Whack a Mole

In the latest on US trade policy, we are now starting to see the economic consequences of starting a tariff war. Farmers have been complaining that they are being hurt irreparably by the imposition of tariffs in retaliation for the tariffs being imposed on China and our allies. The Trump administration is now proposing to employ $12 billion in emergency funds from the Department of Agriculture to subsidize losses of US farmers resulting from the imposition of retaliatory tariffs, specifically on soybeans, pork, sorghum, corn, wheat, cotton and dairy products, just to name a few.

Market-Commentary-Cumberland-Advisors-Trade

What is clear is that the expenditures are not subject to congressional approval. The administration is employing the Depression-era facility called the Commodity Credit Corporation (CCC) established to fund payments to farmers as part of a three-part program that includes direct assistance, the purchase of surplus agricultural products (1), and trade promotion of agricultural products. Two things are missing so far from the discussion of the bailout program. First, there is no mention of when payments will be made or the process by which these payments will be apportioned and paid. Second, since the funding authority under the CCC is capped at $30 billion, we don’t know if this is just the first tranche of future draws.

Not only should Congressional approval be sought for such a program; but also this is only the tip of the iceberg, because the administration has imposed tariffs on many other products, like steel, autos, and electronics, whose producers will also be hurt. Will a life raft be given to Harley-Davidson? Where will the additional emergency funds to help those firms come from – if they come at all?
We now see that not only will taxpayers pay for the misguided approach to adjusting trade barriers in the form of higher prices of goods at home, but this use of taxpayer funds to rescue farmers evidences the administration’s willingness to divert funds from other priorities to fund its trade war. To be sure, the payments to farmers smell of pure politics, since those hardest hit live in states that supported the president in 2016. Does this imply that help will only be extended through the mid-term elections?

Given that only emergency funds are being used on what the administration claims to be a one-time expense, the political claims of others who are being or will be hurt can’t be far behind. And because funds are limited, the administration will be picking winners and losers as it subsidizes some products but not others that have been targeted for retaliatory tariffs. Will funds to support Detroit automakers and US steel producers be available on the same terms and in as timely a fashion?

A more measured strategy to rationalizing trade relationships, one that permits affected parties to adjust, would seemingly involve first working with allies to resolve differences there and then turn to identifying and addressing critical issues, such as the restrictions that China has imposed that have transferred US intellectual property to their domestic industries. The meeting President Trump had yesterday with European Commission president Jean-Claude Juncker and the kind of process and organization that appears to have been agreed upon as a path forward is exactly the kind of baby step that should be taken first. Negotiations that are coordinated with and supported by our allies are sure to be more powerful and less disruptive than attacking both allies and abusers alike and then backfilling with bailouts. We can only hope that this most recent turn represents a more considered strategy going forward.

Robert Eisenbeis, Ph.D.
Vice Chairman & Chief Monetary Economist
Email | Bio


(1) For background on the CCC see https://fas.org/sgp/crs/misc/R44606.pdf


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Fed Independence

In the wake of the turmoil in Washington, DC, over his performance in Helsinki, President Trump also took a sideswipe at the Federal Reserve, criticizing the FOMC’s recent efforts to normalize policy.

He argued that raising rates threatens the expansion and on top of it has contributed to the rise in the value of the dollar, just when the euro was shrinking, the effect of which is to further disadvantage US producers.

Most presidents – though not all – have understood that Fed independence ensures separation from the Treasury and serves as a check on fiscal excesses. When a central bank takes orders from the fiscal side of government, history shows that inflation and economic decline soon follow. Witness the German inflation of the Weimar Republic, the 1992–1994 experience in Yugoslavia, the 1990 experience in Peru when inflation doubled every 13 days, the persistent problems in Venezuela, and the hyperinflation of Zimbabwe, just to name a few.

There have been many times in the past when presidents expressed frustration with Federal Reserve actions, but those criticisms lacked teeth when it came to actually affecting the Fed’s conduct of monetary policy. One noteworthy period when there was a cozy relationship between Fed leadership and the president was during the chairmanship of Arthur Burns. Burns steered policy in such a way to accommodate the fiscal interests of President Nixon, and the result was stagflation in the 1970s and a disastrous experiment with wage and price controls. We experienced an unprecedented inflation that took courageous action by then-Chairman Paul Volcker to break the back of inflation at the cost of a recession, thus proving that the lack of independence represents a severe threat to economic stability and prosperity. Similarly, President George H. W. Bush blamed the Fed for not cutting rates, and that reluctance to act he alleged cost him the election.

Interestingly, the issue of independence came up last week, on Wednesday, in two entirely different contexts and different venues, in both instances during hearings by the House Financial Services Committee. The first occurred during Chairman Powell’s semiannual testimony on monetary policy before the full House Financial Services Committee, when Congressman Hensarling suggested that the size of the Fed’s balance sheet in itself might pose a threat to its independence because of the temptation on the part of Congress to induce or cause the Fed to purchase private sector assets. As evidence he also referenced the fact that raiding the Fed’s balance sheet has already taken place. Two examples he gave were the use of Fed resources to fund the Consumer Financial Protection Bureau and the deployment of some of the Fed’s surplus to fund the Highway Bill. While Congressman Hensarling’s concern is valid, neither congressional action was related to the size of the Fed’s balance sheet per se. The Fed doesn’t act like a private bank, attracting deposits and then making loans. Rather, it purchases assets – in the present case Treasuries and mortgage-backed securities (MBS) – by simply creating reserves. That is, it purchases assets and pays for them with high-powered money – which ends up as reserves on commercial bank balance sheets.

The real threat is simply that Congress has viewed the Fed more and more as a piggy bank whose resources can be tapped to fund pet projects, seemly at zero cost to the budget. This temptation has been stoked, in part, by the Fed’s willingness to purchase newly issued MBS – which in this case were liabilities of another set of now-government entities, Freddie and Fannie, which are in conservatorship and whose liabilities are effectively guaranteed by the Treasury.

If Congressman Hensarling and his colleagues are truly interested in protecting the independence of the Fed, to counter this trend they should restrict the Fed’s asset purchases to US Treasury obligations – except in extreme emergencies, such as envisioned in the Dodd-Frank Act – and encourage the rundown of the Fed’s holdings of MBS as soon as feasible.

The second time the issue of Fed independence was implicitly raised was in an entirely different context during a hearing on digital currencies that took place that same Wednesday before the House Financial Services Subcommittee on Monetary Policy and Trade. The discussion was wide-ranging, but some participants argued that if digital currencies proved to be a more efficient means of payments than cash, then such currencies should be made legal tender. Furthermore, the Fed should get into the retail digital currency business. But what was lost in their brainstorming was the logical implication of the Fed’s getting into retail payments. Fedcoins, by virtue of the government’s backing, would likely dominate private sector digital currencies and would surely supplant demand deposits as a component of payments as well. However, the advent of Fedcoins would also imply a huge increase in the Fed’s balance sheet on the liability side, an increase that would have to be balanced with assets – presumably Treasuries. But banks rely upon demand deposits to fund their lending activities; and to the extent that this funding source was significantly reduced or disappeared, then banking as we know it would also be adversely impacted. The political fallout from this disruption would be large, and we do not know what implications such a change would have for financial stability or the implementation of monetary policy. Worst case is that the Fed would be dragged into consumer lending. So the role of digital currencies in the US economy is, as of this writing, not clear; nor is the structure of Bitcoin and similar currencies as anonymous or safe as proponents would have us believe [1].

The threats to Fed independence from the legislative branch have a long history. Congressman Wright Patman (in Congress from 1929–1976) was longtime chairman of what was then the House Committee on Banking, Finance, and Urban Affairs [2]. A populist, he favored low interest rates and continually threatened to subject the Fed to appropriations and/or audit [3]. His main concern was that the Fed was too independent and lacked transparency in its operations and decision-making [4]. Remember, during that period the Fed did not reveal its decisions, nor did it produce meeting minutes. Furthermore, Fed chairmen and governors made only infrequent appearances before Congress.

Patman’s crusade was picked up by Henry Gonzales, another Texan, who rose to the chairmanship of the House Banking Committee in 1989, and who vigorously sought to make the Fed more accountable [5]. Under Gonzales it was revealed that the Fed kept secret minutes of its meetings, destroyed many meeting records, and concealed information on a fleet of airplanes it operated, just to mention a few examples of covert Fed actions [6]. Gonzales even initiated an unsuccessful proceeding to impeach Fed Chairman Paul Volcker. Under Gonzales’ tenure the Fed began publishing minutes of its meetings.

So attacks on the Fed from both the executive and legislative branches of government are real but have mainly succeeded – appropriately so – in making the Fed’s decision process more transparent. But those efforts have had minimal influence on actually policy decisions. The president may not appreciate that the Fed is a creature of Congress and not the executive branch, and that he has little or no power to force either the chairman of the Board of Governors or the FOMC to do his bidding. Nor can he fire them.

