"When a country is losing many billions of dollars on trade with virtually every country it does business with, trade wars are good, and easy to win." This tweet from President Donald Trump in early March sent chills through markets.
The consensus among economists is that these conflicts can in fact be deeply damaging. It is true that large trade imbalances between countries can, in some cases, store up trouble for the future. However, tariffs provide a poor remedy for this affliction, with far more effective policy remedies available.
The U.S. has a long history of employing trade tariffs. The first tariff law passed by Congress under the newly ratified constitution came into effect in 1789, explicitly aimed at raising revenues for the federal government and protecting domestic industries.
This ominous start proved prescient. Indeed, in 1821 nearly all imports (96%) were taxed and the duties imposed equaled 45% of the value of these goods. Research from Dartmouth College suggests that these measures likely weighed on growth, as higher prices for imported capital goods discouraged investment. Indeed, it found that productivity growth was faster in those sectors not affected by tariffs.
For the next 100 years tariff rates in many sectors remained elevated, although an increasing number of imported goods were exempted as global trade grew in scale and scope. However, old protectionist habits die hard. The infamous Smoot-Hawley Act started life as a tariff bill aimed at protecting the struggling agriculture sector, but quickly grew arms and legs as pork barrel politics set in. When passed in 1930, this raised import duties on over 20,000 agricultural and industrial imports. This aggressive protectionist shift was met with reciprocal action from many trade partners, exacerbating the large declines in global trade seen during the Great Depression.
The Smoot-Hawley Act provided something of a nadir for 20th Century trade policy, and was followed by a long period of broad-based liberalization. However, there have been bumps in the road. In 1971, President Nixon briefly imposed a 10% surcharge on all imports as part of a range of policies that have been collectively become known as the “Nixon Shock.” More recently, President Bush imposed tariffs on steel products in 2002. However, these were abandoned in 2005 amid criticism that the policy was costing rather than savings jobs – employees in steel-using industries outnumbered those in steel-producing industries by 10 to one.
Certainly the precedent around trade conflicts does not look good. Economic theory tells us that while trade barriers may protect industries and raise revenue in the short term, these gains are smaller than the costs from higher prices and less choice for consumers and businesses. Moreover, tariff distortions reduce the extent to which countries can specialize in areas in which they have comparative advantages. The upshot is weaker productivity and slower global growth.
In the context of a long history of U.S. tariff measures, the latest trade spat looks mild – thus far. The U.S. administration kicked off the year by slapping tariffs on certain washing machines and solar panels. It followed this up with new measures on steel and aluminum imports. While this sounds alarming, these products only account for around 2% of total imports and 0.2% of U.S. GDP. Moreover, countries supplying around two-thirds of U.S. steel and aluminum imports have been (temporarily) exempted from these measures, blunting their impact.
Deal or no deal
Perhaps most worrying has been the building trade tension between the U.S. and China. Following a Section 301 investigation, which found China guilty of intellectual property theft, the U.S. has proposed tariffs of 25% on $50 billion of goods imported from China. In addition, the president has warned that another $100 billion of goods will face these taxes should China reciprocate. Non-tariff barriers to trade and investment are also starting to emerge. The U.S. Commerce Department announced a ban on U.S. firms selling components and equipment to the Chinese state-owned telecoms giant ZTE.
Perhaps most worrying has been the building trade tension between the U.S. and China.
However, at the time of writing, the president seemed to walk back this proposal, to the surprise of many. Elsewhere, the Committee of Foreign Investment in the US (CFIUS) has halted a string of foreign acquisitions of American firms by Chinese Investors over the past 18 months. Furthermore, Congress is considering legislation which would expand CFIUS’s remit to cover outbound investments and joint ventures.
While these trends are worrying, the U.S. and China are actively engaging in trade talks before tariffs come into force and the hope remains that an agreement can be found. While rhetoric has been increasingly aggressive, both countries are likely to be aware of the damage done to all parties in past trade conflicts. Our central expectation remains that recent trade frictions do not escalate significantly, leading to only modest changes in the global trade environment. However, the risks of a more disruptive trade conflict do seem to have increased.
A difficult balancing act
While we would not agree with the cure proposed by President Trump, it is true that the U.S. and sections of the global economy continue to show large and persistent trade imbalances. Indeed, the latest International Monetary Fund (IMF) external sector report lamented that while global imbalances have narrowed since the financial crisis, they remain large. In some cases, these imbalances may be natural consequences of demographics or local investment opportunities. However, they are often a signal of more unhealthy distortions in the domestic economy such as excessive credit growth, fiscal imbalances or currency manipulation. Addressing these distortions could help cool protectionist sentiment among those countries running large and persistent deficits.
In practical terms, there are a number of things the U.S., China and other countries could do to address these distortions. A tighter domestic fiscal policy would help narrow the U.S. trade deficit, which is likely to rise over coming years as an overheating economy sucks in imports. In China, policymakers could look to provide more of a social safety net, allowing households to save less and spend more. In other surplus countries like Germany, a more expansive fiscal policy could raise domestic investment and growth, helping to moderate the enormous trade surplus. The catch is that these macro policies require cooperation across a range of economies, which looks sadly lacking in the current environment.
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Companies mentioned for illustrative purposes only and should not be taken as a recommendation to buy or sell any security.