Economist explains why Trump is right to fixate on the trade deficit

Investing.com -- Donald Trump’s long-standing fixation on the U.S. trade deficit is well documented.

Since the 1980s, he has framed trade imbalances as evidence that other countries are taking advantage of America. His view equates trade deficits with financial losses, akin to a company’s balance sheet, and helps explain his push for tariffs and a weaker dollar.

Capital Economics argues that while Trump is right to focus on the trade deficit, his reasoning is flawed.

Trade deficits do not inherently harm economic prosperity. Instead, they often reflect strong consumer demand.

“There is a truth in the idea that large external deficits represent a challenge to be addressed – just not for the reason that President Trump believes,” Capital Economics said in a Monday report.

The real concern with the U.S. external deficit, according to the macro research firm, lies in its size and persistence. The U.S. current account deficit stands at over 4% of GDP, and the country has not run a surplus in nearly 35 years.

The key issue is that the U.S. has accumulated significant external liabilities without corresponding investment growth.

“Large and sustained current account deficits – and the associated accumulation of external liabilities – have therefore left the U.S. dependent on maintaining the confidence of foreign investors,” Capital Economics explains.

While the dollar’s role as the global reserve currency has helped sustain this imbalance, America’s net international investment position now stands at nearly -80% of GDP.

Compounding the problem, the U.S. no longer generates higher returns on its overseas assets than it pays on its liabilities, contributing to a growing investment income deficit.

Capital Economics warns that “the steady deterioration in America’s balance of payments deficit is a ticking time bomb under its economy – but also under global financial markets.”

Addressing this imbalance requires more than currency adjustments. Using a theoretical model known as the Swan Diagram, Capital Economics explains how economies achieve internal and external balance.

The U.S., with its large current account deficit and inflationary pressures, needs weaker domestic demand to restore equilibrium. China, by contrast, faces weak consumer spending and deflationary risks, meaning it requires stronger domestic demand.

Ideally, the U.S. would address its imbalance through fiscal tightening, while China would stimulate domestic consumption. This could help rebalance global trade without destabilizing financial markets.

However, Capital Economics is skeptical that such coordination will materialize.

“Unfortunately, the reticence of policymakers in China to expand fiscal support and eagerness of U.S. policymakers to cut taxes – not to mention the more fundamental challenges of policy coordination between Beijing and Washington – mean the chances of this actually happening are somewhere close to zero.”

“But the Swan Diagram’s essential insight is that any ‘grand bargain’ to resolve global imbalances that focuses solely on currency realignment would be unlikely to bear much fruit,” the firm concluded.