How will the Fed respond to these recent pressures? Some have speculated that attempts to influence the Fed will cause the Fed to overreact and accelerate its tightening policy just to demonstrate its independence. If the past is any guide, however, there is little evidence that the Fed has deviated from what it deems to be the appropriate policy path just to stick it to its critics. While most of the FOMC participants and governors are relatively new to the table, the best guess is that Fed’s culture and history will provide them with the backbone to steady the course and not bow to outside political pressures. The bigger risk is that the economy could weaken sufficiently towards the end of this year to cause a change in policy, especially if this slowdown occurs before the election. A backtrack on policy in that economic scenario would pose a formidable communications challenge for the Fed – to explain the change while not appearing to be bowing to outside pressure, especially from a president who is likely to claim credit for the change in policy. This is where the real short-term threat to Fed independence will come from. Over the longer run, however, the real threats may come from a Congress tempted to look for cheap financing for projects, and we can only hope there that the true issues are understood.

Robert Eisenbeis, Ph.D.
Vice Chairman & Chief Monetary Economist
Email | Bio


[1] Anyone who doubts this assertion should just read the recent indictment handed down by the Justice Department in the case of 12 Russians accused of meddling in the US 2016 election. See https://www.vox.com/2018/7/13/17568806/mueller-russia-intelligence-indictment-full-text.
[2] I concentrate here on the period after the 1951 Treasury-Fed Accord and after the Fed stopped pegging interest rates, a policy instituted during WWII that made the Fed effectively subservient to the Treasury.
[3] Having been at the Board of Governors during part of Patman’s tenure in Congress, I can attest to the fact that the mere threat of appropriations or an audit instilled more financial discipline in the Fed’s operations than could be observed in agencies that were subject to appropriations and audit.
[4] See Harrison, William B., “Annals of a Crusade: Wright Patman and the Federal Reserve System,” American Journal of Economics and Sociology, Vol. 40, No. 3, July 1981.
[5] The Committee’s name has changed several times, so for simplicity it is simply referred to as the House Banking Committee.
[6] See history.house.gov/People/Detail/13906.


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Minute By Minute

The FOMC June minutes were released this past week, along with the Committee’s most recent predictions as detailed in its Summary of Economic Projections (SEPs).

Although the press gave attention to the Committee’s views on the implications that the tariffs soon to be implemented might have for growth, in reality the minutes devoted only a couple of sentences to concerns that district contacts had about tariffs. Specifically, “… many District contacts expressed concern about the possible adverse effects of tariffs and other proposed trade restrictions, both domestically and abroad, on future investment activity; contacts in some Districts indicated that plans for capital spending had been scaled back or postponed as a result of uncertainty over trade policy.” Potential impacts on steel, aluminum, and agricultural prices and exports were noted.

While the minutes were largely unremarkable overall, there were a couple of points of emphasis that were different and potentially interesting. For example, the manager of the Open Market Desk pointed out that paydowns and maturing MBS were likely to fall short of the caps that had been established (the max for MBS being $20 billion per month), indicating that reinvestment in MBS was likely to be unnecessary and implying that shrinkage of the MBS segment of the System Open Market Account portfolio would be less than planned. Indeed, as of the end of June, the shrinkage of the aggregate portfolio was about $22 billion short of target, and at the present pace the shortfall will be much greater by the end of July.  Having said that, paydowns could, depending upon what happens to rates, again exceed the target reductions in MBS. So as a contingency, the Desk staff proposed continuing to make small MBS purchases to maintain operational readiness should redemptions exceed the targets and purchases again become necessary.

Additionally, the Committee appeared to have spent considerable time discussing the strength of labor markets and the implications that had for potential wage increases. As for risks, the Committee again noted policy uncertainty, especially with respect to trade policy and the negative implications for investment and business sentiment.

The most interesting discussion, however, in the entire set of minutes was the attention that was paid to the flattening of the yield curve and what, if any, signal that trend may have as a harbinger of a future recession. Several factors in addition to the tightening of policy were seen as possible contributors, including a reduction in the longer-run equilibrium rate of interest, lower inflation expectations, and a lower term premium, in part related to central bank asset purchases. Views appeared to be mixed and relatively split between those who felt that the above factors reduce the meaningfulness of a flattened term structure as an indicator of recession probabilities and those who felt that the flattening curve is still a useful indicator. Staff apparently presented research looking at the usefulness of measures of the spread between the current and expected federal funds rate derived from futures markets as predictors of recessions. In general, the System has continually devoted attention to yield-curve inversions as predictors of recessions, and the general conclusion is that a negative yield curve has led all but one recession since 1955, with a lag of between 6 and 24 months.[1] Bauer and Mertens’ most recent work shows two key things. First, while inversions may signal an increase in the probability of a recession, at the critical threshold of a zero spread, the probability of a recession 12 months ahead is still only 24%.[2] They also note that as of February 2018 the estimated probability based upon the spread that existed at that time was still only 11%, which they viewed as “… comfortably below the critical threshold….”

As for the risks to the economy associated with the potential trade war initiated by the US, it is interesting to look at statistics on US and China trade relative to the size of their respective economies. Current estimates suggest that China’s GDP is about $12.2 trillion, while that of the US is about $19.4 trillion.[3] Of that, US exports of $1.4 trillion are about 7% of US GDP, and imports of $2.4 trillion are about 12.4% of US GDP. Trade is much more important to China than it is to the US. Chinese exports are 17.2% of GDP, and imports (which historically have consisted of raw materials and intermediate inputs to their exports) are about 15.6% of GDP.

US trade with China, especially the deficit, has gotten a lot of attention. However, US exports to China are less than 1% of US GDP, and imports are about 2.5% of GDP. As of this writing, the administration has imposed tariffs on about $35 billion of US China imports, or about 0.2% of US GDP. While these appear to be small numbers, the impacts on certain US industries in many parts of the country, such as soybean farmers in the Midwest, are critically important to their well-being. Unfortunately, what the present approach to trade implies is picking winners and losers who bear the brunt of attempts to rationalize international trade policies, but is based upon the faulty logic that the US must have bi-lateral trade balances  with each of our trading partners.[4]  The political fallout from the coming trade war will be significant, but the immediate worry is not the overall economic impact, which by most measures is small.  Rather the more significant effects will be the impacts that tariffs may have on market psychology and business investment attitudes and decision-making. The emotional impacts may drown the real economic impacts.

Robert Eisenbeis, Ph.D.
Vice Chairman & Chief Monetary Economist
Email | Bio


[1] As but a small snapshot see: Bauer, Michael D., and Glenn D. Rudebusch. 2016. “Why Are Long-Term Interest Rates So Low?” FRBSF Economic Letter 2016-36 (December 5); Berge, Travis J., and Oscar Jorda. 2011. “Evaluating the Classification of Economic Activity into Recessions and Expansions.” American Economic Journal: Macroeconomics 3(2), pp. 246–277; Estrella, Arturo, and Frederic S. Mishkin. 1997. “The Predictive Power of the Term Structure of Interest Rates in Europe and the United States: Implications for the European Central Bank.” European Economic Review 41(7), pp. 1,375–1,401; Mertens, Thomas, Patrick Shultz, and Michael Tubbs. 2018. “Valuation Ratios for Households and Businesses.” FRBSF Economic Letter 2018-01 (January 8); and Rudebusch, Glenn D., and John C. Williams. 2009. “Forecasting Recessions: The Puzzle of the Enduring Power of the Yield Curve.” Journal of Business and Economic Statistics 27(4), pp. 492–503.
[2] See Bauer, Michael D. and Thomas Mertens, “Economic Forecasts with the Yield Curve,” FRBSF Economic Letter, March 5, 2018. https://www.frbsf.org/economic-research/publications/economic-letter/2018/march/economic-forecasts-with-yield-curve/
[3] https://tradingeconomics.com/china/gdp; https://tradingeconomics.com/united-states/gdp
[4] Alan Blinder has a useful discussion of what we know about trade balances in WSJ July 9, 2018.

Links to other websites or electronic media controlled or offered by Third-Parties (non-affiliates of Cumberland Advisors) are provided only as a reference and courtesy to our users. Cumberland Advisors has no control over such websites, does not recommend or endorse any opinions, ideas, products, information, or content of such sites, and makes no warranties as to the accuracy, completeness, reliability or suitability of their content. Cumberland Advisors hereby disclaims liability for any information, materials, products or services posted or offered at any of the Third-Party websites. The Third-Party may have a privacy and/or security policy different from that of Cumberland Advisors. Therefore, please refer to the specific privacy and security policies of the Third-Party when accessing their websites.

