockmarket continued its fall to a low on 13 November of 198.7 on the Dow, and after rallying for six months entered a pernicious and continual bear market to a final low of 41.22 on 8 July 1932.
It is always a mistake to attribute a market failure to a single cause: the only certainty was the market fell. However, the importance of the Smoot-Hawley vote to the stockmarket is often missed by economic historians.
The difference between late-1929 and today perhaps, is that Congress voting for it then was a definite event, whereas Trump’s tariffs are progressing as a fluid mixture of bluff and fact. Another key difference was the dollar’s gold exchange standard of $20.67 to the ounce. So long as the exchange rate was defended, a slump would certainly lead more dramatically to widespread bankruptcies. Markets therefore had to discount the enhanced risks from trade protectionism to the economy more immediately compared with today’s fiat currency economy, when it is assumed future investment risk will be ameliorated by monetary expansion.
Pursuing this line of thought is unlikely to lead us to a definite conclusion. A more fruitful approach is to look at the effect of tariffs and trade protectionism in the context of the credit cycle. We have established from our examination of the 1921 Fordney-McCumber tariffs that early in the credit cycle trade protectionism had a limited impact on financial markets and the economy. It stands to reason that an economy floating on a tide of money and credit is in a different position, and more vulnerable to disruption from upsetting events such as the introduction of tariffs.
Adverse changes in trade policy at any time are an upset to market assumptions, and it is clear from both Smoot-Hawley and common sense that Trump’s trade interventions today are a serious spanner in the works of highly valued markets. That is tantamount at the minimum to a claim that Trump has upset the speculators. This is evidently the case, but to understand why Trump’s trade protectionism should be taken more seriously, we need to examine in greater detail the flows implied in the equation at the beginning of this article linking the two deficits.
Looking at history, we find that the effect of tariff increases has depended on the stage of the credit cycle. The best clearest examples are the tariffs introduced after the First World War (the Fordney-McCumber tariffs of 1922) early in the credit cycle, and the Smoot-Hawley Tariff Act of 1930 at the end of it. On the face of it, Fordney-McCumber had little effect, while Smoot-Hawley, it is generally agreed, had a significant effect. Of course, this is in the context of a US-centric viewpoint.
The Fordney-McCumber tariffs were introduced early in the US’s credit cycle. At that time, the US economy still had the legacy of wartime production, whereby imported goods and agricultural products were minimal, having been virtually eliminated by wartime economic planning. The impact of tariffs on the US’s domestic economy was therefore barely relevant to the economic situation. Consequently, unlike the European economies which had been ravaged by war, US agricultural and industrial production were both higher in 1920 than they had been in 1913, the year before the outbreak of war. The effect on Europe was another matter.
European economies found themselves needing dollars to pay reparations (in Germany’s case) and to repay war debt in the case of the Allies. US Tariffs made it extremely difficult for the Europeans to earn those dollars. A number of European economies collapsed into hyperinflation as governments continued the wartime practice of money-printing to finance themselves and service wartime obligations.
Another factor affecting America was the collapse of agricultural prices from inflated wartime levels. By 1921, wheat had collapsed from $2.58 a bushel to 92 cents and hogs from 19 cents per pound to under 7 cents. Tariffs did not help farmers, because at that time, they depended on export markets to a significant degree. And when other countries introduced or increased their tariffs against agricultural products as a response to US tariffs, they proved to be wholly counterproductive for US farmers.
Of course, tariffs were not the sole problem for America’s farmers. Rapid mechanisation increased Canada’s wheat yields, the Argentine was increasing beef production and Cuba exporting large quantities of sugar. Consumers were benefiting from catastrophically lower prices despite tariffs. Other than the pain faced by producers, pain which in free markets is only alleviated by redeploying economic resources away from overcapacity in agriculture, the overall economic effect of the Fordney-McCumber tariffs on America was not significant.
Smoot-Hawley was different. Congress voted in favour of it on 31 October 1929, and the stockmarket clearly saw it coming. The Wall Street Crash commenced on Black Thursday, 24 October, when the market fell 11% that day, before recovering most of the fall. Black Monday followed, when the market fell 13%. By the close on Tuesday 29 October the market had lost over 34% in just fifteen calendar days.
At today’s stock prices, that would be a loss of over 8,000 Dow points. The stockmarket continued its fall to a low on 13 November of 198.7 on the Dow, and after rallying for six months entered a pernicious and continual bear market to a final low of 41.22 on 8 July 1932.
It is always a mistake to attribute a market failure to a single cause: the only certainty was the market fell. However, the importance of the Smoot-Hawley vote to the stockmarket is often missed by economic historians.
The difference between late-1929 and today perhaps, is that Congress voting for it then was a definite event, whereas Trump’s tariffs are progressing as a fluid mixture of bluff and fact. Another key difference was the dollar’s gold exchange standard of $20.67 to the ounce. So long as the exchange rate was defended, a slump would certainly lead more dramatically to widespread bankruptcies. Markets therefore had to discount the enhanced risks from trade protectionism to the economy more immediately compared with today’s fiat currency economy, when it is assumed future investment risk will be ameliorated by monetary expansion.
