Another day, another stark warning about the perils inherent in following Donald Trump down the path to protectionist trade policies.
When you think about Trump’s tariffs and the reciprocation they’ve elicited around the world, it’s important to strip the discussion of the niceties and superlative-laden populist balderdash.
What you’re witnessing is an epochal shift that, at heart, entails rolling back decades of progress on globalization and liberalization in the interest of promoting nationalism and isolationism. In other words: this is the very definition of a fool’s errand.
It won’t work, precisely because it can’t. I’ve been over this on too many occasions to count in these pages. The globalization of supply chains and the free movement of labor and capital make Trump’s policies an exercise in futility. Even if they were a good idea (which they unequivocally aren’t), they would have no hope of working in practice. Just ask Element Electronics or, amusingly, Chris Cox, the founder of “Bikers for Trump”, who discovered that the only way to make a profit selling Trump memorabilia at the nation’s largest biker gathering is to buy the shirts from Haiti.
There are of course more consequential examples involving multinationals, many of which have been warning for months about the deleterious effects of protectionism on their businesses.
One of the key things to understand about protectionism in the context of markets is the extent to which globalization has been a disinflationary force that’s helped keep inflation anchored in developed markets, thereby ensuring that central banks can keep the spigots open. Recall this from Nedbank’s Neel Heyenke and Mehul Daya:
A consequence of globalisation was disinflation which allowed central banks to cut policy rates (discount factors). This helped stimulate economic growth and fuel asset prices. The destructive inflationary episode of the 1970’s meant monetary policy became focussed on consumer inflation targeting.
If globalization slams into reverse thanks almost entirely to Trump and the populist sentiment he’s legitimized across developed market economies, it could very well drive up domestic prices with the effect of forcing the Fed to lean continually hawkish. That, in turn, would drive the policy divergence between the U.S. and the rest of the world wider and push the dollar higher, a risky dynamic that could spark an unwind in emerging markets and, ultimately, a recession in the U.S. in the event the Fed over-tightens.
The addition of fiscal stimulus to the late-stage expansion stateside makes that outcome more likely as it increases the chances that the Phillips curve snaps back to life dramatically.
“The Fed could be caught behind the curve and might be forced to hike aggressively which could have a negative impact on growth while leaving only inflation behind,” Deutsche Bank’s Aleksandar Kocic cautioned in June, in the context of the Phillips curve. He reiterated that point in a note dated Friday as follows:
Fed hawkishness in the near term has been largely dictated by the concerns raised by nonlinearities of the Phillips curve. For eight quarters prior to the last release, wages have shown steady acceleration with declining unemployment numbers, in sharp contrast with about five years of practically flat response. The Figure shows the post-2007 Philips curve with four quadrants corresponding to different economic regimes. As of mid-2016, the slope has turned from nearly zero to above 60 degrees as we crossed the NAIRU.
This is why folks are so concerned about the next round of 301 investigation-related tariffs which will target some $200 billion in additional Chinese goods. If the USTR goes ahead with that, it will almost surely push up consumer prices in the U.S.
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With that as the backdrop, we wanted to highlight a paper presented at Jackson Hole by the BIS’s AgustÃn Carstens. Here’s the bottom line from his assessment:
Recent measures to reverse globalisation and to retreat into protectionism alarm me, as they no doubt alarm many of you. After decades of setting rules to liberalise trade, we are seeing moves to rip up that rulebook. After decades of striving to open markets, we are seeing attempts to close them. After decades of increasing international cooperation, we are seeing increasing international confrontation. This is reflected in the United Kingdom’s vote for Brexit, nationalist movements in Europe, the shift in US trade policy and the current tariff tit-for-tat. But even before this change in the political winds, in part as a fallout from the post-crisis recessions, non-tariff trade barriers had been on the rise.
Reversing globalisation puts at risk the real economic gains that have come about through closer trade and investment links. This could increase prices, raise unemployment and crimp growth. Retreating into protectionism also risks unravelling the financial interdependencies that enable and encourage trade and investment links. This threatens to unsettle financial markets and put a drag on firms’ capital spending, as investors take fright and financial conditions tighten. Finally, these real and financial risks could amplify each other, creating a perfect storm and exacting an even higher price.
