Currency Trumps Tariffs

President-Elect Trump is right that America's massive trade deficit, especially in manufactured goods, is neither healthy nor sustainable. It's not healthy in that it reduces U.S. manufacturing strength, including in advanced and dual-use industries. It's not sustainable in that at some point other nations will be tired of sending us cars, steel, and machines in exchange for promissory notes. When that happens, America will have to run a trade surplus, producing more than we consume.

So, while the Washington Consensus continues to deny it-even claiming trade deficits benefit the United States-Trump is right to challenge that status quo and finally address the problem. But therein lies another problem: The president-elect's go-to solution-tariffs-won't work. Imposing across-the-board tariffs on most other nations, or even on nations running trade surpluses with America, will almost surely lead to retaliation in the form of tariffs on U.S. exports, leading in turn to a modest decline in the trade deficit, at best. On top of that, the dollar is likely to appreciate, offsetting even more of the cost advantage tariffs provide.

The better policy solution is drive down the value of the U.S. dollar relative to other currencies while also driving up domestic production in advanced technologies and industries.

The Trade Deficit in Manufactured Goods Is a Problem and Needs to End

The United States has been running trade deficits since the mid-1970s. Because of that, the Reagan administration negotiated the Plaza Accord to bring down the value of the dollar relative to major trading partners. As economic theory and logic would predict, the trade deficit then fell to near balance in 1991. But with the expansion of global offshoring, and in particular China's accession to the World Trade Organization, the trade deficit peaked at around 5.7 percent of GDP in the mid-2000s. In significant part because of the increase in U.S. energy production since then, the deficit subsequently fell to around 3 percent of GDP where it remains to this day.

Figure 1: U.S. trade balance as a share of GDP (BEA data via FRED)

Americans may comfort themselves by thinking that most of the U.S. trade deficit in goods is comprised of oil, cheap low-value items, and mass-market consumer electronics. Surely, the United States must run a trade surplus in advanced-technology products from industries such as life sciences, medical devices, optoelectronics, information technology, aerospace, and nuclear power. But in fact, according to the Census Bureau, the United States is on track to run a $265 billion trade deficit in advanced-technology products in 2024. Indeed, between 1999 and 2009, America's share of world exports fell in almost every advanced industry: by 36 percentage points in aerospace, 9 in IT, 8 in communications equipment, and 3 in cars.

Thanks to the large U.S. goods trade deficit, the U.S. share of world exports has declined from 17 percent in 2000 to 8.5 percent now, even as the European Union's share fell from 17 percent to just 14.8 percent. And in 2021, the United States accounted for 78 percent ($845 billion) of the trade deficits run by countries running trade deficits.

Moreover, the accumulation of trade deficits has effectively led to an ever-expanding trade debt. Since 2014, U.S. trade deficits have totaled $6.9 trillion in trade debt (in 2024 dollars), equivalent to $54,000 per household. The United States has financed those deficits partly through foreign investments in U.S. Treasury securities, businesses, and real estate. But that can't go on forever. Eventually, surplus nations will want something other than green pieces of paper with American presidents on them. They will want real goods and services their populations can consume. And when they do, future generations of Americans will have to pay the bill this generation has accumulated by consuming less than it has produced. Yet, while policymakers talk about how it is immoral to pass on a growing budget debt to the next generation, they are strangely silent about passing on a trade debt to the next generation.

Tariffs Invite Retaliation

Reducing the trade deficit, especially in ways that build our advanced manufacturing base, will require two things. One is a robust domestic industrial strategy targeting advanced industries, as ITIF has laid out before. The second is an increase in import prices and a reduction in export prices. There are two main ways to do the latter.

The first is with tariffs, the de-facto trade tool of the incoming Trump administration. But the problem with tariffs is that while they will increase import prices (leading to a reduction in imports), they will also likely increase the price of U.S. exports, because other nations will respond in kind with their own tariffs. Already, foreign leaders in places like Canada, Mexico, and the EU have discussed this as their response. China could do so as well. But it may not be a simple tit-for-tat; Beijing's response to tariffs will likely be more targeted and asymmetric. As Liza Tobin of the Special Competitive Studies Project has noted, "They're already squeezing foreign companies operating in China, and they could turn up the heat on American firms, selecting targets they want to push out of the China market anyway."

The second way to reduce export prices and increase import prices is to devalue the dollar. International economics 101 teaches that a country's currency valuation should fluctuate based on its economy's current account balance. If the country is running a deficit, the value of its currency should fall to make imports more expensive and exports cheaper. Conversely, if a country is running a trade surplus, its currency should rise in value. This is how markets are supposed to work.

Unfortunately, not in America's case. The United States has run a current account deficit pretty much every for the last half-century. And, since the short-lived decline following the Plaza Accord, the dollar has strengthened against foreign currencies. These levels of imbalances are fundamentally destructive and not sustainable.

So, what's going on? The answer is that financial globalization is driving the train. Capital is seeking safety and higher returns, so it is flocking to the least-worst place: the United States. That is driving up the value of the dollar, even as the United States runs record trade deficits. At some point, this might cease when the United States defaults on its national debt, but who knows when that will be.

