Tariffs and Trade Deficits: Understanding Tariffs, Trade Deficits, and Government Debt

Tariffs are the topic du jour. As I said on April 4^th, Trump has put the global economy on track for a global recession.  We are currently waiting to see what responses and “deals” are made between countries in regards to tariffs, so we most likely have many weeks and probably months before we know what the global trade playing field looks like.  While there is significant focus on tariffs, less attention is paid to how tariffs and trade deficits are interconnected, and even less to how trade deficits influence government debt and economic strength. These issues are complex, but I will attempt to simplify the framework and untangle the web.

Part 1: The Basics of Trade Deficits and Government Debt

What Is a Trade Deficit?

Imagine you’re shopping and spending more money than you’re earning (like most Americans). A country does something similar when it has a trade deficit. A trade deficit happens when a country imports more goods and services (like cars, electronics, or clothing) than it exports (like wheat, airplanes, or software). This means the country is sending more money abroad to pay for imports than it’s earning from selling its goods and services to other countries.

For example, if the U.S. buys $100 billion worth of smartphones from China but only sells $30 billion worth of soybeans to China, it has a $70 billion trade deficit with China. The U.S. sends dollars to China to cover the difference, creating an outflow of money.

What Is Government Debt?

Government debt, or national debt, is the total amount a government owes because it has spent more than it collects in taxes. Governments borrow money by issuing bonds (like IOUs) to pay for things like infrastructure, healthcare, or defense. Investors, including foreign countries, buy these bonds, lending money to the government in exchange for interest payments.

For instance, if a government needs $1 trillion to fund entitlement benefits but only collects $800 billion in taxes, it borrows $200 billion by selling bonds which directly adds to its debt.

How Are Trade Deficits and Government Debt Connected?

Trade deficits and government debt don’t directly cause each other, but they’re linked through a chain of economic effects. Here’s how it works in simple terms:

Money Leaves the Country: When a country runs a trade deficit, it sends money abroad to pay for imports. This creates a flow of currency to other countries.

Foreign Countries Reinvest: Those countries often reinvest that money by buying the deficit country’s assets, like government bonds. This provides the government with cash to borrow more, funding its spending without raising taxes.

Economic Pressure: A trade deficit can weaken local industries (fewer exports mean fewer jobs), so governments may spend more or cut taxes to boost the economy. This extra spending is often financed by borrowing, increasing government debt.

Currency and Borrowing Costs: Large trade deficits can affect a country’s currency value. If the currency weakens, the government may face higher borrowing costs, adding to debt. But if the currency is strong (like the U.S. dollar), foreign demand for bonds makes borrowing easier, potentially encouraging more debt.

So, trade deficits create conditions where governments can borrow more easily, especially if foreign countries buy their bonds. If spending isn’t managed and deficits don’t decline then this can lead to growing debt over time.

Part 2: Zooming In on the United States

Historical Look at the U.S. Trade Deficit:

The U.S. has run trade deficits since the 1970s, importing more than it exports every year. In 2023, the total trade deficit was $773 billion, down from a peak of $971 billion in 2022, according to the Bureau of Economic Analysis. The deficit is driven by high consumer demand for imported goods like electronics, cars, and clothing, and a strong dollar (reserve currency status supports this) that makes imports cheaper.

Figure 1 – Total US Deficit has been Growing for 40+ Years

Key trends:

China: The deficit exploded after China joined the World Trade Organization in 2001, peaking at $419 billion in 2018. Tariffs and supply chain shifts reduced it to $295 billion by 2024.

Mexico: The deficit grew post-NAFTA (1994), hitting $172 billion in 2024, driven by autos and electronics.

European Union: The EU’s deficit rose to $236 billion in 2024, led by Germany (autos) and Ireland (pharma).

Vietnam: A newer player, Vietnam’s deficit surged to $123 billion in 2024, reflecting shifts from China.

Japan and Canada: These deficits are smaller but steady, driven by autos and oil, respectively.

