Correcting US payments imbalances: Taxing foreign holders of its treasury securities is better than import tariffs

To correct US current account deficits, dollar depreciation rather than imposition of tariffs is economically the better response. The theory of second best (The Review of Economic Studies, 24, 11) implies that if there is only one distortion then correct it, but the welfare effects of adding a second, supposedly offsetting distortion, may not increase welfare and can reduce it. In the context of an overvalued dollar caused by the dollar's status as the predominant global investment currency—a distortion adversely affecting the US manufacturing sector, the first best policy is not to impose tariffs because this adds a trade distortion on top of an exchange rate distortion and can easily be welfare reducing. US imports may be diverted from China to higher‐cost foreign producers not subjected to the tariff, and tariffs do nothing to promote US exports. The first best policy is directly to reduce the distortion of an overvalued exchange by discouraging excessive accumulation of foreign holdings of US securities held as foreign exchange reserves and by foreign private investors. A tax on the foreign holdings is a way to accomplish this.