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U.S. President Donald Trump's expansionary fiscal-policy plans and activist trade policies are on a collision course that could lead to a trade war. To avoid that war, it's vital that U.S. tax reforms be revenue-neutral and geared at expanding the supply side of the economy.

Now is not the right time for debt-financed "stimulus." That policy would only lead to larger trade deficits and more pressure on Mr. Trump to adopt protectionist trade policies. To provide wise counsel to our American friends and to prepare for a trade war should it erupt, Canadians must understand why Mr. Trump's policies are on a collision course.

Mr. Trump is proposing large tax cuts, a rise in defence spending and a large infrastructure program. If implemented, these initiatives would lead to a large deficit-financed fiscal expansion. According to the Washington-based Tax Foundation, a conservative but non-partisan think tank, the federal government debt would rise by about $6-trillion over the next decade.

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Well-designed expansionary fiscal policy can drive output growth when the economy is mired in a large recession. But that's not where the U.S. economy is now. It's operating at close to full capacity. Under those circumstances, a large fiscal expansion that drives up the national debt will have one immediate result: It will increase the U.S. trade deficit.

To satisfy a fiscally driven higher demand with higher domestic output, the United States would have to employ more capital, more labour or have higher productivity. But the United States is already close to full employment. Even if investment picked up or the United States launched a large infrastructure program, it would take years to meaningfully raise the aggregate stock of capital. Productivity growth is low and unlikely to grow in the short run in response to fiscal stimulus. But if the United States can't satisfy higher demand with more domestic output, the only way to satisfy higher aggregate demand is to buy more goods and services from abroad. So the trade deficit would rise.

The deterioration in the trade deficit will be reinforced by U.S. monetary policy. The Federal Reserve is raising interest rates precisely because it thinks the U.S. economy is close to full employment, and inflation is on the rise. But rising interest rates will attract foreign capital, putting further upward pressure on an already surging dollar. And a stronger dollar will harm exports while encouraging imports. Rust-belt voters will not be pleased.

How will the mercantilists in Mr. Trump's administration react to rising trade deficits? They will likely claim that other countries have increased unfair trade practices and have intervened in exchange-rate markets to keep the dollar "overvalued."

The natural result: even more activist industrial and trade policies. As a candidate, Mr. Trump promised to renegotiate or withdraw from the North American free-trade agreement, block the Trans-Pacific Partnership agreement, impose a 45-per-cent tariff on imports from China and pressure individual companies to behave the way he wants. In addition, Mr. Trump is considering a tax reform that would tax imports while subsidizing exports.

Will other countries quietly accept our dictates? Not likely. China and Mexico seemed to regard candidate Trump's rhetoric as a salve to unhappy voters that would not have real bite. But if the trade bite starts to match the trade bark, countries such as China will surely take retaliatory measures.

How can the United States avoid this looming train wreck? The U.S. tax code needs to be reformed, simplified and geared at maximizing supply-side incentives. But tax reform needs to be revenue-neutral and mindful of the ever-growing U.S. debt. A carefully targeted infrastructure program would also be economically beneficial, especially if infrastructure projects face serious cost-benefit hurdles. Socially beneficial projects that generate future tax revenues can and should be financed by debt, especially when interest rates are still low.

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But a massive debt-financed fiscal expansion to finance pork-barrel projects and tax cuts that don't pay for themselves will lead to rising trade deficits that inflame the United States's worst nativist instincts. The trade war that could result won't Make America Great Again. It will just make the United States and the world – including Canada – a poorer, more dangerous place.

In this context, Canadians should offer the kind of well-meaning sage advice that friends offer friends. Most important, they can lead by example. Canadians can show what well-designed revenue-neutral tax reform looks like. And they can show what wisely designed infrastructure programs look like. At the same time, pragmatic Canadians must prepare contingencies for the great trade war that might erupt.

Martin Eichenbaum is Charles Moskos Professor of Economics, Northwestern University, and an International Fellow at the C.D. Howe Institute.

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