Monday, August 21, 2017

Are "Trump Trade Wars" Inevitable?

President Donald Trump, at his joint address to Congress on February 28th 2017 stated: “I believe strongly in free trade, but it also has to be fair trade. It’s been a long time since we had fair trade. The first Republican president, Abraham Lincoln, warned that the abandonment of the protective policy of the American government would create want and ruin in the country… It’s time we heeded his advice and his ways.”
Free trade has been at the cornerstone of capitalist democratic economies now for many years, so this statement from the President of the biggest trading country in the world looks to President Lincoln to justify a return to protectionism and a reversal of the trend to ever freer trade that has been characterized by the post World War II international economic consensus. This has economists somewhat aghast at what is going on with the Trump administration, as after the new President immediately withdrew from the progressive Trans-Pacific Partnership (TPP) agreement, we also know that the Trump administration is now looking to not only renegotiate NAFTA but also has explored the idea of perhaps bypassing World Trade Organization (WTO) rules so as to impose a border adjustment tax (we'll come to what that is below).

So how will this all play out? Well there is already a battle inside the administration about how protectionist the policy pronouncements will be (see here), and it looks like the battle between the two factions will continue for a while yet, despite the fact that Steve Bannon has left the White House staff. In a recent NYT article (see here) there is doubt that President Trump will be able (or want) to follow through on his campaign promises with as much gusto as he suggested he would on the campaign trail. And in an article in the FT (see here) there were signs emerging that the Beijing relationship has now becoming badly frayed as the Trump administration initiates several unfair trade practices investigations. The danger though here is that the "soft-liners", although they might win in the short run, will not hold the upper hand as we approach the mid-term elections in late 2018 and beyond, as the administration realizes they are being punished at the ballot box for not fulfilling on these commitments.
So let's take stock of where we are in terms of President Trump's campaign promises. In not particular order, they were:

1. Withdraw from TPP

2. Halt T-TIP negotiations

3. Renegotiate or scrap NAFTA

4. Institute a border tax (tariffs) with Mexico so as to pay for a wall on the Mexican border

5. Declare China to be a currency manipulator

6. Impose a border adjustment tax (BAT) as part of the tax reform package that should be forthcoming from the administration.

The first 2 on the list have now been completed, but the third is the one that has everyone guessing as to the consequences, so let's look at NAFTA first. 

NAFTA is now embedded into the North American economy, so changing the basis of the Treaty that established NAFTA requires a summit with both Canada and Mexico, and the negotiations for this summit are now taking place. 

President Trump has made it clear that he wants a complete rewrite of NAFTA, and that led to a tense start to the negotiations, which got underway this week (see here). The Canadian foreign minister, Chrystia Freeland, noted that “We pursue trade, free and fair, knowing it is not a zero-sum game”. She added that: “it is worth pointing out that we are the biggest client of the United States. Canada buys more from the U.S. than China, the UK and Japan combined.” 

Perhaps the US team in the negotiations, led by U.S. trade representative Richard Lighthizer, sees trade bilateral deficits ( - and the US does run a small deficit with Canada) as a measure of fairness of trade with that entity.  Any student of international economics understands that this is not the case - it is simply a component of the overall trade balance, and reflects a balance of comparative advantages between the two countries. Also it should be noted that Trump's ire has not been directed at Canada (with the isolated case of the softwood lumber issue) but in the NAFTA context his ire has largely been directed at Mexico. This is because whereas the U.S. ran a goods and services trade surplus with Canada in 2016 of about $12.5bn, the U.S. ran a goods and services trade deficit with Mexico of $55.6bn.  But as we shall see below, the trade deficit with Mexico is dwarfed by the trade deficit with China.

Now although the topics to be discussed are rules of origin, managed trade (read more quotas), and so-called "Chapter 19" dispute resolution, whatever is in NAFTA 2.0 better reduce the U.S.'s trade deficit with Mexico, otherwise this will likely prompt President Trump to threaten withdrawal from NAFTA. But given the fact that much of the trade between the U.S. and Mexico is intermediate goods trade, it does make sense that the biggest part of the cross border trade would be the finished product (for example a vehicle), rather than the sum of all the parts that might be produced in the U.S. that are exported to Mexico (where the vehicle is then assembled). Given then that it is unlikely that trade with Mexico could ever get to close to in balance (or in surplus), I think that President Trump, given that he has made such a big issue of either pulling out of NAFTA or completely rewriting it, may decide to pull out if the Mexicans don't walk out first.  