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Dollar May Have Not Peaked Yet, Cumberland Advisors CIO Says

Watch at Bloomberg.com: https://www.bloomberg.com/news/videos/2018-06-24/dollar-may-have-not-peaked-yet-cumberland-advisors-cio-says-video

See a related video here: Turkey to Face More Volatility, Cumberland Advisors CIO Says


Links to other websites or electronic media controlled or offered by Third-Parties (non-affiliates of Cumberland Advisors) are provided only as a reference and courtesy to our users. Cumberland Advisors has no control over such websites, does not recommend or endorse any opinions, ideas, products, information, or content of such sites, and makes no warranties as to the accuracy, completeness, reliability or suitability of their content. Cumberland Advisors hereby disclaims liability for any information, materials, products or services posted or offered at any of the Third-Party websites. The Third-Party may have a privacy and/or security policy different from that of Cumberland Advisors. Therefore, please refer to the specific privacy and security policies of the Third-Party when accessing their websites.

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Cumberland Advisors Market Commentaries offer insights and analysis on upcoming, important economic issues that potentially impact global financial markets. Our team shares their thinking on global economic developments, market news and other factors that often influence investment opportunities and strategies.




Suncoast FYI talks with Michael McNiven & James Curran about Financial Literacy Day

Dr. Michael D. McNiven,  Managing Director and Portfolio Manager at Cumberland Advisors, joins Dr. James Curran, Dean of College of Business at USF Sarasota-Manatee, to discuss their upcoming event, Financial Literacy Day.

Attendees of Financial Literacy Day: An Update on the Financial Markets & Economy can receive continuing ed credit from the following orgs:

• AFCPE Post Certification (7 credits)

• CFP Board (7 CE credit hours)

For a detailed agenda and registration information, please visit: www.Interdependence.org




As Wall Street Sinks, Trump Is His Own Worst Enemy

As Wall Street Sinks, Trump Is His Own Worst Enemy

Excerpts below:

As far as the stock market is concerned, U.S. President Donald Trump is, right now, his own worst enemy.

The president – who frequently touted Wall Street’s rally following his 2016 election victory – was partly blamed for a sharp stock selloff on Monday that investors believe is likely to continue, deepening cracks in a nine-year-old bull run.

Trump’s first year as president, the S&P 500 surged 24 percent on bets he would boost the economy with fiscal spending, deregulation and deep tax cuts. Trump tweeted frequently about the stock market as it rallied through 2017. But since a selloff in February, he has been noticeably silent.

But this bull market has frequently staged swift recoveries, and some were poised for opportunity.

 “I’m taking advantage of these markets and am heavily overweighted financials and banks,” said David Kotok, chairman and chief investment officer of Cumberland Advisors in Sarasota, Florida. “I didn’t buy today, we’re in freefall, but I might tomorrow.”

Read the full article online at money.usnews.com




Trade war threat is now Wall Street’s top economic fear, survey says

Excerpt below:

Protectionism tops the list of worries on Wall Street, the survey shows, far outpacing concerns over inflation, terrorism and even the Fed itself.

“The market has shifted from a fear of a monetary policy misstep, tightening too aggressively, to a trade policy mistake, escalating into a trade war with China,” Art Hogan, chief market strategist at B. Riley FBR, wrote in his response to the survey. “The balance of risk for equities has moved from the Fed to the White House.”

Added David Kotok, chairman and chief investment officer of Cumberland Advisors, “One man’s income is another man’s expenses. No one wins a trade war.”

President Donald Trump in recent weeks announced sweeping tariffs on steel and aluminum tariffs, and then exempted Canada and Mexico pending the outcome of talks on the North American Free Trade Agreement. The president has allowed for other exemptions, setting off a flurry of lobbying by countries and companies in the U.S. and abroad. The outcome of the exemption process is unclear so far.

Read the full article at CNBC.




Winners and Losers from Global Trade

David L. Blond, Ph.D, has a distinguished career in international economics and particularly on the issues of trade. He is the president of QuERI-International, Washington, D.C.

He has assessed President Trump’s Tariff and Trade barrier initiative and has articulated some strong opinions. His views are his. They are worth reading and considering in what is about a ten page paper on this subject. Readers may note the documentation and data depiction which are his work.

When it comes to the views of a number of us at Cumberland you can find them here at www.cumber.com/category/market-commentary/.

We thank David Blond for permission to offer his paper to our readers.

A rebuttal to David Blond’s commentary has added to the conversation. You can read that here: Why David Blond is Wrong on Trade

David R. Kotok
Chairman and Chief Investment Officer
Email | Bio


Winners and Losers from Global Trade

In a grand effort to change the subject of the political discussion from Russia to something else, President Trump fired the opening shots in a new trade war. Not content to destroy the solar industry by adding costs without adding supply to solar panels, or making South Korean washing machines more expensive without making American consumers more willing to buy US made (with foreign parts) machines from the one remaining American producer, President Trump fired off the big guns to try to save what remains of the US steel and aluminum industries with new tariffs. The response was, of course, expected.

Over the past twenty years or more I’ve tried to slow the steady erosion of the US industrial base against the tide of history, but right now, at this time, it is far too late to stop what is the inevitable shift in the global distribution of manufacturing. To have saved the US Steel industry we would have had to force US companies to invest in the new furnaces and the US steel workers to cut their wages in a vain effort to gain advantages of scale and compete on price. Our companies chose not to try to fight against the subsidies – from government direct aid to massive amounts of nearly free capital – but to regroup around a few, higher profit, subspecialties. Steel has become highly specialized in more technology interesting and profitable alloys, leaving the lower end, construction steel and non-specialty steel to foreign producers with their massive scale economies. The cost of this change has been, felt, in the secondary industries that transformed commodity steel in small operations scattered across the industrial rust belt. The downstream industries have failed as the few remaining US steel companies with specialized products have maintained their shares. The US Aluminum industry also has made changes that allow it to maintain its position in the world while fulfill its obligations to the environment. Less aluminum for cans, but more for aircraft and even military vehicles has left the industry largely with the same share of the world as it had in the past.

Looking at the chart we can see that while the US lost its nearly preeminent position in both industries that it had coming out of the Second World War over a long period of decline. Over this period the US companies shifted capital from less productive to more productive and profitable industries and also invested overseas. The failure of US capitalism has been borne by the workers and the communities that have been damaged by this neglect. Social morays matter and US capitalism with its emphasis on shareholders value rather than that of all stake-holders is to blame, but what we see today, as the graph illustrates, is a slow erosion, but not the disappearance of entire industries.

In the chart all values have been corrected for changes in prices and in changes in exchange rates. The US share of world output of steel and aluminum metals stabilized around 2010. In the case of US steel the import share is forecast to decline relative to demand for steel in US manufactures as the product mix changes. There is also some growth in import share in non-ferrous manufactures demand. Tariffs will not suddenly return either industry to health. Based on the factors driving consumption the import share of foreign aluminum will likely continue to increase as overall demand shifts from aluminum to more exotic low weight materials like carbon fiber while the foreign aluminum may continue to be imported for low value uses such as cans and other commodity materials made of aluminum. Again not all aluminum is the same for all uses and American companies remaining in the industry have shifted to the higher value output. This is a natural progression as we should see as countries move towards more service and information/science intensive specialties and away from the high impact on the environment and low skill product categories within the industry classification code.

Winners and Losers from Global Trade Chart (1)

What Happens If Trump Gets His Way on Trade

Global trade patterns have been modified over the last fifty years by a series of trade agreements. Largely tariffs in the richest and most important markets are low enough to be barely noticeable in most manufactured commodities. Tariffs against emerging markets have been reduced through special efforts by advance countries to open potential flows to help in the development process. Efforts to reduce tariffs have been, as a result, concentrated on eliminating tariffs on agricultural commodities with limited results since food, unlike manufactures, is one of the essentials to guarantee along with shelter to a people. Much of the progress on reducing tariffs has concentrated on reducing prohibitive tariffs in the emerging and developing country markets.

America has been at the forefront of this effort. But tariffs and non-tariff barriers not just rules for companies to deal with, they are also part of the nation’s foreign strategy. The Trans-Pacific Partnership Agreement was less about tariff levels and more about maintaining long-term trading and political connections. The failure of President Trump to see America’s role as the essential nation for global cooperation is a problem. His rhetoric has damaged our standing with our natural trading partners. But in this article we are looking less at the political and social implications of the failure to keep the momentum going, and more at how difficult reversing the trends that have reduced American manufacturing in some sectors. The reason for this is that industrial capacity has been lost in many industries and technology has made replacing suppliers far more complicated. When I was the Senior Economist at the Pentagon and studying our capability to expand rapidly our defense industrial base, this problem of technological interplay became readily apparent. A landing gear on an F-15 takes at least a year to produce even as the labor hours may be just a third or less of that time. Each time a cut is made in the high tensile alloy, the unfinished billet had to be slowly heated and slowly cooled to release the tension to allow more machining. The unique parts used on military aircraft had to meet mil-specs that made it costly to replace one supplier or open a second source without testing of the replacements. The same is true for much of what passes as new products. While consumer goods might be easier to copy, the margins on these make the cost of the new factory expensive. The advantage of Asian suppliers was not just their low labor costs, but their excess, flexible, engineering and manufacturing capabilities that are not easily duplicated. America’s manufacturing capacity has not declined even as employment in manufacturing has collapsed. Productivity explains most of the loss of jobs , but gains in productivity have come from the inclusion of more foreign sourced inputs in finished products thus real gains in productivity may be an illusion induced by this shift from a vertical to horizontal company organizational approach. The result is that fewer workers are needed as the foreign labor inputs once made in-house or with locally sourced suppliers is not counted when measuring total factor productivity. This pattern of hollowing out companies is likely responsible for most of the gains in productivity and fewer workers producing products for sale domestically.

