In his inaugural speech, President Trump pledged a “revolution of common sense”. However, as French Enlightenment philospher Voltaire warned, “common sense is not so common”. In his recent so-called Liberation Day presentation, Mr. Trump combined a misreading of history and poor economic analysis; unveiling “reciprocal” tariffs on the nation’s trading partners. The aim, we are told, is to prevent the most powerful and affluent nation in world history from being taken advantage of, and to “make America wealthy again”. Correctly, financial markets have interpreted this misguided initiative quite differently.
In this blog, I will challenge the fundamental assumptions of the US Administration’s trade strategy. The imposition of tariffs will not eliminate the US trade deficit, nor will the approach restore American manufacturing jobs. Potus 47 suggests the “short term pain is worth the long term gains”. But, he is only half right. Indeed, in the short term, full implementation of the plan will produce a one-time increase in inflation of at least 4%, and may well lead recession. In the long term, however, protectionism is a prescription for the misallocation of national resources and a prolonged period of stagflation, e.g. higher inflation and slower GDP growth.
The recent delay in implementation is welcome. However, I suspect the Administration is committed to this policy course. Likewise, I do not expect Congress, nor Mr. Trump’s like-minded, feeble Cabinet, to force a change of direction. Moreover, the genie can’t be put back in the bottle. The rules of the game have changed. To be sure, all countries post-Covid are paying more attention to securing supply chains (involving home-shoring, near-shoring, and friend-shoring), reflecting prevailing global geopolitical rivalries. However, tariffs have become tools of international diplomacy, and some US leaders do not believe expanding trade is win-win proposition. Therefore, additional financial market volatility and economic weakness will be necessary before this policy is altered.
Amidst all the uncertainty, I believe a Washington consensus exists to take a tough approach with China. Other Asian nations may also be vulnerable. On an optimistic note, I will offer an alternative course that might reduce the US external deficit, and contribute to America’s future prosperity.
Reciprocal Tariffs: Is America Being Ripped Off?
The notion that America is systematically being exploited by its trading partners is false. Indeed, the post-war multilateral trade regime has successfully produced low and quite uniform tariffs on manufactured goods worldwide (Chart above). To be sure, low-income countries often receive preferential treatment temporarily. Most people believe the reduction of poverty and greater prosperity amongst developing nations benefits all nations and promotes world security.
To be sure, important sectoral differences exist. Agriculture, for example, is shielded in many countries, while US tariffs on food imports are very low (Chart above). Levies are even higher in certain subsectors, e.g. dairy. The US administration has focused considerable attention on the automotive industry. To be sure, US taxes on foreign cars are lower than elsewhere (e.g. 2.5% compared to 10% in the European Union). However, the gap is far narrower in the transportation equipment sector more broadly (next Chart), especially amongst advanced economies.
As manufacturing tariffs are not the cause of America’s trade deficit, the much-hyped bilateral trade negotiations are unlikely to make a huge difference (although they will help appease Potus). Likewise, as most nations view agriculture as a strategic sector, trade liberalisation is unlikely (unfortunately). On the other hand, auto tariff reductions are quite possible, but the appetite for American cars (and food) in Japan and Europe is not great.
While reciprocity appears to make intuitive sense, e.g. tariffs are set bilaterally on a product-by-product basis, the notion has serious drawbacks. First of all, it’s too complicated. With 200 trading partners and thousands of products, Elon Musk won’t be firing any Customs officers any time soon. In contrast, the prevailing WTO trading system is based on a Most Favoured Nation concept. That is, all importing nations experience the same tariff rate, e.g. the lowest one offered to any country. Therefore, all importing countries operate on a level playing field (nondiscrimination), and face the same regulations as domestic producers. The system also allows each sovereign nation to protect specific sectors, if necessary (hopefully not often). In contrast, reciprocal tariffs are discriminatory, and nations lose the ability to shield key sectors. The MFN approach has long been considered the more optimal option.
Currency Manipulation: Systematic Advantage?
Mr. Trump has claimed foreign countries are purposefully undervaluing their currencies to gain an unfair advantage against the USA. Again, there’s little evidence this is occurring on a systematic basis. Indeed, the Chinese Yuan and Euro appear in line with their long-term fundamentals, while some key Asian countries are somewhat overvalued (Chart above). However, there are important exceptions. In particular, the Japanese yen appears very cheap (in response to past deflation), and Japan will be pressured to allow JPY to appreciate (now rising Japanese interest rates will help). Also, the Canadian dollar appears undervalued; having depreciated in anticipation of America’s more aggressive trade policy. Certain mismanaged emerging markets FX are deeply undervalued, e.g. TRY, BRL, and ZAR.
