When governments attempt to reduce bilateral trade deficits through tariffs while simultaneously pursuing expansionary fiscal policies, the outcome is often far from what policymakers intend. Instead of correcting overall external imbalances, this combination tends to distort trade flows, push up exchange rates, and reallocate employment in ways that undermine long-term growth and competitiveness.
At first glance, tariffs appear straightforward: they raise the cost of imports, protect domestic industries, and visibly narrow trade gaps with specific partners. Similarly, large public spending boosts demand, stimulates short-term growth, and provides immediate political gains. But when paired together, the two policies interact in complex ways that disrupt macroeconomic stability and fail to address the underlying drivers of current account deficits.
Tariffs and Their Limits
A bilateral trade deficit occurs when a country imports more from a trading partner than it exports. The U.S., for example, ran a $375 billion bilateral deficit with China in 2017, which critics interpreted as evidence of overdependence. Yet, economists argue that such imbalances often reflect global value chains and comparative advantage rather than harmful economic dependence. What truly matters is a country’s aggregate current account balance — not its bilateral relationships.
Nonetheless, tariffs are a common tool for governments seeking quick results. By raising the cost of imports, tariffs shift trade away from targeted partners. The U.S.-China trade war illustrates this: tariffs reduced Chinese imports but simply redirected U.S. demand to Vietnam, Mexico, and Taiwan. The overall deficit remained elevated. Similarly, U.S. restrictions on Japanese cars in the 1980s led firms to relocate production abroad, blunting the intended effect. Argentina’s tariff regime between 2008 and 2015 followed the same pattern, narrowing bilateral deficits without fixing the broader imbalance.
The Role of Fiscal Policy and the “Twin Deficits”
The key to understanding why tariffs fail lies in the saving-investment identity: Current Account = National Saving – Investment. Since national saving is reduced by persistent government deficits, a country running high fiscal deficits will almost always face current account shortfalls, regardless of trade policies. This phenomenon, known as the “twin deficits hypothesis,” means that tariffs cannot resolve the deeper imbalance unless tariff revenues are specifically used to reduce government debt — an unlikely scenario, given that tariffs represent only a small share of total revenue.
The IMF’s 2023 External Sector Report underscores this point: fiscal policy, not trade restrictions, is the most effective lever to correct external imbalances. Tariffs may alter the composition of imports and exports, but they do not shift the fundamental drivers of the current account.
Exchange Rates and Competitiveness
Tariffs and fiscal deficits also exert strong pressure on exchange rates. A large fiscal deficit, financed by foreign capital inflows, tends to push up interest rates. This attracts speculative inflows, strengthening the domestic currency and making exports less competitive. Even tariffs themselves can lead to temporary exchange-rate appreciation, as initial improvements in the trade balance increase demand for the local currency.
As Paul Krugman, Maurice Obstfeld, and Gregory Mankiw emphasize in their work, relative price adjustments and exchange-rate movements often neutralize the intended benefits of trade restrictions. In practice, this means tariffs rarely translate into lasting current account improvements.
Employment and Sectoral Shifts
The short-term employment effects of tariffs can appear positive, especially in import-competing industries such as U.S. steel. However, firms that rely on imported inputs face higher costs, reduced competitiveness, and job losses. The fiscal expansion further distorts labor markets by encouraging growth in non-tradable sectors, such as construction, at the expense of more productive tradable industries.
Over time, this structural misallocation reduces productivity growth and leaves the economy more vulnerable. Portugal’s experience before the euro crisis illustrates the risks: high fiscal-driven demand shifted labor into construction while services stagnated, creating imbalances that unraveled when external financing dried up.
The Broader Lesson
Combining tariffs with expansionary fiscal policy may be politically attractive but is economically unsustainable. Tariffs can reduce bilateral trade with targeted partners, but they do not fix aggregate imbalances. Instead, they alter trade flows, increase exchange-rate volatility, and reallocate labor toward less productive sectors. Persistent fiscal deficits worsen external vulnerabilities by fueling foreign borrowing and future income outflows.
The ultimate lesson is clear: tariffs may shift where deficits occur, but only fiscal discipline and structural reforms can address why they persist. Governments seeking sustainable growth and competitiveness must look beyond short-term fixes and embrace policies that strengthen savings, investment efficiency, and long-run productivity.
