The Illusion of Tariffs
At first glance, tariffs seem like an easy fix. They reduce imports, narrow bilateral trade gaps, and protect industries at home. In the same way, high government spending fuels demand and stimulates growth. Each of these policies, on its own, appears beneficial.
The problem begins when both are applied at the same time. Instead of fixing trade problems, they reshape the current account in ways that look good on paper but fail in practice. The long-term result is weaker competitiveness, distorted employment, and fragile growth.
Bilateral Deficits Are Misleading
A bilateral trade deficit occurs when one country imports more from a partner than it exports. The United States has long viewed this as a weakness. In 2017, for example, the US ran a $375 billion deficit with China. To many, this suggested economic dependence.
Economists, however, see it differently. Bilateral deficits simply reflect patterns of comparative advantage and supply chains. The real measure of strength is a country’s aggregate current account balance, not the gap with one partner. Tariffs may shrink the gap with China or Japan, but they rarely improve the overall picture.
Lessons From Past Trade Wars
History provides clear evidence. During the US-China trade war, tariffs reduced imports from China, but trade simply shifted to Vietnam, Mexico, and Taiwan. The aggregate deficit hardly moved. The same happened in the 1980s with Japan. Restrictions on Japanese cars pushed firms to move production abroad. Argentina’s experience between 2008 and 2015 followed the same pattern. Tariffs changed who the country traded with but failed to lower the overall deficit.
Why Tariffs Cannot Solve the Deficit
The national income identity explains why tariffs miss the target. The formula is simple: Current Account = National Saving Investment. Tariffs do not appear in this equation. Instead, fiscal policy does the heavy lifting. A government running a large deficit reduces national saving. Unless households save more or businesses invest less, the current account stays negative.
This is the essence of the “twin deficits hypothesis.” A trade deficit and a fiscal deficit are linked. Unless fiscal imbalances shrink, tariffs will not repair the broader trade position. At best, they shift imports from one supplier to another.
The Hidden Tax on Exports
Tariffs also have an unintended side effect. According to Abba Lerner’s theory, a tariff has the same impact as a tax on exports. By raising the cost of imported inputs, tariffs increase production costs for domestic firms. This makes their products less competitive abroad. Exporters effectively face a penalty, even before trading partners retaliate.
The result is slower export growth and weaker long-term productivity. This effect has been seen repeatedly, from US steel tariffs to restrictions in Latin America. Protection today often reduces competitiveness tomorrow.
The Role of Exchange Rates
Exchange rates play a decisive role in the outcome of these policies. Large fiscal deficits often push interest rates higher as governments borrow more. These higher rates attract foreign capital, which strengthens the currency. A stronger currency makes imports cheaper and exports less competitive, offsetting the initial benefits of tariffs.
This cycle played out in Portugal in the early 2000s, as Ricardo Reis observed. Fiscal expansion boosted domestic demand, construction boomed, but services stagnated. When the euro crisis arrived, the result was high unemployment and weak productivity. The same risks apply when tariffs and deficits combine elsewhere.
Employment in the Wrong Places
In the short run, tariffs create winners and losers. Steel workers in the United States benefited when Chinese imports were restricted. But exporters and industries relying on imported parts faced higher costs. Jobs gained in one sector were offset by losses in another.
Meanwhile, fiscal expansion boosted jobs in construction and other non-tradable industries. Over time, employment shifted from productive sectors that fuel long-term growth to those with lower productivity. The structure of the economy tilted in the wrong direction.
The Bigger Picture
In the end, tariffs and fiscal deficits are politically popular but economically flawed. They may shrink bilateral gaps and protect specific industries, but they do not fix the root causes of imbalances. The saving-investment balance remains the real driver of the current account. Without fiscal discipline, tariffs are little more than short-term diversions.
The lesson is simple. Tariffs change where deficits appear, but fiscal and structural reforms address why they exist. Long-term solutions lie in balanced budgets, stronger productivity, and competitive industries not in trade wars.
