… Ready to Go.
In the last week, there have possibly been more articles written on protectionism than the number of tariffs ever implemented.. and that would be going some. The debate engendered by Donald Trump’s steel and aluminium tariffs, that subsequently led to the resignation of his free trading economic adviser, has certainly become very heated. Why? It is symbolic of President Trump’s forthright domestic and international agenda and the world’s opinion of his ‘ Make America Great Again’ strategy. It is certainly at the forefront of a world stage that has once again been fired up. This week’s newsletter explains the reasons why and how this affects markets. And yet it is easy to overstate and draw too many conclusions from this probably first protectionist act that saw Gary Cohn fire himself.
There are normally four, and in this instance five, reasons why any leader would go down the protectionist route:
Donald Trump used an executive order to impose tariffs citing foreign countries’ trade practices with the US as a threat to national security. Trade has been the lifeline of many countries in the modern era and manipulation of trade therefore a strategic weapon. The level of trade and therefore presumably the power of protectionism as a weapon has grown significantly since 1960.
Donald Trump certainly sees protection of domestic industries against alleged unfair trade as a weapon to redress an economic imbalance between other nations and the United States. “Trade wars are good, and easy to win” But he also aims to shift the political balance of power back to America.
Just as sanctions, against the likes of Iran, can be a guided economic missile with a political intent so too trade barriers to the world’s largest economy. Tariffs or also quotas, when combined with possible exemptions (Canada and Mexico), are a means of divide and rule. By bestowing the American equivalent of the WTO’s ‘favored’ or unfavored status, Trump is effectively saying you are either an economic ally helping us make America great again or you’re against us.
There has to be admiration for such patriotic conviction and confidence. But there also have to be concerns about the consequences of such nationalism: tension and escalation. The renowned economist Robert Shiller described the tariffs as the ‘’first shot in a war’. “I’d wonder if this isn’t just a first step, that Trump has in mind raising other tariffs. Even if he doesn’t there will be other countries who will retaliate and they’ll get bigger. That’s what happened in the Great Depression” [of the 1930s].
Other things being equal, the normal three step market response would be an immediate shock stocks and dollar down, commodities and bonds up. But as the near term expectation of possibly growth and certainly inflation kick in, then stocks and dollar would rally as would commodities and yields. Its only in the medium term that you would expect stocks, yields commodities and the Ddllar to fall depending on the scale of the economic fallout. The fear is clearly an economic parallel to the Eisenhower and Dulles’ escalation policy of ‘massive retaliation’ in the 1950s that entrenched the Cold War. The current reality is more akin to Kennedy’s flexible response to match and redress the imbalance. Either way, Donald Trump is raising the ante.
The ostensible aim of the steel and aluminium tariffs is to protect domestic industries against unfair foreign competition. The revitalization of US manufacturing is a main plank of Donald Trump’s industrial policy. Although the manufacturing sector continues to grow at a faster rate than the economy (2.8%) the number of blue collar workers who elected him has steadily fallen in the last two decades (34% decline from 1998 to 2010). The reason is mainly due to increased overseas outsourcing due to the previous relative strength of the dollar, or the weakness of manufacturing competitors’ currencies. Donald Trump previously claimed that China artificially undervalues its currency and gains an unfair competitive advantage by 15-40 percent.
One possible use of protectionism is to rebalance a domestic not just a global economy. Although Donald Trump appears better disposed to struggling manufacturing than the buoyant e-commerce sector, no such claim can reasonably be made within manufacturing. But that is or should be an inevitable consequence of favoring certain manufacturers. Steel and aluminium production represents about 0.33% of GDP but a disproportionately higher amount of the presumably more expensive steel or aluminium is used in production. You would therefore have expected the likes of US Steel to have risen against such stock as Ford Motor company. The short term reaction to Trump’s announcement has been the opposite. A classic case of our ‘buy the rumor, buy the fact oops sell’ ?
Certainly this has been the effect for those following or trading those shares and would apply as well to the general index reaction not just to the announcement but also Gary Cohn’s resignation that has been touted since last August. But that is typically just a variation to the short term reaction and has little bearing on the near to medium term. The further one goes out in time the more important the fundamentals and hence the consequences become.
Before income taxes were introduced in the nineteenth countries were reliant on tariff income as the main source of government revenue. Economic cost benefit analysis of tariffs in this sole respect shows they are no longer effective. Indeed the proposed tariffs (if they had no effect on the level of imports) would contribute 1.05% or $8.84Bn to the deficit of $833Bn. Ironically where Trump’s tariffs may have a budget effect is allowing him to pursue a moe rigorous agenda (see Domestic Policy).
