The Dangers Of Protectionism
Weekly Market Compass: Tariffs take the spotlight once again
By Kristina Hooper, Global Market Strategist. Posted on Expert Investment Views: Invesco US Blog.
Geopolitics is back in the spotlight, with German Chancellor Angela Merkel finally securing a governing coalition after nearly six months of uncertainty, while Italy embarks on its own period of uncertainty given the inconclusive results of its election this past weekend. Italy's voters are following in the recent footsteps of voters in the United Kingdom, the United States, Germany and elsewhere - questioning the "status quo."
Inevitably, that includes questioning current trade and immigration policies. While the official results of the Italian election have not yet been released, it appears that there will be continued uncertainty for some time as parties try to form a governing coalition (as of this point, we don't even know yet which party will be given the first opportunity to form a government). This will be an ongoing saga we will want to follow closely. And that takes us to the biggest geopolitical news of the week.
On March 1, US President Donald Trump announced a 25% tariff on steel imports into the US, and a 10% tariff on aluminum imports. The news reminded me of two books that were formative to framing my views on international trade:
- Back in 1985 when I was a freshman in high school, I read the autobiography of famed US auto executive Lee Iacocca. He devoted the last few chapters to his views on foreign trade and made a compelling case for protectionism, explaining that he believed in fair trade rather than free trade, and that the US needed to protect industries that were critical to both jobs and national defense. In particular, he focused on how Japanese businesses are backed and aided by the Ministry of International Trade and Industry, and advocated for protectionist policies such as a tariff on imported oil and lower interest rates for borrowing by American industries, as well as caps on Japan's market share in critical industries.
- In business school, I took a very interesting class on operations management with a professor who was a strong believer in free trade and competition. He suggested I read a book called The Reckoning by David Halberstam. The Reckoning is a phenomenal book about many things, but one of them is the decline of the American auto industry in the 1970s. The book chronicled how US automakers' dominance of the industry up to that point had rendered it complacent; automakers felt they knew their US customers well and assumed they were comfortable with less reliable, less durable cars with lower fuel economy. That may have been true when there weren't alternatives, but as soon as other options became available, that began to quickly change - and the industry did not respond to consumers' evolving preferences. The book made the case that US automakers couldn't blame Japan for all of their woes.
The risks of protectionism versus the risks of free trade
So how do I view protectionism? International trade is a very complex, nuanced issue, but I believe free trade, all else being equal, is better for consumers, companies and the economy. That's because protectionism has a lot of negative consequences:
- First and foremost, protectionism may lead to inflation, which hurts consumers' purchasing power and can have a particularly negative impact on lower- and middle-income consumers for whom the additional money paid on tariffs could be put to more productive uses.
- Protectionism may also curb competitiveness. It enables companies to be complacent and may protect them from being forced to innovate.
Competition means that there are winners and losers. But losers can benefit through creative destruction as failure forces them to innovate.
Even the perceived downside risk of free trade - running a trade deficit - may not be so bad. That's because:
- Countries that have more money, like the US, consume more goods than other countries. If the US runs a trade deficit, that helps other economies grow - so they can ultimately purchase more of our goods.
- Running a trade deficit with the US gives other countries more money to invest back in the US, such as through Treasury purchases, but protectionism reduces foreign direct investment (FDI). For example, Canadian investment comprised 10% of the total FDI in 2016. However, according to the Bank of Canada's January 2018 Monetary Policy Report, "Trade policy uncertainty is expected to reduce the level of investment by about 2% by the end of 2019."
Bank of Canada Governor Stephen Poloz summarized the risks of protectionism in a March 2017 speech: "Protectionism does not promote growth, and its costs are steep." In fact, most economists agree that protectionism exacerbated the Great Depression:
The Great Depression of the 1930s was marked by a severe outbreak of protectionist trade policies. Governments around the world imposed tariffs, import quotas and exchange controls to restrict spending on foreign goods. These trade barriers contributed to a sharp contraction in world trade in the early 1930s beyond the economic collapse itself, and to a lackluster rebound in trade later in the decade, despite the worldwide economic recovery.1
In addition, trading partners such as China and Japan could retaliate by not buying or even selling US Treasuries. As I warned in a Jan. 29 blog, "Countries can retaliate in other ways as well, given how interconnected we are. One powerful retaliatory tool - which many seem to be overlooking - is that they could choose to curtail purchases of US Treasuries or, even worse, also sell some of the Treasuries they hold, which could, all else being equal, drive up US borrowing costs."
Now, that does not mean that free trade is free from risk. Free trade means that some industries in some countries will lose jobs - and that is always a very high price to pay. We can only hope that governments spearhead effective job retraining programs, so that employees are able to learn new skills for the jobs of the future that free trade will help create.
This also does not mean that free trade is truly fair, as Lee Iacocca referred to in his book. That may be where "soft" protectionist tools can be employed (such as lower-interest rate loans or subsidies for certain industries) which aren't quite as blunt an instrument as tariffs. And, where appropriate, countries can utilize the World Trade Organization to correct unfair trade practices on the part of other countries.
Key takeaway
In short, I have warned for a while that one of the key risks to global economic growth, in my view, is protectionism. Tariffs rarely occur in a vacuum. They can multiply, as we saw in the 1930s. Today, markets appear to be appropriately fearful of them because of the impact they can have on global economic growth; not only did stocks sell off on news of the steel and aluminum tariffs, but we saw the yield on the 10-year US Treasury back down as well, which I believe is an indication of how seriously markets took this threat.
While developments as of March 5 suggest that this tariff announcement is really just a bargaining chip in North American Free Trade Agreement negotiations, we will want to follow the current situation closely given the continued potential for trade wars to erupt.
1 Source: The Journal of Economic History, Vol. 70, No. 4, "The slide to protectionism in the Great Depression: Who succumbed and why?" Barry Eichengreen and Douglas Irwin, December 2010
Important information
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The opinions referenced above are those of Kristina Hooper as of March 1, 2018. These comments should not be construed as recommendations, but as an illustration of broader themes. Forward-looking statements are not guarantees of future results. They involve risks, uncertainties and assumptions; there can be no assurance that actual results will not differ materially from expectations.
The information provided is for educational purposes only and does not constitute a recommendation of the suitability of any investment strategy for a particular investor. Invesco does not provide tax advice. The tax information contained herein is general and is not exhaustive by nature. Federal and state tax laws are complex and constantly changing. Investors should always consult their own legal or tax professional for information concerning their individual situation. The opinions expressed are those of the authors, are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.
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