Trade will be the issue under Trump

Jan 11, 2024·Alasdair Macleod

2024 is a year of elections, the most important being that of America. If Trump is elected in 2025, it will be back to trade protectionism and Make America Great Again. This article explains the likely consequences by explaining the relationship between the soaring budget deficit, the trade deficit, and inflation.

The twin deficit hypothesis is little understood today and was dismissed by Trump and his economic advisers in his first term. Instead, he increased trade tariffs and acted aggressively against America’s main importer, China. I explain the basis of the hypothesis in the context of sound money, before considering it in the slippery world of today’s dollar.

I explain the economic consequences of tariffs and trade quotas. I explain the role of savings and capital investment, and why the inflation outcome in savings-driven economies is so different from those driven by consumption.

There is an historical comparison from the 1920s. Following the First World War, in 1921 the Emergency Tariff Act and the Fordney-McCumber Tariff Acts were introduced in the United States, and in 1930 this was followed by Smoot-Hawley. 

If Trump is re-elected, the repetition of trade restrictionism in his first term will undermine the US economy, which through unintended consequences will lead to a repetition of the 1930s depression. But this time, without an anchor to gold, the dollar will sink with it.

All can be explained through an understanding of the twin deficit hypothesis.


It would be presumptuous to assume that Donald Trump will become the next US President, but the polls suggest it is likely. Assuming he does make it, we are back to MAGA —Make America Great Again. When he was President, Trump’s vision was to repatriate production back from East Asia, especially China. There is no evidence that his views have changed in this respect. It will be back to trade wars through tariffs, quotas, and tit-for-tat. It will likely accelerate the repatriation of production, reversing a forty-year trend. It will lead to higher production costs and to the extent that higher costs can be passed on, and rising consumer prices.

Inevitably, the repatriation of supply chains will lead to supply disruption and product shortages which we saw demonstrated following covid shutdowns, highlighted by just-in-time inventory control. Will MAGA lead to more employment in America? With skill shortages at home and a general apathy towards work, demand for skilled labour may prove hard to satisfy until labour markets eventually adjust, driving up wages as well as prices in the meantime. And this is best case.

On his past form, Trump and his economic advisers expected MAGA to lead to lower trade deficits. If it is a trick that he believes can be pulled off, presumably Trump expects product repatriation to stimulate economic growth, leading to higher tax revenues and room to reduce the tax burden. But he will be inheriting a budget deficit almost certainly in excess of $3 trillion, and the benefits of MAGA (even if it works) will not resolve the revenue problem for several years.

Indeed, I expect the debt ceiling, which is due to be reset on 1 January 2025 to approach $40 trillion. The problem will not so much be its size, but the funding costs unless interest rates decline materially. But that’s in the hands of foreigners, who are showing early signs of not buying US Treasuries collectively. They already have too much dollar exposure, and if Trump raises trade tariffs and trade repatriation is in prospect, then even fewer dollars will be needed by foreigners. And if they don’t buy dollars, then US bond yields will have to remain “elevated”. 

If the Fed reduces interest rates in an attempt to contain the US Treasury’s borrowing costs or goes back to monetising debt, then the dollar is sure to weaken on the foreign exchanges, sending a further signal to foreign holders to reduce their $32 trillion’s worth of short and long-term exposure to equities, bonds, bills, and deposits.

That is before we consider whether interest rates will actually decline this year. The market is betting heavily that they will. The worst kept secret is the state of the economy, which shows all the anecdotal signs of sliding into a slump. Having dismissed Say’s law, Keynesians are saying that recession will lead to falling consumer demand and therefore prices. It is this belief which leads them to expect a full-blown pivot from managing inflation to demand stimulation and debt management through lower interest rates.

They are likely to be wrong on two counts. The first is that they ignore the reduction in product supply as companies lay off workers and go bust, which largely offsets the fall in consumption. And secondly, they take no account of monetary dilution arising from excess government spending, which always increases in a recession leading to a lower purchasing power for the dollar.

The principal reason that the dollar is held by foreign actors is related to trade expectations. Over the decades, a second consideration has taken over, and that is portfolio diversification. US bonds and equities have become the largest destination of global financial investment by far. A slump in business activity and the income streams generated thereby will undermine all financial values, leading to a reversal of those flows.

