When Donald Trump was running for President he accused China’s trade policies and the resulting U.S. trade deficit of being “the greatest theft in the history of the world.”
His position on China has remained unchanged. Trump recently, again, denounced China for manipulating its currency in order to weaken the yuan. Trump argues that a weaker yuan, in other words a stronger dollar, will increase the U.S. trade deficit and harm the U.S. economy.
Both sides on this exchange rate issue want to have a weaker currency. First of all, notice the hypocrisy in Trump’s statement. He denounces China for wanting a weaker yuan because Trump wants a weaker dollar. It’s bad for China to implement policies that weaken its currency, but it’s good for the U.S. federal government to have the same goal of weakening its currency. Trump is criticizing China for doing the exact thing that Trump wants to do.
But beyond the hypocrisy, note that we cannot even be certain that a weaker dollar will lead to a smaller U.S. trade deficit. The trade deficit is the amount of exports, in dollar terms, minus the amount of imports, again in dollar terms. A weaker dollar will lead to higher prices for U.S. imports and fewer imports and lower prices for U.S. exports and an increase in our exports. But if we pay higher prices for imports and buy fewer imports the dollar amount of imports may not decrease. If the effects of higher prices outweighs the effects of a lower quantity of imports, then the weaker dollar would lead to more imports in dollar terms.
Similarly, if the price effect of lower prices for our exports outweighs the effects of selling more exports, then the dollar amount of exports would decrease. In other words, the relationship between the dollar exchange rate and the trade deficit is determined by the price elasticities of demand for exports and imports. (In international trade theory this is called the Marshall-Lerner condition.)
Next, let’s assume that a weaker dollar does lead to the Trumpian goal of reducing the trade deficit. Here we see a contradiction between this policy and Trump’s other trade policy goals. Trump wants U.S. and foreign companies to build businesses and employ workers here in the U.S. instead of in other countries and he believes that his tariff policies will lead to this result. That is to say he wants to increase the amount of capital investment in the U.S. Trump believes that tariffs will increase the amount of foreign investment in the U.S. and/or decrease the amount of U.S. investment overseas.
In the government’s balance of payments, the net capital flows is the amount of capital inflows into the U.S. minus the amount of capital outflows out of the U.S. Trump wants to increase these net capital flows.
The problem here is that the amount of net capital flows is correlated with the trade deficit. Dollars that flow out of the U.S. due to the trade deficit tend to flow back into the country as foreign investment. If the trade deficit decreases, say due to a weaker dollar, than foreigners have fewer dollars to invest in the U.S. Net capital flows will decrease.
Trump seems to want (I say “seems to want” because his position on these matters is often unclear) a smaller trade deficit and increased net capital flows into the U.S. He can’t have both. If the trade deficit decreases, then foreign investment will decrease.
Trump’s position on exchange rates is hypocritical, it’s uncertain whether or not weakening the dollar relative to the yuan will accomplish his goal of reducing the trade deficit, and a smaller trade deficit will lead to less capital investment in our economy.
