Corospondent July 2018

Corospondent - July 2018

Winter 2018

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Trade wars and the last economy standing - July 2018

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Barry Eichengreen

Barry Eichengreen

Barry Eichengreen is a Professor of Economics and Professor of Political Science at the University of California, Berkeley, US, where he has taught since 1987. He is an internationally renowned economist who has written widely on the international economy and monetary systems. He is a former senior policy advisor at the IMF.

CURRENTLY THE US economy is firing on all cylinders, while Europe and emerging markets are struggling. Does this mean that president Trump is right – that trade wars are ‘easy to win’? 

Superficial evidence points in this direction. The Purchasing Managers’ Index, the best real-time measure of US economic activity, indicates that no less than 60% of managers saw conditions as continuing to improve in June. New orders, even export orders, expanded even faster than in previous months. The Atlanta Federal Reserve Bank’s ‘nowcasting’ model shows US GDP increasing at a robust 3.8% rate in the second quarter.

In contrast, growth in the five large European economies (Germany, France, Italy, Spain and the UK) dropped in the second quarter. In emerging markets, meanwhile, financial difficulties are mounting. China’s stock market and currency have lost ground with the ratcheting up of trade tensions. Other emerging markets have experienced capital outflows, forcing their central banks to tighten.

Rather than being destabilised by the White House’s trade threats, the US economy appears to be thriving, while the economies Trump is attacking are buckling under the pressure.

But the evidence for the US is deceiving. The increase in manufacturing output and orders, including export orders, is a direct consequence of worries about trade policy actions. US companies are accelerating production to get more done before their supply chains and access to imported inputs are disrupted. European retailers are anxious to stock their warehouses with American goods before their governments slap retaliatory tariffs on US exports. This frontloading of production and sales bodes ill for the future. Demand and activity are being created today at the expense of demand and activity tomorrow.

One might ask why producers in Europe and emerging markets are not reacting similarly. The answer is that, in fact, many of them are doing just that. They have the same incentive to stock up on inputs and bring production forward before their trade relations are disrupted further. This explains why there is no discernible deceleration of economic activity in China, at least yet, despite the weakness of both consumption and fixed-asset investment. It explains why growth in emerging markets has not softened significantly despite the turmoil caused by higher US Federal Reserve (Fed) policy rates. It explains how growth in the big European economies still hovers in the 1.5% to 2% range despite the uncertainties surrounding the German diesel emissions scandal, the intentions of the new Italian government and Brexit. Producers there too are stealing from Peter in order to pay Paul. In other words, these observations also bode ill for the future.

The longer-run implications for the US economy are especially dire because Trump’s tariffs target mainly intermediate inputs, not final goods, and handicap sectors disproportionately dependent on global supply chains. Steel and aluminium, the targets of Trump’s ‘national security tariffs’, are inputs into production, so taxes on them make the final goods they go into more expensive. For every steel and aluminium industry job created, multiple jobs in downstream industries are lost. Whereas the US steel industry employs 145 000 workers, steel-using industries employ two million.

The same is true of the Section 301 tariffs imposed in response to China’s intellectual property rights abuses – 52% of these tariffs target intermediate goods and another 43% tax imports of capital goods, which are themselves inputs into production. From an economic standpoint, this is known as shooting oneself in the foot.

The same is true of Trump’s proposed tariffs on motor vehicles and parts. US automakers import a large fraction, even the majority, of the parts and components used in their assembly operations. No wonder then that Toyota, which builds Camrys at its plant in Kentucky, estimates that Trump’s tariffs on automotive parts will raise the cost of its sedan by $1 800. And no wonder that the American Automotive Policy Council, representing the Big Three Detroit-based automakers, opposes the president’s trade restrictions.

China, the EU and Canada are largely avoiding this pitfall. The EU’s retaliatory tariffs target Kentucky bourbon and Florida orange juice, which are inputs into consumers’ digestive systems, not into industrial production. China is targeting US soybeans, and Canada US maple syrup, ketchup and strawberry jam. These tariffs will impact the cost of living – imports from the US will become more expensive – but they will not disrupt manufacturing production.  These countries have not been entirely able to resist the temptation to protect and subsidise their own steel industries. But, on balance, they are proceeding in a more sensible manner.

