Mission accomplished!?

The US and EA have reached the outline of deal that is very similar to the US-Japan deal. Tariffs on European steel remain at 50% and are 15% for everything else. That is about halfway between the threatened reciprocal tariff of 30% and the pre-trade-war average tariff of a few percent. Under the deal Europe does not retaliate.

At the start of the trade war some commentators argued that the Administration’s ultimate goal was free and fair trade, and the threats were just a way to get countries to the negotiating table. These deals show that the Administration has zero interest in zero tariffs and other protectionist measures. Tariffs are the goal, not the means.

The devil is in the details

As with the Japan deal there are several additional concessions that are short on details. Europe promises to buy $750 bn in US energy products over the next three years and invest $500 bn in the US. So far this is just a nonbinding verbal agreement and no text has been released.

Perhaps the most important missing “detail” is an explanation of how the administration will get around one of the most basic identities in economics: the balance of payments. If the trade deal causes a drop in the US trade deficit, via higher exports and lower imports, then it means less financing is needed via net capital inflows. And yet both Japan and EA have promised big capital inflows into the US. How are they going to fund the new imports?

Administration economists rarely talk about the impact of policy changes on the economy beyond the “first round” effect. (The exception is that idea that tax cuts pay for themselves by creating a boom in the economy.) In this instance the imbalance between the size of the trade deficit and the size of the capital flow to finance it will cause a bunch of second round effects. These include downward pressure on the dollar that reverses some of the improvement in the trade balance and offsetting movements in other capital flows, including less financing for the US budget deficit. Tracking all this stuff requires a complete model of the economy.

The Art of the Deal

By some accounts this shows President Trump’s savvy in reaching a deal. I would put it differently: I think it shows the strength of the US’s negotiating position if it threatens to end trade and military alliances. This is not something prior Administrations were willing to do.

America’s allies in Europe and Asia are feeling particularly vulnerable to attack these days, with both Russia and China threatening. The US defense umbrella has been a big benefit to US allies—as long as it was reliable. Now they can’t afford to alienate the US before they build their own capability. In the interim, US threats (implicitly or explicitly) to remove that umbrella are a very strong negotiating tool.

Huge bi-lateral trade deficits also put them at a big disadvantage. On a bi-lateral basis, the US has a big advantage in a tit-for-tat trade war, imposing much more damage on the other country than borne by the US. if countries act in in a coordinated or semi-coordinated fashion, and all raise tariffs tit-for-tat, however, the US becomes the biggest loser. (link)

Despite its big size, the EU is hurt in negotiations because it needs to coordinate across countries with very different interests. One sign of their weakness was their proposed retaliation for 30% tariffs. They were proposing targeting only $100 bn (0.4% of US GDP) in US products compared to the US’s target of about $600 bn (3% of EU GDP).

Onward and upward

Both the stock market and the business press seem to view this as the successful end to a long battle. Uncertainty drops along with the US trade deficit, with little apparent impact on the economy. Now the benefits of deregulation and tax cuts can show through.

I strongly disagree. If the entire tariff increase is passed through to consumers then it boasts the price level by roughly 1.8%. Pass through has been slow because: (1) importers front-run the tariffs, (2) companies don’t want to raise prices until they know the tariffs will stick and (3) companies don’t want to attract attention and risk being attacked by the Administration.

In June we saw the tip of the tariffs. Retail prices rose for many imported goods. Meanwhile, the prices importers paid foreign suppliers remained essentially flat, suggesting that foreign companies were not, yet, “eating” the tariffs and that US importers and/or US consumers were absorbing the cost.

My guess is that more than half of the tariff increase will be passed on to US consumers. Unlike in the first trade war the tariffs are too big to be absorbed into lower profits and are too widespread to be avoided by moving supply chains. Overall, I’m looking for about a 1% shock to the cost of living for the average US consumer, causing GDP growth dip below 1% in the coming quarters.

The forever war

Unfortunately, that is not the end of matters. Both financial markets and the business press seem to expect policy uncertainty to fall back close to normal levels. For example, the WSJ reported that: “European industry officials and politicians said the deal leaves the EU in worse shape than before Trump’s return to office but is likely a best-case scenario for European companies because it avoids a bigger fight and will give them more certainty over the coming years.”

Again, I disagree. In my view, if this round of “outline deals” is completed, it will usher in a temporary, noisy ceasefire. The Commerce Department will continue to take actions in individual industries and the President will continue to use tariff threats as an all-purpose policy tool. The recent threat of a 50% tariff on Brazil is a good recent example.

If you give a mouse a cookie

More important, I don’t think the new regime will last long. As we have seen with Trump’s USMCA trade agreement, no deal is final. Moreover, the Administration has learned it can push countries around. If the US can impose 15% tariffs without retaliation, why not more? Administration estimates suggest tariffs will have to triple from current levels to end fix the trade deficit (Chart, first column).

The stickiness of the trade deficit should be apparent in the coming months. The primary cause of trade deficits is not unfair trade practices: even the current policy of tilting the playing field heavily to the US’s advantage will likely have a modest impact on the deficit. In reality, the US trade deficit is driven by strong spending and weak production. That in turn is due to: (1) big and rising budget deficits, (2) low private saving and (3) the attractiveness (so far) of the US as a place to invest.

The trade war is not the only shock hitting the economy. Even as the trade war cools down, shocks to the labor market could gain momentum. Many of the Federal job cuts don’t show up as a lost payroll jobs until October. I also worry about the impact the impact of public services from a smaller and demoralized Federal labor force. A huge increase in the budget for Homeland Security will boost deportations and self-deportations will increase as life in the US becomes increasingly uncomfortable.

Finally, none of the “Trump puts” is near the “strike prices” that trigger policy moderation. The stock market is sending a strong “go” signal as it hits new records. Presidential approval ratings are gradually falling, but remain higher than Biden’s last year, Congress and Trump’s first term. The economy looks okay so far. If the trade war is painless, why stop?