From time to time, US politicians campaign against US trade deficits, and demand tariff or non-tariff barriers to keep out foreign goods. It is evident that neither commercial nor financial markets welcome such measures. Most public discussion of the current account deficit treats trade movements as self-contained, rather than (more accurately) in conjunction with financial movements. Consider a blatant historical confusion: the Bretton Woods negotiations of 1944, which set up the post-WW2 financial institutions that remain largely in place 80 years later. US negotiators apparently thought it possible for the dollar to be used as the essential international currency – hence as the basis for international liquidity — at the same time the US would run nearly permanent trade surpluses. (Surpluses would in fact return dollars to the US, thereby reducing international liquidity.) The impossibility of having both of these simultaneously was overlooked by US negotiators, but was subsequently recognized by economists in the Triffin Dilemma. US trade deficits strained the Bretton Woods fixed exchange rate framework, and exchange rates were allowed to float in 1973. The US dollar remained however as the currency of international liquidity.
The remedy for trade imbalances, if any is to be found, must focus on correcting financial imbalances, rather than on imposing new tariff and non-tariff barriers to trade.
Keynes, representing Britain, was the loser at Bretton Woods. Against the US-led framework, Keynes proposed that balancing international finance flows should be precede extending open, multilateral trade commitments – his goal was not to constrain trade, but to facilitate it. Keynes proposed an international central bank that would issue an international currency, and that would be able to penalize countries that ran ongoing trade surpluses – thereby bringing their capital accounts back toward balance.
Let’s go back for a moment to the 80-year pattern of capital inflows to the US. It is certainly true that a larger US fiscal deficit can lead to a larger capital inflow in the short or medium period to finance it, presumably accompanied by higher interest rates. But in the longer period, Johnson summarizes, capital has moved to the US for other reasons – because the US has been a good place to invest, and because the world wants dollar-based liquidity. The Economist in October 2024 described the US economy as “the envy of the world.” But if aggressive tariff policies leave the impression that the US is withdrawing from the world trading system, especially if it is accompanied by a perception that investment in the US is becoming influenced by political favors and deal-making, it could result in a secular slowdown in capital inflows. A matching effect would be a narrower US trade deficit and, at some point in the future, even a trade surplus. The cure for trade deficits would be worse than the disease!
Supply-side Tax Reductions
The 2017 Tax Act, adopted early in the first Trump Administration, reduced marginal income and corporate tax rates across the board, and added significantly to the US national debt. Johnson notes that the public arguments for its passage recalled those from “supply-side” advocates during the late 1970s that led to Reagan-era tax cuts, especially the 1981 legislation. Robert Mundell, who later received a Nobel Prize for his work on international monetary economics (and who was Johnson’s informal dissertation advisor in the early 1990s), outlined the supply-side framework in the early 1960s. Then at the IMF, he proposed that the Kennedy Administration deploy tight money to protect the dollar and stanch the outflow of gold reserves, while lowering marginal tax rates to boost business profits and hence domestic investment. The 1964 Kennedy Tax Cut reflected Mundell’s “policy mix” under-pining. The 1970s “stagflation” called for similar measures: aggressively higher interest rates to brake inflation and stabilize the dollar (as took place under the Paul Volcker Federal Reserve beginning in 1979), while lowering marginal tax rates to encourage business investment. The key insight was that fiscal expansion, unlike monetary expansion, will boost demand without lowering interest rates, hence is unlikely to weaken the currency or to give rise to higher domestic prices.
In fact, Mundell’s argument in favor of supply-side tax cuts was specific to situations of exchange rate deterioration — and accompanying price inflation — combined with internal slowdown and rising unemployment. But popular supply-side advocates (Art Laffer, Larry Kudlow, the WSJ Editorial Page) have usually overlooked this specificity, and have generalized the argument to embrace tighter money and lower taxes under nearly all circumstances.
To take a counter-example, Mundell proposed a mix of tighter money (to protect the dollar) and higher taxes (to prevent domestic over-heating) when Vietnam-era military spending stepped up in 1965. Generalizing, if the monetary situation is stable, and the economy is growing at a rate consistent with gains in productivity and population, then a fiscal boost in the form of tax cut is likely to have one of two effects. First, absent the offset of monetary contraction, higher profits might cause over-investment and over-heating. Second, if money policy is tightened, higher after-tax profitability will redistribute wealth to those in higher income brackets – while overall economic growth lags. A tax cut would not be helpful in either situation.
The US macroeconomic situations in 2017, and again in 2025, have little in common with those that led to the supply-side mix under the Kennedy Administration beginning in 1962 or during the Reagan and Volcker years almost two decades later. Kennedy and Reagan each faced dollar weakness (and rising prices) combined with slow domestic growth, approaching stagnation. Johnson has argued elsewhere that we have not had a macro-economic environment of inflation and exchange rate pressure combined with weak growth and high unemployment – for which the supply-side mix would be appropriate — since the early 1980s. As Trump assumed power in 2017 and again in 2025, the dollar was stable, even rising slightly, price inflation was low or falling, and real economic growth was steady – in each instance, at least three years into an expansion. Increased deficit spending can be appropriate when the economy is on a downtrend, not when it is expanding – that is a time for shrinking the deficit. A supply-side tax cut can make sense when profits and investment are depressed, not when stock markets are high and rising. If a tax reduction is to be enacted in 2025, it will have to find a rationale other than the one Mundell proposed back in 1962 and 1980.
The Splinter editorial staff was not involved in the creation of this content.
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