Tuesday, 17 July 2018

Trade wars, economic ideology, and why Trump has a point

Trade has become a hot-button issue this year, with Trump having already implemented several rounds of tariffs targeted (primarily) at China, and threatened to continue ratcheting up measures should China follow through with retaliatory measures. The policies have created fears of a brewing trade war, and Trump's bluster has bewildered and dismayed many observers. However, the issues are in my opinion poorly understood and almost never properly articulated.

It is often said that "no one wins in a trade war", but in my view this perspective is both ideological and fundamentally mistaken. The truth is that there are both winners and losers in a trade war (as is also the case with free trade), and if Trump indeed triggers a full-scale tit-for-tat trade war with China, the US will, in my submission, almost inevitably 'win' and be a net beneficiary at China's expense. This is no doubt a highly controversial view - if not sacrilege - but in my view the consensus thinking on this topic is wrong, and Trump is actually right (from an 'America first' perspective).

Interestingly, while almost all commentators and economists have argued everyone will lose from a trade war, and that the US is 'shooting itself in the foot', financial markets have so far begged to differ - US financial markets have performed quite strongly this year (particularly after factoring in the USD's strength vs. other major currencies), while trade surplus nations such as China and Germany have sharply sold off. Financial markets are saying the US will win at China/Germany's expense, and in my view, markets are right and the establishment view is wrong (the economic establishment also believe in efficient markets, so how do they reconcile that dissonance?)

The missing caveat

The widely-acclaimed 'everybody wins' benefits of free trade derive from the concept of 'comparative advantage' - i.e. you produce what you are good at; I'll produce what I'm good at, and we'll trade. That way, we will both end up better off, each enjoying more goods and services at lower cost than we otherwise would have. This is essentially the same concept as the specialisation of labour. Internal 'trade' within a domestic economy involves people specialising in one small task/group of tasks, getting paid, and then using the cash to purchase the myriad other goods and services that are needed or desired. We don't all grow our own food, as that is economically inefficient. Comparative advantage is simply this concept extended from national to international trade.

I have no issue with this perspective. However, crucially, this perspective implicitly assumes the existence of balanced trade: i.e. that every $100 of exports will be met with $100 of imports. To the extent that situation exists, free trade should indeed be pursued vigorously in the interest of maximising the benefits of comparative advantage. However, this immensely important caveat is almost always omitted from the discussion about the mutual benefits of free trade, and is a telling sign of how shallow people's thinking is with respect to the issue (and also how ideological).

In reality, global trade since the 1980s has not been balanced, and has instead become increasingly unbalanced (albeit the imbalances peaked in the pre-GFC years, and were a major contributor to the crisis). For instance, at the moment, China exports US$500bn of goods to the US, but the US only exports US$130bn in goods to China. This results not in equally mutual benefits from comparative advantage to both nations, but instead disproportionate benefits to China's economy at the US's expense (note I am referring to the US vs. Chinese economies, not to listed companies - many of which have operations or supply chains abroad and could be negatively impacted by a trade war).

In theory, in a free market world devoid of trade barriers, trade is supposed to stay approximately balanced through the mechanism of floating exchange rates. If a nation has a significant trade surplus, its currency is supposed to appreciate (and vice-versa), thereby re-equilibrating differentials in competitiveness (incidentally, this is a structural flaw in the Euro, which thwarts this process, and has created immense economic suffering for peripheral EU nations). If China is running a huge trade surplus with the US, it's currency ought to significantly strengthen vs. the USD, rendering China's goods more expensive and US goods relatively less expensive, which through market forces would restore balance in trade (and investment and jobs). However, as is often the case with simplistic, ideological economic theories, this has not happened in practise, because reality is more complicated than the simple theories imply. Instead, trade has persistently remained extremely unbalanced.

Why has trade remained unbalanced?

There are several reasons why the traditional economic dogma has proven wrong. Firstly, in the past 40 years, capital flows have become much more globalised and comparatively frictionless than trade in goods and services, and capital flows have therefore tended to have a larger impact on currency valuations than the flow of goods and services. This has meant that large trade and current account imbalances have been able to persist for much longer than they otherwise would have been able to.

Persistent capital inflows drive up a currency and result in a growing trade/current account deficit. This generally has profoundly negative economic consequences for the trade/current account deficit countries, as it results in (1) the loss of jobs as export and other tradeables industries are hollowed out and moved overseas due to an overvalued exchange rate; (2) the concomitant capital inflows result not just in the accumulation of substantial foreign indebtedness (which can sometimes suddenly flee, spiking interest rates and creating a crisis), but also contributes to the emergence of local asset pricing bubbles, as the capital flows through the financial system into the housing and other asset markets; and (3) the above forces generally combine to generate a significant increase in income and wealth inequality, which is destructive of social, political, and economic cohesion (as blue collar jobs are lost, but Wall Street-type jobs benefit from rising asset prices and debt levels).

