Are 'Trump Trade Wars' Inevitable?

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by: Patrick M. Crowley

Originally published on August 21, 2017

President Donald Trump, at his joint address to Congress on February 28th, 2017, stated: "I believe strongly in free trade, but it also has to be fair trade. It's been a long time since we had fair trade. The first Republican president, Abraham Lincoln, warned that the abandonment of the protective policy of the American government would create want and ruin in the country... It's time we heeded his advice and his ways."

Free trade has been at the cornerstone of capitalist democratic economies for many years now, so this statement from the president of the biggest trading country in the world looks to President Lincoln to justify a return to protectionism and a reversal of the trend to ever-freer trade that has been characterized by the post-World War II international economic consensus. This has economists somewhat aghast at what is going on with the Trump administration, as after the new President immediately withdrew from the progressive Trans-Pacific Partnership (TPP) agreement, we also know that the Trump administration is now looking to not only renegotiate NAFTA but also has explored the idea of perhaps bypassing World Trade Organization (WTO) rules so as to impose a Border Adjustment Tax (we'll come to what that is below).

So, how will this all play out? Well, there is already a battle inside the administration about how protectionist the policy pronouncements will be, and it looks like the battle between the two factions will continue for a while yet, despite the fact that Steve Bannon has left the White House staff. In a recent NYT article, there is doubt that President Trump will be able (or want) to follow through on his campaign promises with as much gusto as he suggested he would on the campaign trail. And in an article in the FT, there were signs emerging that the Beijing relationship has now becoming badly frayed as the Trump administration initiates several unfair trade practices investigations. The danger though here is that the "soft-liners", although they might win in the short run, will not hold the upper hand as we approach the mid-term elections in late 2018 and beyond as the administration realizes they are being punished at the ballot box for not fulfilling on these commitments. So, let's take stock of where we are in terms of President Trump's campaign promises. In no particular order, they were:

  1. Withdraw from the TPP.
  2. Halt T-TIP negotiations.
  3. Renegotiate or scrap NAFTA.
  4. Institute a border tax (tariffs) with Mexico so as to pay for a wall on the Mexican border.
  5. Declare China to be a currency manipulator.
  6. Impose a Border Adjustment Tax as part of the tax reform package that should be forthcoming from the administration.

The first two on the list have now been completed, but the third is the one that has everyone guessing as to the consequences, so let's look at NAFTA first.

NAFTA is now embedded into the North American economy, so changing the basis of the Treaty that established it requires a summit with both Canada and Mexico, and the negotiations for this summit are now taking place.

President Trump has made it clear that he wants a complete rewrite of NAFTA, and that led to a tense start to the negotiations, which got underway this week. The Canadian foreign minister, Chrystia Freeland, noted that, "We pursue trade, free and fair, knowing it is not a zero-sum game." She added that, "it is worth pointing out that we are the biggest client of the United States. Canada buys more from the U.S. than China, the UK and Japan combined."

Perhaps the US team in the negotiations, led by U.S. trade representative Richard Lighthizer, sees trade bilateral deficits (and the US does run a small deficit with Canada) as a measure of fairness of trade with that entity. Any student of international economics understands that this is not the case - it is simply a component of the overall trade balance, and reflects a balance of comparative advantages between the two countries. Also, it should be noted that Trump's ire has not been directed at Canada (with the isolated case of the softwood lumber issue), but in the NAFTA context his ire has largely been directed at Mexico. This is because whereas the U.S. ran a goods and services trade surplus with Canada in 2016 of about $12.5 billion, the U.S. ran a goods and services trade deficit with Mexico of $55.6 billion. But, as we shall see below, the trade deficit with Mexico is dwarfed by the trade deficit with China.

Now, although the topics to be discussed are rules of origin, managed trade (read more quotas), and so-called "Chapter 19" dispute resolution, whatever is in NAFTA 2.0 better reduce the U.S.'s trade deficit with Mexico, otherwise this will likely prompt President Trump to threaten withdrawal from NAFTA. But, given the fact that much of the trade between the U.S. and Mexico is intermediate goods trade, it does make sense that the biggest part of the cross-border trade would be the finished product (for example, a vehicle) rather than the sum of all the parts that might be produced in the U.S. that are exported to Mexico (where the vehicle is then assembled). Given, then, that it is unlikely that trade with Mexico could ever get to close to in balance (or in surplus), I think that President Trump, given that he has made such a big issue of either pulling out of NAFTA or completely rewriting it, may decide to pull out if the Mexicans don't walk out first.

