May 24, 2019 by In the long run

Trade Wars, the prospects for freer trade and the impact on asset prices

Macro Letter – No 115 – 24-05-2019

Trade Wars, the prospects for freer trade and the impact on asset prices

Will the Sino-US trade war breed contagion?
Will the dispute trigger a global recession?
Has the era of freer trade ended?
Will asset prices suffer?

As Sino-US trade talks ended, not only, without a deal, but with another sharp increase in tariffs, it is worth looking at what has happened and why. During 2018 the US reversed 38 years of tariff reduction with a radical abruptness, imposing tariffs on 50% of Chinese imports, China retaliated in kind, imposing tariffs on 70% of US imports. The Peterson Institute – The 2018 US-China Trade Conflict after 40 Years of Special Protection – published before the recent tariff increases, reviews the situation in detail. The author, Chad Brown, begins by looking at the tariff reductions since the late 1980’s. For the US, these tariffs had fallen from 5% to 3%, whilst for China they declined from 40% to 8% by 2017. Over the same period China’s share of US imports rose from near to zero in 1978 to 20% by 2014. By contrast, Chinese imports from the US rose steadily, reaching 10% in 2001 – which coincided with their ascension to the World Trade Organisation (WTO) – however, since then, imports from the US have declined, dipping to 8.5% by 2017. In bilateral terms Chinese imports from the US are about a quarter of her exports to the land of the free.

At first sight, it might seem as if the trade tensions between China and the US are new, but relations have been deteriorating since the bursting of the US Tech bubble in 2001, if not before. Looking at the chart below, which measures antidumping and countervailing tariffs, it appears as if the Chinese did not begin to retaliate until 2006: –

Source: Peterson Institute

Analysing anti-dumping and countervailing tariffs in isolation, however, gives a misleading impression of the US response to China. Peterson research attempts to assess the entire scope of the Sino-US trade dispute, by incorporating all forms of US special protection against China over the entire period. The next chart shows the true scale of US tariff reduction on Chinese imports; seen in this light, the extent of the recent policy shift is even more dramatic: –

Source: Peterson Institute

Using this combined metric, US special protection peaked at 39% in 1986, after which these barriers declined rapidly reaching a nadir at 4.3% in 2005. On the eve of the trade war in 2017 barriers had risen to 8.1%. Prior to the May 10^th tariff increase, that figure had jumped to 50%. An updated version of the Peterson chart of shown below: –

Source: Peterson Institute

The additional tariffs imposed this month will raise the average US tariff on Chinese goods to 18.3%. If Trump follows through with his threat to impose a 25% tariff on most of the rest of US imports from China, the average US tariff toward China would increase to 27.8%.

Source: Peterson Institute

What is the likely impact of these actions on trade and prices? For the US, import prices will increase, but given that US inflation has tended to be below the Fed target, this is manageable; corporates and consumers will pay the cost of tariffs, the tax receipts will help to finance the cost of recent US tax cuts. In China, whilst the impact is still negative, as this recent article from CFR – China Never Stopped Managing its Trade makes clear, the majority of imports are made by state owned enterprises or by companies which have a government permit to import such goods, added to which Chinese inflation has also been reasonably subdued, despite impressive continued economic expansion: –

When the state controls the firms that are doing the importing, a few phone calls can have a big impact. That’s why China can shut down trade in canola with Canada without formally introducing any tariffs.

That’s why China can scale back its purchases of Australian coal without filing a “dumping” or “national security” tariffs case.

And that’s why—when the trade war with the United States started—U.S. exports in a number of goods simply went to zero (normally, a 25 percent tariff would reduce imports by more like 50 percent or something…]

For US companies the four largest exports to China are aircraft, automobiles, soybeans and oil and gas. Of these, only automobiles are sold directly to the private sector. Here are three charts which explain why, for the US (at least in the near-term) there may be less to lose in this global game of chicken: –

Source: US Census Bureau, Haver Analytics

The decline in US imports has been driven by a combination of substitution for imports from other sources and a rising domestic capability to manufacture intermediate goods. Faced with a dwindling market for their exports, the US might be forgiven for wishing to retire from the fray whilst it still has the advantage of being the ‘consumer of last resort’.

To date, US government receipts from tariff increases have amounted to an estimated $2bln. A study by the World Bank and the International Finance Corporation, however, estimates the true cost the US economy has been nearer to $6.4bln or 0.03% of GDP. The chart below shows the already substantial divergence between prices for tariff versus non-tariff goods: –

Source: Financial Sense, US Department of Labor, Commerce department, Goldman Sachs

The impact on China is more difficult to measure since Chinese statistics are difficult interpret, however, only 18% of Chinese exports are to the US – that equates to $446bln out of a total of $2.48trln in 2018, added to which, exports represent only 20% of Chinese GDP – all US imports amount to 3.6% of Chinese GDP.