This happened in the US housing market in the lead up to the global financial crisis (the housing bubble inflated alongside a mushrooming US current account deficit which hit 6% of GDP); drove the boom and subsequent bust in Ireland, Spain, Italy, Greece and Portugal pre and post the GFC (as capital flowed from surplus nations such as Germany into deficit nations in the periphery); and has also recently driven significant house price bubbles in NZ, Australia, and Canada as well - all countries with long-standing current account deficits reflecting persistent capital inflows. Free trade ideology has created imbalances so material that they have created asset bubbles and busts that have crashed many Western economies/financial systems over the past several decades; helped drive record inequality; and promoted increasing societal polarisation and political extremism.

Secondly, aside from the free market forces of capital flows (which are self correcting long term), certain countries have also seen fit to exploit the West's free trade ideology to their own benefit, by 'managing' their exchange rates and fixing them at undervalued levels relative to the US dollar (the world's primary reserve currency). In this manner, instead of their currencies appreciating vs. the USD to rebalance trade, they have been able to generate significant and persistent trade surpluses with the US, thereby boosting domestic demand, investment and job creation and the US's expense.

China has been the most obvious exponent of this mercantilist policy over the past 20-30 years, keeping its exchange rate tightly managed and at a low enough level so as to allow the country to continue to book significant trade surpluses with the US (and in the process accumulate as much as US$3-4tr in foreign exchange reserves - albeit that this policy approach reached its zenith in 2007, not 2017). China has long been well aware that unbalanced 'free' trade does not benefit everyone equally, and China has for many decades been more than happy to exploit the West's foolish and ideological approach to trade (it has also made it very easy for China to recently claim to take the moral high-ground and publicly declare a commitment to 'free trade' - leaving out any mention of 'balanced').

In the same manner, Germany has also benefited from disproportionately high competitiveness within the Euro bloc as well, generating large trade surpluses at the expense of its Southern Europe neighbours. As a result, Germany's economy has done well and unemployment has remained low, while Southern Europe was forced into depression with 20-30% unemployment (it is amazing that 'Euro-skeptic' political movements have taken so long to emerge - about a decade - given how unfair and exploitative Germany & the Euro have been to weaker union members).

But why is a trade deficit bad? Don't consumers benefit from cheaper goods?

The most likely retort at this point is to say, well sure, you may run a trade deficit, but that's still good for the economy, as it results in lower prices for consumers (cheaper imports). While that may appear to be self-evidently true, the problem again is that it fails to see the fuller picture, and in particular, it fails to factor in the impact of economic multipliers

If China can produce a widget 30% cheaper than in the US, due to an undervalued exchange rate, US producers will be uncompetitive and will shut down factories and lay off staff. The capacity will move to China, where new factories will be opened and new staff hired. This will act to boost the Chinese economy (more investment and more jobs, and more consumer spending), and will depress the US economy (less investment, less jobs, less consumer spending).

The free marketeers will argue that this benefits the US because consumers will pay 30% less for the given widget. However, crucially, this argument ignores all the economic multipliers. While US consumers may pay less for their widget at the checkout, the funds are not then able to recirculate through the economy in the manner they would be able to if the goods were locally produced.* One person's expenditure is another person's income - this point is essential to understanding economics. 

In China, the economic multipliers come as factory employees spend their paychecks on domestic goods and services. Electricity consumed by the factories boosts construction demand for power plants, coal mines, and transmission wires. All of these companies benefit and hire more workers, who then also spend more money. This stimulates real estate construction, and mortgage lending, as people can afford homes and have reliable incomes against which to borrow. This creates jobs for construction works, bankers, furniture manufacturers and retailers, and so on.

The economic multipliers are significant, and they are not factored in when the consumer makes their purchasing decision. In this respect, from the perspective of a trade deficit economy, free trade is a tragedy of the commons - consumers make a decision that is in their short term best interest (buy the cheaper good), without factoring in the very negative externalities on their domestic economy. The goal of good economic policy is to correct for market failure/externalities, and free trade rhetoric has neglected this duty. The multipliers also mean that the nonsensical estimates you hear from economists about a reduction in trade with the US impacting the Chinese economy by only 0.2-0.4% are pure fantasy, as they ignore all the economic multipliers.

The effect is exactly the same as the effect Wal-Mart had on small towns. Consumers started to purchase from Wal-Mart instead of local businesses because Wal-Mart was cheaper. But then Wal-Mart sucked the profit out of the town and it ended up in Arkansas (Wal-Mart's head office) or on Wall Street. Local proprietors would have spent their profits at local restaurants and shops, etc. Instead, it got sucked out of the town (i.e. the town had a large 'trade deficit'), which caused more small businesses to fail, which further reduced spending, etc, sending many small towns into a death spiral. Arguing that Wal-Mart was good for local towns as it reduced consumer prices was incredibly short sighted and demonstrated a complete ignorance of the way economic multipliers work. The universal, unqualified enthusiasm for unbalanced free trade is no different (again, balanced free trade is another issue entirely; I have no objection to balanced trade whatsoever).

So what's next?