Pursuing this line of thought is unlikely to lead us to a definite conclusion. A more fruitful approach is to look at the effect of tariffs and trade protectionism in the context of the credit cycle. We have established from our examination of the 1921 Fordney-McCumber tariffs that early in the credit cycle trade protectionism had a limited impact on financial markets and the economy. It stands to reason that an economy floating on a tide of money and credit is in a different position, and more vulnerable to disruption from upsetting events such as the introduction of tariffs.
Adverse changes in trade policy at any time are an upset to market assumptions, and it is clear from both Smoot-Hawley and common sense that Trump’s trade interventions today are a serious spanner in the works of highly valued markets. That is tantamount at the minimum to a claim that Trump has upset the speculators. This is evidently the case, but to understand why Trump’s trade protectionism should be taken more seriously, we need to examine in greater detail the flows implied in the equation at the beginning of this article linking the two deficits.
Why external trade has become central to the whole US economy
Since the oil shocks of the early 1970s, the US has relied on foreign holders of dollars to accumulate US Treasuries issued to finance budget deficits. That recycling of dollars earned by foreigners selling more things to America than America sells to foreigners has through trade imbalances allowed the US Government to run mounting budget deficits.
The Americans have become used to foreigners having no credible alternative to reinvesting their accumulating dollars. However, we can now see that the dollar hegemony behind this proposition is being eroded by China and Russia, acting as the powers which are increasingly directing Asian trade flows. Clearly, as their determination to do away with dollars bears fruit, instead of currently held dollars remaining invested they will be surplus to trade requirements and sold. So far, they have been bought by other foreigners, which is why we see China’s holdings of US Treasuries decline, while those of other foreigners increase, and why Russia’s disposal of cash dollars earned through energy sales has little apparent effect on the exchanges. Meanwhile, the US Government has managed to fund itself without a critical increase in borrowing costs.
This cannot continue ad infinitum, because relative to the volumes of trade concerned and the size of the US economy, there are already large quantities of dollar balances and dollar investments accumulated in foreign hands, which on the last available figures at over $22tn exceed US GDP of around $20tn.
The failure of American trade policy is to not recognise the consequences of upsetting what has become a very delicate balance in capital flows. By imposing aggressively protectionist policies, the Trump presidency has set back cross-border trade significantly, reducing the future availability of dollars from non-domestic sources to fund the budget deficit. Furthermore, US efforts to restrict inward commercial investment by China muddy these waters further.
On these grounds alone, we can see that attempts to restrict Chinese imports are cutting off a vital source of future finance for the US Government. Yet, the accounting identity that explains the twin deficit phenomenon tells us in the absence of an increase in the savings rate the trade deficit will continue. Furthermore, due to tax cuts the budget deficit is still increasing at this late stage of the credit cycle, and an emerging slowdown in the rate of GDP growth tells us it will increase even more rapidly than currently forecast.
Therefore, American protectionist policies risk destabilising the market for US Treasuries, which have increasingly relied on foreign buyers recycling their surplus dollars. The question then arises as to what happens if a contraction in international trade develops out of the current slowdown...
Since the oil shocks of the early 1970s, the US has relied on foreign holders of dollars to accumulate US Treasuries issued to finance budget deficits. That recycling of dollars earned by foreigners selling more things to America than America sells to foreigners has through trade imbalances allowed the US Government to run mounting budget deficits.
The Americans have become used to foreigners having no credible alternative to reinvesting their accumulating dollars. However, we can now see that the dollar hegemony behind this proposition is being eroded by China and Russia, acting as the powers which are increasingly directing Asian trade flows. Clearly, as their determination to do away with dollars bears fruit, instead of currently held dollars remaining invested they will be surplus to trade requirements and sold. So far, they have been bought by other foreigners, which is why we see China’s holdings of US Treasuries decline, while those of other foreigners increase, and why Russia’s disposal of cash dollars earned through energy sales has little apparent effect on the exchanges. Meanwhile, the US Government has managed to fund itself without a critical increase in borrowing costs.
This cannot continue ad infinitum, because relative to the volumes of trade concerned and the size of the US economy, there are already large quantities of dollar balances and dollar investments accumulated in foreign hands, which on the last available figures at over $22tn exceed US GDP of around $20tn.
The failure of American trade policy is to not recognise the consequences of upsetting what has become a very delicate balance in capital flows. By imposing aggressively protectionist policies, the Trump presidency has set back cross-border trade significantly, reducing the future availability of dollars from non-domestic sources to fund the budget deficit. Furthermore, US efforts to restrict inward commercial investment by China muddy these waters further.
On these grounds alone, we can see that attempts to restrict Chinese imports are cutting off a vital source of future finance for the US Government. Yet, the accounting identity that explains the twin deficit phenomenon tells us in the absence of an increase in the savings rate the trade deficit will continue. Furthermore, due to tax cuts the budget deficit is still increasing at this late stage of the credit cycle, and an emerging slowdown in the rate of GDP growth tells us it will increase even more rapidly than currently forecast.
Therefore, American protectionist policies risk destabilising the market for US Treasuries, which have increasingly relied on foreign buyers recycling their surplus dollars. The question then arises as to what happens if a contraction in international trade develops out of the current slowdown...
- Source, James Turk's Goldmoney
