Several months into the Trump Presidency, we argued that while the rhetoric might be populist, Trump governed more or less like a traditional Republican. We're not so sure now.
One of Trump's main selling points as a Presidential candidate was that as a businessman, surely he would know better than most how to create jobs? Well, we'll come to that broader topic in another article, but for now suffice to say that an economy isn't like a business, despite often used metaphors like "Japan Inc."
Nor do countries necessarily even compete with one another even if their companies do. But these simple facts of standard trade theory and macro economics seem entirely lost on parts of the current US administration, with potentially nasty consequences for the world economy and financial markets.
There really is a catalogue of errors, it's actually hard to know where to start. Here is Paul Krugman in response to the G7 summit this weekend. Krugman might not be everybody's cup of tea, but his Nobel Prize was for his contributions to trade theory so he speaks with some authority on these topics (our emphasis):
Then Trump demanded that the other G7 members remove their “ridiculous and unacceptable” tariffs on U.S. goods – which would be hard for them to do, because their actual tariff rates are very low. The European Union, for example, levies an average tariff of only three percent on US goods. Who says so? The U.S. government’s own guide to exporters.
If parts of the US government are even at war with their own established facts, then there is little hope for getting to any kind of agreement here. There are other basic errors like arguing that the EU's VAT is a trade barrier (it isn't, they apply to both foreign and domestically produced goods and are allowed under the WTO), which seems to be the tariffs that Trump is referring to.
But there is a lack of fundamental understanding of the dynamics of trade that is equally worrying and at a basic level, this comes from applying a business analogy.
At a fundamental level, trade flows are shaped by two basic concepts:
- The law of comparative advantage
- Spending versus earning
The law of comparative advantage is deeply counterintuitive, even people trained in economics tend to get it wrong from time to time. It states that trade flows are governed by relative advantage, not absolute advantage.
That is, a country can be worst in producing anything compared to a trade partner, but it will still export its least worst items to the trade partner and both will be better off as a result.
Intuitive help could be gained from the example in which Leonel Messi is better at football but he would still hire a secretary even if he would type faster than any of them because of the high opportunity cost (given his astronomical advantage in football).
Another intuitive help could come from imagining a country which is bad at producing anything and therefore importing a lot. But this leads to a hefty trade deficit, lowering its exchange rate until at least some of its products become competitive on world markets.
Spending versus earning
Here is Trump on the EU (our emphasis):
“If they retaliate, they’re making a mistake because you see we have a tremendous trade imbalance ... There’s very bad spirit when we have a big trade imbalance and they keep raising it so we never catch up. That’s not a good thing to do. And we have very, very strong measures that take care of that ... the numbers are so astronomically against them ... we win that war a thousand times out of a thousand.”... The US president, however, bluntly dismissed her complaint that it was wrong to talk of a trade imbalance as a question of national security. “It is national security, it’s our balance sheet, it’s our strength, it’s absolutely national security,” he said.
The US does indeed have a trade deficit with the EU, but is this the result of EU protectionism? The simple answer is no. Simple macroeconomic identities (that is, a relation that holds by definition as they are the result of accounting rules) argue that a trade deficit is the result of a lack of national savings.
As a country, the US spends more than it earns and the shortfall is financed abroad attracting savings from abroad, which are capital inflows. This puts upward pressure on the exchange rate, which causes the trade deficit.
This lack of savings can be caused by a public sector deficit and/or a private sector deficit: TB = (S-I) - (G-T). This is an identity (TB = the trade balance, S = private sector savings, I = private sector investment, G = public expenditures and T = tax revenues).
In fact, because the US is an attractive place to invest, with deep and liquid capital markets and well-defined shareholder rights, it tends to generate significant capital inflows, which are the real results of the trade deficit.
The funny thing is that Trump might well be responsible for increasing, rather than reducing the US trade deficit by means which are likely to escape his attention.
Take the tax cuts. These have at least four potentially negative effects on the US trade balance:
- Insofar as they lead to increased economic growth, they lead to increased demand for goods and services and hence increased demand for imports.
- Insofar as they lead to a larger public deficit, they further deplete national savings and lead to greater capital inflows (prodded by higher bond yields, for instance).
- Insofar as they lead to a perceived improvement in the business climate in the US, this might very well lead to increased capital inflows.
- Insofar as the tax cuts lead to higher economic growth, they lead to increased inflationary risks and might very well produce more aggressive Fed tightening, further increasing capital inflows and rising the dollar.
The business analogy which parts of the US administration uses like the US is losing because it has a trade deficit, and these must be the result of other parties cheating is simply nonsense.
The US has a trade deficit because others want to invest in wonderful capitalist America, more than Americans want to invest abroad. Simple as that.
Mind you, there could very well be cheating by others (the US itself is also not entirely free of that) but even if Trump manages to force corrective action, the US trade deficit won't disappear.
The US trade deficit will only disappear when US national savings increase, or when foreigners find the US less attractive to invest in. Simple as that.
