By BOQ Chief Economist, Peter Munckton.
- Trade tensions are getting tenser;
- Financial markets have so far absorbed the news well;
- In the short term, the main impact of ramped up trade protection is weaker growth;
- But if sustained it will more likely result in higher inflation.
‘New York, London, Paris, Munich
Everybody talk about Pop Muzik’
Pop Muzik, M (Robin Scott)
Pop Muzik was one of the iconic songs of its day. Conceived during that music period known as ‘Disco’, Pop Muzik reached number one in seven countries. Ironically, even though M was a British band the song did not reach number one in the UK as it was released around the same time as the Art Garfunkel all-time great hit, ‘Bright Eyes’.
One of the messages from Pop Muzik was that everyone around the world was talking about the same issue (Pop Muzik). It was the musical version of globalisation. Indeed, according to Wikipedia the song was written by a English band but recorded in Switzerland. It was a symbol of the trend that world was becoming a smaller place. But recent trade developments have called this trend into question.
As part of his election campaign President Trump made it a core issue that global trade in goods and services was not ‘fair’ to the US. He has already pulled the US out of one trade treaty (Trans-Pacific Partnership), and been re-negotiating another (NAFTA, a treaty between the US, Canada and Mexico). Recently he announced tariffs on a range of goods from China, having previously implemented tariffs on European, Canadian and Mexican goods. And he has made it clear that there will be more tariffs if he does not get his way. In response most of the affected countries have raised tariffs on the equivalent amount of exports from the US. So far Australia has not been one of the targeted countries most likely because we run a trade deficit with the US.
No-one knows how the current trade dispute will play out. One reason is that it is unclear as to what is President Trump’s ultimate objective. Is he aiming to reduce the size of the US trade deficit with particular countries, improve intellectual property protection or protect jobs in particular domestic industries? If the aim is to fix the US trade deficit with particular countries that is unlikely to happen. The main issue is that the US economy spends more than it earns. So even if the deficit could be fixed with some countries, spending more than it earns means the US will end up running a trade deficit with other countries.
Why are economists worried about increasing protectionism? Rising tariffs initially leads to reduced investment as firms become uncertain about their global supply chains and customer markets. Tariffs increase the cost of imported goods and services, reducing the amount consumers can spend on other goods and services. The greater the uncertainty the more likely there will also be an increase in financial market volatility. And increased financial market volatility might be particularly problematic right now given the current high levels of global debt and over-valuation of some assets prices.
In the short term a significant rise in tariffs would likely be a negative for economic growth. Inflation may initially rise, but could then fall as the economy weakens. Firms have become used to competitive markets in recent years so are initially likely to absorb cost increases. In the long term, sustained higher tariffs reduces competition. This means higher prices and lower productivity (because firms facing less competition have less incentive to become more productive). This results in lower growth and higher inflation.
Financial markets have to date taken the rise of trade tensions relatively well. That likely reflects the conventional wisdom that as trade protectionism is bad for all economies Governments will ultimately return to the previous free(r) trade policies. There has been precedence for this view. President Reagan announced tariffs on Japanese cars, and both George Bush Junior and Barack Obama implemented tariffs on some Chinese goods. After some time, the tariffs were reversed with no lasting implications.
International trade in goods and services has become an increasingly significant feature of the global economy, albeit with the occasional up-and-down. The clear exception was the period between the two World Wars. This is often put down to the rise of protectionism in the US following the onset of the Great Depression. While the tariffs imposed by the US (and by all other countries) did impact trade volumes, a relatively bigger decline in trade openness took place before the imposition of tariffs in the early 1920s.
The growth in global trade can be put down to a number of factors. One has (generally) been the good growth in the global economy. Another is that improvements in technology significantly reduced transport and communication costs.
Reduced protectionist measures (such as lower tariffs) also played a significant role. Protectionism is measures that attempt to either limit imports or promote exports. Historically they have most often been used to protect the domestic economy against international competition, with an aim to support domestic industries and/or keep domestic jobs. A related argument is protection against ‘unfair’ competition. Since the Second World War tariffs (and general protectionism) were reduced significantly on the premise that heightened competition would both reduce prices and produce better goods and services for consumers. It would also result in a more productive economy. By and large that has been true, albeit at the cost of those firms and workers in the sectors subject to greater competition.
The growth in trade has been more muted in recent years. By and large that has reflected the weaker global economy (notably lower business investment).
Three potential trade scenarios
Given the uncertainty as to how events may unfold, set out below are three potential scenarios as to how the current bout of trade tensions may play out:
Scenario one: Phony trade war
The rhetoric is high, but action is modest. This is essentially the status quo, as well as a replay of previous periods of trade tensions. The impact on the global economy and financial markets of this scenario is limited. This scenario remains the most likely outcome, and is certainly how financial markets are currently priced. But the chances of more dire scenarios have risen.
Scenario two: Increase in bilateral trade protection
In this scenario tariffs increase between the US and other trade partners but there is no change in trade arrangements between other countries. Modelling done by the Bank of England suggests that a 10% increase in tariffs by the US on all trading partners (and vice versa) could reduce US GDP by 2.5 percentage points (over 3 years), and detract 1 percentage point from global growth (over the same time). In the long term, inflation could be 1 percentage point higher. Recent events suggests that the chances of this scenario has risen. The negative implications are clearly biggest for the US and trading partners with significant exposure to the US economy (notably Mexico and Canada). But because the US economy is the largest in the world everyone suffers, most particularly the other countries directly involved in the trade tiff.
Scenario three: Rise in global trade protection
The most concerning scenario is where all governments increase tariffs. So far there has been little evidence that this scenario will occur. Indeed most countries (outside of the US) have remained committed to the current global trading system. How negative this scenario turns out would depend upon a range of factors (eg, how much tariffs rise, how many countries implement higher tariffs and on how many goods, the outlook for interest rates and fiscal policy).
By global standards the Australian economy has a relatively low exposure to global trade. But this scenario could result in a sharp slowing in the global economy, as well as a significant rise in financial market volatility. The result would have significant negative implications for all countries. A Productivity Commission Report suggested that a significant increase in global protectionism similar to what happened in the 1930s could lead to Australian GDP to be at least 1% lower. As in scenario two, sustained higher tariffs in the long term would result in higher inflation.
The increase in trade has allowed consumers and firms to access a wider range of better quality and cheaper goods and services. A reversal of that trend could have significant economic and financial market implications. Whether a sustained rise in trade protection policy happens, and how big the impact will be, is the talk of New York, London, Paris, Munich….
We live in interesting times.