What I think will possibly transpire is a return to CUFTA, which was the free trade agreement with Canada that formed the original basis for NAFTA. Although other economists might not agree with my assessment, I believe that President Trump will feel that he has to deliver on this particular promise if he is to stand any chance of re-election.  In order for NAFTA 2.0 to eliminate the trade deficit with Mexico would be import quotas.  I think these will be rejected by Canada, as they would also affect Canadian exports to the US. So there is no way forward that would satisfy all 3 parties and therefore this will possibly lead to withdrawal. Since the announcement of Steve Bannon's ouster as a Trump advisor, the probability of withdrawal has gone down, but the trade representative will still have difficulty delivering what the President wants out of a re-write of NAFTA.

When campaigning, Donald Trump also mentioned a 35 percent tariff on autos made by U.S. companies in Mexico. This tariff was originally mentioned with regard to also funding construction of the wall. This tariff would currently go against the rules of NAFTA so is unlikely to be implemented while the U.S. remains inside NAFTA. So if the U.S. does leave NAFTA then this idea might get resurrected as a means to deter manufacturing or assembly going south of the border.

On the campaign trail President Trump also promised to name China as a "currency manipulator".  But having met with Premier Xi Jingpin, Trump declared that China had manipulated its currency in the past, but was moving to correct the level of the yuan, and hence it would not be necessary to name China as a "currency manipulator".  So this is now off the table.  President Trump did, however, decide to pursue several probes against China, most notably on intellectual property (see here), but also on steel. Although the U.S. has not imposed steel tariffs yet, it seems that they are likely to do so (see here).  This so-called "section 232" review ( - that was initiated because of fears that threats to the U.S. steel industry from imports would not be in the interests of national security) has to be made public by mid-January. Then President Trump will have 90 days to react, perhaps implementing a steep tariff on steel imports principally from China, but also from all other steel producers.

The Border Adjustment Tax (BAT) has now also been abandoned as a proposition, but just to keep my readers fully informed, I will explain exactly what a BAT is. A BAT is essentially an import tariff coupled with an export subsidy by means of making exports tax free.  

So that is the current state of play on international trade policy and the Trump administration. As mentioned above, the current administration appears to be particularly concerned about turning the overall U.S. trade deficit into a surplus, or at least reducing it.  In the table below from the BEA, the bilateral trade deficit or surplus for the U.S.'s main trading partners is shown, and it can be seen that the majority of the deficit is with China, and this is fairly consistent over time. 

Source: US Census Bureau, Dept of Commerce

Of course what really matters here is the trend in the data, so I thought I would download the data and see exactly how a long term perspective can show that actually China is pretty much the only problem. 

Data source: Dept of Commerce; Graphic by blog author
Now the graphic clearly shows that although there was a deterioration in the trade balance with countries like Japan, Germany and Mexico over the early 2000s, it is the trade deficit with China that really takes off in the early part of the century, and although for countries like Canada the trade balance has actually improved, for China, with only a brief respite during the great recession, the overall trend has been towards a widening of the deficit.

Chinese President Xi Jinping and U.S. President Donald Trump shake hands
So from an economic assessment, if one agrees with this approach, the President should really focus mostly on China, as this is where much of the trade deficit originates from. But what is the best way to tackle this? The U.S. trade representative has a detailed list of objectives which can be found here, but of course these only state objectives and not solutions.  

On a recent trip to China I visited a large container port off the coast of Shanghai ( - in fact it is at present the largest container port in the world), and was surprised to hear that half of the containers travel to China empty, but every single container is full leaving China. So the main problem with trading with China (and this goes for the EU too), is that China's trade with most of the rest of the world is unbalanced.  

This highlights the fact that although half of this problem is the U.S.'s problem, the flip side is that China clearly has a lack of consumption of imports in the sense that savings are high and when the Chinese do consume, much of their urban dwellers consume Chinese goods. The China issue prompted President Trump and President Jinping to set up a "US - China Comprehensive Dialogue", but as reported in the Financial Times last month (see here), this dialogue is a talking shop regarding the issues to be tackled, but nothing concrete to make it happen, and definitely no sign of agreement on the way forward. 

