Sunday, July 8, 2018

The Tariff Wars Begin

By Roy C. Smith

Officially the trade war with China has now begun as the first wave of tariffs has been imposed and retaliated against. Escalation is likely to follow. Except for Peter Navarro, no serious economist thinks tariff wars can be anything but lose-lose exercises.  Anyway, the timing is all wrong.  

Rising costs in China have made their export machine less competitive with other Asian countries, and China is trying to shift its economy to one with more domestic consumption. Indeed, Chinese exports have dropped from 68% of GDP in 2009 to 38% in 2017 and in Feb 2018, China’s current account balance (goods, services and foreign income) was a $25 billion deficit. This was probably a temporary event, but it signified that China is being driven by market forces to becoming less dependent on exports.  Indeed, as its export capacity declines, China must develop its domestic consumption and employment base to sustain even a (modest for China) 6% growth rate. China’s most important economic initiative – its “Made in China 2025” program that aims to develop the country’s domestic technology industries -- is an example of how it is trying to restructure the economy.

Meanwhile the US economy is recovering. Inflation remains relatively low despite considerable fiscal and monetary stimulus, and unemployment is the lowest since the 1970s. Much of China’s trade surplus is the result of the global supply chain developed over the years by US companies to improve their competitiveness and lower consumer prices. China also invests most of its surplus in US government and other securities and in direct investments in US companies and factories.

All things netted out, China does not pose a threat to the US economy.

So why is Mr. Trump doing this?  There is the “base,” of course, but there are probably more Trump supporters among the customers of Walmart than those whose jobs were lost because of China’s exports.  Whatever the base may believe now, the history of tariff wars is that they hurt people from the working classes (i.e., the base) more than anyone else.  

Mr. Trump invented the China threat, then promised to remove it by negotiating a better deal.

Well, there is room for improving our bi-lateral terms of trade and investment with China, even if they are not essential to our own well-being. Most serious economists believe that while tariff wars are not a good way to settle things, they may be effective as bargaining chips to gain concessions that otherwise might never be given. And the concessions Trump seems to have in mind could be good for all Americans.  Martin Feldstein, an eminent Harvard economist and former Chairman of the Council of Economic Advisers under President Reagan, in a recent op-ed in the Wall Street Journal, points out that if the tariff bargaining chip could be traded for China’s dropping its requirement that US companies doing business in the country have a Chinese partner to whom it must divulge its latest technologies, this alone would be worth all the fuss that departure from international economic orthodoxy has created.

There is a lot more to negotiate as well. Opening of Chinese markets to financial and other services, agreeing to acceptable governance structures for overseas investments, and perhaps most important, limiting government subsidies to state owned enterprises that compete in markets with private companies.  This last one is an especially tough one because there are 150,000 state owned companies of various sizes in China, and even those that are not state owned are beneficiaries of China’s command system for allocating economic resources.  The Made in China 2025 initiative, Mr. Trump suspects, will be laden with direct and indirect subsidies for the technology companies China wants to support.

But negotiations appear to be on hold – not much is happening as the initial tariffs go into effect. China had previously indicated a willingness to discuss many of the demands that the Trump team presented on its two-day visit to Beijing in May, but since then China and most other observers have been searching to learn what the Deal King’s real objectives are.  In the meantime, things are marinating in an environment that seems to favor the US. The US economy may produce a growth rate for the second quarter as high at 4%, and its financial markets and the dollar are strong. China’s stock market, on the other hand, is down 17% this year and the yuan dropped 3.6% against the dollar just since the beginning of June. China’s growth rate is decelerating, despite easy credit conditions, too much debt and too much of it in danger of default. The US is China’s largest export market, and tariffs will slow growth further.  Mr. Trump is probably just waiting for China to blink first.

The situation, however, also presents a great opportunity for the developed world (i.e., the US, EU, Canada and Japan) to present the budding Chinese colossus with a common front to set new trading and investment rules for the next decade. The new rules would update the lax ones that China has been able to get away with since joining the World Trade Organization as a developing country in 2001. If China wants to avoid tariffs in all the world’s largest markets for its goods and services, and have free access to investments in these markets, it needs to make some reciprocal concessions. Negotiating as a bloc would increase the group’s bargaining power to levels China could not resist.

But Mr. Trump is not big on multi-lateral economic agreements such as the Trans Pacific Partnership or NAFTA and he has unilaterally imposed tariffs on steel and aluminum exports from the EU, Canada and Japan.  Nor is he much interested in strengthening and modernizing the World Trade Organization that the US established in 1948 to expand world trade.  Trade now accounts for 60% of global GDP – but it is almost entirely multi-lateral, not bi-lateral as Mr. Trump seems to think.

Nevertheless, Mr. Trump is likely to agree something with the Chinese that he can claim to be a victory, probably just before the mid-term elections in November.  He has already deferred the NAFTA negotiations “until after the mid—terms,” so it is clear he has them in mind, but he might have been better off to have wrapped up NAFTA before the new Mexican president, a populist- socialist assumed office.

He is also waiting for the EU to offer to drop tariffs on imported cars from the US from 10% to the US rate of 2.5%, in exchange for removing the steel tariffs. This seems likely, but relations with the EU have soured significantly since Mr. Trump’s withdrawal from the Paris Environmental Accord and the Iran Nuclear Agreement, and his threats to reconsider NATO if the members don’t increase their contributions to it. There is also the effect of US sanctions on EU businesses doing business with Iran, which are scheduled to go into effect soon even though Europe still maintains the agreement.

The market appears to believe that Mr. Trump’s opening salvos in his multiple trade wars will end up in deals that may provide some marginal gains to the economy, or at least not hurt it very much.

But there is a deeper downside. If, annoyed and humiliated as some of our major trade counterparties may be, they may come under political pressure to push back harder than Mr. Trump expects and not do the deals he wants. There may be a lengthy standoff that could decrease US exports, increase the cost of imports, screw up corporate supply chains and earnings, and slow down foreign direct investment, which together could materially slow US growth in the latter part of 2018 and 2019, when current growth forecasts begin to turn back to the 2% level. Similar, possibly worse, effects could occur outside the US, jeopardizing global growth and triggering a global market sell off, all of which could be blamed on Mr. Trump’s policies.

So far, markets have believed that Mr. Trump’s actions have been part of a broad ranging plan to renegotiate the US’ economic relations with the world, from which no serious harm is likely to result. But if it turns out that there really is no master plan and he’s just winging it, then the emperor may be seen to have no clothes after all, and a major market reaction could result.

As Mr. Trump often says, “we will just have to wait and see.”

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