How Trade Deficits Fuel U.S. Government Debt

The U.S. trade deficit creates a cycle that supports government borrowing.  As we stated in Part 2, US Dollars flow out of the country and then foreign countries like China and Japan reinvest those dollars by mostly buying U.S. Treasury bonds. In 2024, foreign investors held about $8 trillion of the U.S.’s $33 trillion national debt, with Japan ($1.1 trillion) and China ($0.8 trillion) as the top holders. The foreign demand for bonds lets the U.S. government borrow at low interest rates, funding spending on programs like Social Security, defense, or infrastructure without immediate tax hikes. Because the trade deficits can hurt U.S. industries with manufacturing as the focal point, it leads the government to spend money to create replacement jobs or support the economy in general.  This spending adds debt.

This interplay between trade deficits and government debt has huge consequences:

Pros:

Consumer Benefits: Trade deficits mean access to cheap goods, like affordable electronics or clothing, raising living standards.

Low Borrowing Costs: Foreign demand for U.S. bonds keeps interest rates low, making debt manageable (for now).

Global Influence: The dollar’s role as the world’s reserve currency lets the U.S. sustain deficits and debt longer than other countries.

Cons:

Debt Growth: Persistent deficits and borrowing have pushed U.S. debt to 120% of GDP in 2024, raising concerns about long-term sustainability.

Economic Vulnerability: Relying on foreign funding makes the U.S. sensitive to changes in global investor confidence which has a tail risk associated with the level of U.S. interest rates and the value of the U.S. Dollar

Job Losses: Trade deficits often hollow out industries like manufacturing due to offshoring, which increasing inequality and political tensions.

Part 3: How Do You Fix It and What About Tariffs?

If you listened to your economic professors in college, they told you that trade deficits would fix themselves.  They said that in a free market, the country with the deficit will see its currency depreciate (go down in relative value) so its goods would be cheaper and they would start exporting more than they imported.  The problem is that it is not a free market and the U.S. Dollar has remained strong predominantly because it holds the world reserve currency status.

The global trade market is not free because there are trade restrictions, taxes, fees, quotas, licenses, regulations, tariffs etc.  They all serve as barriers to competing countries’ products to defend their local businesses and their products.  This is very active around the world and it is even difficult to pull all of the numbers together to make an apples-to-apples comparison.

Tariffs aim to make imports more expensive, encouraging consumers to buy domestic products and thereby reduce the trade deficit.

Tariffs have the goal of:

Reducing Imports: By raising the cost of foreign goods, tariffs can lower import demand.

Boosting Local Industries: Tariffs protect domestic producers by making their goods more competitive.

Increasing Revenue: Tariff payments go to the government, providing funds to reduce borrowing or invest in export industries.

The Downside of Tariffs:

Higher Prices: Tariffs can raise the cost of products for consumers. If the selling country/company/intermediaries do not “eat” the cost of the tariff and there is no cheaper domestic product, then the cost is passed to the consumer

Trade Wars: Other countries may impose their own tariffs, hurting U.S. exporters. China’s tariffs on U.S. soybeans in 2018 hit American farmers hard.

Shifted Product Source: Tariffs may shift trade deficits to other countries (e.g., from China to Vietnam) rather than eliminate them.

Conclusion: A Balancing Act

Like many things in the world, there isn’t a clear and easy answer.  It is my opinion that the United States has been on an unsustainable path for decades.  There is the ultimate question: “When does the United States have too much debt, lose confidence from investors, destroy the dollar, see rising interest rates/inflation, and lose its world currency reserve status?”  The continued U.S. Government deficit is unsustainable.  A component that assists in increasing the U.S. Government deficit is the U.S. Trade Deficit.  They are deeply interwoven.  The trade deficit also hurts many American workers and the strength and independence of the U.S. economy.  It is beneficial for individuals to buy cheap products from other countries with little friction on imports, but it is detrimental to those who have lost their job or cannot find adequate work to cover living costs. A jobless person doesn’t care about a cheap iPhone. It is my belief that the main components to fix the ultimate question are to significantly reduce the trade deficit, increase U.S. manufacturing exports and related jobs, cut government spending, cut entitlement programs, and allow for a bit of inflation.  That is the goldilocks scenario.  Tariffs are a tool and a component in a vast and complicated problem, so don’t lose the forest for the trees.  We have a lot of innings left.