Two Trump follies exposed in the same week: stocks and trade

This week, President Trump seems to have received two lessons about setting economic targets by which his presidency should be judged.

The first was an all-time record 1,600-point intraday decline in the Dow Jones industrial average. This should have reminded the president that stock prices can go down violently and that it is dangerous to set oneself up to be judged by the stock market’s performance.

{mosads}This would be especially the case if the stock market might be in a bubble as is suggested by the fact that today’s equity valuations are at high levels that have only be recorded three times in the past 100 years.

It is also the case if, as is all too likely, in the months immediately ahead, the Federal Reserve will be forced to raise interest rates more quickly than currently planned to stave off the risk of rising inflation.

The second relates to the dangers of making trade deficit reduction a key policy objective. This week’s official trade numbers indicated that far from declining in President Trump’s first year in office, in 2017, the U.S. trade deficit rose by 12 percent to its second-highest level on record.

Worse yet for the president, far from declining, the U.S. bilateral trade deficit with China increased to the highest level on record, while the deficit with Mexico grew to the second-highest level on record.

Given the stock market’s vagaries and the risk that the stock market might be in a bubble, it needs little explanation as to why the president would be well advised to walk back his tying the judgment of his administration’s economic performance to the stock market.

Less obvious are the two very good reasons why the president should fear that despite his trade protection measures, the trade deficit is all too likely to widen further in 2018. That makes it dangerous for him to keep tying his political fortunes to a trade-deficit-reducing goal.

The first is that a country’s trade balance is arithmetically the difference between what it saves and what it invests. If its savings rate goes down and its investment rate goes up, the trade deficit is bound to increase. This would seem to be precisely where the U.S. is headed in 2018.

The unfunded U.S. tax cut is bound to increase the budget deficit and reduce public savings. Meanwhile, the same tax cut, together with increased infrastructure spending, must be expected to increase the country’s rate of investment.

The second reason to fear that the U.S. trade deficit will widen in 2018 is that with freely floating exchange rates, once again as a matter of arithmetic, a country will have a trade deficit if it has a surplus on its capital account.

Experience should teach us that in times of global financial market instability, money tends to flow to the United States, which is regarded as a safe haven. That in turn pushes up the U.S. dollar, which cheapens the cost of importing and makes it more difficult for U.S. companies to export.

Now, while there can be no certainty that in the year ahead there will be global financial market instability, last week’s global stock market rout should be a reminder as to how jittery those markets can get.

One might also want to keep in mind that the Federal Reserve has allowed financial conditions to get very loose even though the U.S. economy is at close to full employment and is growing at a healthy clip. This makes it all too likely that the Fed will be forced to raise interest rates by more than currently expected in 2018 to avert the risk of inflation.

If that occurs, global financial markets could again be rattled, which would once again draw in safe haven money to the United States and drive up the dollar.

For those two reasons, the president would be creating hostages to fortune by sticking to his trade deficit reduction goal.

Desmond Lachman is a resident fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.