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Long before the time of presidential tweets, there was a Scottish philosopher named Adam Smith. Regarded as the father of modern economics, this eighteenth century pioneer was a strong advocate of free markets and competition as pillars of long-term prosperity. These views translated into the realm of international trade, supporting the notion that free trade among nations leads to increased wealth on both sides. What would the old man from Fife have to say about the current leaders of the two largest economies in the world?... I imagine he’d say “Yer aff yer heid!”
The recent trade spat between the US and China recently took a turn for the worse. Unable to agree on the terms of a new trade agreement, the US increased tariffs from 10% to 25% on $200 billion of Chinese imports. In addition, the US may impose tariffs on the remaining $325 billion of imports. A tariff is simply a tax levied on imported goods.The effect of this US tax hike (tariffs) will be higher prices paid by US consumers and lower US demand for Chinese goods. I suppose the logic behind this antiquated lose/lose proposition is the estimation that the pain imposed on Chinese exporters will be greater than the pain imposed on US consumers. Maybe this will induce both parties to resume negotiations? Hmmm...
As of the time of this writing, China announced it will increase tariffs on certain US imports, effective June 1st, but the details haven’t been released. They may also resort to non-tariff barriers because the value of their imports from the US is significantly lower than the value of their exports. Possible retaliatory tactics could include a currency devaluation, the large scale sale of US Treasuries and increased red-tape bureaucracy applied specifically to US companies operating in China. Chinese authorities may also implement export bans on goods the US needs but can’t easily find elsewhere. For example, China currently produces 90% of the world’s supply of rare earth minerals, which are critical in the production of most electronic equipment; they may simply prohibit sales to US companies.
These policies will result in lower economic growth for both countries. Strategas Research Partners estimates the impact of the recent policies will depress US GDP growth by approximately 0.1% every two months, or 0.5% per year. This estimate is before any retaliatory measures imposed by China or additional measures taken by the US. In other words, things could get worse before they get better. Viewed from a different perspective, the new tariffs will cost American households $500 to $800 per year in the form of higher cost of goods ranging from cellular phones to washers and dryers.
An important consideration of the current trade war is the impact on monetary policy. Having achieved its dual mandate of stable inflation and full employment, the Federal Reserve now has to contend with the impact of the trade war on the economy.Should the trade war continue, economic activity may slow and the current level of interest rates may prove to be too high. We may hear increased rumblings of a Fed rate cut before year end if the situation drags on. Let’s hope it doesn’t.
The challenge is that we’re looking at a binary outcome. In other words, economic prospects will either get worse with every escalation and retaliation or be greatly improved should both sides reach an agreement. Compounding the challenge for prognosticators is the likelihood that the news could come in the form of a tweet.
One compelling conjecture is that President Trump and President Xi Jinping will sign an agreement at the next G20 meeting in Japan at the end of June. This would give both presidents the opportunity to showcase their strong personal leadership for the benefit of their respective countries. Trade is, after all, a win/win proposition!
Adam Smith made a compelling case against mercantilist and protectionist policies when he published his magnum opus the same year the United States declared independence. History is rife with examples of the harmful effects of these policies; the Smoot-Hawley Tariff Act is widely considered to have significantly exacerbated the Great Depression. And yet here we are, in a tit-for-tat.
The above commentary represents the opinions of the author as of 5.15.19 and are subject to change at any time due to market or economic conditions or other factors. The information above is for educational and illustrative purposes only and does not constitute investment, tax or legal advice.Print