The three economic goals of protectionism are:
1. Self sufficiency. Since globalisation and a prolonged period of ‘world peace’ the need for self sufficiency has decreased. Dependency on any one or small group of nations does however leave a country more vulnerable. Canada’s pivotal role in the current steel tariff episode, its membership of NAFTA and the reaction of the Canadian dollar to the initial tariff announcement and then possible exemption shows the risk of over-dependency. About 20 percent of Canada’s GDP comes from goods exported to the United States. It is the US second largest trading partner after China, 16% of U.S. exports go to Canada which is the number one export market for 35 U.S. states and may explain the immediate backlash from even Republican congressmen to the Steel tariffs. The $12.1bln US trade deficit with Canada represents only 2.4% of the total deficit.
2. Reducing Trade Deficit. Protectionism is one of several remedies to a potentially destabilizing increase in the trade deficit by making imports more expensive. In 2017 the Trump strategy appeared more inclined to talk the dollar down to achieve this result. This served as a useful stop-gap until fiscal expansion and consequent economic growth was able to replace the missing manufacturing jobs but has had little or no effect on a deteriorating trade deficit. Indeed a further fall in the dollar could become counterproductive as investors become nervous about the real value of their investment. Given Trump’s recent ‘Dollar will get stronger and stronger’ comments and the introduction of tariffs, you get the idea that the US administration, like us, think that point is now. Tariffs could be seen as the next best tool to reduce the deficit but would have to be on a much larger scale. The entire steel economy only represents 2% of US GDP.
3. Economic Growth and Full Employment. The aim of any economic policy is the pursuit or maintenance of economic growth and full employment. To the extent that protectionism can reduce economic threats and encourage synergies it can be significant in the near to medium term. However, history shows protectionism is not a long term panacea. Moreover in an economy like the US which is near or at full employment, it requires a sizeable increase in productivity and/or an unusually flexible labor force to prevent any gain translating into inflation rather than economic growth.
Domestic Political Power
Donald Trump has struggled to implement a radical agenda with only a small majority in congress. By instructing Commerce Secretary Ross last April to investigate the impact of steel and aluminium on national security it provided the President with the legal power under Section 232 of the Trade Expansion Act of 1962 to bypass Congress (the usual tax and tariff authority) and introduce tariffs under executive order. There is plenty of precedent for this in a century long transfer of tariff authority to the Oval Office eg Nixon cited the Korean War to impose a 10% tariff in 1971. But its significance is twofold. Firstly it has allowed him to implement a protectionist policy that Congress would not have passed. Many Republicans oppose restriction of free trade on principle; ironic as most of the protectionist Presidents have been Republican. Indeed 107 House Republicans wrote a letter of opposition to the President. Senator Jeff Flake said he would propose a bill to nullify the tariffs. “These so-called ‘flexible tariffs’ are a marriage of two lethal poisons to economic growth — protectionism and uncertainty “Trade wars are not won, they are only lost. Congress cannot be complicit as the administration courts economic disaster.” Such a Bill would require a two-thirds supermajority in both house to avoid Presidential veto, divisive and politically dangerous in a midterm election year.
And here is the rub and second significance. The President has struggled with Congress because he lacked leverage and his power of patronage has been somewhat tarnished of late. But he has shown willingness to compromise and water down radical proposals. Only a cynic would suggest tariffs are a hostage to fortune that he is willing to give up. But, as the protectionist policies tend to be short-lived (2002 Steel only last 20 months due to the threat of European retaliation), a watered down temporary version excluding Canada and Mexico may gain him bargaining power with Congress in other areas and further fuel the expectation if not reality of Trumpflationary growth. And that is a process that can be repeated for any other tariff he cares to introduce.
Trump’s agenda may appear simple but his political environment at home and abroad is not. So too protectionist measures. The effect they have on both international and domestic politics and economy is complex. The historical market outcome reflects this diversity.
Impact of Major Tariffs on DJIA 1900 to date
Impact of Major Tariffs on DXY 1980 to date.
Impact of Major Tariffs on US 10 Year Yields 1980 to date.
Many will tell you how the markets will react to Trump’s tariffs by dectuive argument in one aspect. And others will compare this tariff to a similar measure in a different time. But history shows it is rarely so clear cut. The underlying reasons and conditions and therefore reactions have varied. In next week’s newsletter we will use history to show a clear outcome. Markets will remain FIRED up for a considerable period to come.
“Fired up … ready to go” ? President Obama (Election 2008)
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