Beyond tariffs, what can the U.S. do in its quest for trade balance?

By Atul Bhatia, CFA

We’d previously been of the idea that tariffs were an effective way for the U.S. to exploit foreign countries’ reliance on American consumers. In short, a negotiating lever.

While we think that the Trump administration ultimately has to adopt that approach, we don’t believe the so-called reciprocal tariffs announced in the Rose Garden can reasonably be viewed through that lens. The number of countries, the lack of U.S. strategic interests in some very high-tariff countries, and the means of calculating the tax level all indicate to us that the White House’s goals were much broader: a profound restructuring of global production and trade to eliminate or significantly reduce the U.S. trade deficit.

The trillion-dollar question is whether that goal still exists. The consensus view—which we think has merit—is that the administration’s 90-day pause on most of its single-country tariffs will be extended indefinitely. The benign interpretation is that the administration is likewise shelving its aspirations to transform the world’s economic links.

The more troubling prospect, in our view, is that the White House plans to follow through on its public commitments to radically and quickly reduce U.S. trade deficits. If those plans materialize, we think investors should be prepared for additional market and economic volatility. Trying to fix imbalances created over four decades in four years or less is not going to be without collateral damage, in our opinion.

Wrong tool for the right job

It’s important to be clear at the outset that there is a problem with global trade patterns. Having one country run up debts to be the buyer of last resort for foreign country production is not sustainable in the long term. No matter how we describe it—an inevitable consequence of the U.S.’s role as reserve currency provider, exploitation by foreign countries, or Adam Smith’s invisible hand in action—we believe there is a large and growing risk when debt-funded demand is the prop on which we build the world.

On their face, tariffs could kick-start a realignment. The problem is credibility. To work, tariffs must be in place for years and likely decades. It’s simple math. Rebuilding U.S. manufacturing takes factories, and factories take years to build. An investor today needs to know that the tariffs that make U.S. domestic production viable will last long enough to generate a decent return on the investment. That’s not a one or two quarter time horizon.

From our vantage point, the import taxes rolled out in April had a foundational flaw to bring manufacturing back. They were implemented through an executive order based on an emergency declaration. Legally, they can be turned off in an instant by the courts, by Congress, or by the president. An investor cannot realistically project the attitude of the judicial, legislative, and executive branches for decades.

The administration’s pivot away from reciprocal tariffs was, we believe, a tacit recognition that the tool was inadequate for the task. In our view, which is shared by most published forecasts that we have seen, the administration is now looking to tariffs to provide revenue and as a negotiating lever against foreign countries.

Be careful what you wish for

If, however, the Trump team’s goal of reducing the trade deficit and boosting domestic manufacturing in a short time frame survives the tariff pivot, we think it’s clear that there would be real costs to success:

• Lower efficiency: Trade creates gains by letting economies focus on the areas where they are relatively most efficient—the greatest output for the least input. Interfering with that dynamic is going to be less productive. That’s not a deal killer—efficient systems are some of the most fragile and a robust system often has built-in inefficiencies—but it is part of the tradeoff.
• Living less well: The U.S. status quo is a short-term macro positive—the country gets to consume more today and promise payment tomorrow. Paying off debts means consuming less than we could. That’s unlikely to be fun or popular.
• Higher prices: U.S. labour costs more than overseas labour. If the U.S. is going to start building things here with higher-cost labour, it either needs to be more productive or producers need to charge more. We believe it’s bordering on a fairy tale to think the U.S. can achieve the necessary productivity gains to achieve fully balanced trade at current prices, so higher prices are one likely counterpart of “success.”

In short, we believe lower trade balances are likely to end up with slower economic and corporate earnings growth, slower potential growth, and higher prices.

Where to next?

If the administration wants to act unilaterally to quickly reduce the U.S. trade deficit, we think it has few options and no good ones.

Currencies

Weakening the U.S. dollar would help reduce the trade deficit by making U.S. exports cheaper overseas and increasing the dollar cost of foreign goods. This works on the trade deficit for a while, but it comes with some self-defeating baggage.

The issue is inflation. A weak dollar is just another way of saying Americans get less for their money, a pretty effective way of describing inflation. The self-defeating part of currency weakening is that inflation tends to trigger higher interest rates from the U.S. Federal Reserve that—in turn—push up the dollar’s value.

Central banks can try some fancy footwork to avoid this outcome, but the track record is weak. In realistic terms, with global cooperation, intervening to weaken the dollar could reduce—but not solve—the U.S. trade deficit, and likely only for a short time. Without cooperation, we doubt that it can produce even that temporary respite.

Debt

At the end of the day, when the U.S. buys more stuff than it sells, foreigners are left with excess dollars that they use to buy U.S. assets like Treasury bonds. Economists call the former the current account and the latter the capital account. Although these accounts have to balance, it’s not always clear which one drives the bus.

The White House points to currency manipulation by China as a cause of trade imbalances. China might well say that it’s the insatiable U.S. appetite to borrow that keeps foreign countries from importing more U.S. cars—a dollar invested in Treasuries is a dollar that can’t be spent on U.S. goods. Whatever explanation we choose, there’s no denying that there’s a link between access to U.S. assets and the ability to run a persistent trade surplus with America.

A roundabout way of reducing trade deficits, therefore, is to make it more expensive for foreign countries to purchase U.S. assets like Treasury bonds. Essentially, don’t add costs to the goods being traded, but add costs to the surplus that other countries generate. This may seem like a simple and easy fix that automatically ramps up as countries run bigger trade surpluses, but it’s a horrifically bad idea—in our view—in the U.S. context.

To start with, the Trump administration just asked the House of Representatives to add $5 trillion to the roughly $28 trillion that the nation currently owes. Throwing up roadblocks to lenders is just silly.

More importantly, deep and liquid debt markets are a huge economic and geopolitical advantage. For decades, the UK punched above its weight class in the European balance of power because the City of London’s domination of finance gave the British the ability to raise military funding quickly and cheaply. The U.S. currently enjoys a similar advantage and ceding it would be illogical, in our view.

Finally, weaponizing debt would be crossing a line, potentially opening the door to retaliatory selling by existing creditors. When an economy is built on borrowing, bond brinkmanship is risky for creditors and debtors alike.

Tariff redux

Officially, the U.S. has not abandoned tariffs as a means of reducing the trade deficit—quite the contrary, the administration’s statements and actions are both consistent with the idea that trade balance remains at the core of its tariff strategy.

A hardline tariff approach can take many forms. Extremely harsh negotiating positions, for instance. Or widespread use of sector tariffs instead of individual country tariffs—even if applied at a 25 percent level, the broader application and greater difficulty of evasion can give sector tariffs a big bite. Finally, the administration could let large chunks of the reciprocal tariffs resume after the current pause expires. Any of these techniques—alone or in combination—would likely lead to more of the “yippy” behaviour that led to tariffs being paused in the first place. As a result, we think a tariff relaunch is unlikely but should not be ruled out.

End goals, own goals, and shared goals

The consistent theme of these approaches is that they are likely to be both ineffectual and costly.

While we can see the desirability for an administration to leave its mark through quick and impactful action, we believe the economic and market consequences of pulling any of these levers are likely to be dramatic and negative.

Ultimately, we believe the trade balance is not something that can be undone by a single country and certainly not by a single individual. There are profound questions of timing, burden-sharing, and international balance of power. At its best, the administration’s tariff-led attempt to confront trade imbalances could spark the type of long-term, multilateral dialogue that’s needed to build a domestic and international consensus on trade reform. At its worst, however, a go-it-alone approach is likely to be a difficult pill for markets and economies to swallow.

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