Budget cuts can solve Trump’s deficit problem

The trade deficit has been an ­obsession of Donald Trump throughout his public life. Yet his policies have often been at odds with narrowing it.

US Secretary of Treasury Scott Bessent. Picture: AFP

The trade deficit has been an ­obsession of Donald Trump throughout his public life.

And yet as president, his policies have often been at odds with narrowing it.

Business-friendly deregulation and tax cuts boost private ­investment and widen the budget deficit. That pulls in imports and pushes interest rates and the dollar higher, depressing exports. Tariffs, meanwhile, may reduce imports, but also exports, by hurting others’ economies and provoking retaliation.

So is there a policy that can reconcile these otherwise irreconcilable goals? Yes, and Republicans have a golden opportunity to enact it: steep, swift cuts to federal spending. By tamping down demand and inflation, budget cuts would pull down interest rates and the dollar, reducing imports and boosting exports, while preserving the conditions for more private investment.

Twin deficits

At its root, a trade deficit results from a country consuming more than it produces. A budget deficit contributes to this imbalance by injecting more demand into the economy via spending than it subtracts via taxes. This linkage is why the two gaps are sometimes called twin deficits.

The link isn’t fixed. Recessions reduce tax revenue and imports, while private investment booms (like in the late 1990s) increase them. In either case, the trade and budget deficits move in opposite directions.

But deliberately shrinking the budget deficit, via fiscal austerity, or expanding it, via fiscal stimulus, usually spills over to trade. A 2021 study of 33 countries from 1978 to 2019 by the International Monetary Fund found that for a big country like the US, one dollar of fiscal consolidation subtracted US30c to US50c from the current account balance (a broad measure of trade that includes goods, services and investment income).

Last year, the US ran a federal deficit of $US1.8 trillion, or 6.4 per cent of gross domestic product. Treasury Secretary Scott Bessent has proposed reducing that to 3 per cent by the end of Trump’s term. Run that through the IMF’s maths, and you knock $US300bn to $US500bn off the trade deficit in goods and services, which was more than $US900bn last year.

Better than tariffs

Trade deficits aren’t intrinsically bad, but if, like this administration, you happen to disagree, you should address them in the least harmful way possible. Fiscal austerity does the job with much less collateral damage than tariffs.

Inflation goes down instead of up. Trading partners don’t retaliate. There’s no special-interest lobbying or corrosive uncertainty over who gets hit with tariffs for how long.

Austerity’s main drawback is that it slows growth. Countries that undertook austerity after the 2007-09 financial crisis aggravated high unemployment that central banks couldn’t offset with lower interest rates, which were already around zero.

The US is in the opposite place today. Unemployment is low and inflation is above the Federal ­Reserve’s 2 per cent target. Ambitious deficit reduction would nudge inflation lower. The Fed could then cut interest rates, offsetting the drag from austerity, and weakening the dollar. Meanwhile, less federal borrowing would lower Treasury bond yields. In this way a smaller deficit “crowds in” private investment and exports, just as a bigger deficit crowds them out.

By contrast, experience and theory show that tariffs don’t ­reduce the trade deficit. After Trump imposed tariffs on China in his first term, importers shifted to Mexico and Vietnam while a lower yuan helped Chinese exporters absorb the tariff. The 25 per cent tariffs on Mexico and Canada scheduled to take ­effect on Tuesday have weakened their currencies and provoked promises of retaliation. That will sap ­demand for US exports.

Formidable maths

The publicly held federal debt, the sum of all annual deficits, is about to shoot past 100 per cent of GDP. So budget deficits have to come down. Done right, that can also reduce the trade deficit.

While higher taxes could do the job, in practice spending cuts are more effective. In the short run, a dollar reduction in, say, government benefits would reduce consumption and imports more than a dollar increase in taxes because households would respond to the latter by dipping into savings.

In the long run, higher tax rates discourage work and investment, leaving GDP smaller. That’s why a Congressional Budget Office study in 2022 found that benefit cuts achieve a lower debt to GDP ratio than higher ­income-tax rates.

This happens to align with the priorities of Republicans, who want to extend their 2017 tax cuts while adding new ones. But this creates some formidable maths.

Extending the tax cut would leave the budget deficit at 7 per cent of GDP in fiscal year 2029, based on CBO and joint committee on taxation estimates. To get it to 3 per cent and then keep it there would require $US12 trillion of spending cuts over the next decade relative to the status quo, by my calculations. But House Republicans, in their recently passed budget resolution, envision only $US1.5 trillion to $US2 trillion of spending cuts. (They pencilled in additional deficit reduction via a growth dividend from their plans, which my estimates exclude.)

Trade war averted

Trump has made the job ­especially difficult by ruling out any cuts to Social Security or Medicare. Throw in interest on the debt, and half of spending is now off limits. To hit a 3 per cent deficit in 2029 would require cutting 40 per cent from everything else – defence, homeland security, veterans’ benefits, Medicaid, food stamps, welfare, and countless other federal programs. Zeroing out Medicaid and food stamps and firing every federal employee won’t be enough. And Republicans are already baulking at cuts to Medicaid.

So either Republicans put ­Social Security, Medicare and taxes on the table, await a growth miracle, or accept a much less ­ambitious deficit target.

Another caveat applies to using fiscal austerity to reduce the trade deficit. As with tariffs, it doesn’t work if other countries all do the same. Indeed, the US runs a trade deficit not just because it consumes so much, but because others consume so little. The economies of Germany and China are structurally biased against consumption and in favour of exports.

That might be changing. The parties likely to form Germany’s next government want to cut taxes and spend more on defence, power generation and infrastructure. China’s leaders are under pressure to enact fiscal stimulus in response to falling consumption and weak employment. Both worry Trump’s tariffs will kneecap their exports. So how about this: Germany and China agree to stimulate their economies and import more, and the US agrees to shrink its own budget deficit and not impose more tariffs.

Voila: a lower trade deficit without the trade war.