This Is How Trump’s Protectionism Will Push the U.S. Economy of the Cliff

February 8 2017

President Donald Trump is not wasting any time: the negative trade deficit is public enemy number one. Not only did Trump show that he means business by declaring war on the Mexicans as he threatened to impose an import tax on Mexican goods, the same fate awaited China and later Germany: all countries that currently have a positive trade balance. Trump blames the negative trade balance for the disappearance of American manufacturing jobs. Why is Trump completely wrong? And what are the consequences for the U.S. economy, the dollar, interest rates and gold?

A Negative Trade Balance Is in No Sense Wrong

subject to a completely misguided interpretation.

Take Trump for instance. Trump thinks that a negative trade balance is a disaster. On a side note, the other side of the coin is that many people (including many Dutch) are convinced of the fact that a positive trade balance is a boon (after all, that is what the word “positive” implies).

Let us do a little thought experiment.

Take the city of New York for instance. Let’s say that New York establishes formal borders, secedes and becomes an autonomous country, separated from the rest of the U.S. What would the trade balance of New York City look like?

Let us take a close look at the New York economy. How does the composition of the “Big Apple’s” gross domestic product compare to other regions? Well, in the New York economy finance plays an important role (the most important stock market exchange in the world and the biggest Federal Reserve Bank in the U.S. are curiously both located in New York), but technology and tourism are also important contributors to NYC’s GDP.

What does this mean for New York’s trade balance?

That trade balance is painfully negative. New York clearly imports all its needs; the city of New York does not produce energy, food, manufactures, nada. All these things must be imported. A negative trade balance ensues.

Better yet, it might even be the case that, if we take into account the U.S. while excluding New York, that the negative trade balance suddenly turns positive. This might sound surprising, but is rather realistic if we realize that New York City has the highest gross domestic product of all cities in the world. But that is for later consideration.

What happens if we would put ourselves in the shoes of a New York citizen and start complaining about the enormous New York trade deficit with the United States? What happens if the mayor of New York suddenly has the brilliant idea to impose an import tax on the goods imported from the United States?

These Will Be the Consequences of Trump’s Protectionism

The consequences for New York in the above example are crystal clear: nothing good can come from such an import tax. New York citizens now pay more money to acquire (import) goods and have consequently less money left for other purchases. The New York Consumer Price Index (CPI) rises. U.S.-based “exporters” also lose. Because of the price increase, they sell less goods to New York than before. The total trade volume drops. Both the United States and the now seceded New York are worse off than before.

Imports will decrease and, on the net, the trade balance will “improve”: yet New York will not be better off, but worse.

Now, the New York/United States case was just an example. Trump wants to implement these type of trade policies on a far larger scale with Mexico, China and even Europe, important trade partners for the U.S.

Retaliations? A Replay of the 1930’s

These kind of import taxes are generally not well received by the countries that export to the U.S. How do these countries react? In kind. Governments often respond to import taxes with a very own import tax. The consequences are clear: even less trade, and even less wealth.

(The Great Depression became “great” because of the trade war that president Hoover unleashed as a reaction to the recession and the banking crisis. By the end of 1929 the main objective of the U.S. became, just as nowadays, to “protect American jobs.” Henry Ford tried to convince Hoover that he was wrong and called the import tax “economic stupidity.” After introducing an import tax and after other, mainly European, countries took countermeasures, both import and export halved.)

Leaders on the opposite side of the borders, both in Mexico and China, are keen to respond to the import taxes with import taxes on American products. We are having a moment of déjà vu: it is the 1930’s all over again.

Trump's Protectionism and the Dollar

The only thing that we have intentionally overlooked so far is the effect of Trump’s protectionism on the dollar. What happens to the dollar if Trump gets his way and imposes import taxes to eliminate the ghost of a negative trade balance?

An import tax implies that Mexicans and Chinese will have less dollars at their disposal, which results in an appreciation of the dollar against these currencies. Worse yet, Goldman Sachs estimates that with a 20% import tax the dollar could rise another 24%.

An appreciation of the dollar could soften somewhat the price increases of imported products, although these two phenomena (an appreciation of the dollar that compensates for the import tax) do not occur at exactly the same time and to the same extent.

A Gift of Obama (and the Fed)

A president does not act in a vacuum. Every president inherits the policies – good or bad – of his predecessor. And so it might happen that a president inherits an economic downturn as a legacy of the ones that preceded him.

The legacy that Obama leaves to his successor is terrifying: a doubling of government debt, eight years of zero interest rates, ineffective economic “stimulus,” more rules and restrictions and higher taxes.

The fact that Trump will be faced with picking up the tab of Obama’s legacy is inevitable. The debt is there and zero interest rates are not forever. Trump must deal with the final settlement of the debt that is due no matter what. He might like it or not, but that will not change anything about his inescapable fate as president.

The protectionist (and mercantilist) economic policies of Trump will nevertheless lead to increasing inflation in the United States, to an increase in living costs, and initially to a further appreciation of the U.S. dollar.

The fact that Trump also wants to run up the public debt to staggering heights is the metaphoric straw that breaks the camel's back: this deadly cocktail will lead to an earlier settlement of the pending bill left behind by Obama. And that means inflation, higher (nominal) interest rates, economic decline in the United States, a stock market crash, and – eventually – higher gold prices.

Trump’s protectionist and mercantilist policy failures will, after the current debt binge, only serve to accelerate the fall of the American economy.

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