The position for the trade balance becomes complicated. Import tariffs put consumer prices up. And the cost of imported raw materials and intermediate goods, such as semi-manufactured products and vital imported machinery increases as well. Trump presumably expects domestic goods and services to replace imports. MAGA would be returning at the worst possible time, pushing up prices despite lower consumer demand and domestic supply. If Trump as US President wishes to alleviate consumer price rises, and therefore have a shot at funding the budget deficit at lower interest rates, he should forget MAGA and make peace with America’s foreign suppliers by reversing tariffs.

That is not in his DNA, nor in that of his Republican supporters. 

This article looks at the likely consequences of MAGA, and the extent to which it will balance US trade in the context of the twin deficit hypothesis.

The sound money case

So long as credit takes its value from gold, under gold standards there is an inherent stability in prices. By way of contrast, in an unstable fiat currency environment macroeconomic figures and assessments are of little value in economic forecasting, as lamentable experience confirms. Many economists proceed as if currency values in terms of their purchasing power do not vary when they are as a matter of fact horribly subjective and prey to shifts in value. Changes in a fiat currency’s value are down to the collective faith in it more than in changes in its quantity.

For this reason, a starting point for assessing trade imbalances and their relationship with other disparities, particularly a government’s budget deficit, must be under the conditions of an internationally accepted sound money standard, historically the role fulfilled by gold.

A precondition for understanding the sound money case is to resuscitate Say’s law, which defined the basis of the division of labour. Before the days of welfare states, it was unarguably true that we produce to consume. In other words, consumption was firmly tied to production.

Even under sound money conditions, fluctuations in bank credit led to a business cycle of booms and slumps as the availability of credit varied driven by the balance of bankers’ collective greed and fear. Variations in credit availability would affect prices insofar as the resulting consumer sentiment altered the ratio of spending to savings. That need not detain us here. The more important point is that a slump in business activity accompanies a slump in consumer demand because of the link through rising unemployment. A worsening business outlook leads to rising unemployment and therefore a fall in consumer spending resources. This rules out the general slump in prices feared by modern economists.

With respect to trade, Say’s law has important implications. In free markets and sound money conditions, endogenous changes in a national economic condition cannot affect the balance of trade fundamentally, except to the extent that shifts in the relationship between consumption and savings lowers prices for foreign consumers, leading to a degree of goods arbitrage. In consequence, as markets and international trade become more efficient the price consequences of bank credit cycles become less disruptive. This was certainly the experience in the United Kingdom in the nineteenth century as Figure 1 illustrates.

At the commencement of the Napoleonic wars, the suspension of the gold standard led to substantial inflation of prices, driven by wartime government spending. After Waterloo spending was withdrawn, leading to prices falling back to pre-war levels. For the next thirty years the cycle of bank credit expansion and contraction led to prices oscillating around an index level of about 10, which diminished due to two factors. The first was the gradual perfection of the commercial banking system as a whole, and the second was the spreading adoption of gold standards with Britain’s European trade partners. This naturally led to greater price stability

The free trade position with minimal government spending and a balanced budget is relatively easy to understand compared with the fiat currency case. In free trade conditions, consumers are free to benefit from the comparative advantage of choosing goods and services from whomever and from wherever their preferences take them. The same is true for domestic manufacturers sourcing raw materials, manufacturing equipment, and part-assembled products. 

Under a gold exchange system, it is an iron rule that imports have to be paid for in gold or acceptable gold substitutes between transacting parties. A gold substitute is credit which is readily exchangeable for gold coin or bullion at a predetermined fixed weight. In practice, gold only changes hands if there are interest rate differentials between different jurisdictions, otherwise one form of substitute is exchanged for another at a rate determined by the ratio of their gold values by weight. So long as a nation’s currency unit is priced in gold by weight and freely exchangeable for gold, the currency aspect of trade settlement is not an issue, and currency exchange rates are fixed by their common reference to gold.

The base case for trade is that imports should be paid for by exports. In practice, it is never this simple because commercial banking systems can vary the quantity of credit in circulation. Trade finance is generally self-extinguishing. But a more general expansion in the quantity of bank credit in favour of payments to importers could allow a deficit on the balance of trade to arise. But so long as the expansion of bank credit does not lead to more than moderate gold outflows, and so long as the expansion of bank credit is not aimed at financing excess consumption, trade can be expected to return to a balance over time. It will not undermine the value of commercial bank credit, which allowing for specific bank credit risk is tied to the value of the currency. The key is that the issuing authority for the currency must maintain the gold cover for its currency liabilities, guaranteeing the value link. This is achieved by separating the issue function from central banking entirely and handing interest rate policy to the issuer under instructions to use interest rates solely to manage the gold reserves.