Will the Trump administration change course as evidence mounts of negative effects on the US economy? Would a negative reaction by the Standard & Poor’s (S&P) 500, in which US multinational companies are disproportionately represented, rein in the president’s worst instincts? Would Trump think twice following evidence that other countries in fact are prepared to retaliate, contrary to confident assertions by the president’s trade advisor Peter Navarro? The answer, unfortunately, is no. Trump and his advisors understand neither global supply chains nor the distinction between intermediate and final goods. They do not understand that by cutting taxes and thereby pushing up the dollar, they themselves are causing the US trade deficit that the president finds so objectionable.

So if the stock market reacts badly, Trump will ascribe this not to his own policies but to foreigners, stock market manipulators and the Fed. Trump has already warned other governments of further US action if they retaliate. Breaking with precedent, his economic advisor Larry Kudlow has intervened in the Fed’s affairs, urging it to proceed “very slowly” with interest rate increases. Trump’s commerce secretary Wilbur Ross has already criticised “antisocial speculators” for driving up steel prices.

The other reason for doubting a change of policy direction, aside from the fundamental ignorance of those at the top, is that Trump’s dog-whistle politics appeal to his political base. Trump’s bedrock supporters, like the president himself, see international trade as a zero-sum game. They see the mythical flood of merchandise imports, just like the mythical flood of Latin American immigrants (mythical because immigration from Latin America to the US is down, not up), as a fundamental threat to the country, and they are happy to see their president wall them off. Trump is simply delivering on the campaign promises that got him elected, and he is unlikely to turn back, however damaging the consequences. Economists may regard a trade war as hard to win, but for Trump, it remains a political winner.

So what should other countries do? They should carefully calibrate their response to avoid unnecessarily provoking an all-too- easily-provoked US president. They should target exports of bourbon and cranberries from the home states of the US Senate majority leader and House of Representatives speaker in an effort to drive a wedge between the president and Congress, in the hope that the latter might show some backbone and restrain an irresponsible executive.

Above all, other countries should avoid resorting to a further cascade of tariffs. If the US taxes Chinese products, China will divert those exports to other markets, intensifying import competition there and creating a temptation to ratchet up barriers against Chinese goods. The trade war could then go global and spiral out of control. A modicum of export restraint by China would help to limit this danger. That the Chinese authorities have begun intervening in the foreign exchange market to prevent their currency from weakening further and artificially goosing exports is a good sign from this point of view.

If there is a silver lining for South Africa, it is that the country depends less on global supply chains than many other emerging markets. Moreover, if the US economy weakens, the Fed will moderate its pace of tightening, which will help with South Africa’s dollar funding costs. This may be scant recompense. But it is at least something.

SOUTH AFRICAN IMPACT

By Marie Antelme

South Africa is a small, open economy where global growth, trade and overall financial conditions have a meaningful impact on domestic economics. Initial estimates of the direct impact on global GDP of the first round of tariff increases imposed by the US on China were low, at 0.1 to 0.2 percentage points for 2018, with a slightly higher impact in 2019. This would have had a negligible impact on South Africa’s GDP growth, off the current low base.

 However, the newly announced escalation in planned tariff increases are likely to have a more meaningful effect on global growth into 2019 than initial estimates suggest, and the imposition of a global tariff on vehicle imports to the US would more directly impact domestic trade. South Africa exports both vehicles and parts to the US, and imports a proportion of both too. On a net basis, total trade in vehicles between South Africa and the US is about 1.9% of GDP.

More importantly, the indirect effect of an escalation in trade conflict may be much bigger, but is harder to measure. With the expansion of tariffs, the risk of a greater disruption to globally integrated supply chains has increased, and prices are likely to rise. Greater uncertainty would also influence confidence and investment, and may result in tighter financial conditions. The broader impact of a cyclical slowing in global growth on commodity prices and a drop in investor sentiment would see domestic terms of trade deteriorate and the currency weaken, leading to higher inflation and possibly prompting an increase in interest rates.