Measuring the Cost of Anti-Globalization

Simulations are one of the few ways to measure the cost of retreating from the world that has emerged from the steady advance of trade liberalization. As we have shown, the benefits and the costs of this advance are not evenly shared opening the door to protectionist sentiments. But reversing the course also comes with costs. The QuERI Integrated Global Model measures this interconnectivity through a series of equations linking trade with production. Statistically based, econometrically derived, equations reflect the production function including stock of capital to labor ratios, and two major trade components – imports which are in nearly all cases negative to domestic production and exports which are positive. In rare cases the positive export elasticity is greater than the negative import one. Unlike most macroeconomic model for a single country, the QuERI model set is based on a 72 country and 25 year sample of data that allows for countries to pass through various stages of economic development. Lastly results are linked together across industries using input-output linkages and across the world using international trade relationships. Like the best econometric models, the coefficients are related to one another independent of prices and exchange rates. The underlying QuERI data set is likely the largest and most fully integrated long-term reading on industrial, trade, employment, prices, and consumption patterns available anywhere in the world.

The question at hand then is what would be the impact of a full blown, 1930’s style, trade war. The tariffs President Trump has initiated against good advice will not lead to a recovery in US manufacturing or in the core industries he’s targeted. As I said at the start, the train left the station long ago, and it is too late to reverse the integration, only to slow it, adding risk, rather than supporting faster growth in all countries. A model like the QuERI model, however, can be used more selectively to measure the effect of tariffs on a single industry or on a collection of industries. In the example below we want to not pick any one industry, but rather to assume that all countries apply the same tariff increase across all products. We can then measure two things – the impact on exports and imports and the impact on production.

A 10% Tariff Increase – the Global Implications

Integrated global supply chains are not simply between advanced countries and emerging markets, they also exist between countries in each group so any disruption is a major change and can lead to loss of irreplaceable capacity and capabilities. The cost of qualifying a new supplier is often high and the risk to existing business increases if the replacement products are more prone to error or failure. In this example we assume that the imposition of a 10% tariff in the United States creates a chain of causality that expands so that a similar tariff is applied in all other countries. The goal is to find out what the costs of this kind of modest increase in international prices pose to trade and production.

The broad based assumption is that globalization reverses slightly as a result of this added cost for imports. The impact is greatest within the group of advanced country due to their greater integration with the world. The calculated impact is based on the point elasticities for imports and export prices against changes in trade. To insure that we are not over or undercounting the effect we average the total export adjustment from the model and the total import adjustment for each ISIC3 commodity. The share of global trade adjustment is based on the share of the adjustment in individual country imports or exports against the average global trade adjustment. Not all countries are sensitive to changes in price for trade goods. We assume that higher prices will not increase imports although it is possible there is some precautionary trade influenced higher prices. When the price elasticity for imports is positive it suggests that demand is not sensitive to price changes. The assumption of the model is that these changes are modest and it is likely that temporary reductions can take place if the price shoots up too rapidly to be accommodated in the overall cost function for the finished products. The price sensitivity of a country on a rapid development trajectory, like China, is less than for advanced countries with more flexibility of supply or simply to reduce domestic production and import more of the finished manufactures for resale and rebranding (common practices).

Emerging and Developing Nations Came to the Party Late

The pooled-cross sectional model for trade and industry used in my model is based on a “stage of development” so that countries at the start of period of rapid industrialization are assumed to follow paths similar to more advanced countries. In the early stages a country is more dependent on foreign sources of supply. The actual volume of imports is defined by the countries capacity to export or attract inbound foreign investment. Tariffs in these countries tend to be supportive of local business and often are higher than they need to be and these limits can impede real growth and development. Much of the theoretical literature on tariffs is based on the assumption that tariffs dampen imports, but may limit the growth of domestic industries despite the intent. The higher prices for the locally manufactured products may limit the market size and limit growth of the economy as a whole. It was factually true that in the early periods of industrialization the advanced countries had high tariffs to encouraged industrialization. That strategy is not replicable despite the fact that globalization as it stands has failed the emerging and developing nations primarily because the price of finished goods is influenced by the higher prices of the advanced countries. Thus the steel that might have gone into an automobile is priced at the world market prices consistent with the costs of finished products sold in advanced countries. For a country to grow rapidly then wages and prices have to be in line. Today the cost of living in rich and poor countries is often significantly different. We measure these differences through the purchasing power parity index. The cost of living in China is today around .33, while the wages paid to workers even at $ 5.00 an hour (2016) is just .13 of the wages in the United States. In the next graph we see how the advanced countries prices and wages generally are in line so that growth can be sustained from domestic demand and supply alone if need be.

Why is this critical – without a strong alignment between real wages and real prices then internalized, self-initiated, growth is difficult to be maintained without external sources of demand. Export-led growth encourages the import of new technologies while suppressing wages and encouraging the import of foreign luxury goods suppressing local supply. The result is that for many emerging and developing countries there is no simple solution and higher tariffs may not encourage the development of domestic sources of supply. Of course there are exceptions—protection of agricultural products may be important for reasons of the keeping peasants on the farm and insuring that domestic producers continue to stay in the rural communities and maintain food self-sufficiency.

In the charts we can see how the wage rate, represented by 1/wageindex (1.0 = US wages) and the PPP Price index are not fully in line in the emerging markets group. It costs less to live in China than the United States, but the wages in the United States are in line with the cost of living, the wages in China today are suppressed by the need to be competitive on world markets by international trade, so it is hard to sustain growth without exports or government subsidies. If that were not the case then the index for wages and the index for prices would be equal to one another.

Using the Model to Measure the Impact of Tariffs on Trade –the Cost of Reversing Sixty Years of International Trade Liberalization

The QuERI Global Model has a number of advantages when measuring the impact of changes in prices, in this case, ad valorem tariff changes, on trade, industrial activity, and employment. The two charts illustrate the disconnect between relative wages and relative prices. Globalization has widened this gap in rich and poor countries alike. At the same time the dependency between countries for vital raw materials, energy supplies, and intermediate inputs has increased. Disturbing markets and plans can only lead to a disruption in an economy until companies and economies adapt. But during the period of adaptation production is impacted, employment growth reverses, and real wages may decline further as companies attempt to maintain profits.

Trade and Industrial Production Linkages

Within the model there are a number of links between trade and production. The industrial production of traded products includes a variable reflecting the foreign content of factor inputs based on estimates from the QuERI IO models. Foreign content is based on the import share of apparent consumption times the total factor input. For example if to make a car in the United States it takes $ 1000 worth of steel based on the IO column coefficient at the intersection of steel (selling) and automobiles (buying) and if import share of foreign steel is 50%, then $ 500 is allocated to foreign content of steel. Going further down the column of the IO for automobiles we see the share of electronics is $ 1500 and the foreign share of imports of these products is 65% then the foreign content is $975. Adding all of the foreign content value up the total import value is used as an independent variable in the industry production function for automobiles. Repeating this process we can calculate then the likely sensitivity of the industry to the replacement of foreign with domestic sources of supply. In the US the foreign content share for automobiles is 40% of the total value of automobile production. For footwear the foreign share is over 78%. For China the foreign share of production for automobiles is just over 5%. So in any trade war who’s domestic companies would be more seriously impacted?

Reducing foreign inputs to US production will slow growth or even reverse growth in US manufactures so long as substitutes are not available. Given the complexity of much of what is sold as factors of production or as finished goods in retailers, replacement of foreign content will be a slow, painful and possibly impossible process. Adding tariffs will in the short-run reduce demand as some American production may be lost. In the model then the production function has three elements whose interplay determines if production will increase or decrease.

