A Trade War Will Lead To A Recession

Summary

• Economic shocks are a main reason for recessions.
• Oil price shocks and financial shocks are two primary causes.
• We tried protectionism in the 1930s; that didn't end well.

Like many market watchers, I monitor a number of economic indicators, which I periodically revisit to assess the current economic backdrop (here's a link to my most recent piece). The idea behind this constant re-assessment is that an adverse movement will telegraph that a recession is coming, or at least more probable. But, it's also important to remember that what usually causes a recession is some type of economic shock to the economy - an event that in some manner causes a widespread dislocation so severe that economic activity slows and then contracts. There is ample evidence of these events in the historical record. Oil price spikes and financial shocks are two that we are more familiar with. But trade wars are another. We started one in the 1930s; that lead to a worldwide depression. Considering the nearly exponential increase in global integration since then, a trade war would have just as devastating an impact today.

Let's look at the predominate economic shocks that have caused a recession in the past.

Oil Prices

After WWII, the US economy became entirely dependent on oil. Consumers needed it to power their cars; it also provided fuel for trucking transportation, which to this day is vital to the domestic economy. And let's not forget how central the auto manufacturing industry was to US growth in the 50s, 60s, and 70s. When oil prices spiked, consumers reallocated their spending from other goods and services to energy. This can be fatal for the domestic economy because consumer spending accounts for 70% of economic growth. This explains why oil price shocks are a primary reason behind most recessions. James Hamilton, who regularly blogs over at Econbrowser has done a tremendous amount of research on this topic. Here's a link to a paper that explains how oil price shocks are behind a majority of post-WWII US recessions.

Financial Shocks

The financial system stands at the center of the U.S. economy. Economists conceptualize this with the "circular flow" diagram:

In general, financial institutions take small amounts of money in the form of deposits and insurance payments, bundle these payments into larger sums, and then loan money to businesses. Just like oil prices mentioned above, the US economy (actually, any developed economy) must have a well-functioning financial system to grow. When there's a problem with this system, the economy stops growing. The Great Depression and the Great Recession are both examples of a contraction caused by some type of failure of the financial system. (If you'd like to read more about both, here's a link to Irving Fisher's "The Debt-Deflation Theory of the Great Depression" which conceptualizes both events with remarkable accuracy).

While Paul Volcker's raising interest rates in the early 1980s wasn't a financial meltdown, it's also an example of the financial system causing a recession. However, in that case, it was the Federal Reserve deliberately raising interest rates to slow the economy. And the stock market collapse of the late 1990s also qualifies as a precursor to the early 2000s recession.

Trade Wars

The best example of the negative impact of trade wars is the Smoot-Hawley Act, passed in 1930. Here is a brief explanation of the Act and its impacts [emphasis added]:

The Smoot-Hawley Tariff Act of 1930 raised taxes on imports substantially on top of an earlier rise in 1922. The goal was to protect American manufacturers from competition from foreign imports. International trade was a small enough percentage of the American economy at the time that most economists ascribe the tariff a secondary role as a contributor to the Depression in the 38 U.S. However, it had far worse implications at the international level. The Smoot-Hawley tariff was matched by a series of protectionist measures by countries throughout the world. As each nation tried to protect its home production interests through higher tariffs and restrictions on imports, world trade spiraled downward. By 1933 the total imports for 75 countries had fallen to roughly one-third of the level seen in 1929 (Kindleberger 1986).

This chart shows the negative impact:

Trade is now far more central to the US and global economies. The IMF wrote several articles over the last 10 years, showing that weak trade flows were a primary reason for weak global growth (here is one example; see also their World Economic Outlooks during this time). Despite numerous comments and articles about the death of US exports, they're actually growing relative to GDP.

The chart calculated total exports as a percent of GDP. Back in the 1930s, they were far less important to the US economy. Now, they represent about 13% of real GDP.

The increase in trade has allowed countries with a lower standard of living to produce less sophisticated goods (textiles being a price example), while more developed countries (such as China) are manufacturing higher-quality goods. And supply chains are now global; they're based on the free flow of goods across borders. A trade war in this environment would deliver a fatal blow to global growth, which is finally hitting on all cylinders. It is literally the worst policy option available.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Comments

[Lance Brofman]

It may be that the race is not always to the swiftest, nor the fight to the strongest-but that's the way to bet.
1943 Version

It may be that a government led by protectionist populists with very little understanding of economics, does not always result bad economic outcomes- but that's the way to invest.
2017 version

The famous statement above attributed, in its' many forms to various individuals and cited in a 1943 publication as being from Damon Runyon, has an updated 2017 version. .."
https://seekingalpha.c...