What I think will possibly transpire is a return to CUFTA, which was the free trade agreement with Canada that formed the original basis for NAFTA. Although other economists might not agree with my assessment, I believe that President Trump will feel he has to deliver on this particular promise if he is to stand any chance of re-election. A way for NAFTA 2.0 to eliminate the trade deficit with Mexico would be import quotas. I think these will be rejected by Canada, as they would also affect Canadian exports to the US. So, there is no way forward that would satisfy all 3 parties, and therefore, this will possibly lead to withdrawal. Since the announcement of Steve Bannon's ouster as a Trump advisor, the probability of withdrawal has gone down, but the trade representative will still have difficulty delivering what the president wants out of a re-write of NAFTA.

When campaigning, Donald Trump also mentioned a 35 percent tariff on autos made by U.S. companies in Mexico. This tariff was originally mentioned also with regard to funding construction of the wall. This tariff would currently go against the rules of NAFTA, so is unlikely to be implemented while the U.S. remains inside NAFTA. So, if the U.S. does leave NAFTA, then this idea might get resurrected as a means to deter manufacturing or assembly going south of the border.

On the campaign trail, President Trump also promised to name China as a "currency manipulator". But having met with Premier Xi Jingpin, he declared that China had manipulated its currency in the past but was moving to correct the level of the yuan, and hence, it would not be necessary to name China as a "currency manipulator". So this is now off the table. President Trump did, however, decide to pursue several probes against China, most notably on intellectual property but also on steel. Although the U.S. has not imposed steel tariffs yet, it seems that they are likely to do so. This so-called "Section 232" review (that was initiated because of fears that threats to the U.S. steel industry from imports would not be in the interests of national security) has to be made public by mid-January. Then President Trump will have 90 days to react, perhaps implementing a steep tariff on steel imports principally from China but also from all other steel producers.

The Border Adjustment Tax (BAT) has now also been abandoned as a proposition, but just to keep my readers fully informed, I will explain exactly what a BAT is. A BAT is essentially an import tariff coupled with an export subsidy by means of making exports tax free.

So, that is the current state of play on international trade policy and the Trump administration. As mentioned above, the current administration appears to be particularly concerned about turning the overall U.S. trade deficit into a surplus, or at least reducing it. In the table below from the BEA, the bilateral trade deficit or surplus for the U.S.'s main trading partners is shown, and it can be seen that the majority of the deficit is with China, and this is fairly consistent over time.

Source: US Census Bureau, Dept of Commerce

Of course, what really matters here is the trend in the data, so I thought I would download the data and see exactly how a long-term perspective can show that actually China is pretty much the only problem.

Data source: Dept of Commerce; Graphic by blog author

Now, the graphic clearly shows that although there was a deterioration in the trade balance with countries like Japan, Germany and Mexico over the early 2000s, it is the trade deficit with China that really takes off in the early part of the century, and although for countries like Canada the trade balance has actually improved, for China, with only a brief respite during the great recession, the overall trend has been towards a widening of the deficit.

So, from an economic assessment, if one agrees with this approach, the president should really focus mostly on China, as this is where much of the trade deficit originates from. But what is the best way to tackle this? The U.S. trade representative has a detailed list of objectives which can be found here, but of course, these only state objectives and not solutions.

On a recent trip to China, I visited a large container port off the coast of Shanghai (in fact, it is at present the largest container port in the world), and was surprised to hear that half of the containers travel to China empty, but every single container is full leaving China. So, the main problem with trading with China (and this goes for the EU too) is that its trade with most of the rest of the world is unbalanced.

This highlights the fact that although half of this problem is the U.S.'s, the flip side is that China clearly has a lack of consumption of imports in the sense that savings are high, and when the Chinese do consume, much of their urban dwellers consume Chinese goods. The China issue prompted President Trump and President Jinping to set up a "US-China Comprehensive Dialogue", but as reported in the Financial Times last month, this dialogue is a talking shop regarding the issues to be tackled, but nothing concrete to make it happen, and there is definitely no sign of agreement on the way forward.

Clearly, the Trump administration has changed tracks, and instead of calling the Chinese currency manipulators, has decided to go after the Chinese on various fronts by launching probes in specific problematic areas. The results of these probes, though, if acted upon, will likely prompt reprisals and perhaps WTO arbitration cases against the U.S. Certainly, the Chinese appreciate that although the U.S. is not their largest trading partner (the EU is), there are considerable risks to domestic economic growth if there is a trade war with the U.S.

So is a trade war inevitable with China? I think that the answer here is still up in the air, but I still think the most likely outcome is narrowly in favor of a trade war. This is the case particularly if we see a degradation in the NAFTA talks appearing over the next few weeks. A sign pointing in a different direction has also appeared, though, and that relates to the earlier probe on steel which the president launched. There has still been no announcement as to the results of this probe, and this is likely because the announcement has been held back, as it would be damaging to trade with China. How to handle this will definitely require some diplomacy, as President Trump will not want to make outright enemies of the Chinese.