How Trade Wars Turn into a Currency War Before Becoming a Hot War

Trade wars are not always about trade. There are often many underlying reasons for two countries to engage in a trade war that the citizens on either side may never hear about. The challenge with trade wars is when they are not resolved quickly, they can turn into a currency war. Once the currency manipulation is pushed to an extreme, a hot war frequently takes over. After all, there is an only saying that “when goods don’t cross borders, soldiers will.”

Trade wars typically begin when one trading partner feels they are being taken advantage by the other. Such feelings are common when trading, especially in our modern world, as trade may balance itself through multiple trading partners.

In our financialized world, one country may exchange goods for currency, which is then used to purchase the debt of the other country. While it may appear that goods for debt are not equal trade, if the trade leads to further trade, then it may be a good relationship.

The first step in most trade wars is to pass prohibitive laws and regulations to drive foreign competition out by making their products too difficult to import or too costly over similar domestically produced goods. When such tactics fail, tariffs are often used next.

Tariffs are a tax on the imported good levied against the consumers. Many people believe a tariff is a tax paid by the exporting nation, but it is paid by the consumers of the importing nation. For example, if there is a 10% tariff on $100 billion of imported goods, then the importers pay a $1 billion tax in the form of a tariff when the goods reach domestic soil. The exporting manufacturer or producer does not pay the tax.

Consumers do not feel the immediate effects of a tariff since the tax is commonly assessed against goods that have yet to leave the exporting nation’s soil. Goods that were loaded on a cargo ship prior to a tariff going into effect are not subject to the tariff. The supply chain, in general, keeps consumers from feeling the immediate effects of a tariff as wholesalers and retailers likely have inventory available that has not been subject to any tariffs.

Eventually, consumers do feel the weight of the tariffs as higher prices are passed down. Due to the added cost of the tariff, consumers have less money to spend on discretionary goods and services, which causes the economy to slow. Tariffs are nothing more than a form of monetary tightening, similar to the effects of the Federal Reserve tightening monetary policy.

Tariffs often lead to an increase in prices without a corresponding increase in corporate earnings and profits or wages. Corporate earnings and profits slow as tariffs increase since consumers have less money to spend on goods and services. Even though consumer prices rise due to tariffs, wages do not, which is why tariffs are harder on lower-income households.

To quell the unrest that begins bubbling up as households fall further behind and begin to voice their displeasure, the two countries often turn to currency manipulation to soften the effects of the tariffs. While the intent of the tariffs may be to protect domestic manufacturing jobs, tariffs do lead to tighter financial conditions.

To alleviate tighter financial conditions, a country will look towards its central bank to lower interest rates to devalue its currency. By lowering interest rates directly or through a bond purchase program, a central bank can lower the value of their currency relative to their foreign trading partners. A weaker currency spurs consumer-price inflation, which should cause consumers to increase their current consumption over future consumption.

The problem with currency manipulation is it can only go so far before it too has unintended consequences. In an effort to win the trade war, both countries will attempt to use its central bank and financial sector to print more currency. At some point, consumer-price inflation arrives, which forces a country to cease its currency-printing operations or face the problems with rising inflation.

The solution to rising consumer-price inflation has always been to raise interest rates. When the U.S. went off the gold standard in the 1970s, consumer-price inflation took off and the Federal Reserve was forced to raise interest rates in an attempt to slow the proliferation of inflation. While there may be talk about deliberately devaluing currency during a trade war, doing so will force the central bankers of that country to resume tightening monetary policy.

Once tariffs and currency-printing have been pushed to their limits, both countries are highly likely to attempt to resolve their differences. Should both countries continue with their trade dispute after tariffs and currency printing have failed, then a hot war is the next level of escalation. In our modern world of warfare, citizens have little desire to get involved in what could be an extremely deadly war.

Throughout the history of the world, countries using tariffs to protect their domestic industries who get in a spat with another country will next use currency-printing to outlast their trading partner before succumbing to a hot war. The success of a trade war relies on the desire of a country’s citizens to fight it. If the citizens support the long-term goals of the trade war, then the conflict can last. The ultimate winner is not the country who fires the first round, but the country who is able to stave off a recession longer than their opponent.

The U.S.-China trade war is at the currency manipulation stage as evident by China revaluing the Yuan on nearly a daily basis and President Trump voicing his displeasure towards the Federal Reserve who is attempting to remain apolitical. China is quickly running out of options as further devaluations of the Yuan would lead to rising inflation. The Federal Reserve, on the other hand, wishes to remain independent of the White House and has chosen to let the economic data dictate changes towards monetary policy, as they should.

Both economies are rapidly heading towards a recession, one that will end up affecting both countries. The probabilities are high on both sides that a recession will be the catalyst to end the trade war, or at least to calling a truce. It will just depend on how far both sides wish to take the cold war, but I have a feeling we are closer to the end than the beginning.

Many investors believe the eventual conclusion of the trade war will be extremely bullish for stock prices, even though stock prices have not negatively reacted to the trade war. Just like with monetary policy, which has an eighteen-month lag, tariffs have an equally long lag as well. Even if both sides dropped its tariffs tomorrow, there are still billions of dollars’ worth of tariffed goods in the supply chain.

While many investors believe stock prices are going to explode higher upon the resolution to the trade war, the long monetary lags from the existing tariffs and the Fed’s tightening cycle have yet to work themselves through the economy. It is more likely that both the U.S. and Chinese economies will enter a recession before a resolution is made. How both sides handle their relationship during the next recession will likely determine if the trade war is escalated to a hot war.

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