The scale of the dispute (bilateral rather than multilateral) should not detract from its international significance. One institution which seen its credibility undermined by the imposition of US tariffs is the World Trade Organisation (WTO) – Chatham House – The Path Forward on WTO Reform provides an excellent primer to this knotty issue. Another concern, for economists, is that history is repeating itself. They fear Trump’s policies are a redux of the infamous Smoot-Hawley tariffs, imposed during the great depression. Peterson – Does Trump Want a Trade War? from March 2018 and Trump’s 2019 Protection Could Push China Back to Smoot-Hawley Tariff Levels published this month are instructive on this topic. These tariffs were implemented on 17^th June 1930 and applied to hundreds of products. To put today’s dispute in perspective, the 1930’s tariff increase was only from 38% to 45% – a mere 18% increase – this month tariffs have increased from 10% to 25%: a 150% increase. Those who note that 25% is still well below 1930’s levels should not be complaisant, China remains a WTO member, were it not, US average tariffs would now be 38%. Back in 2016 President Trump talked of raising tariffs on Chinese imports to 45%, a number cunningly lifted from the Smoot-Hawley playbook.

One of the counter-intuitive effects of the 1930’s tariff increase was price deflation, in part due to many tariffs being imposed on a per unit cost basis. Today, per unit tariffs apply to only around 8% of goods, added to which, due to monetary engineering, by central banks, and the issuance of fiat currency by governments, the threat of real deflation is less likely.

Another risk is that the Sino-US spat engulfs other countries. The EU (especially Germany) has already suffered the ire of the US President. Recent trade deals between the EU and both Canada and Japan, have been heralded as a triumph for free-trade, however, they are an echo of the trading blocs which formed during the 1930’s. To judge by Trump’s recent tweets, for the moment, China has been singled out, on 13^th May the President said: –

“Also, the Tariffs can be completely avoided if you buy from a non-Tariffed Country, or you buy the product inside the USA (the best idea). That’s Zero Tariffs. Many Tariffed companies will be leaving China for Vietnam and other such countries in Asia. That’s why China wants to make a deal so badly!”

Even if the trade dispute remains a Sino-US affair, there are other unseen costs to consider, on productivity and investment, Bruegal – Implications of the escalating China-US trade dispute takes up the discussion (emphasis mine): –

The direct aggregate effect of the tariffs on the welfare of the US and Chinese, while negative, is likely to be very small… because they represent a transfer from consumers, importers and partner exporters to the government… sooner or later, the American consumer will bear much of the cost of the tariff though higher prices, but also that tariff revenue will return to American residents in some form. The negative aggregate welfare effect of tariffs thus arises because, at the margin, they displace more efficient producers by less efficient ones… because, at the margin, tariffs artificially reduce the consumption or use of imports in favour of domestic goods or goods imported from third parties…

The distributional effect of tariffs is likely to be very uneven and severely negative on some people and sectors… while the Treasury will see increased revenue, and some producers who compete with imports will gain, small companies that depend on imported parts from China are likely to be very badly affected by tariffs…

Larger importers will also be adversely affected… US farmers who depend on Chinese markets have already been badly hurt by Chinese retaliation…

The biggest adverse effects of tariffs on aggregate economic activity is through investment. Lower investment is the natural result of the tariffs’ big distributional effects… and the uncertainty they engender. This effect on ‘animal spirits’ is difficult to model and impossible to quantify with precision… The extraordinary sensitivity of stock markets to trade news and their volatility is just one manifestation of this effect. The widening growth gap between the global manufacturing and services sectors evident in recent quarters is another, as is the slowdown in investment in many countries.

Bruegal go on to discuss the risk to the international trading system and the damage to the credibility of the WTO. Finally they suggest that the trade dispute is a kind of proxy-war between the two super-powers: this is much more than just a trade dispute.

Putting the Sino-US dispute in an historical context, a number of commentators have drawn comparisons between China today and Japan in the 1980’s. I believe the situation is quite different, as will be the outcome. Again, I defer to Bruegal – Will China’s trade war with the US end like that of Japan in the 1980s? The author’s argue that Japan chose to challenge the US when it was close to its economic peak and its productivity was stagnating. China, by contrast, has a younger population, rapidly improving productivity and, most importantly, remains a significant way below its economic peak: –

…Because China is at an earlier stage of economic development, it is expected to challenge the US hegemony for an extended period of time. Therefore, the US-China trade war could last longer than the one with Japan. With China’s growth prospects still relatively solid – it will soon overtake the US economy in size and it does not depend on the US militarily – China will likely challenge US pressure in the ongoing negotiations for a settlement to the trade war. This also means that any deal will only be temporary, as the US will not be able to contain China as easily as it contained Japan.

