How a Trade War Will Hurt the Economy

Is the United States headed for a trade war?  And, if one comes, will a trade war hurt the world economy?

The answer to the first question is I don’t know.  The answer to the second question is yes, a trade war will hurt the economy, but the U.S. economy will probably muddle through, albeit with more expensive imported goods and a lower standard of living.

Just as Smoot-Hawley was a predictable political response to the decline in worldwide aggregate demand which began in 1929, the 2016 election of a protectionist as President of the United States was, in retrospect, a political response to the loss of the U.S. industrial manufacturing jobs over the past twenty years.

The chart above shows that the recovery of GDP since the Financial Crisis and the continuing output gap has been consistently disappointing.  The large and persistent output gap, representing the difference between actual GDP and the Congressional Budget Office’s (CBO) estimate of the maximum sustainable output of the economy, suggests that something permanent has impaired the U.S. economy.  The continued disappointment in GDP growth, combined with a persistent trade deficit and increasing economic inequality, represent structural economic and social problems with no easy solution in sight.

In 1930, in a response to a sharp downturn in economic activity that began with the 1929 stock market crash, Congress passed the Smoot-Hawley Tariff Act.  In 2016, in response to a persistent output gap, the United States elected Donald Trump as President, promising stronger trade tariffs and a weaker dollar to protect domestic jobs.

Four Key Differences between 1929 and 2018

While Smoot-Hawley didn’t cause the Depression, it also didn’t help.  To be sure, a trade war will not help the global economy today if it happens.  Having said that, global trade has evolved since the Great Depression and is very different today, for several reasons.  Below are four key differences:

1.In 1929, the United States had a trade surplus, with net exports of goods and services exceeding net imports, whereas today the United States runs a large trade deficit.  In 1929, the United States was the producer to the world, much like China is today.

1. World trade was largely balanced in 1929 with the U.S. trade surplus representing less than 1% of GDP, whereas in 2016 the U.S. merchandise trade deficit represented 4% of GDP (see chart below).  The United States trade deficit is far from balanced.  Likewise, the trade surpluses of countries like China, Taiwan, South Korea, and Germany are far from being balanced.

1. Trade is far more important today to the global economy, so the stakes are higher for all parties involved in global trade, including but not limited to the United States and China.  Mathematically, this means that the value of exports and imports relative to world GDP is at a much higher level today than it was in 1929.

2. In 1929, tariff rates were already high, with an average import duty of 13.5% in 1929, and the increase after Smoot-Hawley was not significant.  By 1931, the average tariff rate in the United States had only increased to 17.8%.  Today, the average U.S. import duty is just 1.5%.

These differences suggest that the potential impact of greatly increased tariff rates is likely to be greater today than the increased tariffs implemented in 1930 under Smoot-Hawley.  Trade wars are always a drag on the economy, but the more dependent the world economy is on trade, as it is today, the bigger the adjustment for the global economy once a trade war begins.

Everyone will be hurt in a Trade War, but the United States will be hurt less

Trade barriers make imports more expensive for consumers, thus creating inflation and suppressing aggregate demand.  Because of its effect on demand, protectionism has a negative impact on economic activity for all parties involved.  That said, in a trade war, trade surplus countries such as China are generally hurt more than trade deficit countries.  The GDP level of a surplus trade country like China is enhanced by its net exports to other countries.  Similarly, trade deficit countries, such as the United States, suffer relatively less in a trade war because their net imports detract from GDP.

Given this dynamic, in retrospect, it seems odd that the United States passed Smoot-Hawley at all in 1930.  As a trade surplus country at the time, the United States clearly stood to lose more than it had to gain from lower levels of world trade because, in 1929, the United States exported more goods and services than it imported.  Indeed, when global demand declined as a result of the 1929 crash and subsequent banking crisis, every country suffered, but, as the world’s leading exporter, the United States economy suffered more.

Today, in contrast, the United States is in a different situation.  Because of China’s large trade surplus, China’s GDP growth would suffer more than the U.S. GDP growth in a trade war.  Two Australian economists,  Warwick McKibbin and Andy Stoeckel, modeled the impact of a 10% global tariff on GDP for each country, and they came to the conclusion that U.S. GDP would decline by an estimated 1.3%, while China’s GDP would decline by an estimated 4.3%, or more than triple the U.S. decline.

In other words, there are no winners in trade wars, but some countries lose more than others.  The United States, with its large and highly diverse economy, should muddle through a global trade war comparatively better than export-driven economies such as China, Taiwan, Japan, South Korea, and Germany, in my view.  These surplus countries simply do not have the domestic demand to replace the export-related demand coming from the United States.

How the United States Will Suffer in a Trade War

U.S. GDP will hold up better than the GDP of surplus countries in a trade war.  Wages will rise, and domestic producers should enjoy increases in sales and profits due to lower levels of foreign competition.  However, the United States will experience plenty of problems and adjustments of its own if a trade war happens.

Below is a short but important list of economic adjustments that the United States will have to make if a trade war happens:

• Higher priced imports will create inflation and reduce U.S. living standards.
• With higher inflation, interest rates could rise further, making it difficult for investors to generate an attractive return on domestic stock and bond investments.
• The United States will enjoy less global influence. Other countries work closely with the United States due in part to the size and openness of its markets.
• Foreign central banks will be reluctant to purchase U.S. Treasuries, making it more expensive for the United States to finance its debts.

These adjustments would be difficult under almost any circumstances.  It has been several generations since the United States experienced high and accelerating inflation.  The last time it happened, in the 1970s, the level of financial leverage across the U.S. economy was much lower than it is today.  As inflation and interest rates increased, the economy was able to adjust.  With much greater financial leverage today, however, the economic adjustments are likely to be more painful this time.