Published on 04-22-2025
The president's administration has enacted taxes on imported goods (tariffs) at the highest level in the last century. The administration's chief concern is that the U.S. runs large trade deficits (we buy more goods from other countries than those countries buy from us). Their plan to fix the trade deficit is to tax, and therefore reduce, imports.
If you think importing goods and running trade deficits is harmful to an economy, taxing imports as a fix has both a surface plausibility and a long history. For 250 years starting in the 16th century, European countries pursued similar “mercantilist” policies. They sought to export as much as they could while restricting imports, in order to stockpile gold. Of course, it’s logically impossible for every country to export while refusing to import, which led to trade wars and then to actual wars.
We now understand that mercantilist policies were extremely harmful, and that importing helps consumers and firms. It gives them access to goods at lower cost and with greater variety than they could access in the domestic economy. Exporting without importing is exactly like working hard all day every day and never spending any money on decent food, clothes, housing or things you enjoy.
Still, we are running very large trade deficits … a trillion dollars a year. Even if imports are good for consumers, shouldn’t trade flows in and out of a country at least be balanced? And if they aren’t, how could you go about correcting them?
This may seem counterintuitive, but economists who study international markets know that the U.S. trade deficit is not caused by foreign countries imposing high barriers to our exports. Trade deficits are caused by an imbalance between our savings and investment.
Let's start with some basics. Every dollar of output produced by a firm is a dollar of income that flows to someone. When Subaru sells a car for $40,000, a group of people (workers, managers, investors, input suppliers — and their workers, managers and investors) are collectively paid $40,000.
At the household level, every dollar of income goes somewhere. You spend it, or you save it, or you pay it in taxes. If you want to spend more than you earn, you have to borrow it. That borrowing might be a Vegas vacation charged to a credit card. Or it might be a 20-year-old taking out a student loan and investing their time in the classroom instead of holding a full-time job.
Notice that our 20-year-old student needs two things to make this work. They need food and housing and educational services and electronics, none of which they produce. At the household level they are “importing” these things. But because they aren’t earning an income (they aren’t “exporting”) they also need someone to fund their purchases. They need goods and they need capital.
Happily, there are a bunch of 40-year-olds in their prime producing years. They will produce more food, housing, educational services and electronics than they can consume, and sell them to our student. But remember, a dollar of output is also a dollar of income. Because our 40-year-olds are producing more value than they consume, they also have savings, which they lend to students to pay for all that consumption.
This borrowing and lending makes everyone involved better off. Our 20-year-old receives money they didn’t earn, and consumes goods they didn’t produce. But the loan frees up time to invest in their future productivity and earning. Our 40-year-old gives up some consumption to invest in the student, not because they are nice, but because they want earnings compounding in a 401K. When they are 70, they can go back to consuming without producing.
The same basic idea is true at the national level. If a nation wants more consumption and investment goods than it produces, it needs two things. It needs someone to supply extra goods (imports exceed exports). And, it needs to borrow the capital to buy those goods. The trade deficit is exactly balanced with capital inflows needed to finance it.
But are trade deficits good or bad for the economy? Trade deficits can be good if foreign capital enables us to invest in future capacity and enjoy growth from that investment. Trade deficits can be bad if foreign capital only funds current consumption.
That’s no different than a household. I can incur debt because I am investing in schooling or perhaps buying an asset like a house that will appreciate over time. Or I can incur debt because I want to have a really fun weekend in Vegas. One of these makes me richer over time. The other poorer.
In tomorrow’s post I’ll explain why the U.S. trade deficit got so large, how it connects to government budget deficits, and whether tariffs or some other policy offers the best fix.
David Hummels is a Distinguished Professor of Economics and Research Associate of the National Bureau of Economic Research. He served as Dean of the Mitch Daniels School of Business at Purdue from 2014-2023 and has worked as a consultant for and visiting scholar at a wide variety of central banks, development banks and policy institutes around the world.