Conventional wisdom is America’s imposition of tariffs will lead to a stronger US dollar, as nations devalue exchange rates to regain competitiveness. I continue to doubt this will happen uniformly. First of all, USD is very overvalued, and I expect pro-growth Donald Trump would welcome a weaker dollar (Jerome Powell less so perhaps). As mentioned, JPY will be pressured to appreciate, and CAD is already cheap. On the other hand, the Mexican peso may be very vulnerable. Likewise, as I believe China will be America’s biggest target, I think CNY may undergo competitive devaluation. If so, other Asian currencies, especially VND, IND, THB, and PHP may be most at risk.
Who’s at Risk: China and Asia Likely Targets
Who are the likely targets of the Trump trade policy, and who’s most vulnerable (the answer is not necessarily the same). The primary targets will have large bilateral trade surpluses with the USA, show signs of imposing NTM restrictions on American goods and services, and perhaps those nations whose imbalance has increased since the Trump tariffs of 2018.
As tariffs do not directly alter the underlying causes of America’s external deficit, the levies are unlikely to reduce the worldwide shortfall. This is what happened follow the 2018 tariffs hikes. Indeed, despite the imposition of charges, America’s world-wide imbalance continued to increase. To be sure, as China was the primary target, the US bilateral deficit shrank sharply (Chart above). However, Americans simply bought stuff from other countries, and imbalances worsened significantly with Mexico, Canada, the EU, Vietnam, Taiwan, Korea, and Thailand (many engaging in the re-export of Chinese products).
The Chart above identifies those countries with whom the USA has large trade deficits. As tariffs and FX manipulation do not appear to be responsible, Mr. Trump has suggested non-tariff restrictions (NTM) are at play. As a deficit country, the USA has an export/import ratio below 100%. Countries with whom the US has especially low X/M ratios might be relying on NTMs.
Some implications? As China has the largest bilateral imbalance and a very low X/M ratio, I expect it to be American #1 target (Chart above). Likewise, other Asian countries have similar traits: their bilateral surpluses have increased in recent years, and many have been re-exporting Chinese goods to the USA. They too will be at risk.
On the other hand, while Canada and Mexico have large and growing surpluses with the USA, neither appears to impose widespread NTMs — their X/M ratios are near or above the US average. The same is true for the European Union. If common sense were to prevail, these regions should be able to appease the Trump Administration. But, as we know, common sense is not so common.
In addition to identifying likely targets of America’s trade policy, economic vulnerability will depend on how much trade each nation does with the United States (Chart above). Mexico and Canada, clearly, are most at risk. Likewise, many of the export-oriented Asian nations are heavily dependent on the US market. Countries with large domestic markets may be less exposed, e.g. India, Indonesia, Brazil, and China (despite being the #1 target). Given the enormous two-way trade flows between the USA and EU, Europe will push back on Trump’s tariffs. Meanwhile, the UK is less vulnerable as the USA runs a surplus with Great Britian.
Reducing Deficits & Creating Prosperity: A Better Way
The Trump 2.0’s trade plan will fail both to reduce the US trade deficit and to boost prosperity over the medium term. Fundamentally, America’s persistent external shortfall reflects the nation’s low savings rate compared to its trading partners (Chart above). Therefore, eliminating the red ink would require a combination of higher US savings and increased spending (less thrift) abroad. Cutting the runaway US Federal budget deficit would be a good place to start. To be sure, high and widespread tariffs could help reduce the trade deficit, but only at the expense of higher inflation and a consumer-led US recession.
The additional flaw in the Trump program is a lack of understanding of comparative advantage. The United States is a service-based economy — the sector represents 80% of GDP. And, America is very good at it. Services represent an increasing share of US foreign trade (Chart above), and will eventually surpass the amount of goods sold abroad.
And, barriers on US service exports are far more restrictive than those on US goods. America’s approach to service sector trade is more open than in other countries (next Chart). Greater attention should be given to liberalising trade in these businesses, where America enjoys a comparative advantage. The USA also has a competitive edge in technology and high valued-added manufacturing. Focusing on eliminating NTMs on US exports in these key growth areas should be a priority also.
I understand the political logic of focusing on Wisconsin dairy farmers and rust-belt states requiring economic transition. But, America’s future opportunities and prosperity lie in these rapidly-growing sectors. Education and training are critical components of America’s future success. Eliminating the Department of Education seems at odds with this goal. Over the medium term, American protectionism would lead to the misallocation of national resources; inevitably, leading to higher inflation and slower GDP growth.
Finally, the notion that foreign manufacturers will flock to the USA following tariff hikes is nonsense. First of all, other countries remain committed to free trade, and will deepen trade ties elsewhere, possibly at America’s expense. To be sure, America will always be a vital market for global firms. But, an ever-changing trade regime creates unwelcome uncertainty and weaker growth prospects. And, high US tariffs would restrict the supply of intermediate goods required by both foreign and domestic producers.