HOW TO REDUCE THE TRADE DEFICIT

Three ways to reduce the trade deficit are:

If the administration is serious about reducing the trade deficit, there are ways to do it. Trade policy, however, is not on the list. Although it seems intuitive that trade policy should be the appropriate instrument for a trade deficit—just as fiscal policy is the right tool for a fiscal deficit—the economics do not work that way. Higher tariffs on one country or product divert trade to other countries or products, distorting consumption but leaving the trade balance roughly unchanged. Higher tariffs on all countries will reduce imports, but they will also reduce exports, again leaving the trade balance roughly unchanged. The reason is that import tariffs reduce the demand for foreign currency and the dollar strengthens, thus the tariffs reduce both imports and exports and distort consumption and production. Overall, higher tariffs can be expected to reduce trade and income, but with a negligible impact on the trade deficit.

To eliminate the trade deficit and service our debt, we must lower costs of production relative to prices. There are four options:

* We can inflate, as many now urge. Inflation lowers the value of the debt and devalues the dollar. The decline in the value of the debt transfers wealth

from the rest of the world but, sooner or later, inflation raises all prices including interest rates and wages. The rise in wages and other costs of production offsets the effect of the devaluation on trade.To reduce the trade deficit permanently, we must reduce the cost of domestically produced goods. Inflation not only fails to solve the trade problem but, by encouraging consumption it makes the problem worse.

* We can protect against imports using quotas, surcharges and perhaps tariffs. This lowers spending on imports but invites retaliation and shrinks the amount of world trade. A lower level of trade makes more difficult the task of squeezing out $60 billion to pay interest on our foreign debt.

In addition, to all the other, well advertised disadvantages of trade restrictions, we must add that they are in a real sense counterproductive when we view the trade and debt problems as a whole.

* We can devalue the dollar. We have done a lot of that in the past two years. A real devaluation, unlike inflation, raises prices relative to costs of production. This method of adjustment, like protectionist policy, reduces standards of living relative to foreigners and perhaps in absolute terms. We cannot avoid devaluation, but we should avoid policies aimed at manipulating exchange rates and “talking the dollar down.”

* We can increase productivity. There are many ways to do this, none easy to accomplish. At the national level, the four most important policy changes in my judgment, are: (1) Without increasing taxes, shift taxation from capital to consumption so that the share of consumption spending falls and the share of capital spending rises to levels substantially above those achieved in the last twenty years; (2) Reduce government spending, particularly consumption spending and, if possible, shift government spending from consumption to productivity enhancing investments in infrastructure; (3) Make a commitment to maintain these policies – and a long-term to pro-growth strategy – to reduce uncertainty about future after tax returns to investment. Elements of this strategy include more deregulation, less costly means of reducing pollution, enforcing product liability, safety and health. (4) Shift from a policy of lending to foreign debtors to a policy of encouraging repatriation of foreign capital and debt reduction by foreign debts. It makes little sense for a debtor country, the United States, to borrow and sell assets to finance loans to Latin American debtors. Instead, we should encourage Latin Americans to sell equity in their large state sectors or to adopt policies that attract some of the capital held abroad by their citizens.

The problems of trade and debt require that we produce more relative to what we spend and that we transfer part of the difference abroad to service the debt.

The four options take different approaches to the problem. Inflation does little to solve the trade problems. Devaluation (in real terms) and protection solve the problem by lowering standards of living at home relative to living standards abroad.

None of these options works to increase output and productivity. A general tax increase to reduce the budget deficit would raise the tax on investment to maintain government spending on consumption. This is the opposite of a policy to close the gap between spending and production by increasing production.

It is only by adopting measures that increase productivity that we can hope to service our debt while shifting output from domestic use to exports without increasing inflation and without permanently reducing standards of living relative to foreigners and, perhaps, absolutely. Reductions in government spending on consumption, higher taxes on private consumption and lower taxes on investment and capital shifts resources toward investment and raises productivity.https://www.blogger.com/blogger.g?blogID=2828107132000738644#editor/target=post;postID=6491092612199849287