The Threat of a Damaging Trade War

Author: Bill Witherell, Ph.D., Post Date: March 9, 2018

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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