The Zeitgeist: January 3, 2017
TRUMP AND THE ALMIGHTY DOLLAR
Nobody has any idea what the Trump administration intends to do on trade and tax policy. Some of what we’ve heard is smart and elegant, if also misadvertised (the Brady tax reform blueprint). Some is devoid of much upside as well as wildly risky (a general import tariff). And some is just plain nuts (a punitive tariff on U.S. firms who “export” jobs or measures to erase bilateral trade imbalances).
But there is one thing you can be sure of. Any or all of these initiatives, should they be enacted, will push the dollar further upward. And they would come on top of Trump’s fiscal and monetary inclinations which are already slated to push the dollar upward.
The Trump Tariff. Let’s start with the general import tariff, a pugnacious let-‘em-have-it idea which Trump himself has been promoting for years and which seems to have guided his choice of the industrialists, lawyers, and economists who will be advising him on trade. These include Wilbur Ross (at Commerce), Peter Navarro (head of a newly created White House National Trade Council), and Robert Lighthizer (just named U.S. Trade Representative). The Trump team generally feels that U.S. prosperity depends on negotiating "better" deals that "give away" less imports and "pry open" markets to more exports. And the best way to assure both, they believe, is through a tariff.
Last week, Trump’s transition team leaders suggested that a 5% or 10% general import tariff might be about right—at least to put our trading partners in a deal-making frame of mind. The Trump team is apparently convinced that a tariff is a reliable means of reducing America’s trade deficit.
Yet very few economists, left or right, agree with this view. The effect of a general import tariff, they say, will have little or no impact on our current account. Even in the short run, few importers will be able to absorb the full impact of the tariff without passing on some of the cost to customers. These customers in turn will respond to higher prices by buying less. Over time, as both importers and consumers find new ways to avoid pain, the aggregate decline in import sales (net of tax) will grow. This decline will dry up the supply of dollars in FX markets, which in turn will both ratchet up the dollar and pull down exports.
So an import tariff pulls down exports? That’s right. In fact, exactly eighty years ago economist Abba Lerner formulated the Lerner Symmetry Theorem (1936), a staple of international trade theory stating that a tax on imports is the functional equivalent of a tax on exports. Think about it: If foreigners are earning less $ from our imports, they have equivalently less $ to spend on our exports. The dollar rises so that FX supply and demand can rebalance.
After everyone adjusts, where does a general import tariff leave us? With less imports and less exports (that is, less trade overall), a higher dollar, and a fat revenue stream to the U.S. Treasury. The biggest U.S. winner will be the federal government; smaller winners will be firms that can substitute for the lost imports at the margin (though at higher prices). The biggest U.S. loser will be consumers; smaller losers will be export firms facing lost profits at the margin (due to lower prices). Overall, thanks to “deadweight” efficiency losses, what’s lost by the losers will exceed what’s gained by the winners—not just in the United States but also abroad.
A provocative variant of the general import tariff is the more punitive (say, 35%) tariff that Trump says he wants to slap on a single offending economy (say, China or Mexico). Here, the overall impact will be similar—less trade, a higher dollar, U.S. consumers socked by a stiff tax, etc.—but the details will differ. Here, partially offsetting the much larger losses of Chinese exporters will be gains by rest-of-world exporters, who will be able to join U.S. firms in substituting for lost Chinese sales to U.S. consumers. But again, the global losses will outweigh the global gains. Or, to put it differently, U.S. consumers get hit twice—first by the tariff they pay on any Chinese import they buy, and second by the higher price they must pay to any alternative seller.
In fairness, to be sure, economists do point to certain instances where a tariff can make a country better off. There's the "infant industry argument" (hardly relevant anymore to the United States). There's the curious "optimal tariff theory" case in which the price elasticity of import demand is so much higher than that of export demand that a large economy gains by bending the terms of trade in its favor. The Trump team may believe that the world is so full of monopolizable goods and services that this theory makes sense. Few economists would agree. There's also the Keynesian demand-boost argument for tariffs, but this only works with fixed exchange rates—which again no longer has much relevance.
