World War II got off to a slow start. It officially began on September 1, 1939, with the invasion of Poland by German and Russian troops. The next advance was not until May 10, 1940, when Germany invaded Belgium, the Netherlands, and France. The eight-month interval was known by some as the “phony war,” given that there was no activity of any substance. This interval lulled some into thinking that Hitler would be satisfied with the conquest of Poland, and he was not seeking a larger involvement. History would prove such thinking wrong.
This past week something similar happened to the United States’ trade war with China. Negotiations have been going on for most of the duration of the Trump administration. Last week, there were talks of additional tariffs along with the hope of some rapprochement with China. The forces of additional tariffs won out, and now billions of dollars in trade between the two countries will be taxed at 20 or 25 percent.
The trade dispute reflects a long-held view of the President of the United States that a trade deficit in goods between countries amounts to some sort of weakness on the part of the country running the deficit. Thus the trade deficits of this country were the result of a failure to impose an “equalizer” in the form of a tariff to protect domestic manufacturers against unfair foreign competition. With much lower wages and living costs, goods made abroad undercut domestic competitors, and this resulted in bankruptcies and the migration of factories abroad to obtain lower wages with US ownership. In much of the rural areas and especially in the rust belt, this scenario by candidate Trump resonated. A promise to bring the jobs back from abroad and in doing so, “Make America Great Again” (MAGA) propelled him into the Oval Office. Attacking China is his effort to deliver on his campaign pledge.
The trade issue resonated on other levels as well. For those worried about America’s place in the world, suppressing China seemed easier than competing with it, especially if a person believes that China does not play fair. The fear of being overtaken by another country fuels much of the xenophobia that some feel is necessary for survival. The problem is, if both sides are xenophobic, who is left to express reason?
Economists who advocate unhindered trade speak of comparative advantage. If one country can make textiles more cheaply, let them. Their wealth generation will make them buyers of wine, technology, and software from affluent countries. Both sides benefit because they are producing for others what they do best.
The current plan to place 20 or 25 percent tariffs on almost all trade between China and the United States negates the idea of comparative advantage. The Chinese will pay more for goods made in America, and Americans will pay more for goods imported from China. Up until now, non-consumer goods had most of the imposed tariffs, or intermediate goods, which are used to build something else. Because of this, tariffs have been slight to non-existent for most consumers. That is about to change.
First, understand that a tariff is a tax paid by the consumer of the importing country. The Chinese government does not pay tariffs. American and Chinese consumers pay them. For this reason, when introduced into the mainstream, they are considered inflationary. Especially hard hit are fungible goods like farm products, which any competing country can provide.
One idea is that by slapping tariffs on Chinese goods, the US will encourage cheaper imports from other countries. However, the data so far shows that the output from competing countries winds up priced as if also carrying the tariff, with the difference pocketed by the non-Chinese manufacturer. In a similar vein, domestic producers will raise their prices by the amount of the tariffs to fatten profits, secure in the knowledge that so long as tariffs exist that the excess profit will flow to them since they no longer have Chinese competition breathing down their necks.
Do tariffs lead to higher employment? Not really. While there has been a revival of some steel mills here, companies who have to pay 25 percent more for expensive steel suddenly realize they cannot compete with non-Chinese imports and lay people off. Job gains and losses net out to close to zero.
Finally, are tariffs inflationary? Yes, very much so. Especially after the decision this week to impose 20 or 25 percent fees on a broader sweep of goods, the price increases imposed by tariffs will be impossible to avoid. Like World War II, the beginning was slow, but the pace going forward will be much faster. Like any war, there will be a lot of collateral damage. Historians will tell us if it was worth it.
It is probably a source of great frustration to the President that he cannot call for an election now. With low unemployment, low inflation, and high numbers of job creation, Trump would seem to have economic data for another four years.
Alas, the elections are not for another 18 months. In that time, almost anything can happen, and almost anything will. Economic data is positive, but there is always the problem of the implication of the budget deficits, tariffs, immigration, etc. Whether the President can skate by on these issues until November 2020 is anyone’s guess. Economic forecasts now call for a slowing but still growing economy for the balance of the year. Until 2020 becomes more focused, we will stay with the trend of slower but steady growth.
Interest rates continue to stay low, in the process fueling everything from stock prices to private equity takeovers. An obsession with letting the inflation rate dictate the prevailing interest rate has resulted in very low rates for some time, to say nothing of a valuation bubble in certain financial assets.
The prevailing talk is for the Federal Reserve actually to cut interest rates sometime this year, a view embraced by the administration’s spokespeople, who want cheap and abundant money to be flowing come election time next year. The Federal Reserve is not on board for such a cut, making it problematic.
With the trade war now open and raging, the currently subdued inflation is kindling searching for a match. A cursory stroll through a Walmart or Costco will confirm how much the US imports from China.
An excellent preview of the inflationary effect of tariffs comes from the washing machine industry. With 25 percent duties put on imported washers and dryers early on, unit volume of laundry appliances is down five percent compared to last year, while prices are up seven percent.
The May 13th decline of some 2.4 percent in stock prices underscores the attention investors give the world outside our borders. Already the President, who yesterday said that hiking tariffs were a foregone conclusion, is now saying that he has not decided to raise tariffs on some $325 billion in Chinese imports from America.
As a world leader, you can only change your mind so many times before people begin to lose faith in your ability to mean what you say. Trump continues to insist that China will pay for the tariffs. The reality is that the American people will pay in the form of higher prices for any number of items they buy. They will pay more for the imports of other countries as well as the output of domestic producers, both of whom will have less competition.
Whether cooler heads will prevail is not known. What is known is that the country cannot continue to live in a state of perpetual crisis, especially of our own making. If the future cannot become more stable, stock prices will suffer. Markets are incredibly adaptable, but they need a given state in which to adapt. We are not getting that.
Warren M, Barnett, CFA
May 14, 2019