Tariffs and Currency: Trump's Trade Deficit Conundrum

Source: FT Chinese Network

Since Trump was elected president, he has declared that he will use tariffs to solve the trade deficit problem that "robs American jobs"; and many American politicians have also declared that tariffs will only bring inflation.

The US trade deficit problem has not been a day or two, and the solutions of successive presidents are also different. Economic theory tells us that the best way to reduce imports, boost exports, and reduce trade deficits is often to devalue the currency - this will increase the prices of imported goods and services calculated in the domestic currency and reduce the prices of exported goods and services calculated in foreign currencies, thereby suppressing imports and encouraging exports.

As the theory says, many US presidents have regarded devaluing the dollar as the only way to solve the trade deficit problem - this story has been played out as early as the Reagan era. In the 1980s, when Reagan was first elected president, the US economy was suffering from severe inflation. In order to ease inflation, Reagan supported the plan of Fed Chairman Volcker to raise interest rates by double digits to recover money and reduce the burden on small and medium-sized enterprises through tax cuts.

Although the substantial interest rate hike reduced inflation, it also caused the dollar to appreciate significantly. When Reagan first took office in January 1981, 1 US dollar could be exchanged for more than 200 Japanese yen; by the peak of the interest rate hike policy in November 1982, 1 US dollar could be exchanged for more than 270 Japanese yen. Although the interest rate hike policy ended in 1983, the exchange rate of the US dollar to the Japanese yen remained at a high level of more than 260 Japanese yen until January 1985, when President Reagan's first term ended.

The high domestic interest rates have caused the US manufacturing industry to bear heavy capital costs, greatly affecting its competitiveness; the substantial international appreciation has enabled Western European and Japanese manufacturing industries, represented by automobiles, to gain ground in the United States. Under the combination of the two, the US automobile and other manufacturing industries were defeated, and the anger of the workers was rampant. In 1982, this anger finally reached its peak with a tragedy - in June 1982, Chinese American Chen Guoren living in Detroit was beaten to death by two unemployed auto workers.

Reagan, who fixed the inflation problem in his first term, had to fix the trade deficit problem in his second term. Therefore, at the beginning of Reagan's second term in 1985, when the United States was dealing with the export surplus of Japan, Germany, France and other countries to the United States, the Plaza Accord was launched to make the yen, pound, franc and German mark appreciate significantly against the US dollar, which greatly stimulated US exports to Europe and saved the life of the US industry.

Since then, the US government has frequently used the trick of adjusting interest rates to establish a business model of "low interest rates, low exchange rates and low tariffs". Due to the low federal funds rate, the corresponding interest expenses of national debt are low, which can control government spending; and the controlled government spending allows the government to cut taxes, thereby reducing the burden on enterprises. On the other hand, the government can borrow money to build infrastructure, and at the same time, low interest rates reduce the US dollar exchange rate, thereby promoting exports and suppressing imports, which generally stimulates domestic demand. Combining the two, the situation of manufacturing enterprises has been improved to a certain extent.

It is said that the earth is a cycle of twenty years. In the past twenty years, China's economy has developed rapidly, gradually replacing Japan, Germany, France and Britain in manufacturing. The renminbi is no exception - since 2005, the exchange rate of the renminbi against the US dollar has appreciated all the way, from 8.3 in 2005 to 6.3 in 2013 with the steady increase of US interest rates and the renminbi exchange rate reform. The large appreciation of the renminbi against the US dollar has greatly improved the US trade deficit: on the one hand, Chinese people began to travel and study in the United States, and service trade exports became one of the important commodities "exported" by the United States to China.

However, Trump discovered a problem after taking office. The devaluation of the US dollar in order to alleviate the trade deficit in the Reagan and Obama eras actually caused uneven development among the states of the United States. For example, the inbound tourism developed by the depreciation of the US dollar naturally benefits states with more scenic spots and more developed tourism industries; studying in the United States benefits states with developed education; purchasing agricultural products benefits agricultural states in the Midwest. In the end, it was found that industrial products such as automobiles in the "Rust Belt States" in the Midwest are difficult to benefit from it.

As for why the manufacturing industry is a mess and rotten wood cannot be carved, this is closely related to the Galapagosization of American industries. Lowering the exchange rate is good for international development, but international development first requires the industry itself to have the ability to internationalize. And Galapagosization just describes the situation where products are not competitive internationally under the background of trade protectionism.

We are more familiar with the Galapagosization of Japanese society, but the United States also has similar problems. For example, the domestic automobile industry in the United States has long abandoned the car industry under the trade protection policy for small trucks and instead engaged in the production of small commercial vehicles. However, the "small" commercial vehicles of the United States are still too big for Europe, Japan or China - the smallest pickup truck in the United States is often 5.5 meters long and 2 meters wide, but the vehicles used in Europe, Japan and eastern China, which are small and densely populated, are often 4.5 meters long and 1.6 meters wide. In this context, the American automobile industry has long been Galapagosized, becoming a customized product that can only meet the domestic market and be sold in foreign markets at will.