These were precisely the conditions that prevailed under working gold standards before the First World War, allowing for the error in the 1844 Bank Charter Act with respect to interest rate management objectives.

As noted above, most of commercial bank credit created for trade finance is self-extinguishing. Credit advanced for the purposes of financing the shipment and transfer of ownership of goods is paid back on delivery, or at least when the value of imported goods is realised for the importer. But a temporary trade deficit arising out of an expansion of industrial investment, when it leads to imported raw materials, machinery, and part-assembled goods is normal at a time of economic expansion. 

Other factors aside, a trade imbalance factor might persist for as long as a relative rate of expansion between nations continues, being the initial consequence of an increased investment in production. The capital investment is acquired by an expansion of credit in its several forms, to be substantially offset by consumer savings. In time, increasing capital investment tends to lead to better values for consumer goods thereby offsetting demand for imported substitutes. The same factors lead to increased exports of goods and services under the rules of comparative advantage exploited by foreigners in turn, benefiting all trade partners. But so long as bank credit is not created as a substitute for consumer saving thereby leading to excess consumption, with timing differences imports and exports are bound to offset one another allowing for timing differences.

This gives us a clue as to how the twin deficit phenomenon arises, whereby a trade deficit appears to develop at approximately the same time as a budget deficit. In a free market and sound money trade model, changes in the level of commercial bank credit do not lead to permanent trade imbalances. It is the expansion of the currency acting as a gold substitute without offsetting gold imports that leads to a trade deficit. And it is the inflation of the currency which funds a government’s budget deficit.

As noted above, if bank credit is expanded for non-productive purposes, then that leads to trade deficits to the extent that it finances excess consumer purchases. But under sound money conditions, consumers tend not to borrow excessively for consumption, restricting debt to what they can afford to repay. This was the origin of Dickens’s Micawberism about how spending in excess of one’s income led to misery, written in 1849 at the time when Britain’s gold standard crystalised consumer attitudes at the time.

To summarise the conditions of sound money and free trade unhampered by government intervention, we can express it in the following accounting identity:

Trade Deficit @ Budget Deficit — (Savings—Capital Investment).

This is the basis of the twin deficit hypothesis. If there is no change in savings and capital investment, then through credit creation by the currency issuer to finance a government’s budget deficit a similar trade deficit will arise. It is a conclusion reinforced by Say’s law because government demand not met by revenue nor production can only lead to an increase in imports over exports.

The gap would be filled by gold inflows if the currency issuer raised interest rates with the specific objective of attracting additional gold reserves to cover its additional currency liabilities, necessary to retain the currency’s credibility as a gold substitute. And that explains what the sole purpose of interest rate management should be.

The consequences of tariffs

Admittedly, the sound money and free trade model is an ideal, which assumes that the state doesn’t intervene in trade matters. In practice, this has almost never been the case. Before the evolution of other taxes, customs and excise duties on imported goods were a principal source of government revenue. In the eighteenth and nineteenth centuries, these duties discriminated in favour of European nations’ colonies against foreign interests. The political lure of trade tariffs was protectionism, giving trade advantages to settlers encouraged to emigrate to their colonies.

The protectionist benefits of being in a group of colonies evolved into pure protectionism of vested interests in the wake of the First World War, which set back the trend towards the economic integration of the world economy. 

America changed from being a net international debtor to the world's largest creditor as a result of the war. It loaned dollars to Germany, so that Germany could pay its reparations to France and other European Allies. And they in turn could pay their war debts to America. Consequently, the dollar’s importance rose eclipsing that of sterling, and the world's most important financial centre shifted from London to New York.

Previously, most significant economies were on gold standards, but these were abandoned by all the European combatants while America only joined the Allies three years after it started. America was therefore able to retain her gold standard. This disparity led to obvious currency and trade tensions. War debts were paid out of depreciating currencies into one hard one — the dollar freely convertible into gold.

Reparations, war debts, and the repayment of billions of dollars of private foreign investment loans all hinged on the free movement of goods and services, which required export surpluses to the US in the hands of debtors to repay gold or dollars. By hyperinflating their currencies, Germany, Austria, Hungary, and Poland obtained a significant price advantage for their compensating exports to America. American vested interests pushed for tariffs against this “unfair” competition.

In 1921, the Emergency Tariff Act to aid agriculture followed by the Fordney-McCumber Tariff Act in 1921 were the legislative result of political pressures, putting great stress on the international financial structure. Between them, they raised tariffs by an average of 55%. The largest creditor with the largest economy and the world's largest gold reserves now made it harder for its debtors to meet their obligations. Inevitably, other governments took similar measures in response by erecting their own import tariffs and quotas. Domestic content regulations, export subsidies, foreign exchange controls and other mercantilist mechanisms followed.