If you are looking for a more global explanation of the current dispute between the US and China, then this article from CFR – The Global Trading System: What Went Wrong and How to Fix It is instructive: –

As economist Richard Baldwin lays out in his book The Great Convergence, the Industrial Revolution of the 19th century had launched Europe, the US, Japan and Canada on a trajectory that would see their wealth surge ahead of the rest of the world. In 1820, for example, incomes in the US were about three times those of China; by 1914 Americans would be 10 times as wealthy as Chinese. Manufacturing clustered in the technologically advanced countries, while advances in containerized shipping and the lowering of tariffs through trade negotiations made it possible for these countries to specialize and trade in the classic Ricardian fashion.

The information technology revolution of the 1990s turned that story upside down. With the advent of cheap, virtually instant global communications via the Internet, it became possible – and then imperative for competitive success – for multinational companies to take their best technologies and relocate production in lower-wage countries. Manufacturing output rose in middle-income countries like China, India, Thailand, Poland and others, while falling sharply in the US, Japan, France, the UK and even Germany…

The global great convergence, however, coincided with a great divergence within the wealthy countries (and many developing countries as well). The new technologies and the disappearance of trade barriers upended the balance between labor and capital in the advanced industrialized countries, and contributed to soaring economic inequality…

In the US in 1979, an American with a college degree or higher earned about 50% more than one who had only a high school education or less. By 2018, American workers with a four-year college degree earned almost twice as much as those with just a high-school education, and were unemployed half as often, while those with a professional degree earned nearly three times as much.

The author goes on to liken today’s tension between the US and China with the situation which existed between the UK and US at the beginning of the 20^th century: –

The world today again faces the same governance gap – a US that no longer has the economic muscle nor the political will to organize the global system, and a rising China that is reluctant to play a greater role.

CFR ask what the prospects maybe for renewed globalization? They identify three key elements which need to be addressed in order for de-globalisation to be reversed: a trade war truce (once both sides wake up to the extent of the empasse they have engineered), a filling the Leadership Vacuum (caused by both sides turning their backs on the WTO – they need to reengage and lead the world towards a solution) and, especially for the US, meeting the challenges at home (Trump cannot rely on a trade war in the long-run to solve the problem of inequality within the US).

Conclusions and investment opportunities

What is the likely impact on financial markets? To answer this question one needs to know whether the current trade war will escalate or dissipate: and if it escalates, will it be short and sharp or protracted and pernicious?

Alisdair Macleod of Gold Money – Post-tariff considerations identifies the following factors: –

The effect of the new tariff increases on trade volumes

The effect on US consumer prices

The effect on US production costs of tariffs on imported Chinese components

The consequences of retaliatory action on US exports to China

The recessionary impact of all the above on GDP

The consequences for the US budget deficit, allowing for likely tariff income to the US Treasury

Leading, in MacLeod’s opinion, to: –

Reassessment of business plans in the light of market information

A tendency for bank credit to contract as banks anticipate heightened lending risk

Liquidation of financial assets held by banks as collateral

Foreign liquidation of USD assets and deposits

The government’s borrowing requirement increasing unexpectedly

Bond yields rising to discount increasing price inflation

Banks facing increasing difficulties and the re-emergence of systemic risk

The author suggests that, all other things equal, tariffs should lead to price increases, but, with the US consumer already heavily burdened with debt, consumption demand will suffer.

I am less bearish than MacLeod because, if the Sino-US trade war threatens to puncture the decade long equity bull-market, we will see a combination of qualitative and quantitative easing from the largest central banks and aggressive fiscal stimulus from the governments of G20 and beyond. I wrote about this scenario (though without reference to the trade war) earlier this month in Macro Letter – No 114 – 10-05-2019 – Debasing the Baseless – Modern Monetary Theory. My, perhaps overly simple, prediction for assets in the longer-term is: bonds up, stocks up and real estate up.

In an alternative scenario, we might encounter asset price deflation and consumer price inflation occurring simultaneously. Worse still, this destructive combination of forces might coinciding with a global recession. The severity of any recession – and the inevitable correction to financial markets that such an economic downturn would precipitate – will depend entirely on the time it takes for US and Chinese trade negotiators to realise the danger and reach a compromise. I believe they will do so relatively quickly.