That doesn't mean that trying to get rid of trade barriers isn't a lofty goal, but we've been pretty successful at that in multiple trade rounds since WOII on a multilateral, rules-based basis, which is now all in jeopardy.
Trade flows, deficits and surpluses are rather elusive for policy makers to get a grip on. We have already explained above what determines trade deficits and surpluses but suppose Trump's negotiating style actually gets concessions from trade partners like Mexico and Canada. Will that reduce the US trade deficit even with these countries?
No, not as long as the US still spends more than it earns (that is, has a savings shortage), and here is how that would play out, from CNBC (our emphasis):
The Mexican peso and Canadian dollar slumped Tuesday amid concerns any deal could be months away, and the U.S. may try to seek bilateral talks instead. The peso also was hit after Mexico responded to U.S. tariffs on metals with a list of tariffs on U.S. steel, apples, potatoes, cheeses, bourbon and pork, for which it is the largest export market.
You see, any of the concessions supposedly won in negotiations can quickly erode in currency markets.
No zero sum game
Here is Trump again:
“It’s not a question of ‘I hope it will change’”, he said. “It’s going to change, 100%. Tariffs are going to come way down because people cannot continue to do that. We’re like the piggy bank that everybody’s robbing. And that ends.
This is another way in which business analogies will trip up analysis is assuming trade is a zero-sum game, where our loss is somebody else's win, and the trade balance is simply the scorekeeper.
Trade is a positive-sum game. China exports a lot to the US, it gets richer as a result and because of that, it also imports a lot more, even if it doesn't import as much from the US.
More importantly, this also works in reverse, which we will discover at our peril if these trade wars start in earnest:
- Tariffs are simply a tax on consumers and domestic producers of imported inputs, so this increases prices and cools the economy all by themselves.
- They tend to disrupt the complex global supply chain, causing further disruptions.
- These disruptions also spread to other countries, as for instance much of what China exports in finished goods contains a high foreign parts content, especially in high-tech. Punishing China with tariffs also punishes Korea, Japan, etc., see figure below
- Then there is the retaliation. Other countries are not going to take this lying down, especially when they see the US actions as illegitimate (like the steel and aluminium tariffs on 'national security' grounds or tariffs on EU exports because of their VAT regime, which doesn't confer any competitive advantage, see below).
So trade liberalization is essentially a positive sum game, but the reverse is also true, which is why few countries grow rich under a protectionist regime.
But there are further enormities that at least part of the Trump administration seems to be wedded to, like VAT, managing bilateral trade deficits, and arguing trade deficit lowers GDP and jobs.
Here is Trump's economic plan:
Here is the key unequal tax treatment issue: While the US operates primarily on an income tax system, all of America’s major trading partners depend heavily on a “value added tax” or VAT system. Under current rules, the WTO allows America’s trading partners to effectively create backdoor tariffs to block American exports and backdoor subsidies to penetrate US markets.
This is simply nonsense. Perhaps the fact that they are allowed under WTO (in fact most countries have a form of VAT or sales tax) which has been more or less a US creation might already point you in that direction, if not, here is Krugman:
Think about two firms, one domestic and one foreign, selling into two markets, domestic and foreign. Ask how the VAT affects competition in each market. In the domestic market, imports pay the border adjustment; but domestic firms pay the VAT, so the playing field is still level. In the foreign market, domestic firms don’t pay the VAT, but neither do foreign firms. Again, the playing field is still level. So a VAT is just a sales tax, with no competitive impact.
It's likely that when Trump rages about these high EU tariffs, given that EU tariffs are low, he's likely to talk about VAT. His own economic plan points to VAT as conferring an unfair competitive advantage to the EU.
Mercantilism gone wrong
Peter Navarro, Trump's trade adviser argues that reducing the trade deficit boosts GDP, dollar for dollar. Anything that reduces the trade deficit by $10B will increase GDP by the same amount. This is simply nonsense and frightening nonsense from such a guy who shapes US trade policy.
The general consensus of the responses summarized below is that both Navarro and Trump suffer from a massive “understanding deficit” about international trade issues (or “trade deficit disorder” as Stephen Roach describes it below), and deserve a failing grade for International Trade 101.
Another part where parts of the Trump team's profound misunderstanding about international trade shows up is their emphasis on correcting bilateral trade deficits, like the ones the US has with Mexico, China or the EU.
It seems that they will force China to buy more US goods (like agricultural goods, oil and gas), but that will not eliminate the US trade deficit, it will simply shift it elsewhere as long as national savings aren't affected (see above).