(1) Net Change in Production = Net Change in Foreign Content $ + Net Change in Exports – Net Change in Imports.
(2) Net Change in Exports = function of Impact of Foreign Tariff Changes on US Exports (positive)
(3) Net Change in Imports = function of Impact of US Tariff Changes on Imports (negative)

President’s Trump’s idea that a tariff might reduce or eliminate or dependence on foreign suppliers is a myth born as much out of ignorance as political calculation. The American manufacturing base has been hollowed out and is a part of the global supply chain of global companies with markets in all parts of the world. Fifty years of continuous efforts to reduce tariffs have been successful creating a world market and worldwide production system. But the emergence of China and its low cost wages and lower cost capital and ideal location in the heart of an emerging Asia has changed the balance. Higher tariffs will end up damaging the American economy more than China. The foreign content in US manufacturing, investment goods purchased, and consumer products sold by retail and wholesalers makes any effort to disrupt trade self-destructive. The next table illustrates this in the starkest terms – the share of foreign content in US domestic manufacturing has been growing year by year. The share of foreign content in US investment expenditures for machinery and equipment has also been growing over this period. Any effort to enter into a broad based trade war would lead to the destruction of American industries ability in the short-run to manufacture almost anything except, perhaps, rubber mats for automobiles.

Foreign content in finished products is significant. Clothing and apparel 71% in 2015, household operations 48%, furniture, finishing and other equipment 37%, other transportation and communications 48%, medical care and health including pharmaceuticals 45%, entertainment and cultural expenditures 48%. Place tariffs on imports from China and in the short-run there will be empty shelves and limited consumer choices in the stores, ultimately small and large stores will close leaving millions of people from warehouse workers to sales people out of work.

Foreign content in finished products is significant.
Foreign content in finished products is significant.

Foreign content in finished products is significant.
Foreign content in finished products is significant.

Using the model we can simulate how a 10% change in tariffs as measured through a 10% change in import price will impact the world economy. In this example the 10% unilateral change in US tariffs – pushing them up to closer to 12 to 14% from around 2 to 4% where they currently are. In this scenario we assume that the world reciprocates and applies a similar increase in cost to imports from all sources. If globalization is the problem and its impact on countries ability to manufacture has been substantial, then we should expect that the change is universal, the beggar thy neighbor approach usually leads to higher tariffs across the board worldwide. The question we ask – who wins and who loses from this change. The degree of dependence, however, varies and the weights of imports and exports vary in all countries. The net impact then will be different for rich and poor, trade intensive and trade neutral countries.

10% Tariff Impact on All Countries & Regions
10% Tariff Impact on All Countries & Regions

As table shows if there is a trade war and it settles down to around a 10% increase in tariffs levied against all countries imports and exports, given the dependency, the impact of this symmetrical war (unlikely as countries will more selectively target the industries and countries imposing the added tariffs) which does not bias the impact against one country and not another, the United States with its greater dependence on foreign imports will be more directly impacted than other countries. The differences in shares between US and Germany are a function of the mix of products imported and not from differences in the product specific price elasticities. The cost of President Trump’s trade war for the United States could be a 1.1% decline in real production of manufactures, a nearly 1% decline in output of primary products including soybeans and corn exports. The most important loser from any trade war is the United States. Imports would be 5.5% less while exports would be 2.2% less so that the net trade deficit could be smaller as a result of the tariffs. It would cut around 1.1% from US manufacturing output and reduce employment in manufactures by 1.3%. These results are the build-up from the bottom-up at the industry level (more than 170 industries including services).

This modeling exercise only takes into account the impact on production from the reduction in imports used as intermediate inputs to production. A more complete analysis will use the full inter-relationships within the model to measure the effect on production of less foreign products for sales to consumers and less capital goods able to be deployed to growth productive capacity. It is likely that given the significant, sometimes 30 to 50% shares of foreign content for personal consumption and business investment that the full effect of a trade war will be greater. Perhaps more damaging is that the war would be concentrated against a single country, the United States, while other countries and groups of countries maintain their past trade relationships. Like dropping out of the Trans-Pacific Partnership, threatening to pull out of NAFTA, canceling negotiations on the European US trade agreement, the net result will be to isolate the United States from the world.

Benefits and Costs of Global Specialization – How to Measure Trade Displacement.

Much of the debate over the past years about the benefits and the costs global specialization, primarily the rapid advance of China as a major manufacturing center has been less about the financial costs – the $ 12 trillion dollars of additional liquidity that the US consumers offered to the world (the cumulative US trade deficit from 1990 through 2015 compared to the over $ 3 trillion dollars in trade surplus run-up by China over this same period—and more in terms of the jobs lost and the impact of foreign products on American wages in manufacturing.

The flow of US dollars has is the lubrication for the world economy adding liquidity to rich and poor countries alike. Without the US acting then as the little blue engine that ‘could’ for the world economy, the miracle that has lifted a billion people from poverty to wealth or near wealth could not have happened, it came at a cost to America’s massive, post-war, industrial base. It came as a benefit to American consumers and companies (and investors) in the form of supporting a higher standard of living at a lesser cost than internal resources alone could support, and a better margin on sales for companies supporting the growth in the stock market values of companies even as old name companies in commodity type industries such as steel and aluminum suffered.

There are many ways to measure the trade deficit. The nominal deficit is driven by differences in relative prices of exports and imports. A price index is an approximation of the changes in the price of the components of the commodity group. The BLS, the government agency that develops price and wage indices based on surveys, but there are some major product groups where absolute prices have declined even as the capabilities offered for these prices have increased. For example computers and chips available are multiples of prior computers and chips in terms of capabilities for the same basic prices paid in the past. In the BLS indices for these technology intensive products prices are assumed to decline so real value increases. This potentially distorts the relationship between nominal and real deficits. Another problem comes from exchange rates which vary over time distorting the real value changes from the nominal cost changes. Our primary focus then will be, like in the case of macroeconomic models, changes in real activity with price changes and exchange rate changes excluded.

With the dollar as the numeraire currency through which much of world trade flows, the need for dollars is great. If the US fails to run a large trade deficit each year, the cost of buying and selling dollars would necessarily increase leading to higher costs to support the larger amount of world trade that is dependent upon using dollars for the transaction. Dollars are also needed to repay debts denominated in dollars or support other financial flows. The following chart perhaps illustrates that there could be a causal link between the size of the US trade deficit in constant dollars as a share of total US exports and imports and the rate of change in world real GDP output excluding US real GDP growth. The Asian crisis that sent the Emerging Countries into a tailspin and collapsing stock markets over the 1997-99 period may have been due to a liquidity shortage as the US deficit pushed towards closer balance starting in 1993 and reaching an apex in 1996 with world output (excluding US) for three years between 1994 and 1997 was 3%, but as the US fiscal stimulus from our trade deficits declined over those years, and without alternatives to replace the extra liquidity, raw material prices growth collapsed and world output slowed dramatically from 3% to 1%, and 2% in the following year. Fearing a global depression, the Clinton economic team combined with the Federal Reserve stepped in to stimulate growth in US trade and the US deficit grew strongly as world trade growth reached over 10% and the deficit reached a low point of -3.5% while world output growth expanded strongly until as the US deficit relative to total trade declined year by year until we reached the Lehman Brothers in 2007-08 and world output suddenly went from positive to negative in one year. The US recovery has been followed by a return to past periods of the US running trade deficits. In the QuERI model, like non-US world output, these stabilize in the long term at around -25% and world output stabilizes in the 2-3% range.

If the global growth depends upon the US running a stable, long-term, trade deficit, then the industrial base in the US will necessarily suffer from a shortage of demand or a steady drum beat of competition that keeps real wage growth in check. In short we may be locked into a damned if we do and damned if we don’t pattern. When I was at the Pentagon during the period of the Reagan build-up, I would explain to the critiques back in 1982-84 that economies have a natural structure that may adjust over time as defense contractors shift resources form military to civilian needs, but no economy can adjust fast enough to accommodate a sudden cessation of demand without dire consequences. Thus the world depends upon US surplus demand. The Chinese government would gladly burn the excess reserves in dollars than spend them in buying US steel or aluminum. The demand for dollars is greater today than when the idea was first suggested back in the 1970’s. The dollar is not just the transaction currency for trade, but more importantly the transaction currency for world debt denominated in dollars. The failure to provide sufficient excess liquidity shrinks the amount available. It drives up the price of the currency, but even a strong dollar and a growing trade deficit will add enough free exchange especially if the US domestic demand increases from a stronger economy.

Renegotiating Trade Agreements Doesn’t Add Industrial Capacity in the United States

I pointed out in an earlier paper on the future of globalization, that there is nothing that President Trump has said or tweeted about the failure to protect American manufacturing from the ravages of unfair trade practices of some countries or the willingness of American companies to outsource supply to foreign subsidiaries at the cost to historic relationship with workers and communities. I have been saying for years. But I’m enough of a realist (or powerless) to know that these business decisions can’t be easily reversed. Once a company chooses to leave, shutters a factory, lays off workers, then the capacity is gone. If it is reformed it will be with more capital and fewer workers or a new advanced product no longer able to be built in an old style plant. The US government owns vast reserves of machine tools in massive factories built during World War II and no longer needed. When I was at the Pentagon I visited many of these factories mothballed except for a few, new, style machines doing what work remained. The private sector is less forgiving and older plants simply rust away or is torn down to build track houses(1).

