After the opening trade salvos, the big guns are readying

Protectionist measures are negligible so far but markets are now focusing on escalation.

With the US fiscal stimulus now implemented, and the North Korea summit deemed successful, the Trump administration is turning its full attention to the next elements in its midterm election strategy: immigration control and large scale protectionist measures aimed at China, Nafta and the EU. In short, reverse globalisation.

The initial trade salvos from the White House have been modest in scope, and well targeted to inflict little damage on US consumers. But, in the last week, American threats have escalated markedly and financial markets, especially in Asia, have started to pay more attention. Talk of this developing into a full scale global trade war is no longer regarded as completely fanciful.

Of course, President Trump’s unsettling negotiating style deliberately lurches from one extreme to another, making frequent surprises inevitable. Today’s worst enemy becomes tomorrow’s best friend, with very little in between.

But the longer-term trend does not look very reassuring. The President’s trade team has been building a consistent narrative about China’s “unfair” trade practices and its “theft” of American intellectual property for over a decade. This seems to be conviction politics, which will not disappear on a whim.

 


 

So far, the specific 25 per cent tariffs announced by the US Trade Representative cover $50bn of imports from China, to be introduced from 6 July onwards. China has announced retaliation on a similar scale. The economic impact will be negligible.

Last week, however, the President indicated that, if China does indeed retaliate, he would ask the USTR to widen the tariffs to cover a further $200bn of imports from China at a 10 per cent rate, with another $200bn waiting in the wings.

In addition, the US is threatening measures under the Article 301 investigation into China’s alleged misappropriation of intellectual property, and separately has issued threats to impose 25 per cent tariffs on about $360bn of US auto imports, including those from China and the EU. Announcements along these lines now look almost inevitable this summer.

The first $50bn of Chinese imports into the US is equivalent to only 0.2 per cent of US GDP in 2017; the next $400bn against China would take the total to 2.2 per cent; and the tariffs on global auto imports would raise the overall figure to 4.1 per cent of US GDP, a number that is hard to ignore, even if it takes effect over several years.

President Trump's Main Threats of Escalation of the Trade War

The initial effects of these tariffs, which together would probably involve an average tariff of 17 percentage points on a third of US imports, would be to directly increase the US consumer price index by over 1 per cent, a headache for the Federal Reserve. This inflationary effect would probably be mitigated by a rise in the dollar as the US trade deficit shrinks.

This may not seem too bad, but other countries would almost certainly ramp up their retaliation, damaging output and employment in the US economy. This, and likely confidence effects in asset markets, would obviously pose large downside risks for US GDP growth well before the end of President Trump’s first term.

The end game is hard to predict. In previous articles (here and here), I suggested that a full scale global trade war, involving tariffs at 10 percentage points on all traded goods, could reduce the level of global GDP by 1.5-3.0 per cent cumulatively over many years. The hit to US GDP would be of a similar magnitude. Confidence effects and dislocation to production as global value chains are disrupted could increase this further.

This is a major shock, but it is worth noting that, even in a fairly extreme scenario, the effects of a trade war would probably not be as large as the damage done by the Great Financial Crash, which caused a drop in GDP in the advanced economies of about 5 per cent on impact.

 


 

What are the risks of this major escalation actually taking place?

Paul Krugman, in a brilliant analytical piece, reminds us that large countries like the US always have a self-perceived incentive to impose very high tariffs, because they are powerful enough to force other economies to accept lower selling prices to mitigate the fall in their exports when tariffs are levied. Viewed myopically, this increases real incomes in the US as American import prices fall relative to export prices.

The so-called “optimal” tariff maximises these gains, after subtracting the longer term losses to economic efficiency from the tariff. Recent studies suggest that “optimal” tariffs could be huge, with Krugman’s best guess being around 40 percentage points on all goods.

However, this reckons without the effects of retaliation from other large economies. Both China and the EU face exactly the same incentives as the US and could impose large tariffs on imports from the US, reversing some or all of the theoretical American gains. Everyone is worse off.

In a co-operative equilibrium, all large countries would understand the co-ordination problem and therefore agree to impose very low tariffs. That is how the global trade system was established after the second world war.

However, in a Trump-style competitive trade war, the result could easily be a bad equilibrium in which everyone imposes very high tariffs forever. In Krugman’s nightmare scenario, global trade could shrink by around 70 per cent, taking it back to its 1950s share of GDP, even though GDP itself would fall by only a couple of percentage points. Global onshoring would be the dominant economic force of the 2020s.

 


 

Fortunately, there are many political and economic countervailing forces that should kick in well before the pessimistic end game is approached. A trade war inevitably results in huge losses among export sectors inside all the large economies (for example, steel producers in China, car manufacturers in Germany and soyabean growers in the US). These interest groups, both businesses and employees, are certain to become extremely vocal very quickly, and they should start to have political clout before too long.

The entrenched business interests that created globalisation in the first place will surely not remain passive while the postwar economic edifice is deconstructed in front of their very eyes. That, anyway, is the optimistic bet that the markets are still making.

 

 


Disclaimer

Source: This note is based on material which appeared in an article by Gavyn Davies published in the Financial Times on 24 June 2018.
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