Others have done an excellent job of explaining the folly of targeting bilateral trade deficits. See for instance nicely summed up by the philosophy of money:
Trade wars and budget deficit arguments are even sillier than this. The unit of ‘nation’ or ‘public sector’ is ultimately arbitrary. We can break the economy down into cities (as Paul Krugman does here) or countries within a nation, observing that Scotland has a ‘deficit’ (and surplus!) with England. Every economic entity either spends more or less income than it receives – nations, governments, the private sector, firms, households. But why not break it down further – to individuals? Every individual runs a ‘trade’ surplus or deficit with the rest of the economy. The super-rich can run quite large trade surpluses – in other words, they sell far more to others than than they spend. Bill Gates runs a massive trade surplus with the rest of America. In fact, his cumulative trade surpluses are the reason he has accumulated $91bn in assets. He spends far less than he earns, he is huge saver.
If the most important US trade problem is with China and the concerns of safeguarding US intellectual property and opening up the Chinese economy more (even if its trade surplus has really come down from 10% of GDP a decade ago to a modest 2% of GDP today), the US has gone in a funny way about it.
Staying in the Trans Pacific Partnership would have created a trade block without China which would have significantly increased leverage over Chinese trade policies.
Upsetting Western allies by slapping tariffs on some of their exports for 'national security' reasons eliminates them as allies against China.
Fighting trade wars on so many fronts and upsetting so many trade partners (Canada, Mexico, the EU, China, other Asian countries) etc., could easily backfire.
Demolishing the rules-based international order
If the US can turn to protectionism on spurious national security grounds, this sets a dangerous precedent and perhaps the most lasting damage is the erosion of the rules-based international order on which US corporations have prospered and which are mostly of the US own design.
The EU doesn't charge high tariffs for US imports, VAT doesn't confer any trade advantage, eliminating bilateral trade deficits won't eliminate the US trade deficit, invoking steel and aluminium tariffs on allies because of 'national security' concerns, the US will "win any trade war" etc., etc.
The list of uninformed positions and communications on trade is large and growing, which leaves US trade partners with the vexing question of how to negotiate trade deals when one side simply gets basic facts wrong and doesn't seem to understand the basic mechanism determining trade flows.
Add to that the policy flip-flops (on ZTE, China tariffs, allies' exclusions from aluminium and steel tariffs, etc.) and the chaos inside the US trade team which consists of different factions and is directed by a President who is uninformed (or worse) and doesn't seem to know what he wants. From the FT:
Most of all, there is a president determined to keep his campaign promise to get tough on trade but with little consensus on how to proceed... Some experts say Mr Trump has become emboldened because few of his actions have created havoc in the markets. One person close to the White House says the danger now was that he was increasingly not listening to his advisers and was vaulting impulsively from decision to decision, sometimes without any vetting. “Even when his actions anger friends and allies, Trump doubles down, never admits a mistake or concedes a weakness. He has decided that he has to take the reins on trade himself,” he says. “Nobody speaks for the president on trade because he hasn’t empowered anyone. But he can’t even speak for himself because he hasn’t decided what to do yet.”
Or here is Bloomberg:
Parsing Trump’s statements on Nafta can by dizzying. On Friday, he reiterated a threat to quit the existing pact altogether if he doesn’t get his way, only days after Kudlow said Trump wouldn’t walk away. And after the Trudeau meeting Friday, the White House released a statement saying “the two leaders and their delegations are close to a deal,” while Lighthizer said a few weeks ago that the nations are “nowhere near close to a deal.”
Not inspiring much confidence.
Trade wars create disruption, job losses, inflation and a loss of confidence, although in principle, some of these effects can be mitigated by central banks maintaining overall demand, but this disruption is nevertheless going to bite.
No less a figure than JPMorgan's Kolanovic has tried to calculate the impact on US equities:
He estimates that US equities have already absorbed a 4.5% hit — give or take 1%. Applying that to current market capitalization, Kolanovic says this translates to $1.25 trillion of "value destruction" for US firms. For context, that's roughly two-thirds of the positive impact of fiscal measures. JPMorgan "A negotiation that includes bluffing/threats can be successful in a two-party negotiation setup, but is more likely to deliver self-defeating results in a complex system such as global trade," said Kolanovic.
There is no doubt this will be much worse should the trade tensions escalate.
The present US government is obsessed with its trade balance but there simply is no economic rationale for that. The US trade deficit is simply the result of the US being an attractive place to invest, which leads to capital inflows and a strong currency.
Changing trade deals aren't going to change this, much less any focus on bilateral trade balances. Any success there and larger deficits will simply pop up elsewhere.
There is a whole raft of communications from people included in US trade negotiations, the President very much included, that show a lack of even basic understanding of the underlying mechanism and even some of the basic facts.
As a consequence, the US government, insofar as it takes a unified and consistent position, is endangering long-term partner relationships with very little upside, and much downside risk.
It must be bewildering for the likes of Canada to be told their steel and aluminium exports are a US security risk or the EU being told their VAT system rigs trade in their favor. It's simply nonsense.
Comparing countries to companies can explain for much of the irrational trade positions the President takes so his business background could actually be a handicap here. Unlike companies, countries actually do not compete with one another, and the trade balance is an imaginary scoreboard, determined by other forces.
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.