This situation is compounded by the fact that the "Washington Consensus" has long held that maintaining a strong dollar and ensuring the dollar serves as the global reserve currency are both good for America. In 2008, in the face of growing trade deficits, President George W. Bush made it clear, saying, "We're strong dollar people in this administration, and have always been for a strong dollar." President Obama's Treasury secretary, Timothy Geithner, proclaimed, "We will never seek to weaken our currency as a tool to gain competitive advantage or to grow the economy." Under President Trump, U.S. Treasury Secretary Steven Mnuchin said, "I support a stable dollar," by which he meant he opposed trying to reduce the value of the dollar. Biden administration Treasury Secretary Janet Yellen has maintained this stance, saying that the United States would not intervene to help raise the value of the yen and lower the value of the dollar.

In the rare instance where a Washington official did not support Washington's strong-dollar consensus, the pressure was on. Former Bush administration Treasury Secretary Paul O'Neill recalled, "I was not supposed to say anything but 'strong dollar, strong dollar.' I argued then and would argue now that the idea of a strong dollar policy is a vacuous notion." For these and other heretical views, O'Neill was replaced by someone who knew how to sing the right tune.

Opposition to Forcing the Price of Dollar to Become More Competitive

So, why is there such strong resistance to letting the value of the dollar become more competitive? First, hard-core conservatives worry about "debasing" the dollar. These folks are often "gold bugs" seeking to tie the value of the dollar to the price of gold. The problem is that in virtually every other area these conservatives favor markets setting prices. "The last thing we want is for some socialist administration to take away our freedom by engaging in price controls," they might say. Yet, defending a strong dollar is engaging in price controls. In writing about China's systematic devaluing of its currency in the 2000s, Fred Bergstrom, former president of the Peterson Institute, wrote, "Such unilateral steps by the United States… could hardly be labeled 'protectionist' since they are designed to counter a massive distortion in the market … and indeed promote a market-oriented outcome." (Alas, the Peterson Institute has shifted gears and now supports a strong dollar.)

Second, monetary policy in the United States is largely driven by the financial sector. Wall Street benefits from a strong dollar because it increases the value of financial firms' assets. Third, the Treasury Department, which controls this policy space, has long held deep and inflexible views about maintaining strong dollar.

Finally, holding the globe's reserve currency provides the U.S. government with a valuable weapon it can use to punish adversaries. Indeed, Australia's Lowy Institute uses this as one measure of their Asia Power Index. This is why many U.S. policymakers, especially those in foreign and defense policy, so strongly defend a strong dollar, ignoring its longer-term corrosive effect on the U.S. defense industrial base.

Why a More Competitively Priced Dollar Is in the U.S. National Interest

There are two critical problems with defending a strong dollar at any cost. First, over the moderate to long term, a strong dollar and serving as the world's reserve currency are a result of competitiveness and national strength, not the cause of it. As U.S. competitiveness continues its long slide downward, particularly in advanced industries, it is only a matter of time before the dollar is dethroned.

Second, a strong advanced industrial base is much more important to U.S. national power than having the world's reserve currency. Wars are won or lost on kinetic weapons, not currency flows. And a strong dollar acts as acid that eats away at the foundation of U.S. industrial capacity.

In 1985, President Reagan instructed then-Treasury Secretary James Baker to meet with Baker's counterparts from France, Japan, Germany, and the UK and broker a deal to drive down the value of the dollar relative to those nations' currencies. Baker did-that deal was the Plaza Accord-and it worked. America's trade deficit fell from 2.6 percent of GDP in 1985 to 1.3 percent in 1990. This is consistent with academic evidence that finds that a strong dollar boosts the U.S. trade defense.

Reagan did this for several reasons. First, there was a much stronger bipartisan consensus in Washington that trade deficits mattered and that they hollowed out U.S. production, some of it critical to national defense. Second, many leading U.S. companies, like IBM and Caterpillar, pressed the administration because the high value of the dollar made their products uncompetitive. Today, many U.S. multinationals produce a significant share of their output overseas, or rely heavily on imported inputs, making a strong dollar at best ambiguous to their interests.

But today the choice the Trump administration appears to be weighing is between tariffs or something else. Those who oppose tariffs can hope that Trump is bluffing (unlikely); that he will be constrained by his political appointees, as he was in his first term by his Wall Street-oriented Treasury Secretary Munchkin (much less likely this time); that the courts will stop him from instituting tariffs (maybe, but unlikely, and certainly not a remedy anytime soon); or that Congress will intervene (perhaps, but tariffs will likely get as much bipartisan support from Democrats and Republicans as no tariffs).

So, if action is to be taken to change the prices of imports and exports, the far more positive step would be to forge a Plaza Accord II that pressures other nations to raise the value of their currencies relative to the U.S. dollar. Although, China will not do that voluntarily, so other actions will be necessary to drive the dollar down relative to the RMB.

Finally, by pushing to restore the price of the dollar to one that is competitive in global markets, the Trump administration also can help restore Americans' faith in globalization. And more importantly, because U.S. currency devaluation rightly will be seen as responding to market forces, not protectionism, other countries will be much less likely to respond in ways (such as their own tariffs) that counteract these necessary import and export price changes.

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