President Trump is tariff-happy. The impetus for his trade war is the U.S. trade deficit, a deficit that he believes is the result of foreigners taking advantage of the United States through “unfair” trade practices.
Trump, like most businessmen, thinks deficits are bad. When a business runs consistent budget deficits, it must either raise more capital to finance those deficits or enter into bankruptcy. But what is true for running a business is not necessarily true for running a country. Indeed, Trump’s line of thinking represents a classic fallacy of composition—the belief that what is true of a part (a business) is true for the whole (the economy).
Trump is wrong on two counts. The U.S. trade deficit is not caused by foreigners—it is homegrown, made in the good old U.S.A. It also is not inherently bad; in fact, for Americans, it is a privilege. Both of these errors stem from Trump’s unawareness of the close connections between saving, investment, and a country’s trade balance.
A country’s trade balance is always accompanied by a corresponding gap between its domestic saving and domestic investment. If a country’s domestic saving is greater than its domestic investment, like China, Switzerland, and Germany, it will register a trade surplus. Likewise, if a country saves less than it invests, like the United States, it will register a trade deficit. The United States’ negative trade balance, which the country has registered every year since 1975, is “made in the U.S.A.,” a result of investment running ahead of its domestic savings. To view the trade balance correctly, the focus should be on investment conditions in the domestic economy, not nefarious foreign actors.
What follows from the savings-investment identity is that a country can only run a trade deficit to the extent that it is able to finance surplus investment with the rest of the world’s savings. For many countries, persistent trade deficits are worrisome because inflows of external savings are fickle. Higher interest rates are needed to retain external finance, which can slow growth and lead to currency depreciation. If the ability of a country to finance its deficits is called into question, a sudden stop of capital inflows may even precipitate a currency crisis. The opposite has been the case for the United States over nearly five decades. Foreigners are not just happy to finance our trade deficits. They are so eager to accumulate claims on the United States that external financial inflows lower U.S. interest rates and strengthen the U.S. dollar. Thanks to the ability of the American government and the U.S. financial system to attract and retain external finance, Americans are able to consume more than they produce. What’s more, the U.S. enjoys robust investment and economic growth despite its low domestic saving rates.
Why do foreign investors afford Americans this privilege? The simple answer is that, for many reasons, the United States is the best place in the world to invest. The U.S. dollar is the world’s reserve currency—investors have confidence in it. The U.S. also has strong property rights, robust legal and banking institutions, a lot of talented human capital, and the largest and most liquid capital markets in the world.
The premise underlying Trump’s tariff program is simply untrue. In fact, reality turns Trump’s premise on its head. For Americans, deficits are good, not bad. Furthermore, deficits are not caused by foreigners eating our lunch. The United States itself has created its trade deficits by making itself the leading destination for the world’s savings. That’s why Nobelist Milton Friedman concluded that: “One of the things that baffles me is the extent to which people regard the trade deficit as a bad thing.” It baffles us, too.
The opinions expressed in Fortune.com commentary pieces are solely the views of their authors and do not necessarily reflect the opinions and beliefs of Fortune.
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