Published 06 May 2025
There is much to dislike in the way the Trump’s tariffs were derived. But a real effective depreciation of the US dollar is needed if the policy goal is to return the American economy to external balance, given the dollar’s overvaluation and persistent US deficit spending. Supply-side reform and higher investment in the US are also necessary to meet Washington’s desire of self-sufficiency in critical areas of manufacturing.
The gap between world gross domestic product (GDP) stated in nominal dollar terms and world GDP stated in purchasing power parity (PPP) terms has never been bigger. In 2023, world GDP in PPP terms was US$184 trillion compared to the nominal value of world GDP of US$106 trillion: a gap of US$78 trillion. The World Bank uses the United States as the comparator for its PPP calculation, so the US economy is the same size in nominal terms as it is in PPP terms.
While few economists believe that the market exchange rates and PPP exchange rates should always match, common sense suggests that over time and, in the absence of trade barriers, there should be a tendency towards equality. The period of hyper-globalization of the last decade of the 20th century and the first decade of the 21st century should have been a major impetus for convergence between market and PPP exchange rates. The fact that trade as a percentage of GDP is near an all-time high, and yet the gap between nominal GDP and PPP GDP is also at a high, suggests something is seriously wrong with the adjustment mechanisms that are supposed to balance trade over time.
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The gap has existed since the early 1990s when the World Bank data series began and has always been in the same direction. The PPP number has always been larger than the one derived from market exchange rates, which tells us that world price levels have always been below US levels when expressed at market exchange rates. This means the dollar has always been overvalued.
The biggest contributor to this gap is China. The difference between the two measures of GDP in China reached nearly US$17 trillion, representing of 21.6% of the world’s total gap. China’s nominal GDP in 2023 was RMB126 trillion, while the average market exchange rate for the year was RMB7.08 to the dollar, meaning a nominal dollar GDP of US$17.8 trillion. The PPP exchange rate, however, was RMB3.63. At that exchange rate, the size of China’s output in dollar terms would have been US$34.7 trillion.
What is also very striking is how few countries have an exchange rate that is expensive on a PPP basis vis-a-vis the United States. These countries are the ones whose PPP-adjusted GDP is in fact lower than their GDP at market exchange rates. This pool of countries is limited to just seven countries or territories with an aggregate nominal GDP of less than 1% of the world total. Switzerland is really the only significant economy that falls into this bracket.
In 2023, the last year for which the PPP data is available, US exports totaled US$3.05 trillion, while total domestic demand in the rest of the world (RoW) was US$77.5 trillion. In other words, US exports met just 3.9% of RoW final demand. If the rest of the world’s purchasing power increased by US$78 trillion as their exchange rates moved to PPP levels, it is not unreasonable to expect that US exports of goods and services would rise at least in proportion to the 2023 propensity that the rest of the world had for buying US goods and services. In fact, it is likely that greater affordability would lead to a rise in the marginal propensity of the RoW to buy US goods and services.
The Trump administration appears to have arrived at the view that a weaker dollar alone will be insufficient to erase America’s current account deficit. In large part this is probably because the administration has rightly concluded that Chinese authorities are unlikely to facilitate a dramatic appreciation of the renminbi, and China is the largest source of global production in excess of domestic demand. An alternative way to look at America’s current account imbalance is through the prism of the savings-investment gap. In the case of the US, the gross savings rate is low relative to GDP, insufficient to self-finance gross fixed capital formation. In the absence of increasing efficiency of investment, this would constrain US GDP growth at a level hardly commensurate with Making America Great Again.
The desire to decouple from potentially damaging trade dependencies by boosting domestic production in areas where US manufacturing has been eroded or completely vanished in recent decades will require significantly higher levels of aggregate investment in the economy. If this is to be done without net foreign capital inflows, which is the implication of a balanced current account, it must be done by raising the domestic savings rate, which obviously entails an offsetting fall in domestic consumption as a percentage of GDP.
A further variable is the degree to which the public sector deficit can be shrunk without impacting GDP. Shrinking the federal government deficit – currently over 6% of GDP – will directly help shrink the savings-investment gap, but at the expense of GDP unless those resources can be redeployed into the private sector. If they can be redeployed in a way that is more productive, then shrinking the government sector could actually increase GDP through the ensuing productivity gains. This, however, will take time.
Tariffs and other trade measures should be reserved for partners in the global trading system that use non-market means to prevent market adjustments from occurring, not applied to rule-abiding responsible participants in the system. If America gets the policy mix right, the world could end up with a far more sustainable and less volatile global macroeconomic environment in which trade can thrive.
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Stewart Paterson is a Senior Research Fellow at the Hinrich Foundation who spent 25 years in capital markets as an equity researcher, strategist and fund manager, working for Credit Suisse, CLSA and most recently, as a Partner and Portfolio Manager of Tiburon Partners LLP.
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