Donald Trump's administration this week announced new tariffs on solar panels and washing machines. It has hinted at more to come. The rationale for these measures is that they'll reduce American trade deficits—in particular, the widening deficit with China—and thus benefit the U.S. economy. Rather than take Washington’s assumptions at face value, however, we must consider how protectionism affects capital flows.

Michael Pettis
Pettis, an expert on China’s economy, is professor of finance at Peking University’s Guanghua School of Management, where he specializes in Chinese financial markets.
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Policy makers largely ignore the indirect impact of trade intervention on capital. But what happens to capital is ultimately what will determine how these measures affect the economy.

Consider the case with China. If protectionist measures did in fact cause China's trade surplus with the U.S. to drop, there are broadly three ways it could happen. Chinese investment flows to the U.S. could remain unchanged. They could drop. Or they could rise.

In the first case, America's trade deficit with the world would remain unchanged as a portion of its deficit with China would simply shift to other countries. This may seem counter-intuitive, but if Chinese exporters sent as much capital to the U.S. as before, the resulting effects on the economy—on the dollar, interest rates, lending standards and so on—would keep the deficit as high as ever, with no change in U.S. debt or unemployment.

In the second case, if protectionist measures disrupted China's capital exports, its capital deficit and trade surplus would then decline, as would the U.S. capital surplus and trade deficit. This would result in a reduction in America's overall trade deficit, underpinned either by lower debt or lower unemployment.

In the third case, finally, protectionist actions might result in increased Chinese capital exports to the U.S. In that event, even as China’s trade surplus with the U.S. fell, America's deficit with other countries would rise by even more, increasing its overall trade deficit, underpinned this time either by rising debt or rising unemployment.

Much of the debate over Trump's trade policy seems to miss the point that the economic effects of any trade measure depend on how it affects capital. This is because policy makers assume that capital flows simply respond to changes in trade. Although this was true for most of modern history, it no longer is—and hasn't been for more than five decades.

For centuries, capital flows were quite small and consisted mainly of trade finance, with the capital account adjusting automatically to changes in the trade account. That made predicting the consequences of protectionist measures easy: They would reduce the bilateral trade deficit and thus the overall deficit.

But it no longer works that way. Global capital flows are now huge and driven mainly by the independent decisions of millions of investors in the U.S. and abroad. Because the capital and trade accounts must still balance to zero, however, the direct impact of intervention is usually subsumed under the indirect effects on capital flows.

So what are the consequences for current policy?

Protectionist measures may indeed directly affect bilateral trade. But if America's capital inflows rise, so must its overall trade deficit. This is because higher inflows will cause adjustments in the economy—potentially including lower credit card rates, a stronger dollar, weaker lending standards, higher unemployment and surging asset markets—that cumulatively cause savings to drop and force the overall deficit to rise, even as the deficit with China falls.

Why might protectionist measures increase capital inflows into the U.S.? If they increased financial and economic uncertainty in China, they could cause Chinese capital flight to increase sharply. By raising American growth prospects, they could also boost capital inflows into the U.S.

What's important to recognize is that the deep trade imbalances afflicting the U.S. in recent years mainly reflect the impunity with which other countries exploit access to its capital account. Capital markets in the U.S. are deep, flexible and completely open, making it easy for countries that aim to run trade surpluses to park their excess savings there.

As a result, the U.S. is forced to absorb roughly half the world's excess savings. Even though American businesses are sated with cheap capital, and sit on hoards of unused cash, money is still pouring into the U.S. and forcing its capital account into surplus. It thus has no choice but to run a trade deficit.

Rather than intervene directly, only to undermine global trade and worsen these imbalances, Washington must address the role the U.S. plays in absorbing global capital. This is the only way to resolve American trade deficits.

This piece was originally published in Bloomberg.