Got that? This is absolutely a bad a idea and no populist propaganda either emanating from politicians or from the bevy of fringe blogs that promote this nonsense, is going to change that. Those folks either don’t know what they’re talking about or, far more likely, are seeking to capitalize in one way or another off the gullibility of uneducated voters in developed market countries.
Carstens continues, noting the following about inflation, globalization and the interconnectedness of value chains:
The globalisation of firms and markets has no doubt contributed to the persistently low level of inflation in recent years. Low inflation has been driven by two long-term forces: trade and technology. Fostered by liberalisation, increased trade openness and, in particular, competition from imports produced in countries with lower wages, drove down prices in advanced economies, but also reduced workers’ bargaining power. And technological advances, especially automation in manufacturing, have brought down global production costs. These two forces go hand in hand. Innovation and more open markets have radically reshaped global production, replacing locally segmented manufacturing with global value chains (GVCs). These depend on financial openness.
What happens if we continue down this road? Well, again, it’s simple. Here’s Carstens:
Tariffs could push up US prices, possibly requiring monetary policy to react through more rapid increases in interest rates. Such a response would widen the interest rate premium to the rest of the world and could drive the dollar higher. This would hit US exporters with a double whammy, and emerging market economies with a triple whammy. For emerging markets, a stronger dollar tightens financial conditions, triggers capital outflows and slows growth. The dollar is already much stronger against emerging market currencies, other than the renminbi, than it is against those of other advanced economies.
An additional twist is that US dollar strength could tempt authorities to impose even higher tariffs or even additional protectionist policies. Can the first salvoes in a currency war be long in coming?
Does that last bit about an “additional twist” sound familiar to you? It should. Recall the following from “Presenting The Dollar Intervention Delusion“:
But the quintessential example of Trump driving himself crazy is what we’ve variously dubbed the “dollar insanity loop” wherein the combination of late-cycle fiscal stimulus and tariffs point to higher inflation outcomes (at least in the short term) and thereby beget a more hawkish Fed. Of course a hawkish Fed is USD+, and the stronger the dollar, the less effective the tariffs. Trump’s “solution”, thus far, has been more protectionist cowbell. To the extent protectionism is inflationary in the early stages, he’s running up the down escalator.
The dollar’s strength is in part due to the read-through from tariffs on domestic inflation and the assumed monetary policy response, but the stronger the dollar, the weaker the tariffs, which leads the administration to impose still more tariffs, which only increase the odds of an inflation overshoot, making the Fed more hawkish, driving the dollar even higher, and around and around we go. It is patently absurd.
There’s a wealth of additional color in Carstens’ full paper (embedded below), but here is the key section where he describes how all of this comes together to create a “perfect storm”:
A perfect storm?
Today, we must recognise the potential for real and financial risks to interact, to intensify and to amplify each other. Protectionism could set off a succession of negative consequences. If all the elements were to combine, we could face a perfect storm.
Consider that non-US banks provide the bulk of dollar-denominated letters of credit, which in turn account for more than 80% of this source of trade finance. The Great Financial Crisis highlighted the fragility of this setup, since non-US banks depend on wholesale markets to obtain dollars. Ten years on, we should not forget how the dramatic fall in trade finance in late 2008 played a key part in globalising the crisis. Any dollar shortage among non-US banks could cripple international trade.
On top of that, trade skirmishes can easily escalate into currency wars, although I hope that they will not. As we saw earlier with Mexico, imposing tariffs on imports tends to weaken the target country’s currency. The depreciation could then be construed as a currency “manipulation” that seemingly justifies further protectionist measures. If currency wars break out, countries may put financial markets off-limits to foreign investors or, on the other side, deliberately cut back foreign investment, politicising capital flows.
In addition, we must be mindful of long-observed knock-on effects from tighter US monetary conditions, given the large stock of dollar borrowing by non-banks outside the United States, which has now reached $11.5 trillion. Policymakers in advanced economies should not shrug off the growing evidence that abrupt exchange rate depreciations reduce investment and economic growth in emerging market economies. This has implications for everybody, in that weaker economic activity reduces demand for exports from advanced economies. That would close the circle of trade tensions affecting the real economy via the financial channel of exchange rates.
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Great article, H.
Another good piece. Thanks.