However, staying at home does not mean that you can be free from foreign competition - even in the Galapagosized market, foreign competitors can survive and develop through imitation. For example, even in the traditional "pickup truck" industry in the United States, Japanese companies have developed products such as Toyota Tacoma to challenge the status of American companies; as for other fields, the competition from Chinese companies is countless, needless to say.

At the same time, even if the demand is Galapagosized, the raw material supply chain is often globalized. Even for "locally produced" products such as pickup trucks, there are often a large number of foreign parts in the industry. In this context, the exchange rate policy will have significant problems - with the depreciation of the US dollar, the costs of industries that rely on foreign supply and do not have the support of domestic upstream industries will naturally rise.

In this context, the exchange rate policy did not work. The Trump team can only turn to tariff barriers - unlike the exchange rate that is flooded and shared by all, in the eyes of American politicians represented by Trump, tariffs can be "targeted" against final goods without affecting the import of parts.

But there is no such good thing on earth. Sooner or later, you will have to pay it back. As a trade protection policy, the essence of tariffs is to raise the price of imported goods to the same level as domestic goods - after all, if foreign traders lower their prices, the price with tariffs is still lower than that of domestic goods, then people will still not buy domestic goods. At the same time, for domestic product manufacturers, after the tariffs are added, the best game strategy is actually to maintain the existing production capacity: once the production capacity is expanded and the market share increases, the government will think that the problem has been solved, and will stop or reduce tariff subsidies instead.

Under the logic of "doing business with the government", instead of improving their products and increasing their competitiveness, domestic manufacturers should directly manage upwards, first increase the price of domestic products, and then cry poor and lobby the government to increase tariffs, so as to earn the extra profit space brought by the tariff increase.

Therefore, the policy is constantly increasing under the "left foot stepping on the right foot" logic of "adding tariffs-imported goods prices increase-domestic goods prices increase-market share first rises and then falls-lobbying the government to further increase tariffs", which eventually leads to a general increase in social commodity prices. This has created the rare spectacle of "tariff-type inflation" in the world-all the tariffs added are imposed on consumers.

In order to reduce inflation, the Federal Reserve will correspondingly implement a high-interest rate policy, trying to ease inflation by recycling money. As early as the end of the Obama administration, interest rates began to rise; and during the Trump administration, interest rates continued to rise until 2019. If it were not for the epidemic, interest rates would probably rise further.

However, there is a big problem with the high-interest rate policy-the profit margin of the real economy is not that high.

Normally, to improve the situation of domestic voters as industrial workers, we should actively introduce foreign capital and encourage direct investment from domestic capital. More investment increases the supply of local factories and "bosses", so that industrial workers can gain an advantage in the game with bosses, and the situation of workers can be improved. This is something that every country in the world has experienced - even in the United States, port workers have reaped real dividends from the expansion of port trade.

But the current situation in the United States is completely the opposite: the high interest rate policy has greatly hit the willingness to invest in the US manufacturing industry. Therefore, taking foreign capital as an example, although the US FDI has soared all the way, the funds invested in the United States are indirect investments (such as securities investment), and the direct investment that actually falls into the manufacturing industry is actually declining year by year. Foreign capital is already like this, and domestic capital is even more needless to say. Since there is less direct investment in the manufacturing industry and the number of companies has not increased, it is difficult for workers' bargaining power and situation to be improved.

At the same time, the high US dollar exchange rate and severe domestic inflation have caused Americans to start traveling abroad and spending money outside. We often hear in the news that Hong Kong people go north to Shenzhen to spend money, largely because the Hong Kong dollar is pegged to the US dollar, the appreciation of the RMB, and the high prices of everything in Hong Kong. The United States, as the original body, is certainly not far behind: if you look at the number of US passports issued, you can see that Americans' enthusiasm for outbound travel has soared with the US dollar interest rate hike in 2015. Now, 25 million US passports will be issued in 2024.

At the same time, the appreciation of the US dollar brought about by the US interest rate hike has largely offset the effect of tariffs on "raising the price of foreign products", making the tariff policy not implemented. Although American politicians have often said that China is a "currency manipulator", in fact, even if they do not import from China, goods will be imported from other countries (even the "Vietnam" and "Mexico" that everyone has known before). American manufacturers have not benefited from tariffs, but have suffered from high capital costs caused by rising interest rates and outflows of demand caused by rising exchange rates.

Looking back, this has become a rare wonder in the world - high tariffs, high inflation, high interest rates, and high exchange rates. The above four factors can coexist in one country, which is really amazing and eye-opening. The only beneficiaries are probably the rich who survive on deposits.