Everything in the Republican plan for rebuilding American manufacturing hinges on stimulating investment in the US. In theory this should reduce demand in real terms, but in practice it may not. The significant share of foreign content in US made manufactures today – well over 25% in nearly every sector. A stronger dollar may come from the effort to protect US companies. If the trade deficit declines and if there is a surge of foreign investors taking advantage of the reduced tax burden and the threat of more American protection, then the stronger dollar will make imports cheaper and exports dearer, limiting the effect of the Trump-Republican plan for protecting US industry from foreign competition. It is the expected future strength of the dollar that make US exports uncompetitive in more markets and the less cost to foreign imports that changes the trade balance from negative to positive in dollars but adds to the problem caused by the real trade balance that impacts employment.

Don’t Mess with What’s Working – Mr. Trump, Do No Harm

We can measure the trade deficit in many different metrics. A more interesting approach to measuring the trade deficit or surplus is in terms of the total loss or gain associated with the intermediate inputs that are not included in the export and import data. If the United States or any country could make everything needed to manufacture all the products without trade it would be autarkic (standing alone). To make a car you need, however, the contribution of other companies selling the steel, plastic, engine parts, and even consulting services. If we add these indirect sales in we have a total full-in trade value for exports and imports. In the table following we summarize the impact of the trade balance on the United States economy including the direct and indirect trade and the total number of jobs in manufacturing and in other industries lost as a result of the deficit. The cost to the economy is just 3 million jobs.

Revised Balance of Trade
Revised Balance of Trade

A Trump-like world view of “America First” might assume that everything you need should be made here. If the rest of the world assumed the same then we can measure the “Shadow” deficit or surplus by including the indirect or intermediate sales that are lost when an automobile is imported from Germany. As is indicated in the table following this one, the actual share of foreign content in US factor inputs that can be traded across borders is 35%. For purist, however, full independence from the world would mean that everything that is made here comes from here. The other side of the same coin is that US exports are zeroed out. Adding in the indirect sales the size of the deficit increases in the case of real trade, but actually decreases slightly in nominal terms. The difference is which industries benefit from the alternative. When all this is translated, industry-by-industry into employment losses due to the trade deficit the cost is around 3 million jobs. This works out to 2.2 employees per million dollars in deficit.

Productivity versus Trade – Where Did the Manufacturing Jobs Go?

Productivity is a dual edged sword, it gives with one hand and takes with another. In November 2002 I published an article in The Manufacturer titled “The Double Edged Sword” dealing with the give and take that comes from productivity improvements:

We live in a world where efficiency is God. Magazines — even The Manufacturer –glorify the benefits of “lean manufacturing”, yet productivity growth is a double-edged sword. It gives to some and takes from others. We are caught in a jobless recovery (2003-4) caused, in part, by the down side of productivity improvements in manufacturing and business services – over supply, low prices, and lay-offs.”

Unlike manufacturing in many other advanced and emerging markets, the share of traded goods in the United States economy is less than in other economies. Two forces are at work here – the United States economy has shifted towards a service intensive economy faster than others with specialization allowing efficiency gains as in-house or vertical parts of the production process are outsourced to more efficient or lower cost suppliers (some owned by these same companies and others at arm’s length). The second force is the specialization within the supply chains, breaking production into more sub elements with each of these made by companies with unique technologies or lower cost labor and capital. This means that the last step in the manufacturing process may be done in the United States but the inputs come from outside. The labor used to make these inputs is not counted in the employment totals with the labor associated with managing a worldwide supply chain (the non-traded goods inputs and the management costs) included. The output or domestic sales are the total sold so the full factor productivity is higher. For a country with a healthy export of these factors of production to other countries the traded good share of production is higher as these companies are being directed in their production by the firms they supply to and who sell their products.

In the tables following we see the share of traded goods in the United States versus some of its major competitors and then the foreign content share. In general China’s traded goods share is higher than for the United States while its foreign content share of traded goods is less so that a trade war will hurt the US more than it will China.

Traded Goods
Traded Goods

 

Measuring Employment Losses – Deficit versus Productivity

The hollowing out of the manufacturing sector for large companies has continued to reduce the share of traded goods in the domestic manufacturing input-output formula. The cookbook recipe described in tables for the US, China and Mexico illustrates this quite well. The proportion of factors needed to make something should be about the same in each country except it is not the same. The differences come in part from the degree to which the companies rely upon outside suppliers – domestic and foreign – to do what used to be done in-house. The vertical integration of the past has given way to a more distributed system relying upon global supply chains and outside sources of supply for semi-finished manufactures.

There are many ways to measure trade’s impact on employment. Given the better data available only from 1996 we use the employment/output factor for this year to fix the employment and compare this to the yearly employment per unit of output. If the productivity had stagnated then the actual damage to US employment from the deficit would have been significantly larger – 4.3 million jobs compared to 1.6 million direct employment losses alone. At most around 3 million jobs are lost due to the trade deficit. This is a full in cost including intermediate transactions lost. Productivity improvements in manufacturing, many due to the transfer of lower value intermediates to foreign suppliers may account for the drop in manufacturing employment. In 2015 if there had been no change in productivity the total employment would be 29.7 million compared to 10.9 million jobs actually reported. Jobs per million 1995 dollars declined from 4.3 to 1.69. Manufacturing job loss, while possibly as much as 3 million jobs in 2015 taking into account indirect measures, is only one factor in explaining the number of manufacturing jobs lost. In 1996 there were almost 17 million employed by the manufacturing sector. That number in 2015 is just 10.8 million. If productivity per unit of output had remained fixed at the productivity as of 1996 the total number of manufacturing jobs would have been 29.7 million. The trade deficit –$ 700 billion in 1995 $s ($ 1085 billion with indirect sales included) – reduces employment by 3 million jobs, however, looking at the table below we see without including the second order effects the employment costs of the trade deficit in 1996 was just 1.4 million jobs and in 2015 with the improvements in productivity it was 1.6 million.

Final Thoughts on Trade and Employment

We can’t disengage from the world, the US as we have observed is, at least in terms of trade, the one essential nation. Our currency is the underlying currency used for trade and finance, our companies are engaged in operations worldwide so that there is no single product group that can be made without some kind of foreign content included. The products we buy and sell are more complex, more protected by patents, and often relying on patented inputs that can be made only by one supplier in one country. So any effort to save a 1000 jobs in steel or aluminum will yield higher profits, temporarily for companies protected by these barriers, but in the long run they will be losers as well, as the open markets on which we depend become more compartmentalized.

Over the past forty years that I’ve been working with trade data and developing models to understand at the most basic level how the world operates, I’ve seen it all. I watched, when I built the first commercial model for trade at a commodity and bilateral or trade route level to help the ocean shipping and air freight industries plan, how changes in the Japanese yen’s price from 300 to 100 yielded little in the way of changes in the US-Japanese trade balance due to the Japanese exporters cutting prices to match the loss of dollar purchasing power in the Yen. At the same time, I observed too how discussing trade barriers against automobiles and semi-conductors shifted meant that Japanese companies began to build operations in the United States. Frictions with respect to trade caused by Trump like threats may be useful, at least in some cases, to change industry behavior.

As the chart shows the 1990’s into the first part of the next century were periods of rapid and sustained growth in world trade. The high point came in 1998-2000. The United States economy was booming and the formerly rapidly growing countries of Asia, Latin America, and Eastern Europe had slowed with currencies collapsing as roaring stock markets turned south. Over the next nearly ten years, until the 2007-09 financial crisis, there was a gradual increase in the share of world consumption of traded products that came from outside the country. This period of sustained integration helped more countries out of the poverty trap, but at a cost to jobs and incomes in the advanced countries. In some ways the slower growth observed since 2011 through today should have been expected. There is a maximum rate of substitution of traded products for domestically manufactured products and we are reaching a saturation point. The ratio of trade growth to GDP growth no longer averages to 2.0, but is now closer to 1.0. It may creep up after 2025 to around 1.3, but without some sudden explosion in demand and supply, it is unlikely to ever reach 2.0 or greater for more than one year or two over the next decade.

World Trade Share of Consumption / World Trade Real Growth
World Trade Share of Consumption / World Trade Real Growth

President Trump’s heart is in the right place with respect to wanting to rebuild manufacturing here as it once existed. That style of business organization is dead, not just here, but in other parts of the world as well. Everyone benefited from the specialization that has occurred over the past thirty years. It is not an impossible task, nor is it not prudent to try to reduce the imbalances we have in world trade as a longer term goal, perhaps replacing the dollar as the necessary underpinning to maintain global liquidity with IMF SDR’s as was once the goal. There are good ways of doing this that are less disruptive and less prescriptive. In the past I’ve suggested a couple solutions to reduce the US trade deficit and preserve US manufacturing by slowly winding down the size of the US trade deficit without selecting winners and losers:

(*) A system of import warrants given to exporters or directly issued by the government setting some limit to imports relative to exports. An importer would need to buy on the open market an import warrant before importing the products so that the free market price of the warrant is set by the market. Such a system could slowly push the trade deficit down without choosing winners and losers.
(*) Changing the corporate tax code so that companies buying more in the United States and selling more outside the country would pay a lower tax rate on profits, while companies selling more in the US and buying less here would pay a higher marginal tax rate.
(*) Working with the rest of the world to change WTO rules making it mandatory that countries running a trade deficit more than 1% of their GDP must impose a 10% surcharge on imports; while a country running a surplus more than 1% of GDP must impose a 10% surcharge on export prices. With these rules applying to both chronic deficit and chronic surplus countries we expect a gradual adjustment and reduction in global trade imbalances.

