Tariffs Don't Fix Trade - Capital Flows Do
The cost of escaping a recession
In an open economy driven by global finance, the external balance is determined by capital flows, not by trade itself. Formally, the balance-of-payments identity states:
Current Account + Financial Account = 0
Current Account = − (Financial Account)
Thus, net foreign capital inflows, a financial-account surplus, require a current-account deficit. As long as investors around the world seek out U.S. assets, the United States must import more than it exports. This reverses conventional thinking: it is capital inflows that cause the trade deficit, not the other way around.
In such a system, tariffs do not reduce the external deficit directly. If imports do not contract in volume immediately, tariffs merely alter income distribution domestically. The relevant identity is:
(Sp−I) + (T−G) = (X−M)
where Sp denotes the private-sector savings (households and corporates), I denotes private investment, T is Taxes, G is public sector spending, X and M denote exports and imports, respectively.
With capital inflows holding the trade deficit in place, a tariff only raises T, increasing public saving, by definition, reduces private saving by an equal amount. Consumption and investment remain unchanged in this first round; the tariff is nothing more than a transfer from private saving to public saving, showing up as a hit to household cash-flow or corporate profits, not to GDP.
In the second round, the normal response is for imports and consumption spending to drop on the back of the rise in the prices of imported goods and drop in real disposable income. However, asset prices can mask the income shock. Ongoing capital inflows inflate equities, bonds and real estate, generating a wealth effect. Households and businesses maintain spending by consuming out of net worth rather than income. Imports remain elevated, and the external deficit, forced by the surplus in the financial account, does not close. The tariff does nothing to improve the current account, it only erodes the private sector’s financial buffer beneath the surface. In the chart below we show the strong relationship between nominal PCE and households financial assets. We should add here that the data on households financial assets for Q2 was not released yet, but given the strong recovery of the stock market reaching new record highs, we expect a strong rebound.
But this is a fragile equilibrium. If capital inflows slow, or if asset prices stall, the wealth effect vanishes. The private sector can no longer maintain spending in the face of lower disposable income and begins to retrench. At this point, the IS identity re-asserts itself: private saving rises relative to investment, consumption and investment fall, and imports finally contract. Only then does the trade deficit begin to narrow. Tariffs therefore improve the external position only indirectly, via a contraction in domestic demand after the wealth-fuelled illusion breaks.
In short: tariffs do not cure trade deficits so long as the rest of the world keeps financing U.S. spending. They simply raise the odds of a sharper domestic-demand recession once the capital inflow that props up the system inevitably cracks.