An Introduction to Trade Deficits and Tariffs

Countries have been trading for a long time

Our planet is economically non-homogeneous, with an uneven distribution of just about everything.  Implying that most countries will continuously experience both shortages and excesses of various goods and services.  In response, trade happens, the voluntary win-win exchange of goods and services, addressing each other’s economic needs.

Before we explore the economic trade between countries, one must understand that it is the respective consumers and businesses that are exchanging goods and services with each other, and not the countries themselves. Meaning that the same economic principles apply, whether local or international, but now with the added complications of tariffs, currency exchange, embargo's, etc.

To avoid inefficient and inconvenient bartering, plus appreciating that there are about 130 different world currencies (with over 8,000 thousand unique currency pairs), an internationally accepted currency (or money) is required to facilitate international trade.

It wasn’t so long ago that gold was the accepted global money, and it also was not so long ago that most of the world’s currencies were pegged to the dollar, which was in turn pegged to gold.  While this made currency conversion easy, in the end it was not workable, as different countries prefer to deflate their currencies at different rates.

So instead, we have settled on using just a few relatively stable and liquid “reserve currencies” for international trade, those that are trusted more than rest.

The dominant reserve currency is the dollar, a reflection of the significant size of the U.S. economy, its military dominance, and the historical fact that while not perfect, the dollar has historically maintained its value over time better than most other currencies.

While there is little doubt that the usage of reserve currencies has contributed to global economic growth, the fact that only a few select currencies are used is a point of contention.  More on that in a later blog.

Using the dollar as the reserve currency, let’s take a simplified look as to how goods are exchanged between two countries.

In 2024 the U.S. exported $143 billion worth of goods to China, while China exported to the U.S. $439 billion worth of goods.  Resulting in a “trade deficit” of $296 billion (from the U.S. point of view).  Will initially assume that the exchange rate between the dollar and the Chinese yuan (CNY) is 1:7, which is approximately true.

Note the non-symmetrical nature of this diagram.  The “importers” conduct business with the “exporters” in dollars only, while the usage of the yuan is limited to the trade between Chinese individuals and the Chinese based importers and exporters.

This exchange template is repeated throughout the world, with potentially over 8,000 country trading pairs.  Meaning yes, there are a lot of dollars out there (north of a trillion) being exchanged every day to facilitate international trade.

Also note that while the U.S. simply exchanged dollars for an equal dollar amount of goods, China netted an extra $296 billion dollars, thanks to the “trade imbalance”.  Why did this happen?  While on the surface everything appears to balance out from a “wealth exchange” point of view, in reality, the yuan is not “floating”, in that the Chinese government manipulates is value. Specifically, it purposely devalues the yuan, with the stated goal of discouraging imports and encouraging exports.

If China were to take that $296 billion dollars and separately exchange it for yuan, this would increase the demand for the yuan, and decrease the demand for the dollar, causing the exchange rate to shift towards less yuan per dollar.  Which implies that this currency manipulation, the devaluation of the yuan, is one reason why China receives these $296 billion dollars.

Why is this cash inflow for the government desirable (from the Chinese point of view)? Is not this price increase for all goods imported into China, and less revenue for their exports, essentially a double tax on their businesses and consumers?

Yes, it is.  But the Chinese government long ago made the decision that protecting the domestic growth of their manufacturing sector was more important than an open, freer market. It appears to have been at least partially successful up until now, but the long term success of a partially closed economy is open to debate.

What exactly does China do with those $296 billion dollars? Stash the bills in a big vault? Probably not, as they could use them for example to purchase oil or other commodities.  Or to diversify and purchase other reserve currencies.  The dollars that they choose to keep would almost certainly be converted to U.S. Treasury debt to offer some protection against dollar inflation. Which in turn helps the U.S. government borrow more and keep interest rates relatively low.

To further analyze the impact of the yuan devaluation, consider what would happen with a slightly stronger yuan, specifically, a 5 CNY to 1 USD exchange rate:

At first glance, nothing appears to have changed, in that both sides are still wealth flow neutral, with China accruing an annual $296 billion in US dollars.

But economics is dynamic, and one must consider what happens moving forward.  Because the yuan is now about 30% stronger vs the dollar, U.S. imports to China will drop in price, while Chinese exports to the US will increase in price.

Over time, the situation will adjust reflecting consumer behavior.  In this case, due to the 30% increase in price of Chinese goods, it will be assumed that the net amount of Chinese goods exported to the U.S. will drop by 10%, while the net amount of goods exported from the U.S. to China increases by 10%.

This new stable state is reflected in the next diagram.

Note that one effect is that China’s inflow of U.S. dollars for the year decreased from $296 billion to $238 billion, a 20% drop. Thus, confirming my prior observation on the relationship between currency manipulation and foreign dollar accumulation. Which corresponds to a reduced trade deficit.

Conclusion: Devalued currencies encourage greater trade deficits.

Now consider the case where the Chinese government imposes an additional 10% tariff on imports from the U.S. After some settling time, with the tariff acting as an additional tax on imports, the Chinese consumers purchase less US products, reducing US exports by 10%, back down to $143 billion.

In addition, the Chinese government will collect the $14 billion in tariff tax revenue, thus increasing the annual dollar inflow from $238 billion to $252 billion.

It is important to note that for the Chinese consumer, imposing the import tariff had a similar effect to devaluing the yuan.

Conclusion: Higher tariffs encourage greater trade deficits.

Which raises the question, how different is currency manipulation from tariffs in terms of economic impact? Perhaps not that different at all. While there has been a lot of news lately on tariff wars, perhaps there needs to be equal attention paid to currency manipulators.

While China is probably the guiltiest when it comes to currency manipulation, it can be argued the purposeful devaluation of one’s currency, even if just 2%, is a form of currency manipulation. Persistent inflation is the result of monetary policy, meaning that it is a political decision, often the result of politically pressure to “weaken” one’s currency, to make “exports cheaper”, to “protect” certain domestic manufactures.

It is a game that almost all countries play, the result being less economic growth for all. There is a reason why the individual states of the U.S. use a common currency, and do not charge inter-state import taxes.

Because it works.