How about the future health of millions of Americans who buy steel products or whose employment depends on the USA having access to the world steel market rather than artificially propped up prices from tariffs. We can expect more of this again:

L.A. Wire Maker Seeking Protection From Creditors
March 11, 1989 | DENISE GELLENE, Times Staff Writer
Davis Walker Corp., the nation's largest independent maker of wire and wire products, said Friday that it filed for protection from its creditors while it reorganizes under Chapter 11 of the bankruptcy code. The 62-year-old Los Angeles steel processor said it was a victim of import restrictions that forced it to buy costly domestic steel from mills in the East and South.

. All protectionism is destructive. However, protecting basic materials like steel and aluminum is particularly harmful since it makes products manufactured in America uncompetitive in the world market. .."
https://seekingalpha.c...

https://seekingalpha.c...

[VaslavN]

I beg to differ w/ the article title.

[Grisby]

Good, I think this is probably what we actually desperately need. Trump's attempts to increase economic prosperity through protectionisim will likely backfire. Although this board will not be sympathetic, the ever increasing race for more and more must be repressed and Trump is likely unwittingly helping. Substantial reductions in consumption, growth and population are required if we are to survive much longer as a species, there is already way too much global economic and physical growth and too many people to sustain ourselves and the planet.

This may seem harsh (and it is) and not what anyone wants to hear but everything I've leaned in my long good life tells me it's true so I'm saying it anyway.

[AUMON]

That is a myopic view when what we see is the world is awash in overabundance and overproduction. The world has much prosperity yet the prosperity is not being fully shared and much of it goes to waste. The reason for protectionism is because the level of competition around the world has allowed many industries to over produce. The planet can easily sustain multiples of the current world population without any further harm if resources were managed without the greed of those majors who create and control laws that skew prosperity.

[Grisby]

Agreed that wealth is most unevenly distributed but that only exacerbates the present situation of ever increasing damage to Earth, our only viable life support system. Much less negative human impact is now desperately required, particularly from the wealthy who also hold the most potential to make the necessary changes. But as they likely will not, trade wars may be the next best thing.

[MonteQuest]

"The planet can easily sustain multiples of the current world population without any further harm if resources were managed without the greed of those majors who create and control laws that skew prosperity."

Many carrying capacity studies show the earth's sustainable population is about 2 to 3 billion. More optimistic ones say 5 billion. None say multiples, even with better management, resource distribution and renewables.

[ifollow]

With or without trade war, recession is bound to happen. They could “manipulate the data a bit more to stretch the expansion. However consumer debt level can’t be reduced but up to a point that citizens not only cut spendings but eventually go bankruptcy. Cycle cycle cycle

[Ben Gee]

If the US go it alone, the rest of the world may continue to grow, leaving the US behind.

[Skaterdude]

Growth outside the US is partly dependent on US consumption.

[Finici]

Skaterdude -

Growth inside the US is partly dependent upon 'outside' consumption.

"...Agricultural exports are an important and growing driver of the U.S. agricultural economy. While ag exports are typically talked about in broad terms, it’s important to remember 1) exports account for a different share of production for each crop 2) the size of and concentration of trade partners varies and 3) the impact of trade with Canada, China, and Mexico today – and since the 1990s- is significant.

See http://bit.ly/2D1coHq.

In 2008-2010, the 'shining star' in the otherwise rather sick US economy was agriculture.

Jay

[Skaterdude]

I totally agree. I didn't mean to imply the trade was one way or that dependencies are one way

[MonteQuest]

@Hale

Thanks for your article!

"This explains why oil price shocks are a primary reason behind most recessions."

Yes, I follow this closely. Have you looked to see if it is the sudden "spike" in the price or just the overall rise to an unaccustomed price level? Commodities seem to spike 3 months post spike.

[xpan]

"THE trade war", not "a trade war". The guy has started the trade war, and it doesn't look like he will stop. This will ignite the inflation, forcing the Fed to tighten aggressively, crushing the economy as well as the stock market. No worry, all of that will be blamed on Obama.

[Calculus]

certainly unemployment could spike quite dramatically on "commodity king Trump" news. very bad news for the building trade in the immediate term to have this type of "war talk." not convinced a recession is imminent given the massive energy and aggregate production boom still rolling going on almost 20 years now.

Bad news for Manhattan real estate obviously. "from billions to worthless" would appear.

[Buy Buy Buy]

If Trump is doing something, look first for how it benefits him personally. Look second for how it benefits the top .1% who donate to him.
Look third for how weakens the relationship between the U.S. and its traditional allies (Pleases Putin)
Look fourth for how it hurts blue states.
And lastly look for how it distracts from another news story that he wants out of the headlines.