Those who insist that a trade war is about who wins or loses either in the short or long run most likely do not understand what international trade is.
Those who surmise that anyone pointing out the American consumers, especially the less well-off bear a huge brunt of the consequences from the trade war, are framing it as “Americans lose most” miss the point that trade is neither a war nor a competition of who loses most.
To understand trade, there are a few fundamental concepts that we must bear in mind when discussing this topic. So let me list them here, some taken from my previous tweets and posts, giving flavour to each of the concepts and trusting readers to dive into the definitions or deeper discussions available elsewhere if they so wish:
- Trade is a system
Trade is a system of networks consisting of:
- Various agents, from entire countries to the smallest wholesalers who import and export widgets,
- Manufacturers and producers, companies with their relative advantage derived from their respective locations, efficiencies and way of business, access to raw materials and natural resources, know-how and above all, their ability to scale,
- Standardisation, rules, regulations and agreements forged by a history of drawn out negotiations,
- The supporting financial, legal and logistical structures such as insurance, credit, guarantees and loans, collateral, contracts, shipping, warehousing, brokerage, advertising, trade-related technology including data and platforms. Furthermore, foreign direct investments and capital flow play an important part.
- Governments and central banks with their policies, custom systems, currencies.
If trade is a system, therefore, a trade war is a system that is going to war with itself; like a man’s arm reaching for a saw to cut his own legs off.
- Comparative advantage
A country that does not appreciate its own comparative advantage will not make the best decisions, let alone policies on trade. For example, the UK’s comparative advantage is overwhelmingly concentrated in the service industries so it baffles me why it hasn’t tried harder to protect this sector from the effects of Brexit.
In the technology sector, China is quickly building up a workforce that are able to handle both design and high-tech manufacturing. My favourite example is in the development of neural networks which was going nowhere before 2011. Then, only a few hundred people were working on NN. It took ten thousand smart enthusiastic Chinese graduates to enter the field for it to move forward. In terms of the sheer number of graduates, organisation and pure profit motive, China now has the upper hand.
Currently, there is a massive push in China to advance its semiconductor and battery technology, which also covers technology for ancillary activities, such as lithium extraction for batteries. In fact, a Chinese government report declared that the cost of extracting lithium has been slashed to a “record low” of RMB 15,000 (US$2,180) per ton by a new breakthrough process.
It also niggles me that Donald Trump is so gung-ho on protecting steel and aluminium as well as certain agricultural sectors, rather than focus on what the US wants its future workforce to look like, with a long term plan that includes education and training. Just like China, the US needs its own “Made in US 2025”.
- Exchange rate pass-through
Exchange rates matter a lot. According to the IMF a few years ago, large depreciations substantially boost exports. The results indicate that these depreciations average 25 percent in real effective terms over five years. The export prices in foreign currency fall by about 10 percent, with much of the adjustment occurring in the first year. China has been accused of artificially keeping the RMB exchange rates low in order to maintain competitiveness.
What about the US? A 2016 study showed that the pass-through on imports and consumer prices is relatively modest. A 15 percent dollar appreciation reduces consumer prices by a quarter of a percentage point in the short run, and by four-tenths of a percentage point after two years.
It is not the same story for the US exports. Most of the trade balance adjustment following a dollar appreciation takes place through the export (and not the import) channel. The reason for this is that the US exports and imports are predominantly denominated in US dollars.
Fast forward a few years, the most recent episode of tariff drama shows that the main channel for the US is the inflation channel. Studies found that Chinese exporters did not absorb any of the tariffs in their profit margins and import-competing US producers raised their prices in response – a double-whammy for the American consumers.
In a small, open economy however, a depreciated currency may not be enough. UK exporters saw little benefit from the Brexit depreciation while UK consumers mostly had to pay up for increased import prices.
In contrast, Japanese exporters have a strange fixation to maintain the stability of their export prices in overseas markets and absorbing exchange rate fluctuations through profit margins.
- Barriers to trade
Free trade agreements increasingly focus on NTBs or non-tariff barriers to trade, with special emphasis on competitiveness and regulatory alignment. The EU-South Korea FTA for example, includes a competition chapter which prohibits and penalises certain practices which distort competition. Competition is hard to monitor and regulate. According to Cecilia Malmström, the EU trade commissioner, the EU is not particularly happy with the level of South Korean compliance.
Regulatory transparency and a new approach on trade and sustainable development are also features of the agreement. These may also monitor standards and values, including workers’ rights and environmental commitments as “comprehensive” trade agreements take on a whole new meaning in modern trade – helped along by woke consumers’ ethics and sensibilities.
Perhaps we should also not be naïve that there are “informal” non-tariff trade barriers where non-friendly countries can delay customs formalities at the ports or borders.
- Substitutability and intermediate goods
Roughly half of US imports are intermediate goods and not finished products. Tariffs will increase the cost of production for imported foreign components, unless these inputs are sourced domestically. For example, around one-third of auto imports for finished cars or trucks used at US factories are intermediate products. The larger the share of non-substitutable intermediates, the more problematic tariffs are for the firms.
Trump hopes that the tariffs on steel will induce investments in domestic steel production. The question remains, will there be investments and if so, which kind of steel will be prioritised by domestic companies? Will the choice of investments fulfil all the different types of steel products that the US requires? Investment decisions are taken with multi-decade horizons, far beyond anyone’s presidency. These are things to think about when it comes to substitutability.
Furthermore, global value chains are designed such that they are regulatory and logistically efficient. For that to happen, it is beneficial to belong to an economic area and even more beneficial that intermediate goods can ping-pong across borders until they become finished products. This is the gravity theory of trade – the less distance, customs formalities at the borders and time spent in transit the better.
Many goods are tied up with services as well. The EU head negotiator Michel Barnier complained that Theresa May wanted regulatory alignment for goods only and neglect services. He said that services are in every product – for a mobile phone it is 20-40% of the total value.
Speaking of phones, more than 50 percent of jobs in smartphone manufacturing are in the final stages of production, so policies that cause only parts of the supply chain to shift may not create many jobs. An estimate of a 37 percent increase in production costs if they were made in the US which in turn leads to about a 15 percent increase in the price for consumers in the US. It will also take at least 5 years to move supply chains for smartphones to the US.
- Globalisation and agreeing to a rules-based system
A rules-based system has its disadvantages but to my mind, the certainty and efficiency it provides to the global market is invaluable.
Rules may shape the global value chain. For example, the rules of origin in trade agreements that require a certain amount of content to be produced in a particular country determines the way companies organise their supply chains.
Rules give rise to arbitration facilities, consequences that will come into effect should a clause in the trade agreement be broken. Despite the poor health of the WTO, it is still an idea and institution that should be championed. A trade agreement is only as good as the legal infrastructure that upholds it.
Rules normally result in standardisation, which begins at the technical aspect of production and may eventually result in the rise in the quality of products through positive spill-overs, technology transfers and know-how.
In addition, the nobler purpose of trade as a tool for peace as both Ireland and Northern Ireland have found out, should not be underestimated. Trade peace rather than trade war should be the bandied terms to nurture a global prosperity.
The main message of this post is that if you want to discuss any trade war, you need to look at all these other issues as well, and more.
EightAteEight 