Sunday, November 13, 2016

What would a trade war look like today?

One of the many risks of a Trump presidency is a disruption in trade.  But, in thinking through the issue, I can't quite imagine what would happen in today's context.

The large trade deficit today is peculiar.  Part of the reason it is so large is that many of our most productive corporations operate in frontier information and financial sectors that don't involve the movement of goods across a border.  So, if Google makes a profit in Australia, it is more likely to register as the revenue and profit of a foreign subsidiary than as an export.  Part of the trade deficit is simply the result of this semantic distinction.

But, the trade deficit is the mirror image of the capital surplus.  We send a lot of dollars overseas to buy goods, and instead of using those dollars to buy goods from the US, foreigners save a lot of those dollars and invest them in the US.  Funny thing is, though, after decades of this - after trillions of dollars of excess investment - the income US investors make on foreign investments outpaces the income that foreigners make on their US investments by a wider margin than ever before.  Foreigners are running to stay still, at best.

I think the reason for this is that the US has many global corporations who are earning above market returns.  (I have come to attribute that to the role of urban housing in the information economy, but that's a complicated story.)  Whatever the cause, the implications of this are interesting.  US firms are reinvesting our foreign profits in high return operations.  If we reinvest $100 billion that will earn 10% returns, then if foreigners can only earn 5% returns, they have to invest $200 billion in the US just to maintain a stable net international capital income.

This is why we have a sustainably large trade deficit.  Foreigners have to keep selling us stuff in order to maintain a capital income.  If they stopped selling us stuff to invest it, our net foreign income would balloon, and our firms would end up owning an accelerating portion of their capital.  Currency values, interest rates, trade levels, etc. adjust to an equilibrium that draws foreign capital to the US.

So, given this context, what would happen if the US imposed a policy with the aim of reducing the trade deficit?  The causal factor for the deficit - the need for foreigners to save - would not go away.  It wouldn't be that difficult for foreign markets to enact tariffs, etc. to instigate a trade war.  But, they would need to stop our corporations from getting revenues through their foreign subsidiaries.  That is a little more difficult and intrusive.  It would involve some sort of capital repression, nationalization, etc.  Would they be willing to go that far?

If they didn't go that far, and there was still pressure to gather dollars in order to invest in US assets, then what would give?  Would the trade deficit remain, and US tariffs would end up being a revenue source for the US government, with little effect on trade?  Would production move back to the US?  If it did, and the trade deficit declined, then would our foreign assets and income balloon?  Would the dollar rise in value?

I'm having trouble imagining all the moving parts.  Anybody have any ideas?

11 comments:

  1. Simple: Place a tariff/tax of 25% of retail value on all goods and services entering the U.S. (in the case of services provided to the U.S.) but manufactured or originating outside the U.S. Implement this in conjunction with a zero tax rate for businesses within the U.S. The objective is to bring back jobs and make this country economically healthy again. To the extent this causes other countries to enact tariffs I say simply that's their business and their problem. Our problem is our people/citizens and our country.

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    1. I think you're right about the corporate tax rate. I suspect some of the capital flows are a tax arbitrage between US firms that keep profits abroad and foreign savers who can invest the cash back in the US without the tax consequences. But, I admit I am having trouble thinking through the process of exactly what effect that would have.

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  2. If you read Michael Pettis, he thinks that as long as the demand for safe assets is there, we mathematically have to run a trade deficit. Because what goes in must come out, and what comes in is stuff and what goes out is debt.

    So the interesting question is NOT "What happens here?", the interesting question is: "What gives elsewhere in order that the status quo continue?"

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    1. That's the question. Do you have any ideas? What would give?

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  3. Let me take a swing, even though I'm a total novice here.

    What would happen if we start out in equilibrium (where our capital account surplus balances our current account deficit), and then suddenly and without warning made all imports from China illegal (an infinity-percent tarriff)?

    I think the yuan would plunge relative to the dollar, and both import and exports would grind to a halt. The plunge would stop when the the capital account by itself was in balance, i.e., an exchange rate such that the dollar-return of Chinese-owned US assets exactly matched the yuan-return of US-owned Chinese assets. (I'm assuming here that both Chinese exports and imports drop to 0, imports because they're illegal, exports because with a near-worthless yuan, the Chinese couldn't afford to import much of anything from us).