Clearly the Trump administration has changed tack and instead of calling the Chinese currency manipulators, has decided to go after the Chinese on various fronts by launching probes in specific problematic areas. The results of these probes though, if acted upon, will likely prompt reprisals, and perhaps WTO arbitration cases against the U.S. Certainly the Chinese appreciate that although the U.S. is not their largest trading partner ( - the EU is), that there are considerable risks to domestic economic growth if there is a trade war with the U.S.

So is a trade war inevitable with China?  I think that the answer here is still up in the air, but I still think the most likely outcome is narrowly in favor of a trade war. This is the case particularly if we see a degradation in the NAFTA talks appearing over the next few weeks.  A sign pointing in a different direction has also appeared though, and that relates to the earlier probe on steel which the President launched. There has still been no announcement as to the results of this probe, and this is likely because the announcement has been held back as it would be damaging to trade with China. How to handle this will definitely require some diplomacy, as President Trump will not want to make outright enemies of the Chinese.   

Wednesday, February 8, 2017

A Realistic or Panglossian Brexit? What lies beyond Article 50.

Source: Chicago Showbiz
Pangloss was a character in Voltaire's Candide ( - which was made into a wonderful opera incidentally, by the late Leonard Bernstein), who suffered from unbridled optimism. Obviously with Brexit the Panglossian "best of all possible worlds" (or as a note on a memo that was recently leaked to the UK press said "to have your cake and eat it") is unlikely to come to pass in the difficult negotiations ahead - but to me that is hardly a surprise, as I will explain in this econoblog.  

We now have some clarity on what is going to happen regarding the UK's exit from the EU (otherwise known as Brexit). UK PM Theresa May has determined that the type of Brexit that occur has to be of the "harder" variety, and she made a speech to this effect, and you can read the full version of the speech here.  Also, after the challenge made in the UK High Court (roughly equivalent to the US Supreme Court), the UK Houses of Parliament has had to vote on a bill to take the UK out of the EU, and although many of the MPs themselves wanted to remain, there was a "whip" to ensure that the vote (498 to 114) to start the Brexit process formally by allowing the PM to trigger Article 50 (which then is the official notification to the rest of the EU that the UK is on a 2 year timetable to leave).
Source: Getty Images

Some commentators, such as Martin Wolf of the FT (see here) had already gone on record to say that he thought the only feasible outcome is now a so-called "hard" Brexit. Martin Wolf stressed that the linear (or quadratic) programming problem that satisfies all the political and economic constraints for a deal is essentially an empty set. So Martin Wolf sees this as leading to the hard option, with no soft "squidginess" allowed.  I think that indeed "ceteris paribus", this is certainly the direction of the negotiations, but that the mostly likely outcome will be more nuanced than this.

My reasoning is as follows  "Ceteris" does not have to be "paribus", so although we ulimately need some practicality imposed on all this, clearly EU immigration is the big sticking point that leads to what most economic commentators believe is an "empty set". But I think as the weeks and months have passed since the referendum the general public is now beginning to get it's mind around the tradeoffs involved with the practical steps needed to achieve Brexit, and understands that leaving the single market is the only way forward, but even PM May has already suggested some "squidginess" here, in referring rather mysteriously to what she called "customs agreements".

OK, so let's back up a moment and remind ourselves of the distinction between a customs union and a single market.  A "single market" means you have the "4 freedoms" - free flow of goods and services, workers and capital - in other words free flow of all goods and factors of production.  A "customs union" is different - it is a free trade agreement where the participants agree to a common external tariff (CET). And then of course you have a free trade agreement (FTA) where each country can set it's external tariff separately.  So for example there are countries in Europe that are members of the single market, but not of the customs union ( - Norway and Iceland for example), and countries that are members of the customs union but not of the single market ( - Turkey, Andorra and the Isle of Man).

So how do PM May's "customs agreements" fit into this framework?  I had actually never heard the expression before PM May's talk, so what might it mean?  Remember that PM May has stated that she would like a free trade agreement (FTA) with the EU, which then suggests no CET, so my interpretation of a "customs agreement" is that for trade in certain sectors, the UK would agree to use the EU's CET.  In other words this opens up a "sector by sector" negotiation.  But are these two concepts (FTA and a CET in certain sectors) compatible?