What Could Go Wrong? Dismal as they are, these are the best-case scenarios. Many more negative outcomes can be imagined. By violating long-standing agreements with trading partners, a peremptory Trump tariff will almost certainly encourage growing disregard for international treaties and conventions generally—everything from IP protection to legal due process. Many of these agreements of course hugely benefit Americans. It could also lead to tit-for-tat retaliation from trading partners, in a potentially catastrophic spiral in which each move and countermove succeeds only in reducing total trade.
Global trade has already decelerated since the GFC. In recent years, for the first time since the Great Depression and World War II, global trade growth has not kept up with global GDP growth. Presumably, the next U.S. president does not want to push this into a nose dive. For anyone who has forgotten the legacy of the Smoot-Hawley beggar-thy-neighbor era, let me reprint here Charles Kindleberger’s unforgettable cobweb chart on what happened to global trade during the first few years after the 1929 Crash.
Back in the 1930s—the world’s last Fourth Turning, in my parlance—the flames of tariff-hike aggression were fanned by the same brand of authoritarian populism that we see on the rise again today. Back then, as today, the world was full of citizens who wanted to make their nations “great again” and who valued national solidarity and community over globalism and higher living standards. Back then, as today, the most popular leaders were those who embraced that trade-off.
We’re not dealing here in hypotheticals. By means of various laws enacted over the last century, the U.S. President possesses broad authority to enact a general or country-specific tariff through executive action—without any need for any new legislation. (See the recently rediscovered Tariff Act of 1930—still in force!) Trump could thus get a tariff up and running within his first few days in office. What’s more, Trump knows who got him where he is today: He cares more about energizing his voter base than about pleasing the policy experts or the market. And, ominously in his case, what pleases one very often horrifies the other.
The Brady Tax Reform Plan. The GOP leadership in Congress, including both House Speaker Paul Ryan and Senate Majority Leader Mitch McConnell and their staffs, are aware of the danger. So they are dressing up their corporate tax reform plan, generally based on the proposal by House Ways and Means Committee Chair Kevin Brady, as a friendlier substitute for Trump’s tariffs. The Brady Plan basically requires firms to include all imports in their tax base and allows them to exclude all exports from their tax base. Thus, like a VAT, it taxes imports and subsidizes exports. And because it’s like a VAT, the GOP leaders are hopeful it would pass muster with the WTO and U.S. trade partners. (No one on Capitol Hill can actually call it a "VAT" because the word is unmentionable in GOP leadership circles.)
There is much to admire in the Brady Plan’s corporate tax reform, which is largely based on an simple yet sophisticated proposal by UC Berkeley economist Alan Auerbach. It is a big improvement over today’s U.S. corporation tax: It eliminates double taxation of capital income, puts debt and equity on an even playing field, is much easier to administer, and eliminates most forms of global tax arbitrage. It’s basically a flat-rate tax (20% is the most-quoted number) on corporate cash flow, with the flow measured according to where the sales occur. The VAT-like border adjustments ensure that taxes follow sales.
Overall, the Brady Plan would tilt corporate financing from debt back a bit toward equity. It would tilt the overall U.S. tax incidence from income back a bit toward consumption—though in a progressive manner (since, unlike a true VAT, wages and salaries aren’t included in the base). It would also hugely favor the relocation of global production into the United States for the simple reason that it doesn’t tax a firm’s production activity at all.
Indeed, one useful way to think about the Brady Plan is that it imposes a 20% progressive VAT while entirely eliminating the traditional corporate tax. Most high-income economies besides ours already have VATs, but all of them also have production-based corporate taxes. If the Brady plan were enacted, the United States would suddenly go from having a relatively high-rate corporate tax to having, in effect, none at all.
Is the Brady Plan a good idea? No doubt it’s a simpler, fairer, and more efficient tax than the U.S. corporate tax we have now, a barnacle-covered relic from the Woodrow Wilson era. Not only would it put an end to “tax inversions,” it would probably give a big boost to FDI into the U.S. economy.
Will it ever be enacted? Tough to say. The plan would create substantial winners and losers. (See this cool interactive calculator by AEI economist Kevin Hassett.) Even after the expected dollar-up FX response, many exporters would be big winners, some even racking up large tax credits. Equivalently, many importers and firms that currently practice cross-border tax arbitrage (think: Silicon Valley) would be big losers, some even seeing all their current earnings taxed away. Walmart and the National Retail Federation are screaming holy murder. Because losers speak louder than winners, it’s hard to see this winning passage without major changes.
