As of last Friday, the trade war with China was kicked into high gear, which means it is finally time for the real negotiating to begin as both sides are making it clear that they will not bend to the demands of the other. Tariffs are a tax on the consumers in the importing nation, which means consumer prices tend to rise or corporate profits tend to fall in response to a tariff war. A short trade war during a period of monetary easing can be profitable for businesses, but a long, drawn-out trade war during a period of monetary can easily push our economy into a recession.
The trade war with China began in January 2018 when President Trump placed a 30% tariff on imported solar panels, which China responded with a tariff on imported washing machines. Since January both sides have escalated the trade war and as of last Thursday, the United States had a 10% tariff on $200 billion of imported goods. As of last Friday, the tariffs increased from 10% to 25% on $200 billion of goods and the Trump Administration began the process to impose tariffs on an additional $300 billion of Chinese imports.
Despite the tweets and misinformation about the status of the negotiations, both sides have been rather cordial as both sides continued to hold meetings as the threat of additional tariffs remain in the background. Last Friday things took a turn for the worse when the Chinese trade delegation walked out of their last meeting in response to President Trump increasing the tariffs from 10% to 25% on $200 billion of goods. While both sides left the last meeting open to further talks, the situation quickly escalated.
President Trump directed his staff to begin the process to increase tariffs on the remaining $300 billion of imported Chinese goods from 0% to 25%. China responded by stating they have the monetary tools to persevere through the trade war and while they remain open to further talks, those talks must be held in Beijing going forward. In addition, China made it clear that the United States would first need to remove all the tariffs since January 2018, which is unlikely to happen.
Trade wars are costly to both sides. Prior to the start of the trade war, China’s economy was already slowing and due to the trade war, it is slowing at an even faster rate. U.S. consumers are paying more for everyday goods and services, which means less money for discretionary spending. Estimates show the trade war will cost American households between $400-800 a year in increased costs. While many Americans support a hard line against trade with China, most do not understand how tariffs work.
Tariffs are a tax for the consumers who live in the importing nation. When a good arrives in the United States, the importer pays the tariff to the United States government. The cost of the tariffs can be absorbed by the company or passed on to the consumer through higher prices. If a company cannot absorb or pass the increased costs forward, then the company will be forced to source their product elsewhere or face closing their doors.
The United States has a long history of using tariffs to protect domestic manufacturing. To protect the colonists, the U.S. government enacted high tariffs. The revenue from tariffs was used to fund the Federal government in lieu of a Federal income tax prior to the passage of the 16th Amendment. The challenge with tariffs is that it leads to higher unemployment and higher consumer prices for industrialized nations.
After the Trump Administration implemented the tariffs, consumer prices increased. So far, Wall Street has assumed the tariffs are bullish, as importers scrambled to build their inventories ahead of the tariffs. The idea being, if the tariffs were dropped, then companies could pass the higher prices off to consumers while pocketing the difference. This can work when trade wars are short or during periods of monetary accelerations, but with the Fed tightening and both sides at an impasse, as now, inventory building will come back to haunt corporations in the coming quarters.
The reason tariffs cannot work for the United States is that we are the reserve currency of the world. Since most global trade is conducted in U.S. dollars, it is our responsibility to run increasing deficits to provide the global economy with enough dollars to facilitate global trade. By enacting stiff tariffs, global trade slows, which reduces the number of dollars for trade.
Between the Fed tightening monetary policy and the trade wars, World Dollar Liquidity, which is the amount of dollar available for global trade, is contracting. The contraction in the Chinese economy is more due to the actions of the Fed than it is the tariffs, but the tariffs are going to exasperate the problem.
Countries use tariffs to protect their domestic manufacturing base from cheaper foreign competition. Without a unified, global currency system, the opportunity will always exist for countries to manipulate their currency to facilitate exports. When a country devalues its currency, it makes their goods, services, and labor cheaper, which tends to lead to lower unemployment and greater economic prosperity.
The problem with persistent trade wars and currency devaluations is that the standard of living from prosperous countries, such as the United States, tend to fall to the level of the exporting nation. This is partially why our standard of living continues to fall while the wealth of our nation is concentrated in an ever-smaller part of our population. An alternative solution to tariffs, which would still allow global trade to flourish, is a Border-Adjustment Tax (BAT).
Under the current tax law, a business can deduct the cost-of-goods-sold regardless of where those goods are acquired. Under a BAT system, only the cost-of-goods-sold that were manufactured in the United States would be deductible as a business expense. A BAT system incentivizes companies to manufacture products inside the borders of the importing nation, which helps maintain the standard of living within that country.
Under the current system, an apparel company could manufacture a pair of jeans in a foreign country, import them to the United States, and deduct the cost of manufacturing against their gross revenue. Under a BAT system, only an apparel company who manufactured their jeans in the United States would be able to deduct the cost of manufacturing, which would increase the taxes to any apparel company who is manufacturing jeans outside our country. If the BAT model is applied to every company, across every industry, then it is easy to see why such a system would lead to higher domestic employment.
A BAT system does not penalize a foreign company from taking their profits home since it just encourages the domestic production of goods. When all companies are forced to produce within the United States, following the laws, regulations, and wages of our great country, then the playing field equalizes. Whereas under our current system, a domestic worker has to compete with a foreign worker for the same job, while under a BAT system, domestic and foreign workers are no longer competing for the same job.
The other benefit to a BAT system is there is no further need to tariff incoming goods, as our borders can be open to anyone who wishes to import goods. But only those who manufacture domestically will be able to flourish, due to the inability to deduct the cost-of-goods manufactured outside the United States. While there are no pending proposals for a BAT system, America should be looking to such a system to protect its workers and manufacturing base.
For the moment, the world awaits a policy response from China, who vowed to respond in-kind should the United States increase the rate and the number of goods the tariffs would apply to. While China has responded with a 25% tariff on $60 billion of U.S. goods starting on June 1st, this is minimal compared to what China can do on a bigger scale. From a consumer perspective, consumer prices are going to rise. From a corporate perspective, passing on higher prices will likely lead to lower demand as the Fed continues to tighten monetary policy.
From an investing standpoint, stock investors who have been chasing the market higher, are in for a shock. Corporate profits and earnings should fall as burgeoning inventories stack up in warehouses. Treasury bond yields should fall and Treasury bond prices should rise as lending demand falls, which is consistent with periods of monetary decelerations. Crude oil prices should fall as demand falls. Should the Trump Administration make good on its promises to help our farmers by buying agricultural commodities, then this sector could be a strong performer.
The risk the Trump Administration is facing is driving the U.S. into the next inevitable recession that is coming as it is impossible for the Fed to tighten monetary policy without causing a recession. For those who think the Fed can react fast enough, they cannot. The monetary lags, or how long it takes the economy to feel the effects of the Fed easing or tightening, are likely close to two years in length, which means the broad economy has yet to feel the effects of the Fed’s balance sheet unwind from October 2016.
The stakes are high and the risks to investors who have been chasing the stock market are also high, especially since most investors are no longer protecting their portfolios from the downside risks of a recession. While history has not been kind to countries waging trade wars, investors should look to the bigger picture – this is likely a move by the United States to break the political power structure of China. The risks are high, as the global economy is already slowing, which means this tariff war could lead to a longer and deeper global recession than anyone expects.
Perhaps the Chinese negotiating delegation read a copy of “Art of the Deal,” as they walked away from the negotiating table last week.
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