We recently asked an expert historian colleague what lessons he learned from his 40-plus years of studying geopolitical history. Without missing a beat, he said mankind can be counted on to repeat mistakes that seem way outside the realm of common sense. Look no further than the internecine warfare of WWI. One would think after that destructive experience, there would be no way the powers that be would want to do that again 20 years later. But they did!
Given the spike in capital market volatility, investors are wondering (again) about the potential mistake of President Trump's protectionist trade agenda.
History suggests trade wars and protectionism are not good for the global economy and do not end well. The last time this “strategy” was put to use in force was back in 1930 when the Smoot-Hawley Tariff Act (named after the congressional sponsors Reed Smoot and Willis Hawley) raised U.S. tariffs on over 20,000 imported goods. The consensus view among clear-thinking economists and historians (including the one we were chatting with) is that the tariffs exacerbated the Great Depression.
So why is President Trump and his administration announcing potentially economically destructive tariffs now? Our guess is the timing is about right to start campaigning in advance of the November mid-term elections. Supporting the steel and aluminum industries by putting tariffs on imported goods plays well with the President’s political base and supports his promise to bring back jobs. He also believes China and our country’s "very bad" trade deals signed over the last 30 years are solely responsible for the loss of American jobs and the U.S. trade deficit.
If it were only that easy!
The so-called trade deficit is simply an accounting identity associated with national income. We learned it in our college intro economics class and recall the formula drilled into us:
(S-I) + (T-G) = (X-M)
S-I = private savings minus private investment
T-G = tax revenue minus government spending = the budget surplus/deficit
X-M = trade exports minus trade imports = trade surplus/deficit
This identity means the sum of the surplus (or deficit) of private savings over investment and the government budget surplus (or deficit) is equal to the trade surplus (or deficit).
Remember, this is an accounting identity, so it must be true. The country today has a large trade deficit, which means that X-M is a negative number. If X-M is negative, then either or both S-I or T-G MUST be negative. This means either or both that we have negative private savings (we don't) or we have a budget deficit (we do).
In other words, placing tariffs on goods and pulling out of trade agreements like NAFTA are highly unlikely to shrink the trade deficit — unless such policies succeeded in plunging the U.S. into a tailspin in which investment collapsed relative to the sum of public and private savings. And that would not be good.
Moreover, the President's tax reform and recent two-year budget agreement, which both increased the deficit and spending, will boost deficits at a time in the business cycle when we should be running surpluses.
All other things equal, this will likely increase the trade/current account deficit!
If the Trump Administration reacts to such a rise with a more brazen and aggressive protectionist stance, we could end up in a Smoot-Hawley loop de loop. Their perspective seems to view an accounting identity (the trade/current account balance) as a zero-sum game to be won or lost.
This is wrong. And that may be what is keeping investors up at night.
We cannot reduce our trade deficit without boosting our domestic savings vis-à-vis our domestic investment. Ramping up fiscal deficits in an arguably fully employed economy takes us in exactly the opposite direction.