But let’s return to the GOP leaders’ argument that their tax reform package preempts the need for Trump to impose a tariff. Their reasoning is that the VAT-like border adjustments, by taxing imports and subsidizing exports, function like an import tariff. Indeed they do. And this is why they will not achieve Trump’s goal of closing the U.S. current account any better than a tariff would. Under the Brady plan, as under a VAT, the dollar would rise until the net impact of the taxes and subsidies is neutralized.
The Trump team may like the Brady Plan. Business leaders have for decades claimed that a VAT makes an economy more competitive in trade. Almost unanimously, for just as long, economists of all stripes have disagreed. In fact, it is very likely the Brady Plan could well increase the current account deficit by raising the rate of return on FDI to the U.S. economy and thus increasing the size of capital inflows. This would mean that, when it comes to the magnitude of U.S. trade deficit (and the altitude of the U.S. dollar), the Brady Plan would be even worse than a tariff.
Other Trump Options? At this point, it may be worth asking: What could the new president do that would actually raise total exports relative to total imports? To answer this question, we need to look at the flipside of the current account. We need to look at the capital account, investment outflows minus inflows, which is where the long-term balance is determined. To close the current account deficit, we either need to (1) decrease the attractiveness of the U.S. economy to foreign investors or (2) increase the U.S. national savings rate. Either course of action would cause the dollar to sink and the current account deficit to shrink.
The easiest way to do (1) is to pressure the Fed to bring down the yield curve. There’s little chance that’s going to happen soon. The U.S.-versus-rest of world yield gap is rising—and according to most of the Trump team (and Trump himself) this can’t happen fast enough. It is widely assumed that Trump will appoint more hawkish Fed governors when their seats become vacant.
The easiest way to do (2) is to close the federal deficit through some combination of spending cuts or tax increases. Trump appears to have no such inclination either as a short-term or long-term objective. He ran on a platform advocating an opposite mix that would add an estimated $5.3 trillion in deficit spending over the next decade. GOP leaders in Congress are getting ready to restrain his fiscal largesse. In theory, the revenue raise from a Trump tariff could be used to close the budget deficit. In practice, everyone is assuming that such revenue will be lost in a sea of much-larger tax cuts and defense and infrastructure hikes.
Dollar, Full Speed Ahead. One can imagine many possible futures for the Trump presidency. But if any substantial part of his policy program is enacted, it will almost surely lead to further growth in the current account deficit and, even more, to a further rise in the dollar. When you scan his full agenda—on tariffs, on taxes, on tax policy, on monetary policy—it is hard to see anything that doesn’t push in that direction. I've written at length about why the Donald ain't Ronald. But in this one respect, their initial advocacy of strong-dollar shockonomics, the parallel is apt.
What's more, the dollar is still trading near its long-term historical average relative to other currencies. As such, the dollar could still have a long way to go. According to the Fed's real trade-weighted index, the dollar could rise another 8% before reaching its high in February 2002, and another 23% before reaching its high in March 1985 (just before the Plaza Accord).
Even disappointing U.S. economic or market performance need not derail this scenario, so long as major parts of Trump's tariff, "export boosting" tax plan, and/or deficit-spending package are enacted. With any of these in place, remember, a higher dollar becomes the new normal. As for a foreign policy crisis or a global market crash (I'd say the odds of both are rising with Trump), these scenarios would also redound to the dollar's advantage through the "safe haven" channel.
The only scenario that would seriously threaten the higher dollar outcome would be a cross-the-board Trump whiff on policy (no tariff, no tax reform, little fiscal boost) plus some sort of U.S.-centered market downturn. Let's imagine, for example, that the Fed gets too aggressive in its hikes (effectively bursting Yellen's "big, fat, ugly bubble"), which then forces the Fed to consider reversing course. OK, yes, all this would open up a bearish dollar outlook. Investors long on the dollar need to keep a keen eye on what's happening in the White House, Capitol Hill, and the Eccles building.
