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It is common in current US political discourse to hear it asserted, as an incontrovertible truth, that the US economy is smaller because of the US trade deficit–or equivalently, that tariffs to reduce imports will cause the US economy to grow. Such claims are generally not well-founded. But here, I want to point out one of the arguments for this claim that reflects a more fundamental misunderstanding.

As you will learn from any introductory economic text, there are several ways of measuring the size of an economy, and one of the standard approaches is:

GDP = C + I + G + X – M.

This “national income accounting identity,” as it is sometimes called, is based on the idea that a nation’s economic output can be used in several main ways: it can be consumed (C), it can be invested (I), and it can be part of government consumption (where this term includes only government use of goods and services, not government spending that only represents a pass-through of income to households or firms). The final two terms cover international trade. Some portion of a nation’s economic output can be exported to other countries, but we also need to take imports into account, which wereproduced elsewhere.

This equation is not a “theory” about how the economy works. Instead, an “identity” is a statement that is true by the definition of the terms. This is one of the ways in which GDP is defined. If you go to the website of the Bureau of Economic Analysis and look at a press release for recent estimates of GDP, these are the categories that you see being estimated.

The problem arises when someone takes an accounting identity and believes you can just move the numbers around to achieve a goal. Maurice Obstfeld explains the issues in “Mistaken Identities Make for Bad Trade Policy” (Peterson Institute for International Economics 24-13, October 2024). He writes:

The national income and product (NIP) identity is often the basis of claims that a trade deficit—an excess of import spending over export earnings—causes reduced economic growth and job losses. The identity reflects that a nation’s total production output (gross domestic product, or GDP) must be consumed by households, invested by businesses, purchased by the government, or exported abroad.

GDP = consumption + investment + government purchases + net exports.

The last term on the right is net exports (export receipts minus import expenditures), the balance of trade. It is included because some parts of national consumption, investment, and government purchases are imported from abroad, and these components (which add up to total imports) must therefore be subtracted from the right-hand side above to make the identity a true representation of how GDP is allocated among its possible uses. The preceding relationship is an identity because every product within GDP that is sold on the market is purchased for some use: double-entry bookkeeping.

The claim that trade deficits (negative levels of net exports) cost production and jobs follows immediately from a superficial application of the NIP identity. Suppose net exports fall further, causing the trade deficit to grow, but nothing else on the right-hand side changes. Then the identity implies that GDP must be lower by the same amount. This opens a faulty line of reasoning through which bigger trade deficits are necessarily a drag on output and employment.

Perhaps the key phrase in that explanation is “but nothing else on the right-hand-side changes”. To be more specific, say that imports fall (set aside for the moment why they fall). Say that 100% of that decline in imports is matched by increased domestic output, so that GDP rises. However, “nothing else on the right-hand-side change”–that is, even though domestic production goes up, neither private nor government consumption rises, nor does investment, nor exports. Obstfeld puts it this way:

The prediction that implicitly underlies their calculations, however, is that if imports fall by some amount (for example), an equal amount of consumption or investment demand will automatically be redirected toward domestic products, leaving the sum of total consumption and investment spending unchanged. In terms of the NIP [national income and product] identity, they argue that net exports on the right-hand side will rise without any accompanying changes in the other right-hand side quantities, necessarily leading to higher GDP in precisely the amount of the trade balance improvement.

The flaw in this argument is that the trade deficit rarely if ever changes without some accompanying movement in consumption, investment, or government spending—and the way in which the trade balance interacts with other economic activity depends critically on why it is changing.

Notice the rhetorical shift that often happens here. We started with a statistical definition of GDP, which will always be true, because it’s the definition. It is true that if imports fall, something else in that definition of GDP will have to change, to preserve the identity. But the statement that the change will entirely happen in the form of greater domestic production is a specific theory about what will change–and it’s not at all obvious that the theory is correct. Here are some alternative theories about effects of import tariffs:

If the US imposes tariffs on imported goods, US imports will decline. However, other countries will retaliate with tariffs on US exports, so US exports will decline as well. If these two effects exactly offset one another, so that the lower US imports and lower US exports are the same, the trade deficit does not change and GDP does not change. Instead, there is a dislocation and reallocation in the US economy in which export-oriented industries take a hit, while US production for the US domestic market rises.

Or say that the US imposes tariffs on imported goods, so that US imports decline. This will necessarily mean that foreign producers who used to be selling into the US market are earning fewer US dollars. In the foreign exchange market, the supply of US dollars declines, and the exchange rate of the US dollar rises. As a result, US exports become more expensive in global markes, and exports end up falling as well.

Or say the US imposes tariffs on imported goods, so that US imports decline. Many of those imported goods are used by US firms as inputs to production. The reason US firms import these inputs is that they are either less expensive or higher quality (or both) than the same product would be if produced in US borders (if indeed they are even produced at all within US borders). Thus, all the US firms that have been depending on imported inputs (which includes most large and successful US multinationals) are facing a rise in their costs. As a result, they may decide to cut back on their levels of investment.

Or say the US imposes tariffs on imported goods, so that US imports decline. Many of these imports are purchased by consumers, who choose these items because that they are either less expensive or higher quality (or both) than the same product would be if produced in US borders (if indeed the product is even produced at all within US borders). Thus, when these consumers face the necessity to purchase alternative goods,they will be buying something that they would have preferred less–based either on higher price or a difference in quality. As a result, consumers may decide to cut back.

I want to emphasize two points here.

One is that all of these possibilities, as I have laid them out here, remain all consistent with the basic definition of GDP. The basic definition of GDP does not tell you which of these outcomes are more or less likely–it only tells you how GDP is calculated. The definition of GDP does not tell you that if tariffs are imposed on imports, GDP will rise, or that it will fall, or that it will remain the same. The definition doesn’t tell you whether a change in tariffs will affect exports, or consumption, or investment. It’s just a definition, not a theory of how the economy will react. Anyone who starts with the statistical definition of GDP, and then asserts that lower imports will necessarily lead to equivalently higher domestic production, is pulling a fast one. In Obstfeld’s phrasing, they are assuming that “nothing else on the right-hand-side changes.” It’s a whale of an assumption.

The other point is that to distinguish between possible theories, one needs to look at evidence. Obstfeld goes into considerably more detail about what theories are likely to play out in response to restrictions on imports, and why. For example, the “theory” that other countries will respond to tariffs by retaliating is happening in real time. The “theory” that tariffs on imports lead to a stronger exchange rate, and thus depress sales of exports, has happened in practice. Firms and households do suffer when their access to the imported goods they would prefer to have purchased is restricted.

There are lots of other arguments about import tariffs: I’ve discussed some of them in the past, and am sure to discuss more in the future. But the argument that import tariffs will increase total domestic production, when based on the definition of GDP and the national income and product identity, should be an embarrassment to anyone making it, and it should be ridiculed and laughed down wherever it is encountered.

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