    If we imposed tariffs less than infinity percent but more than zero, then you get a similar effect, but less. The Yuan drops relative to the dollar, the volume of trade in both directions drops, and the dollar return to US holders of Chinese assets falls, and the Yuan return to Chinese holders of US assets rises. The yuan-price of US assets held in China rises, and the dollar-price of Chinese assets held in the US falls.

    How did I do?

    -Ken

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    1. Huh. You got farther than I did. I don't think Chinese currency would take that much of a hit, just because of trade with the US, though. There are a lot of other trading partners.

      I'm trying to think of what would happen in your last paragraph if the tariff was global - not just with China. Our foreign subsidiaries would collect profits. They would have to get dollars in order to bring them back home to buy American goods. So, I guess you're right. There would be tremendous upward pressure on the exchange value of the dollar, until something gave and we allowed a trade deficit to reappear. I think you're right. In theory it would create extreme currency pressure, and in practice, there really isn't a way to get rid of the trade deficit.

      I'm glad Tyler linked to this, but I was hoping he'd do one of his stream of consciousness posts on what he thinks the implications would be.

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    2. Glad I passed the laugh test at least!

      Yes, sorry, my whole "analysis" was also based on a counterfactual where the US and China are the only countries in the world.

      Once we add in a bunch of other countries that trade freely with both US and China, I think what you'd see in the case of a total US-China trade blockade would be a slight dip in the Yuan and slight strengthening of the dollar, combined with a lot of "three-way" trade where France buys stuff from China and sells stuff in the US, a kind of arbitrage of our barrier. i.e, our bilateral barrier would be pretty leaky, so the main effect would be to reduce our trade deficit with China and increase it with a bunch of other countries, combined with a slight strengthening of the dollar and a slight dip in the Yuan.

      The more we convinced other advanced-economy countries to go along with our blockade, the greater the swings in the currencies, the lower our individual and collective trade deficit with China, and the lower our capital surplus.

      In the extreme where all other countries refuse to trade with China, then the Yuan's value relative to other currencies becomes determined by the capital account balances. Basically, the Yuan adjusts such that China's capital account nets out at zero, and China's current account balance has to be zero because there's no trade.

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  4. Problem - Improving the domestic manufacturing environment while providing for the need for foreign investors to save. Do I read this correctly?

    Potential solution - My first thought is to go with Buffet's Import certificate plan which balances out exports and imports. It is effectively a tariff, but it will also cause disruption in the market. But that doesn't solve the savings issue. The solution could be the following - a new class of corporate liability should be created which is denominated in ONLY goods or services that the corporation provides. The note reads "I promise to pay the bearer 100 eggs" or "This note is good for 1 hour consulting with a senior partner". This is definitely easier for goods producing organizations. The validity of these notes could vary as per various clauses (depending on how much disruption is sought to be avoided). So, the import certificates can be offsetted by normal goods exports as well as the sales of these certificates to foreigners. The markets figure out a way to get the actual products to the actual users with better efficiency as time goes by. Actual sales are promised, so the problem of thriftville and spendville which Buffet worried about is taken care of and the savings aspect that you are worried about as well.

    The things to resolve are - where in the corporate bottom line do these new liabilities appear? Do they get resolved after debt, before debt, after equity, etc.

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    1. I think I gave you the wrong impression. I don't think the trade deficit has much to do with falling manufacturing employment, and I don't consider either of them a problem, per se. I don't think either would be a problem if we hadn't killed the residential construction labor market and if we allowed them to move to the high income urban centers where the jobs are.

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  5. Even 30 years ago what was then the Big 5 accounting firms had staffef up units to help corporations source profits in the lowest-rax districts globally.

    Since then, there has been an explosion of tax havens, such as the recently reported on nation of Panama.

    There has also been an explosion of cash in circulation. I mean like $4500 per US resident.

    Who knows anything?

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  6. Even 30 years ago what was then the Big 5 accounting firms had staffef up units to help corporations source profits in the lowest-rax districts globally.

    Since then, there has been an explosion of tax havens, such as the recently reported on nation of Panama.

    There has also been an explosion of cash in circulation. I mean like $4500 per US resident.

    Who knows anything?

    ReplyDelete