Attempting to predict what President Trump might do next is fraught with danger, but, due to the inherent weakness of the democratic process, I expect the US administration to concede. The US President has an election to win in November 2020; the President of China has been elected for life.

May 10, 2019 by In the long run

Debasing the Baseless – Modern Monetary Theory

Macro Letter – No 114 – 10-05-2019

Debasing the Baseless – Modern Monetary Theory

Populist politicians are turning to Modern Monetary Theory
Fiscal stimulus has not led to significant inflation during the last decade
MMT is too radical to be adopted in full but the allure of fiscal expansion is great
Asset markets will benefit over the medium-term

A recent post from the Peterson Institute – Further Thinking on the Costs and Benefits of Deficits – follows on from the Presidential Lecture given by Olivier Blanchard at the annual gathering of the American Economic Association (AEA) Public Debt and Low Interest Rates . The article discusses a number of issues which are linked to Blanchard’s speech: –

Is the political system so biased towards deficit increases that economists have a responsibility to overemphasize the cost of deficits?
Do the changing economics of deficits mean that anything goes and we do not need to pay attention to fiscal constraints, as some have inferred from modern monetary theory (MMT)?
You advocate doing no harm, but is that enough to stabilize the debt at a reasonable level?
Isn’t action on the deficit urgent in order to reduce the risk of a fiscal crisis?
Do you think anything about fiscal policy is urgent?

Their answers are 1. Sometimes, although they question whether it is the role of economists to lean against the political wind. 2. No, which is a relief to those of a more puritanical disposition towards debt. The authors’ argument, however, omits any discussion of the function of interest rates in an unfettered market, to act as a signal about the merit of an investment. When interest rates are manipulated, malinvestment flourishes. They propose: –

…that the political system should adopt a “do no harm” approach, paying for new proposals but not necessarily making it an urgent priority to do any more than that. Adopting this principle would have the benefit of requiring policymakers to think harder about whether to adopt the next seemingly popular tax credit or spending program. Many ideas that seem appealing judged against an unspecified future cost are less appealing when you make their costs explicit today.

Yes. At this point the authors’ make the case for addressing the shortfalls in the social security and health budgets. They make the admirable suggestion that better provision is not only necessary but desirable, however, to achieve their goal they warn more will need to be contributed by individuals. Sadly, I expect politicians to cherry pick from the Modern Monetary Theory (MMT) menu, they will not champion the case for higher individual contributions. 4. No. Here I am in begrudging agreement with their conclusion, although I worry about their projections. Fiat currencies and artificially low interest rates underpin the current political system. It is hardly surprising that developed country government activity, as a share of GDP, has risen. 5. Yes. Again, I agree with the need to think about fiscal policy, though I anticipate that Peterson’s proposals are likely to exacerbate the current problems further.

A prelude to MMT

The reason for highlighting recent Peterson commentary is because it represents the acceptable face of a more dubious set of proposals, known collectively as MMT. These ideas are not particularly modern, beginning with the Chartalist tenet that countries which issue their own fiat currencies can never “run out of money.” For a measured introduction to this topic, Dylan Matthews has published a brilliant essay for Vox – Modern Monetary Theory, explained. Here are some of the highlights: –

[The starting point is]…endogenous money theory, that rejects the idea that there’s a supply of loanable funds out there that private businesses and governments compete over. Instead, they believe that loans by banks themselves create money in accordance with market demands for money, meaning there isn’t a firm trade-off between loaning to governments and loaning to businesses of a kind that forces interest rates to rise when governments borrow too much.

MMTers go beyond endogenous money theory, however, and argue that government should never have to default so long as it’s sovereign in its currency: that is, so long as it issues and controls the kind of money it taxes and spends. The US government, for instance, can’t go bankrupt because that would mean it ran out of dollars to pay creditors; but it can’t run out of dollars, because it is the only agency allowed to create dollars. It would be like a bowling alley running out of points to give players.

A consequence of this view, and of MMTers’ understanding of how the mechanics of government taxing and spending work, is that taxes and bonds do not and indeed cannot directly pay for spending. Instead, the government creates money whenever it spends…

And why does the government issue bonds? According to MMT, government-issued bonds aren’t strictly necessary. The US government could, instead of issuing $1 in Treasury bonds for every $1 in deficit spending, just create the money directly without issuing bonds.

