Smoot-Hawley, Trade War and Potential Consequences

With President Donald Trump now having taken over the White House, the new administration’s trade policy will become the focal point of attention. President Trump’s campaign rhetoric was aggressive and whether or not he will follow through on his campaign promises will have serious economic and financial consequences around the globe.

From Smoot-Hawley to “Border Tax”

The last time the world experienced a full-fledged trade war was in the 1930s. The Smoot-Hawley Tariff was enacted in June 1930, pushing America’s tariff levels to record highs on more than 20,000 import items. This prompted widespread retaliations from America’s trading partners. Although it is difficult to quantify the impact of the 1930s trade war on overall global trade, the Smoot-Hawley Tariff greatly accentuated the collapse in world trade and sharply increased the depth of the Great Depression.

The new Trump administration is threatening to impose a “border tax.” The president’s advisors insist that the border tax is no different from a value-added tax (VAT), which is widely used in the rest of the world to the disadvantage of American exports. I believe paralleling a border tax with VAT is a rogue argument. A typical VAT does not distinguish whether goods are produced domestically or from abroad, while the proposed border tax will only be imposed on goods imported into the U.S. It is a tariff. The only difference is that traditional tariffs are collected at customs, while border taxes are collected at retail stores.

How the rest of the world will react to the proposed “border tax” is rather predictable: other countries will likely retaliate by imposing similar tariffs on American exports, increasing the risk of a trade war. The practical question is, “what would be the consequences in the event of a trade war?”

Real versus Nominal Shock

In the 1930s, the world economy operated on the gold standard. As such, the Smoot-Hawley Tariff raised the prices of imported goods, leading to a sharp reduction in America’s import demand. The ensuing foreign retaliation led to a similar fall in foreign demand for American exports. In the end, consumers paid higher prices, while receiving lower real income. Producers made fewer profits—or went belly-up altogether. In other words, the Smoot-Hawley Tariff created a sharp reduction in real output, undercutting the standard of living both within and outside the U.S. economy.

Today, we operate in a floating exchange-rate system, which could make the impact of a trade war less predictable. The flexibility in the foreign-exchange markets could act to greatly reduce the negative trade shock to the real economy. In the event of a trade war, for example, America’s key suppliers or trading partners could drive down their local currencies to the same extent as the rise in tariff in order to fully neutralize the negative impact of the new tax. Of course, these trading partners will likely also retaliate by raising tariffs on American imports.

The net consequences of these foreign-exchange market adjustments—together with expected retaliatory tariffs imposed on U.S. exports by trading partners—would seem to suggest the burden of adjustment would mostly fall on U.S. exporters, who could face a double whammy from a stronger dollar and higher foreign tariffs. On the other hand, import inflation in the U.S. economy could stay surprisingly muted because the impact of the so-called border tax would be largely offset by lower foreign currencies. However, inflation rates in the rest of the world could be higher due to much-depreciated local currencies and higher tariffs on U.S. goods.

Trade Balance and Monetary Standard

The U.S. dollar is the de facto global monetary standard. When faced with a trade war, the rest of the world would likely respond by devaluing their respective currencies against the dollar in order to fend off recessionary and deflationary pressures. Such an action would not necessarily be a coordinated one from the rest of the world, but rather a collective result from individual market reactions.

The greatest fallacy of “Trumponomics” is that it is predicated upon the belief that the U.S. trade imbalance has resulted from other nations taking advantage of the U.S. The external trade balance of a nation is largely the result of its domestic savings-investment behavior—any country with deficient savings relative to its desired investment will result in a current account deficit. And vice versa. Putting up tariffs would only produce nominal adjustments via the foreign-exchange market; it will not resolve the problem of a current account imbalance.

The U.S. current account deficit is the only mechanism through which global dollar supply can be increased. In other words, the fluctuations in the U.S. current account balance are also reflective of global money demand. This is precisely the reason that since the collapse in the Bretton Woods system in the early 1970s, the only times when the U.S. has run a current account surplus or substantially reduced its deficit were when the world economy was in recession.

In this sense, it is ironic that Trump’s goal of a U.S. current account surplus will not be successful unless he succeeds in driving the world economy into deep recession, see Chart 1 below, which overlays global recessionary periods with the U.S. trade balance-to-gross domestic product (GDP) ratio.

Final Thoughts

The expectations of a lower corporate tax and higher tariff levels have driven the U.S. dollar higher since November of last year (Chart 2). In the event of a trade war, the dollar could be pushed even higher. If the new administration indeed initiates protectionist policies, the dollar bull market may have an extra mile to go.

The bond market’s reaction to Trump’s fiscal plan is overdone and a pause in the selloff will be extended. The inflationary impact of a potential trade war would be greatly mitigated by a strong dollar, which means that any significant trade friction may have a limited impact on bonds.

It is possible for 10-year Treasury yields to flirt with 3% some time this year, but I have a hard time seeing bond yields move substantially above that level. Should the dollar gain substantial ground on a full-blown trade war, the U.S. Treasury bond market could even rally, pushing yields back down. The equity market has focused on the positive aspect of Trump’s stimulus plan but longer term, the risk associated with protectionism and a strong dollar could threaten America’s corporate profitability, which is unambiguously negative for stock prices.