The nationalism that swept the world after the Great War demonstrated itself in a widening range of trade barriers and subsidies. In many countries, the post-war price collapse in agricultural prices encouraged farmers to demand special protection from their governments to avoid having to adjust to new economic realities and the expansion of mechanisation and more efficient farming methods. The demand for protection from foreign suppliers was met with wide-ranging tariffs and subsidies that prolonged the readjustment of agriculture to market realities.

Tariffs are an addictive solution, in that they put off dealing with the economic adjustments necessary for businesses to remain competitive. So it was that the Smoot-Hawley Act of 1930 doubled down on the tariff precedents of the tariff acts of 1921 and those that followed. Will a Trump administration make a similar error? It is more than likely.

Like Fordney-McCumber, Smoot-Hawley was highly protectionist. Average tariffs on dutiable imports were raised from anything between 38% to 60%. Inevitably, other countries responded with tariff increases of their own. And the contraction of global trade that resulted backfired badly against the US, deepening her depression when bank credit was being wiped out by multiple bank failures.

Doubtless, before these tariff wars and when currencies were credible gold substitutes, the link between the balance of trade and the balance on a government’s budget can be easily explained. But that is in a sound money environment. Government intervention in the economy, however it is argued on protectionist grounds, becomes a slippery slope towards intervention in all other private sector affairs. The experience of anti-trade policies such as tariffs and quotas at best reduces the efficient functioning of an economy and at worst is a disaster. The history of tariffs in the 1920s should provide a cautionary tale for the next American administration not to repeat Trump’s MAGA. 

Trade in an unsound money economy

Sound money and free markets are not today’s conditions. The erosion of them can be traced back to the consequences of the First World War, which ended the golden era of the industrial revolution. Driven by vested interests and creeping socialism, sound money became progressively undermined until in 1971 the feeble Bretton Woods Agreement, designed to give prominence to the dollar as the international gold substitute, finally collapsed. Since then, American propaganda has expunged gold from the monetary system, replacing it with her fiat dollar, whose value depends totally on faith in its credibility.

Markets have become increasingly regulated and the classical view of economic actors entering into transactions purely on the basis of the customer always being king has been traduced. It is the height of irony that these unstable conditions have only served to enhance mathematical analysis of economic and credit relations when the instability of mediums of exchange render these calculations entirely worthless.

With respect to demonstrating the twin deficit hypothesis in fiat currency conditions the impermanence of value introduces additional difficulties. To a casual observer, it is no longer meaningful. But Figure two of the two deficits shows there still appears to be some correlation.

There are some significant distortions in the chart’s presentation. Trade figures are calendar year, while budgets are fiscal year to end-September. The sharp rise in the budget deficit in 2009—2011 was a distortion due to the financial crisis. And the record budget deficits of 2020—2021 were due to covid shutdowns and imports being affected by the chaos in international logistics that followed. Furthermore, just as increases in money supply take time to work through into consumer prices, there is an unquantifiable period between excess government spending and its effect on the balance of trade.

But in the broadest sense, we can see that since 1998 there does exist a twin deficit phenomenon. But to nail it properly, we need to look further at the relationship in a fiat currency context. First, let us remind ourselves of the accounting identity linking the two deficits.

Trade Deficit @ Budget Deficit — (Savings—Capital Investment).

In the context of the current fiat currency regime, we need to examine further the consequences of changes in savings and investment.

The role of savings

Savings are consumption deferred. In other words, they are credit put aside with a view to fund future consumption. As Keynes pointed out in his paradox of thrift, an increase in savings leads to a reduction in immediate consumption. Variations in the rate of savings affects consumer demand, and therefore has an impact on prices.

Say’s Law tells us that we produce to consume, and that domestic production is broadly tied to demand. That is a generalisation which takes no account of a propensity to save. But clearly, the greater the portion of income consumers on average allocate to future consumption, the greater is the level of goods and services relative to demand. A surplus of product arises, which tends to drive the general level of prices lower. 

The expansion of credit, in large part engineered by monetary policy in a fiat currency environment offsets this trend. Monetary policy aims to achieve a balance whereby credit is expanded to offset the savings level, so that the general level of prices rises modestly — currently agreed to be about 2% per annum. But some nations have a greater propensity to save than others. Japan, for instance, has a persistently high savings rate, which allows the Bank of Japan to expand its liabilities (currency plus other elements of its base money) without them feeding into higher consumer demand. It has allowed the Japanese government to run consistently large deficits without those deficits being reflected in the trade position.

