Bob Parker, longtime head of GDP accounts at the Commerce Department's Bureau of Economic Analysis, personal friend, and organizational (NABE, NBEIC) colleague, helped me develop a simplified approach to understanding the impact of President Trump's policy on trade, as best we know it. Many thanks to him for his guidance.
We created a very simple case study when I asked Bob about this. I happened to be wearing a pair of Lands' End jeans that were sewn in Sri Lanka. So I said, "Let's use these jeans as an example of the issues."
The email I sent to Bob Parker follows:
Bob, GDP accounting is on final finished goods, as I understand it. So what happens with partial assembly abroad? Case 1. Jeans made and sold wholly within the US. All parts in in the supply chain are domestic US.
The other part of case 1 is a single change in one labor component. The sewing is done in Sri Lanka. So the material is shipped there, sewn, and shipped back. Final sale is here in US, just as with the domestically sewn jeans. In other words, the only change is the labor component for sewing.
We assume the final sales price is equal in both instances: $100. We also assume the value of the Sri Lankan labor is $5. In the US, the same labor would cost $10. We ignore shipping cost, finance, and currency exchange rates and deal with a single variable. Result: Sri Lankan labor yields $5 more profit for Lands' End.
Bob, how is case 1 differentiated in GDP accounting? Do you net off export and import items in a middle stage of the chain? Do you count only final sales in GDP?"
CASE 1 - What happens when part of production is "off-shored" to Sri Lanka? (A simplified version - no transportation costs; everything takes place in a single period to avoid accounting for inventories; sales are made at back door of plant.)
1. Firm produces denim for $10, pays $10 wages to employees to sew jeans, sells to households for $100. For expenditures approach, PCE = 100; GDP = 100. For income approach, wages = 10; profits = 90; GDI/GDP = 100.
2. Firm produces denim for $10, offshores sewing to Sri Lanka for $5; sells to households for $100. For expenditures approach, PCE = 100; Exports = 10; Imports = 15; GDP = 95. For income approach, wages = 0; profits = 95; GDI/GDP = 95.
The bottom line is that GDP will be smaller as a result of lost wages due to offshoring."
We then discussed a case 2 that involved the movement of a plant back to the US.
CASE 2 (a simplified version) - What happens when GM closes a plant in Canada and moves production to a new plant in Tennessee?
Now, when the plant ships a car for sale in the US and the car is sold, GDP includes the trade margin on the car made in Canada. The "wholesale" value of the car appears in imports (a negative in the calculation of expenditures GDP), and the retail value of the car is added to personal consumption expenditures (PCE).
When the Canadian plant is closed, GDP initially will be larger by the amount of investment to build a new plant. The investment will appear in the gross nonresidential fixed investment component. Subsequently, when cars are produced at the new plant and sold in the US, the retail value of the sale of each car produced at the new plant will appear in the PCE.
The bottom line is that, over time, GDP will be larger as a result of the change of plant location.
As we know, the trade-off is cost of production here versus cost of production "there." And that means selling price differences. And that may or may not mean rising prices here."
We think we are seeing a possible reasonableness creeping back into the Trump Administration's trade policy. The border adjustment tax seems to have died quickly. China is no longer a "currency manipulator." The urge for abrupt changes has morphed into a slower and more studied approach, or so it seems. The president still blusters and tweets, but those around him (Ross, Mnuchin, Cohn) seem to be more centered, even as they must sometimes delicately walk back what appear to be extreme statements from this president.
In our view, the same thing will occur in global finance, central bank cooperation, debt management. The economic and finance professionals around President Trump know that the US is better off without trade wars. They also know that a sound financial system is one of our strongest deterrents against global enemies. And lastly, they know that Brexit has triggered changes in global finance and that a reliable America with less financial regulation is an attractive place for global capital.
We remain nearly fully invested in our US ETF accounts. We favor an overweight position in banks and financials. At least that is where we are today. All this could change at any time because of many possible events that are currently risks but not realized risks.