What else is easy to win (in addition to trade wars)?

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The US continues to walk away from the rules-based system that it helped to build over the past several decades.  The imposition of tariffs on aluminium and steel imports on (little used) national security grounds, followed by a series of transactional carve outs for specific countries, reflects an increasingly unilateral US trade policy approach.  The direct effect of these tariffs is unlikely to be significant.  But these actions weaken the foundations of the international trading system.  And if actions are launched at the WTO in response, and judgement is made against the US, the risk of an existential crisis for the WTO rises.

After 12 months of relative calm, the systemic concerns held at the start of the Trump Administration are manifesting more clearly.  Mr Trump seems to be overcoming the constraints of the ‘globalists’, reverting to his long-standing instincts on trade.  Consistent with his 1987 full page ad in the New York Times blaming Japan (and US fecklessness) for the US trade deficit, Mr Trump has recently tweeted that ‘trade wars are good and easy to win’; that ‘we are on the losing side of almost all trade deals’; and that the EU treats the US ‘very badly on trade’ (although the weighted average tariff into the US is almost exactly the same as the EU).  In short, the Trump Administration is becoming more ‘Trumpian’ and we should expect growing tensions around trade.

The likely flashpoint is the imposition of deeper trade and economic sanctions on China for theft of intellectual property, a lack of reciprocity in its domestic markets, as well as state support.  There are legitimate issues here that need to be addressed; and recent developments in China suggest that these problems are becoming more acute.  In response, the EU, Australia and others, as well as the US, are being tougher on Chinese trade and investment.

Responding to these challenges from China would be demanding at the best of times.  But the America First approach of the Trump Administration further raises the risk profile around the response.  An outbreak of trade conflict between the US and China – the world’s two largest economies – would weaken the current global economic recovery.  This systemic risk does not yet seem to be fully priced in.  After an initial hit as the steel and aluminium tariffs were announced, most equity markets bounced back to be roughly even over the following week.  But the growing prospect of trade conflict with China is beginning to weigh on markets, and I expect this to continue.

The emergence of a more ‘Trumpian’ Trump Administration also creates additional sources of institutional risk, with material implications for the global economy.

The US has anchored the global economic system over the past several decades by acting as the reserve currency issuer.  This is not an exorbitant privilege for the US.  Demand for the USD means that the US benefits from lower interest rates (and seigniorage revenue), as well as reduced market discipline on its policies, but faces a higher exchange rate than otherwise that constrains its export growth.  Indeed, running a trade deficit is something required of reserve currency issuers.

But there is a risk that the unilateralist US approach to international trade will also be reflected in reduced willingness to support the reserve currency system where it conflicts with domestic goals.  There is precedent: the US unilaterally ended the convertibility of the USD into gold in 1971 – ‘our dollar, your problem’ as then Treasury Secretary John Connally stated.  Current Treasury Secretary Mnuchin may not be as blunt, but he made ambivalent comments in January (subsequently walked back) on a strong USD.  And although incoming NEC head Larry Kudlow argued for a strong USD on Thursday, it is not clear that Mr Trump agrees (particularly as the recent fiscal stimulus collides with his demand for a lower trade deficit).

If the US is less committed to playing this role, the USD becomes less attractive to hold – and is less compelling as a safe haven in times of crisis. Barry Eichengreen recently noted that reserve currency status partly reflects geopolitical realities. It is possible that the America First agenda on trade and other global issues is one source of the current USD weakness.  Although the share of USD in global central bank reserves has been relatively stable, and the USD dominates the settlement of international transactions, concerns about the commitment to a strong USD could accelerate the transition to a multi-reserve currency system.  This would likely be a very bumpy process.

And there are other institutional risks from a more Trumpian Trump Administration, such as pressure on the independence of the Fed as interest rates begin to move up.  I have noted that the politics of normalisation will be challenging.  And it is not difficult to imagine Mr Trump directly challenging the norms and institutions underpinning the Federal Reserve.  Do not rule out a weakening of Fed independence, with lower interest rates and higher rates of inflation than otherwise.

My concern is that the recent trade measures may be a harbinger of political pressure on a broader range of economic institutions.  There is growing risk that the US retreats from several long-standing institutions and practices.  Small economies benefit from these global public goods, and this weakening is a source of particular exposure.  After a Goldilocks start to 2018, the bears may be returning.

 

David Skilling