By Daniel Brodén
As is customary after each Trump tweet, the reaction of Donald Trump’s critics following his declaration that “Trade wars are good, and easy to win” contained equal parts bewilderment and amusement. Given the President’s proclivity to ignore facts and to say what serves his immediate purpose, it is understandable that there is a knee jerk reaction from the public to mock any statement he makes. However, whilst at the same time it is flawed, this seemingly ridiculous tweet actually contains some truth.
One could argue that it is easy for the US to win in a trade dispute because it is a net importer of goods and services. In this way, the US is offering exporting countries a source of extra demand and a market where their products can be consumed. If the US were to reduce its net imports this would mean fewer orders for factories in countries such as China, Germany and Mexico. These exporting countries would suffer slower economic growth as a result, and in this sense, it is the US that holds the strongest hand in any potential trade war where global trade shrinks. That is not to say that picking this fight is a good idea. It could have negative consequences for the US as well. But the point here is that America does actually hold an advantage as it has less to lose in this economic fight. As we have seen, the EU and China have responded with rather small and targeted threats of their own tariffs on US goods. Which is probably more of an attempt to gain bargaining chips of their own in this war of words, rather than because of any wish to escalate this conflict, which it would not be in their interest to do.
But, while the US holds an advantage, where Trump’s reasoning goes wrong is in the way in which he seems intent on fighting this trade war. The key here is that trade imbalances cannot be understood (or resolved) without the consideration of global capital flows. Grasping how trade and capital flows are related demands an understanding of some basic macroeconomic principles. A book that explains this in a straightforward way is Michael Pettis’ The Great Rebalancing.
As he explains, any country that is a net importer of goods and services must, by definition, also be a net importer of capital. Think of it in terms of an individual: if you spend more than you make then that difference has to be financed with money from someone else, for example with a loan from a bank. The same thing goes for countries. If a country is a net importer of goods and services it is the equivalent of it spending more than it earns and thus other countries have to provide the financing. Capital flows are the financial necessity that allows a country to be a net importer. Whether a country ends up as a net importer or exporter, however, is not as simple as the decision that an individual makes to spend over and above his or her income. It used to be the case that trade imbalances were mostly determined by differences in the cost of traded goods, where capital flows adjusted with changes in trade but, as Michael Pettis notes in a recent piece for Bloomberg view, those days are long gone. With the liberalization of global capital flows – which went along with the globalization wave that we have experienced during the past few decades – capital can now move relatively freely (and in huge amounts) across the globe depending on the decisions of millions of investors and other investment professionals. Big capital inflows to a country will work their way through that country’s economy in various ways, for example, potentially setting of an asset price boom or increasing consumer borrowing, with a trade deficit as an end result. Thus, in this day and age it is these huge capital flows that affect the outcome of a country’s trade position rather than trade determining the size and direction of capital flows.
Given that it is capital flows that have primacy and drive the changes in trade between countries, to impose tariffs on a couple of billion dollars of goods amounts to nothing other than small beer in this situation. Unless capital inflows to the US are reduced, the trade deficit will persist. As Pettis explains, one also has to understand the role of the US dollar as a world reserve currency to see why tariffs are likely to prove ineffective. The capital markets in the US are deep, flexible and completely open, and in an uncertain world, the US’s role as a traditional “safe haven” for investments could mean big inflows of capital into the US which will dwarf the impact of any tariffs. Hence, as long as the US is a net importer of capital it must by definition also be a net importer of goods and services – ensuring a global dependence on its markets as a source of demand.
Where does all this leave us? As far as useful initiatives goes, imposing tariffs might give the US president an opportunity to take to Twitter and act tough on China, something which might play well with his core constituency, but it is not going to help the American worker. A more useful approach would be to initiate plans for infrastructure spending, something that the country really needs. And if the Trump administration wants to reduce the trade deficit, it is only when capital controls are considered that they are likely to succeed with this objective.
So, are the US tariffs on imports unimportant and likely to be of no consequence? While they are likely to be ineffective from the US perspective, where the tariffs could end up having pernicious consequences is in the arena of foreign policy and geopolitics.
The tariffs can be viewed as one piece of the America first policy propagated by the Trump administration where unilateral action is much preferred over negotiated multilateral compromises. As such, it is another source of friction both for the US’s traditional allies as well as strategic rivals like China. With the recent list of demands, where the US require China to cut the bilateral trade surplus by $200 billion, the tension between the two countries has now increased further. Although these demands are unlikely to be accepted as they stand, given that China has more to lose in a potential trade war it is possible that it will seek a conciliatory approach. However, rather than direct its response through the use of economic policy, which could escalate tensions around trade, China could well end up pulling on other levers to fight back. One example could be on the issue of North Korea. Having just received Kim Jong-un in Beijing, China is thought to have signalled that it is still a vital part to any negotiated settlement of the nuclear issue on the Korean peninsula. An uncooperative stance by China on this issue and others could be one side-effect of the increased friction with the US. With the recent addition of the notorious warmonger John Bolton to the White House as national security advisor, this certainly does not offer much of a consolation for an avoided trade war.
By Daniel Brodén
Image: Melinda Nilsson