Trump knows he has a strong hand, because the US only exports US$130bn of goods to China, while China exports US$500bn of goods to the US. Consequently, a tit-for-tat trade war taken to its logical extreme (i.e. a complete cessation in goods trade between the US and China) would therefore result in a net loss of US$370m of first-round economic activity (i.e. excluding economic multipliers) in China, and a net gain of US$370m of first-round economic activity in the US, as the production of those goods shifted from China to the US.

This is why Trump is able to immediately threaten to increase tariffs yet again if China attempts to respond 'in kind'. China's threats are not credible because the US has the power to reduce the trade deficit with the China, whereas China has no such power or ability. Trump's message to China is this: we are going to reduce the trade deficit one way or another, whether you like it or not, and all China can do about it is complain, as they are powerless to do anything about it. And truth be told, they have brought this situation on themselves through decades of exploitive trade practices.

Many people fear a US-Sino trade war could result in a recession in the US. I fear the opposite - I fear that it could create serious overheating and inflation in the US. This is because the first thing that will happen in an all out trade war is that companies with large US sales but offshore/Chinese manufacturing will rush to build factories in the US as fast as they possibly can to preserve their US sales base. This could be excessively stimulatory at a time when US unemployment is already only 4%; massive fiscal stimulus is already underway; and the shale O&G and technology sectors are also booming. The US could start growing at 4-5%+ and it could be highly inflationary and result in much more rapid Fed tightening (US corporate profitability could also start to fall from relatively high levels, as labour finally starts to regain some bargaining power after 40 years of bludgeoning).

This will be very bad for asset prices - particularly in the emerging world (something we have already seen this year) - although it is possible the USD and US equity prices will remain supported on accelerating growth (as has also happened this year). Should serious overheating happen, however, it would likely also be negative for US asset prices as well, if multiples compress & interest rates rise too rapidly.


*Or to the extent they recirculate, they manifest in terms of asset & credit bubbles rather than middle class economic activity. This is because the foreign reserves accumulated alongside a trade surplus need to remain held in the USD. If they were spent on imports, the middle class & blue collar workers would benefit. Instead, they are effectively lent to the financial system which acts to drive down interest rates, increase asset prices and real estate speculation, and boost banking profits. This promotes the build up of economic imbalances and rising economic inequality.


  1. Hi there. I've tried to post twice. Seems only posting anonymously works.

  2. Entering into a trade war with government that holds all the economic levers, is unbelievably risky. There is no way to predict the outcome, and the unintended consequences will come from far left field. GAME ON.

  3. Wouldn't it be more likely manufactures would just move to another country with cheap labour? Thailand?

  4. I think you are overstating the loss of multiplier effects in trade. To say there are no multiplier effects from consumer savings on imported goods is incorrect, in my opinion. Consumers are 70% of the American economy. If they save 20% on the price of clothing imported from China, they will spend the savings on other items. Other industries (primarily services in the last 30 years) benefit from the savings on imported goods.

    Second, your WalMart analogy is also oversimplified for the same reason above. Consumer savings doesn't go into a black hole, it gets spent elsewhere. Small Town retail was hammered by WalMart, no question. But the decline in small town American population is not mainly a result of WalMart, it is a result of massive productivity increases in agriculture over the past century. Fewer people are needed for farming.

    I think there is a better argument to be made about the impact of trade on returns on capital (re: Piketty). I would be going out on a limb to thereorize too far there...But in my own experience living in Nebraska, I see the farm communities hollowing out, but the major ag businesses in Omaha like Lindsey and Valmont (irrigation), Farm Credit (banking), Green Plains (ethanol)... All doing quite well.

    I would say Moline, Illinois has done quite well (John Deere) while all the farm towns around have dwindled.

    1. Thanks for your comments. I agree with you on the 30% savings. It’s the other 70% that’s the problem. 30% gets recirculated instead of 100%.


  5. Great article!

    Another problem with the "free trade" perspective is that it ignores the external costs of unemployment/underemployment in the US. For example, the $1.5T in Federal student loans, many of which will default, are directly related to the ~millions of manufacturing jobs the US lost to Germany and China.

    As a taxpayer, I'm much happier to subsidize excess labor through modestly higher prices on goods than through the welfare state. The welfare state might keep people from starving but, as evidenced by economic depression in the Rust Belt, it can leave people without hope or purpose.

    Another problem with the free trade doctrine is all the things which are artificially expensive in the US (e.g. college textbooks and perscription drugs). It's really cruel to price labor globally when someone in Malaysia has a dramatically lower cost of living than someone in Ohio due to these artificial barriers.

  6. Really got a useful blog to read today. Its very informative, keep posting more like this.
    Sebi registered advisory company

  7. How does this work in reverse when it comes to Trump's policies on trade sanctions? Without checking the numbers, I presume that it would imply that Iran runs current account surpluses, otherwise the trade sanctions would actually help them instead of harm them.

  8. Maybe I misunderstand your post but it seems you are not including the capital account in your analysis. https://mises.org/library/trade-deficit-austrian-perspective