My answer to this question depends on who you are.  I think to the UK, these two concepts are completely compatible, as they just see trade in goods and services continuing as before, except with certain sectors having to have tariffs the same as the EU's tariff levels to ensure that no "trade deflection" occurs ( - companies trading through the UK because for example it has a lower external tariff than other countries).  But to the EU this is not compatible, as the customs union is just not the same as an FTA to the EU, because with FTAs there has to be a geographical distance there (or internal value added thresholds) to permit different external tariff rates.  So for example the EU now is moving towards an FTA with Canada in both goods and services, but this is in a limited number of goods and services (given how small the Canadian economy is compared to the EU's) and so differential external tariffs are not likely to cause a company to set up in Canada in order to export to the EU, or vice versa.  The same cannot be said of the UK though as it is much closer to the rest of the EU, and there is a lot more trade in goods and services between the two entities.  So I think that an FTA with the UK will not be that attractive to the EU, but they will go along with the "customs agreements".  Incidentally a useful map of all the trade agreements that the EU has with the rest of the world is shown below.
Source: HM Government - Alternatives to membership: possible models for the United Kingdom outside the European Union (Annex A) p.45, 2016.
So, the Brexit is likely to be hard, but I think that free trade will only exist with the EU in certain sectors where "customs agreement" have been negotiated.  So, this leads me to further think that the "Swiss model" is still the best model for negotiation between the EU and the UK. And here, by Swiss model I mean the structure of the negotiations, not the exact template that the Swiss have right now, as clearly the free movement of people is not something that will happen.

The Swiss model contains many of the advantages that the UK desires in its post-Brexit relationship with the EU – a bespoke series of bilateral agreements that would minimize the economic damage from Brexit, while allowing the UK and the EU the latitude to tailor these agreements to ensure that the underlying cause of the Brexit vote is honored if not entirely in substance, certainly in spirit, while also pursuing common economic and political interests.  While the "full" Swiss model will take a long time to come to fruition, in my assessment it certainly trumps the other alternatives.  

So what would a Swiss model look like if applied to the UK?  This is difficult to say, as the Swiss agreements are numerous and extensive in their coverage (see for a good summary).  Clearly there are certain bilateral agreements that the Swiss already have on the books which could be simply transferred in template directly to the UK ( - for example research, media, education, civil aviation and pensions), but there are areas of mutual interest where the UK and the EU would have to create new bespoke agreements (areas such as trade in goods, trade in financial services, FDI, and migration), and this will pose significant challenges for both sides. 

For example in migration, mutual interest might be served by instituting a NAFTA-style agreement on movement of qualified labour.  In NAFTA, a degree from a North American institution of higher education together with a job offer gets you a NAFTA visa which allows educated workers from Mexico, the US and Canada to work anywhere within the NAFTA zone.  A similar clause has also been put into the Canada-EU comprehensive economic and trade agreement (CETA), so there is precedent for this already.  Implementing a similar agreement for a bilateral agreement between the UK and the EU would allow free flow of educated workers, while still permitting the UK to institute its own rules on inward migration for unskilled workers. 

On trade, sectoral customs unions (or "customs agreements") would be negotiated for example for automobiles and other vehicles, for pharmaceuticals and for certain agricultural products.  A similar approach could be taken with financial services, with certain types of financial services (such as foreign exchange transactions, banking services and marine insurance) wrapped up in a bilateral agreement.  

The Swiss model is a compromise model, but it is a flexible model that can cater to the requirements of both the EU and the UK, and probably the biggest advantage of this model is that new areas can be added over time, so that the 2 year deadline becomes irrelevant, as the relationship is ongoing and integration becomes dynamic, rather than the static level of integration that is the hallmark of a conventional FTA.  It hopefully offers the best deal (where it exists) for each sector and common interest, so contains elements of both “hard” and “soft” Brexit strategies.  Obviously the biggest hurdles to achieving this model are the set-up costs. These will undoubtedly be significant, and some areas and sectors may end up being excluded at first, so there may also be significant “transition” costs to the eventual new arrangements for some sectors and common interests.

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