David L. Blond, Ph.D
President, QuERI-Internatonal, Washington, D.C.

Dr. David Blond has been studying, using sophisticated models and quantitative methods, the impact of trade on a countries growth and development for more than forty years. The QuERI Global Trade and Industry model is the most complex model of the global economy covering 72 countries and more than 400 industries. It can be used to more precisely measure the impact of tariffs, including the 25% steel and 10% aluminum tariffs on the US and other economies in a multi-sector world. For more information on the model and for developing consulting assignments, please contact David. Blond at 301-704-8942 or davidblond2000@gmail.com.

Queri-International specializes in developing models and providing analysis for companies and governments using econometric techniques using proprietary data from its large global data bases combined with other data from public and private sources. For more information contact Dr. Blond at davidblond2000@gmail.com, www.queriinternational.com.


(1) In my economic trilogy, The Phoenix Year, Wattle Publishing, 2014, fiction of course, I make companies in the final volume do what is unnatural, hire when there is a deep recession, invest and hire, all in the name of cooperative growth. To do this I have to destroy private wealth concentrating the ownership of 200 plus of the largest companies in a single Trust dedicated to solving problems globally. In the real world, however, no CEO can afford in this highly analytical financially driven economy to take losses in the hope that other companies follow the same path in order to grow the economy when there is a recession or worse, a depression.


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There is an Old Saying

There is an old saying: “You can lay all the economists end to end and they will still not reach a conclusion.” While there may be some truth to this, there is widespread agreement among most economists (with Peter Navarro perhaps being an exception) that unrestricted trade is beneficial and protectionism is bad for any country.  Trade wars can never be won and they are detrimental to an economy, as the US experience with the Smoot-Hawley tariffs during the Great Depression clearly demonstrated.

To point out the folly of a trade war is not to say that some countries aren’t pursuing unfair practices. We know that they are and action is appropriate. China may be dumping steel on the market at below cost, but that can’t go on forever, and China is not the major supplier of steel to the US. In 2017 China accounted for only 2% of US steel imports.  Furthermore, no entity can overcome a negative spread on a product by increasing sales volume. But the proper response to abuses and attempts to corner a market is coordinated pressure and political pressure by allies together with us of the WTO dispute process, not tariffs. Pursuing remedies is a long and torturous endeavor, but so is dealing with retaliatory responses when a country like the US suddenly makes a unilateral move to impose tariffs or engage in other protectionist acts, especially those that harm our allies.

Such actions don’t often – if ever – lead to wins, let alone easy wins, as the President will soon find out. In the past the US has occasionally engaged in protectionism by imposing unilateral tariffs. Interestingly, one of the most recent episodes was carried out in 2002 by the Bush administration. While Republicans are most often supporters of free trade, President Bush imposed a complex set of temporary three-year tariffs on steel imports, mainly from the EU. Given this comparatively recent episode and the fact that it involved steel, one of the two products targeted by the tariffs being rolled out by the Trump administration, the 2002 experience may provide some clues as to how President Trump’s tariffs will fare.

Before we turn to the history of the 2002 effort to impose steel tariffs, it is important to put forth some basic statistics on US steel and aluminum imports. The US is the world’s largest importer of steel, yet it actually accounts for only 8% of total world steel imports, and it imports steel from over 110 countries.[1] The top ten sources of US imports account for 78% of the total, with the largest four being Canada (16%), Brazil (13%), South Korea (10%), and Mexico (9%). Note that 25% of our total imports come from our closet North American neighbors. More importantly, the steel imports by the US from Canada and Mexico account for 89% and 68% respectively of their total steel exports. Thus, tariffs imposed by the US on imports from these two countries that our closest neighbors would be devastating to their steel export business. That belated realization is clearly behind the fact that President Trump backtracked on his initial tariff announcement and exempted these two countries from his tariffs. He has also hinted that some others, like Australia (less than 1% of US imports), may also be exempted, as they were from the Bush tariffs in 2002.

How significant are steel imports relative to US production? In the aggregate imports account for about 1/3 of US steel consumption, with domestic production accounting for the rest. The US steel industry has been in a long, steady decline, lagging behind because of its failure to invest in new technologies to produce steel, the impact of union activity, and competition from low-cost producers abroad. Even if successful, the US steel industry does not have the potential to create hundreds of thousands of new jobs, as is argued. Just as an illustration, a new plant in Austria now produces with 14 employees what it would have taken 1000 to produce with the technology employed in the 1960s.[2]

Aluminum import realities raise similar concerns. Canada supplies approximately 59% of US aluminum imports, which are even more important to the US than Canadian steel imports. Other key suppliers are Russia (6%), United Arab Emirates (6%), China (5%), and other countries (24%). In total, the US imports about 90% of its primary aluminum. The imposition of tariffs on Canadian aluminum would devastate that industry and raise costs in the US for no good reason. Finally, aluminum is made from bauxite, but the US has few meaningful supplies of bauxite, mainly in Arkansas, Alabama, Georgia and Virginia, which make the Trump administrations national security rationale for its imposition of tariffs on aluminum suspect.

While the Constitution grants Congress the authority to regulate international commerce, Congress has, through a series of actions beginning in 1930, delegated to the President the authority to impose tariffs.[3] Section 232 of the Trade Expansion Act of 1962 authorizes the Secretary of Commerce to conduct an investigation of the impacts of imports and possible threats to national security; and if the President agrees, the Secretary can then take actions like raising tariffs. Given the dependency of the US on Canada for both steel and aluminum and Mexico for steel, which are now exempt, the imposition of tariffs under the emergency provisions of applicable US law would likely be accompanied by abrupt responses by many other affected suppliers, similar to those mounted by the EU in response to the 2002 Bush tariffs.

Exactly what did happen in 2002, and what were the consequences that might reveal the likely outcome today if tariffs were unilaterally increased? The Bush administration imposed tariffs ranging from 8% to 30% on a variety of steel products, in part to make good on a campaign promise designed to appeal to voters in the Rust Belt states of Ohio and Pennsylvania.[4]  However, unlike relying on the Section 232 national security threat authorization employed by the Trump administration, Bush relied upon Section 202 of the Trade Act of 1974, as amended in 1994, authorizing the President to investigate and impose temporary tariffs upon imports that might adversely affect domestic industries.[5] This action was not taken in a vacuum: It followed a series of earlier US complaints to the WTO against the EU and UK and ensuing counterclaims aimed at conserving duties on steel.[6]

The WTO Agreement on Safeguards governs the circumstances and requires studies and related supporting documentation for a country to impose tariffs. The US supplied the relevant documentation, which also contained recommendations for remedial tariffs. Then, on March 5, 2002, President Bush imposed a series of tariffs, which were to remain in place for three years, on a range of steel products. Interestingly, these tariffs also included exceptions for members of NAFTA, namely Mexico and Canada, as well as for Israel, Jordan, and South Korea, along with relaxed levies against steel from Brazil and Russia. Note that these exceptions were essentially for the major suppliers of steel to the US other than the EU.

While tariff changes were being contemplated in the US, the potential affected countries, mainly in the EU, indicated their intention to retaliate, just as countries now are already lining up to oppose the Trump tariffs. After the Bush steel tariffs were imposed, the foreign response was quick, as some seven countries filed a class action suit against the US with the WTO. Read (2005) provides a detailed chronology of the sanctions and tariffs imposed by the EU and the decision by the WTO that rejected the basis and justification for the US tariffs. On December 10, 2003, faced with the adverse decision and the growing threat of a trade war, President Bush rescinded the tariffs before the EU implemented its full list of sanctions. The tariffs lasted a much shorter period than was envisioned because of the impending trade war, the flimsy rationale employed by the US to employ them, and risks to the US that were involved.

What were the economic consequences of the tariffs while they were in place?[7] There were both direct and indirect impacts on both the US economy and our trading partners. Most impacted were those companies that had an inelastic demand for steel inputs. In the US these tended to be among the nearly 200,000 small firms with less than 500 employees.[8] Researchers have studied this episode, and here is a brief summary of those findings.