The same cannot be said of the United States, which not only has a generally low savings rate but continually accumulates consumer debt. The savings rate is not a measured statistic, merely being assumed between estimates of total income and GDP — it is an unexplained balance. But consumer credit drawn down is measurable. According to official figures, US personal savings totalled $840 billion in November,[i] while all consumer credit stood at $5,009 billion[ii]. The degree to which this excess spending is fuelling price inflation as opposed to the trade deficit is only evidenced in the deficit, because measures of consumer price inflation are heavily biased to the downside, as independent estimates from John Williams of demonstrates. And the general level of prices is immeasurable, being only a broad concept.

Capital investment

The twin deficit hypothesis posits that an increase in capital investment increases the trade deficit. Returning to our accounting identity

Trade Deficit @ Budget Deficit — (Savings—Capital Investment),

we can see that unless savings increase to fund capital investment, the trade deficit must increase relative to the budget deficit. The way to understand the real world impact of capital investment is that it is spent on goods and services, creating demand just as consumer spending creates demand.

The eventual outcome differs from that of immediate consumption, assuming that capital investment is applied productively. Returns on investment are expected to emerge from increases in both product quality and quantity designed to satisfy evolving consumer tastes, usually at more competitive values. While capital investment initially increases a trade deficit relative to the budget deficit, other things being equal it can result in the trade gap being narrowed through import replacement and/or increased exports.

The distortion from inflation

The consequence of a budget deficit not funded out of savings is credit debasement. But if the budget deficit is funded out of savings, it is at the expense of capital investment for private sector production. Alternatively, if the budget deficit is funded by enhanced savings consumer spending is accordingly subdued and price inflation moderates due to the processes outlined above. This effect is particularly noticeable in savings-driven economies, such as China and Japan, where consumer price inflation is considerably less than in consumption-driven economies. Furthermore, according to twin deficit theory if savings are great enough, they can turn a budget deficit into a trade surplus — again, the examples of Japan and China prove this point.

The cleanest demonstration of the twin deficit phenomenon is the sound money example, because in that case the purchasing power of circulating credit is stable. We must now consider the situation under fiat currency regimes, when the purchasing power of circulating credit declines. 

If the foreign exchange assessment of a currency’s value coincides with the domestic assessment, then a decline in purchasing power will be closely reflected in the foreign exchanges. However, this is rarely the case, with foreign exchanges sometimes anticipating a fall in a currency’s purchasing power relative to other currencies; in which case imported goods gain no price advantage. If, however, a currency is overvalued imported goods do get a price advantage, likely to increase the trade deficit relative to the budget deficit. Clearly, the relative valuations given to fiat currencies has a distorting effect.

By making imported goods relatively expensive, trade tariffs and import quotas become even more tempting as a means of limiting a trade deficit, when the free market remedy is to reduce the budget deficit. Instead, the excess of government spending financed by the expansion of the central bank’s base money coincides with import restrictions to drive up manufacturers’ input prices and consumer prices alike. Put another way, if imports are restricted in a fiat currency regime, the consequences feed into higher prices relative to the rest of the world.

In general terms, we can see that the difference between the twin deficit phenomenon in the free market, sound money case and that of the interventionist fiat currency system of today is that the latter has a propensity towards raising prices, reflected in a falling purchasing power for fiat currencies.


In the debate over the relative merits and demerits of the next US President’s policies, trade is yet to become a public issue. But there is already a trend towards weaponizing tariffs, started by President Trump in his first term. If he is re-elected, we can expect a return to Trump’s policy of Making America Great Again.

The consequences for global trade are to contract, or even worse. The precedent can be clearly seen from US trade policies between her 1921 tariff acts and 1930’s Smoot-Hawley, the latter contributing in no small measure to the collapse in world trade and America’s own depression.

The twin deficit hypothesis examined in a fiat currency context explains how a budget deficit not being reflected in a trade deficit undermines the currency. Much flows from understanding this simple relationship, and how rejecting the comparative advantage offered to consumers and producers alike of being free to acquire goods and services from whomever and wherever they may be is so destructive for world trade and the economic conditions of a nation attempting to close a trade deficit without addressing its budget deficit.

[i] See St Louis Fed release table 2.6 Personal Income and its Disposition, Monthly, November 2023, line item 34

[ii] See St Louis Fed release tables: Consumer credit outstanding, November 2023.