The Mitchell/Wray/Watts MMT textbook argues that the purpose of these bond issuances is to prevent interest rates in the private economy from falling too low. When the government spends, they argue, that adds more money to private bank accounts and increases the amount of “reserves” (cash the bank has stocked away, not lent out) in the banking system. The reserves earn a very low interest rate, pushing down interest rates overall. If the Fed wants higher interest rates, it will sell Treasury bonds to banks. Those Treasury bonds earn higher interest than the reserves, pushing overall interest rates higher…

“In the long term,” they conclude, “the only sustainable position is for the private domestic sector to be in surplus.” As long as the US runs a current account deficit with other countries, that means the government budget has to be in deficit. It isn’t “crowding out” investment in the private sector, but enabling it.

The second (and more profound) aspect of MMT is that it proposes to reverse the roles of fiscal and monetary policy. Taxation is used to control aggregate demand (and thus inflation) whilst government spending (printing money) is used to prevent deflation and to stimulate consumption and employment. Since MMT advocates believe there is no need for bond issuance and that interest rates should reside, permanently, at zero, monetary policy can be controlled entirely by the treasury, making central banks superfluous.

At the heart of MMT is an accounting tautology, that: –

G − T = S – I

Where G = Government spending, T = Taxation, S = Savings and I = Investment

In other words…

Government Budget Deficit = Net Private Saving

You may be getting the feeling that something does not quite tally. Robert Murphy of the Mises Institute – The Upside-Down World of MMT explains it like this (the emphasis is mine): –

When I first encountered such a claim — that the government budget deficit was necessary to allow for even the mathematical possibility of net private-sector saving — I knew something was fishy. For example, in my introductory textbook I devote Chapter 4 to “Robinson Crusoe” economics.

To explain the importance of saving and investment in a barter economy, I walk through a simple numerical example where Crusoe can gather ten coconuts per day with his bare hands. This is his “real income.” But to get ahead in life, Crusoe needs to save — to live below his means. Thus, for 25 days in a row, Crusoe gathers his ten coconuts per day as usual, but only eats eight of them. This allows him to accumulate a stockpile of 50 coconuts, which can serve as a ten-day buffer (on half-rations) should Crusoe become sick or injured.

Crusoe can do even better. He takes two days off from climbing trees and gathering coconuts (with his bare hands), in order to collect sticks and vines. Then he uses these natural resources to create a long pole that will greatly augment his labor in the future in terms of coconuts gathered per hour. This investment in the capital good was only possible because of Crusoe’s prior saving; he wouldn’t have been able to last two days without eating had he not been able to draw down on his stockpile of 50 coconuts.

This is an admittedly simple story, but it gets across the basic concepts of income, consumption, saving, investment, and economic growth. Now in this tale, I never had to posit a government running a budget deficit to make the story “work.” Crusoe is able to truly live below his means — to consume less than his income — and thereby channel resources into the production of more capital goods. This augments his future productivity, leading to a higher income (and hence consumption) in the future. There is no trick here, and Crusoe’s saving is indeed “net” in the sense that it is not counterbalanced by a consumption loan taken out by his neighbor Friday…

When MMTers speak of “net saving,” they don’t mean that people collectively save more than people collectively borrow. No, they mean people collectively save more than people collectively invest.

MMT goes on to solve the problem of achieving full employment by introducing a job guarantee and wage controls.

If, by this stage, you feel the need for an antidote to MMT, look no further than, Forty Centuries of Wage and Price Controls: How Not to Fight Inflation by Dr Eamon Butler of the ASI. Published in 1978, it documents the success of these types of policy during the past four thousand years.

Conclusion and Investment Opportunities

The radical ideas contained in MMT are unlikely to be adopted in full, but the idea that fiscal expansion is non-inflationary provides succour to profligate politicians of all stripes. Come the next hint of recession, central banks will embark on even more pronounced quantitative and qualitative easing, safe in the knowledge that, should they fail to reignite their economies, government mandated fiscal expansion will come to their aid. Long-term bond yields will head towards the zero-bound – some are there already. Debt to GDP ratios will no longer trouble finance ministers. If stocks decline, central banks will acquire them: and, in the process, the means of production. This will be justified as the provision of permanent capital. Bonds will rise, stocks will rise, real estate will rise. There will be no inflation, except in the price of assets.

John Mauldin describes the end-game of the debt-explosion as the Great Reset, but if government borrowing costs are zero (or lower) the Great Reset can be postponed, but the economy will suffer from low productivity growth due to malinvestment.

In the Long Run

Macroeconomics and the Markets

Month: May 2019

Trade Wars, the prospects for freer trade and the impact on asset prices

Debasing the Baseless – Modern Monetary Theory