Eight weeks ago, economists did not rank a trade war as a significant disruptor of the US economy. Now, many economists think the trade war policy, engaged by the current administration, may put not only the US but the rest of the world into recession.
This has come about due to a president who has for years believed that the US got the short end of the stick on global trade, witness the deficit the US has with the rest of the world. In a way, this position should come as no surprise, as Trump ran on reducing the trade deficit in the industrial heartland, where factory after factory was shuttered as production was shipped abroad. While the overall economy benefitted from lower prices on imported goods that were made for less than could be produced domestically, specific groups of workers suffered as facilities were closed and production transferred elsewhere. The inability or unwillingness of the US government to retrain production or otherwise soften the blow of taking production offshore is one of the missed opportunities of this situation.
Now, a president who has firmly believed that the trade imbalance needs to be addressed is advised by an economics professor, Peter Navarro, who has little professional following and whose ideas are promoted by Commerce Secretary Wilbur Ross, who made his fortune buying up small steel mills and breaking unions to make them profitable. This being the Trump administration, Ross still owns them. This trio reminds you less of a brain trust and more like the cast of characters of The Mouse That Roared, a movie starring Peter Sellers if the country they led was the United States with an inferiority complex.
So the president starts off by ordering tariffs of 25 percent on imported steel and 10 percent on imported aluminum. When it was discovered that the biggest sources of such imports were our allies, exemptions were carved out. Then, the president decides to slap tariffs on $60 billion of imported Chinese goods. While the specific goods have not been listed, it is assumed that auto parts, furniture, and the like will be included.
The futility of these moves should be obvious to all. Trying to target specific goods from specific countries is difficult at best, and perhaps counterproductive. Chinese electronics will now perhaps come labeled as from one of the Southeast Asian countries, such as Indonesia or Vietnam, avoiding duties in the process.
Trump has tried to legitimize his tariffs by saying he is punishing China for taking trade secrets from the United States. The problem is, stealing trade secrets goes back to the Industrial Revolution when Britain would pay Italian workers to smuggle out drawings of textile looms so that they could be replicated and improved upon in the United Kingdom. Later, a young US did the same thing to the UK. The way a country stays ahead of those stealing trade secrets is to innovate at such a rate that the purloined data is overtaken by new ideas. A country can also seek redress through the World Trade Organization (WTO), a body that Trump neither considers nor respects, being international in scope.
The second aspect of trade is the changing composition of it. Ten years ago, the United States imported ten million barrels a day of oil from other countries. Soon, we will be net exporters. Yet the overall trade deficit has widened slightly, due to the expansion of trade in other categories. Thus the futility of targeting specific items for tariffs.
Finally, consider the role of fiscal policy in trade. As the federal deficit increases, the need to market US government debt abroad rises. The only other option would be for Americans to buy more debt by saving more, which would trigger a recession given the lower resulting consumption. To put dollars abroad that can purchase our debt, a trade deficit is required. Seen this way, we export our government’s deficit, and import foreign goods to give other countries the funds to buy our debt created by the deficit. Thus, a key component of a trade deficit reduction is an equivalent decline in our federal deficit. However, the government deficit is scheduled to go up and not decline, so our need to import more goods than we export is increasing and not decreasing.
Seen this way, the trade war is self-defeating. Even if we did succeed in reducing our trade deficit, the result would be higher interest rates, as an inducement to raise domestic debt demand would be needed to offset the decline in foreign US debt purchases. Add to this the fact that there are not nearly enough workers to produce what is imported, the strategy is an invitation to disaster.
For a president who cannot be bothered with details, all this is of no account. Couple this with the appointment of a National Security Advisor, John Bolton, who as recently as four weeks ago advocated in print a pre-emptive strike on North Korea. He has also favored canceling our treaty with Iran so that their return to constructing nuclear weapons can be used as a pretext for military involvement there. Markets are nervous. They should be.
The economy continues to do well. We are expected to generate growth, net of inflation, of close to three percent this year.
The problem is, to attain a balanced federal budget, economic growth of four percent per year was forecast by the Trump administration for each of the next ten years, on average. This was the rate of growth needed to offset the decline in revenues from his tax cut package. After this year, the limitations of the number of workers and the forces of demographics are predicted to cause the economy to decelerate. Decelerating growth means declining tax revenue growth and higher deficits.
Interest rates are set to rise, as the Federal Reserve tries to offset the inflationary effects of higher stimulus with higher interest rates, so as to reduce demand before inflation becomes an issue.
While the number of increases by the Fed has recently been predicted to be four this year, with one having already occurred, the number and size will probably be predicated on events not yet evidenced. With almost no one in Washington to practice fiscal responsibility, it has fallen on the Federal Reserve to use interest rates as a way to control demand.
This is the opposite tack of eight years ago when then-President Obama wanted to stimulate the economy with higher deficits. The Republican opposition, preaching fiscal rectitude, would not hear of it. Thus, the Fed had to lower interest to almost zero to stimulate demand. A different president, a different party in control, a far stronger economy, and a Federal Reserve taking the opposite strategy from the recent past.
Inflation, which most have experienced for years, is finally becoming an issue for the government. Previously, inflation was occurring more in services than goods. The government is fairly good about tracking inflation in goods. It is less successful tracking inflation in services.
However, with energy prices ascendant, a falling dollar causing imports to rise in price, and a tighter labor market prompting pay raises, inflation is getting to the point that it is too pronounced to be ignored by government data. A case in point: the average price for a new car sold is more than $900 higher than last year.
As previously mentioned, higher inflation rates prompt the Federal Reserve to raise interest rates at an increasing rate to stay ahead. Perhaps the most vulnerable casualty of this is the federal budget, as higher interest rates increase the size of the federal deficit. The Federal government is the largest debtor in the world and thus pays more as interest rates are increased.
The Stock Market
After finishing its first down quarter since 2015, the stock market would seem to be ready for a comeback. The problem is, much of the decline came from over-valuation of certain tech stocks like Facebook and Google, along with the negative remarks by Trump on Amazon.
The tech leadership of the stock market has been challenged. Since these firms are so large, their direction can influence the broad indexes. Whether the aura of this group has been broken will be seen with time.
In the meantime, there are a number of stocks that are selling for far more reasonable multiples than the overall market. This may be where the new leadership will come from.
Warren M. Barnett, CFA
April 2, 2018