Preliminary studies estimated that the tariffs would increase steel prices by about 9% and save about 8900 steel jobs, reflecting a cost of about $450,000 per job. A second ex ante study estimated that the tariffs would cost the country about $2 billion but save only 3500 jobs at an estimated cost of $584,000 per job. An ex-post study of the event suggested that the main benefits were a forced restructuring of the steel industry, mergers, abandonment of obsolete plants and equipment, and new investment. At the same time, steel prices went up 39%. One negative consequence of the disappearance of several producers was the shifting of some $8 billion in pension liabilities to the Pension Benefit Guaranty Corporation. In terms of the indirect effects, a study indicated that 50,000 jobs were lost in the fabricated metals industry segment, and overall some 197,000 jobs were lost, which is more jobs than were involved in the making of steel. The impact on aggregate welfare was estimated to be relatively small, in the range of $65 to $111 billion. The impact as a percentage of GDP was infinitesimal.

Clearly, the 2002 experience offers lessons for the present administration. History may be about to repeat itself, for two reasons. First, the choice of the Section 232 national security rationale (and reliance on studies justifying its use) is even more suspect than the rationale used by the Bush administration to justify its tariffs. Second, given the speed at which the affected parties, especially the EU, are already preparing retaliatory tariffs, a case is sure to be brought swiftly before the WTO. These facts suggest that those who oppose the imposition of tariffs are correct. Third, tariffs on steel are not a way to create jobs, on net.

What should we demand as the proponents of the tariffs, and especially the President, as they proceed with their protectionist policies?  They must be pressed to quantify the gains they are attempting to achieve, both in terms of employment and impacts on prices, welfare, and GDP. Unless these ex-ante objectives are clearly articulated, we will be left with false claims of an undocumented victory, when this misguided set of policy actions unwinds.

Robert Eisenbeis, Ph.D.
Vice Chairman & Chief Monetary Economist
Email | Bio


[1] See Global Steel Trade Monitor, International Trade Administration, December 2017. https://www.trade.gov/steel/countries/pdfs/imports-us.pdf. We are overgeneralizing by using the term steel. Steel actually comprises many sub-products, such as pipe and tube, flat, long stainless, semi-finished, etc.
[2] https://www.bloomberg.com/news/articles/2017-06-21/how-just-14-people-make-500-000-tons-of-steel-a-year-in-austria
[3] For a detailed discussion see Congressional Research Service, “Presidential Authority of Trade: Imposing Tariffs and Duties,” Caitlain Devereaux Lewis, December 9, 2016.
[4] The rest of this commentary relies upon the very thorough and comprehensive study of the entire 2002 tariff episode by Robert Read, “The EU-US WTO Steel Dispute: the Political Economy of Protection and the Efficacy of the WTO Dispute Settlement Understanding,” Chapter 7, in The WTO and the Regulation of International Trade:Recent Trade Disputes Between the EU & US, edited with Nick Perdikis, Edgal Elgar, 2005.
[5] See Kevin Ho, “Trading Rights and Wrongs: The 2002 Bush Steel Tariffs,” Berkeley Journal of International Law,Vol. 21, Issue 3, 2003 fn 2.
[6] See Read fn 4 for a detailed discussion of the WTO Agreement on Safeguards and related international agreements governing the imposition of tariffs.
[7] For more detail see Read (2005) and references therein, fn 4 above.
[8] See Read (2005)


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The Threat of a Damaging Trade War

The Trump administration is raising fears of a possible trade war, a development that is unsettling markets around the globe, upsetting some of our closest allies, and causing great concern to both a wide swath of US business leaders and to leaders of the President’s own party. Following the President’s announcement last week that he intended to impose sharp tariffs on steel and aluminum imports, our concerns increased substantially when Trump claimed that it would be “easy” for the US to win a trade war. We strongly disagree. There are no winners in a tit-for-tat trade war; every country including the US would lose. And Monday we learned that the President’s top economic advisor, Gary Cohn, has chosen to resign rather than support the President’s stated intention to implement a protectionist trade policy.

Gary Cohn has been the steady hand on the tiller of the administration’s economic policy and deserves considerable credit for the economic achievements of the past year, in particular the tax cut package. Investors are concerned that Cohn’s departure leaves the White House only with advisors pressing for a confrontational, protectionist trade policy. Cohn fully understands the importance of open markets for the US economy and US workers and businesses. Cohn’s decision to resign implies he believed he could not succeed in his year-long battle to convince the President of this view. We share the concern expressed by Senate Majority Leader Mitch McConnell that “this could metastasize into a larger trade war….” Reports that the administration is considering limits on Chinese investments in the US and tariffs on Chinese products add to this concern. Reportedly, he is seeking a $100 billion reduction in China’s trade surplus with the US.

The President’s lack of understanding of basic trade economics and both historical and current trade developments is striking. His statement that “Trade wars aren’t so bad” conflicts with the painful lessons from the history of past trade wars. The Smoot-Hawley Tariff Act of 1930 was followed by tariff increases by Canada and Europe in tit-for-tat restrictions that greatly slowed the US and global recovery from the Great Depression.

Following the Second World War global leaders, determined to avoid future trade wars, came together in 1947 to negotiate the General Agreement on Tariffs and Trade (GATT), with the purpose of achieving a “substantial reduction of tariffs and other trade barriers and the elimination of preferences, on a reciprocal and mutually advantageous basis.” Eight global rounds of trade negotiations followed, with the Uruguay Round in 1994 ending in the creation of the World Trade Organization (WTO). That organization provides a forum for negotiating further reductions of trade barriers, settling trade disputes, and enforcing the agreed global trade rules among nations.

The United States economy and global trade have prospered under this global trading system, which contributed greatly to the recovery of the war-torn economies of Europe and Asia, and more recently fostered the remarkable growth of South Korea following the Korean War and spurred the development of many emerging-market economies. Moreover, the benefits of an open trading system are not just economic. Nations with economies that are increasingly integrated through trade, investment, and financial flows are less likely to undertake actions that could lead to war.

The President says he cannot find any country with which the US has a trade surplus. Really?? CNBC quickly noted that the US has a merchandise trade surplus with more than half of our trading partners, including Britain, Brazil, and Belgium. Our trade policy should not have the objective of reducing all bilateral trade deficits to zero. Nor should the President neglect the facts that the US is now a service economy and has a $243 billion trade surplus in services. Five times as many workers are employed in the service sector as are employed in manufacturing. Evidently the notion of comparative advantage, one of the few matters on which almost all economists agree, is not understood in the White House in the absence of Cohen.

As one learns in Economics 101, the law of comparative advantage states that a country should produce, and export, those goods or services which it is most efficient at producing and buy from other countries those goods or services for which its comparative advantage is less. All countries benefit from free trade, specializing wherever they have a comparative advantage. Technological and other structural developments can make significant changes in a nation’s comparative advantages. Consider, for example, the effect of the development of fracking to produce oil and natural gas, which has given the US a huge production advantage. In the case of steel production, however, the US’s large coal-fired steel blast furnaces that have been shut down are unlikely to be put back in production as a result of the projected tariff on steel. That technology is no longer appropriate for the US, which now makes much of its steel from scrap, and it would be an inefficient use of resources.

The United States could certainly benefit from a more effective trade policy aimed at reducing barriers to trade through well-thought-out and forceful negotiations and taking actions that are consistent with global trade rules. Efforts should be made to strengthen the effectiveness of the WTO’s enforcement of its trade rules. Confrontation and protectionism, on the other hand, are most likely to lead to retaliation in kind, with all becoming worse off.

On Thursday the President imposed a 25% tariff on steel imports and a 10% tariff on aluminum. Softening his message somewhat, he excluded Canada and Mexico as key regional allies and left the door open for other exceptions based on national security grounds, hinting Australia also may be exempted. There also is the possibility that some US firms will be exempted if they show a need for some types of steel unavailable from US producers. This is a step in the right direction. Equity markets now appear to be somewhat more relaxed about the risk of a trade war.

Nevertheless, we have not yet seen the anticipated action on China. Perhaps the most effective response to the many challenges posed by China, including restrictive trade measures and weakness in intellectual property protection, would be for the US to negotiate a return to the Trans-Pacific Partnership (TPP), a trade agreement among the major trading partners of the Pacific region with the exception of China. On Thursday, 11 nations including Japan, Canada, Mexico and Australia, signed the TPP agreement in Chile. A return of the US to the TPP would strengthen the collective negotiating strength of these countries. Taking actions that risk starting a trade war with the country that is the largest holder of our debt and whose cooperation we need on a host of issues, including North Korea, would not be welcomed by global markets. China’s Foreign Minister has warned China would take “appropriate and necessary responses”, noting that no one wins a trade war and adding that China and the US should strive to be partners rather than rivals. House Speaker Paul Ryan observed with respect to China’s trade practices “the better approach is targeted enforcement against those practices.” We are monitoring these developments closely.

Bill Witherell, Ph.D.
Chief Global Economist
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