To be sure, the dollar cannot keep rising forever. Sooner or later, it will trigger events that will force all the players in this drama to change course. It may be a market decline, touched off by the worsening drag on U.S. exporters or the monetary strangulation of dollar-based EM economies. Or it may be a political challenge, posed by disgruntled Trump partisans wondering why they're still losing their industrial jobs (even while getting taxed, by now, on their purchase of retail imports). It may be a crisis that forces political leaders to respond at a moment not of their own choosing. Or it may be more like Reagan’s “Plaza Accord” turnabout (in 1985), a well-orchestrated reversal in policy direction.
Yes, in time this trend will reverse course. But that’s down the road. For now, Trump is embracing the Almighty Dollar. For now, USD is a buy.
NewsWire
- Janet Yellen recently gave a commencement speech at the University of Baltimore in which she told graduates that their degrees are more valuable than ever before. While a college degree definitely confers many benefits, plenty of Millennials that graduate into low-paying jobs with thousands of dollars of debt wonder if it was worth the cost. (The New York Times)
- Recent research confirms that Baby Boomers are using more marijuana and drinking more heavily than previous generations of seniors. Engaging in risky behavior poses additional hazards for seniors who are more likely to injure themselves in an intoxicated fall, and are more likely to take prescription drugs (many of which do not mix well with alcohol). (The Washington Post)
- Uber has announced that it will be defying California state regulations by continuing to test its self-driving vehicles in San Francisco. Uber executives contend that they don’t need a permit because their test cars still need a human operator—which speaks to the readiness (or lack thereof) of true self-driving cars. (The Guardian)
- A report listing when different career paths were most desired by college freshmen shows that the clergy enjoyed its highest popularity with Boomers in the mid ‘60s, law and business were favorites with Xers in the late ‘80s, and health care has become desirable with Millennials in the early 2010s. These professions line up with these generations’ foundational traits: moralistic Boomers, pragmatic Xers, and service-oriented Millennials. (Higher Education Research Institute)
- Companies are increasingly abandoning rituals like yearly performance reviews, and are instead using technology to give their employees more frequent, automated feedback. Though these systems are a likely hit with Millennials who crave constant feedback, managers must be sure not to abandon the one-on-one sit downs that young employees need. (Quartz)
- A new car sticker reading merely “GEN.X” (designed to mimic those awarded for marathons) was recently released by a Gen-X blogger. While it’s uncertain how many Xers will want to identify as part of their own generation, the creator’s tagline for this take-no-prisoners bunch rings true: “[L]ife is a marathon and our race has been like no other.” (JenX67.com)
- A new series of books called KinderGuides wants to make literary classics more accessible to very young readers by heavily shortening and sanitizing novels like On the Road, The Old Man and the Sea, and Pride and Prejudice. Parents often see their Homelander children as wise beyond their years—and want to make sure they are ahead of their peers. (The New York Times)
- The federal government has been taking money out of Social Security checks at an alarming rate in order to recover unpaid student loans. This trend is on track to intensify as more Boomers retire and more Millennials rack up student debt, leaving many financially unprepared Boomers and Xers in poverty. (The Wall Street Journal)
- While e-commerce retailers have recently been dominating holiday sales, downmarket department stores like TJ Maxx, Marshalls, and HomeGoods have still been able to get people to line up. The thrill of physically tracking down the perfect item while shopping can still bring out bargain hunters—for the right price. (Bloomberg Business)
- While fabric softener sales have been declining for years thanks to technological and fabric-related improvements, it appears that Millennials are accelerating the decline. Analysts blame the shift on everything from a distaste for chemicals to the rise of athleisure—but another possibility is that young people can’t afford to splurge on a laundry nonessential. (The Wall Street Journal)
Did You Know?
No Holiday Break for Brick-and-Mortar. The e-commerce boom has benefited e-tailers and in-person retailers alike. But like eggnog, an abundance of a good thing can prove to be too much: Last Christmas season, Toys “R” Us was forced to cancel some online deals because it lacked the capacity to fulfill the onslaught of online orders. To avoid a similar snafu this year, Toys “R” Us has equipped nearly all of its 870 stores to carry out Web orders—which executives say has doubled the company’s shipping power. Other retailers are bracing for the shopping rush in similar ways. Kohl’s is beefing up the incentives for its fulfillment-center workers through higher wages and better bonuses. Target has more than doubled the number of its stores that are equipped to ship goods. Sure, the heavy flow of online traffic around the holidays may only come around once a year—but as logistics professional David DuBose says, “You build a church for Easter Sunday.”
