The Economic Impact of the Trade War

September 24, 2018

by Scott Brown
of Raymond James
There is currently little doubt that the U.S. and China are in a trade war, where retaliation begets
retaliation. Conflicts with Mexico, Canada, and the European Union are effectively in a temporary
ceasefire, but remain unresolved. It’s unclear how long these conflicts will last and how far they will go.
Yet, following President Trump’s decision last week to impose further tariffs on China, and China’s
promise to retaliate, the stock market rose. This could simply reflect trade policy news fatigue, but
more likely, the overall economic impact of trade policy disruptions has been minor and is projected to
be limited even if trade tensions escalate. The longer-term effects are likely to be more consequential.

This summer, President Trump imposed 25% tariffs on $50 billion in Chinese goods ($34 billion on
July 6 and $16 billion on August 23, mostly industrial inputs). China, which had warned of retaliation,
responded with 25% tariffs on $50 billion in U.S. exports (agriculture and cars). In response, President
Trump imposed 10% tariffs on an additional $200 billion in Chinese goods (intermediate goods, capital
goods, and consumer goods) effective September 24, which will rise to 25% on January 1, 2019. The
initial 10% was meant to limit the impact during the holiday shopping season. China indicated that it
will respond with increased tariffs on U.S. exporters (including suppliers of inputs and capital
equipment), but does not plan to weaken its currency. In turn, President Trump has threatened to
impose tariffs on an additional $267 billion (effectively, all imports from China).

The focus on the U.S. trade deficit with China is misguided. Granted, China has been a bad player in
global trade. However, the way to deal with that is through coordinated efforts with our allies (which is
partly what the Trans Pacific Partnership was about). Our trade deficit with China is due to two key
factors. The first is that the U.S. consumes more than it produces (or equivalently, we don’t save
enough – and remember that the federal budget deficit, which has risen sharply, is part of national
savings). The second is that China is generally an assembler, pulling in inputs from outside the country
and exporting intermediate and finished goods. China’s current account surplus was 1.3% of GDP in
2017 – not large. The U.S. deficit with China is really a deficit with the rest of the world. Production (or
assembly) may move to other countries, but China has massive capacity, and scale matters.

In recent decades, China’s economy has been centered on exports and infrastructure. It is now
transitioning to a more balanced economy, developing more internal demand, especially consumption.
The U.S. has a comparative advantage in services and has long maintained a surplus with the rest of
the world, including China, in trade services. The current trade conflict threatens to leave the U.S. (and
its companies) out of the growing Chinese market, potentially for a very long time. Trade policy has

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also created tensions with our key allies, Canada, Mexico, and the European Union.

Following WWII, the implementation of a global trading system was seen as a means to prevent
further military conflict. The General Agreement on Tariffs and Trade (GATT), which began in 1948,
significantly reduced tariffs and trade barriers. GATT was replaced by the World Trade Organization
(WTO) in 1994. Trade agreements have cemented political alliances, making the world safer, and
improving living standards. Is the WTO a perfect system? No, but that doesn’t mean you should
dismantle it.

It’s long been assumed that President Trump could simply pull the U.S. out of the North American Free
Trade Agreement (NAFTA). However, it’s now unclear whether that is within his power. Article II-
Section 2 of the Constitution gives the President the authority on treaties, but Article 1-Section 8 gives
Congress the authority on commerce. So, is NAFTA a treaty or does it regulate commerce? That is an
issue that would need to be decided by the Supreme Court, which would take some time to resolve.

Tariffs are not paid by the foreign country. They are a tax on U.S. consumers and businesses. Higher
input costs may not be passed along fully, which means that they hurt manufacturer profit margins.
The 20% tariff on imported washing machines led to a 20% rise in the price of domestically produced
washing machines, but that matters little to the producer when you are paying more for steel and
aluminum. This latest round of tariffs on Chinese goods matters more directly for the consumer (the
list of products is here) and the final round (tariffs on the remained of imports from China) would
amplify that impact.

Trade policy developments have had a significant impact on some sectors of the U.S. economy
(farmers, users of steel and aluminum), but the overall impact has been minor. GDP growth in the
remainder of the year may be a tenth of a percentage point or two lower than it would be otherwise
(hardly noticeable), although that impact can be expected to pick up in 2019 (as the full tariff on
Chinese goods goes into effect). Tariffs will add to consumer price inflation in the near term, but not
necessarily over the long term. The key factor, which will be a focus for Fed policy, is inflation
expectations.

By themselves, increased tariffs will not push the economy into a recession, but they could make a
downturn worse than it would be otherwise. Supply chains will be reorganized and consumptions
patterns may shift, but the U.S. economy will likely become more vulnerable to whatever economic
shocks may come along in the future.

The opinions offered by Dr. Brown should be considered a part of your overall decision-making
process. For more information about this report – to discuss how this outlook may affect your personal
situation and/or to learn how this insight may be incorporated into your investment strategy – please
contact your financial advisor or use the convenient Office Locator to find our office(s) nearest you
today.

All expressions of opinion reflect the judgment of the Research Department of Raymond James &
Associates (RJA) at this date and are subject to change. Information has been obtained from sources

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considered reliable, but we do not guarantee that the foregoing report is accurate or complete. Other
departments of RJA may have information which is not available to the Research Department about
companies mentioned in this report. RJA or its affiliates may execute transactions in the securities
mentioned in this report which may not be consistent with the report's conclusions. RJA may perform
investment banking or other services for, or solicit investment banking business from, any company
mentioned in this report. For institutional clients of the European Economic Area (EEA): This
document (and any attachments or exhibits hereto) is intended only for EEA Institutional Clients or
others to whom it may lawfully be submitted. There is no assurance that any of the trends mentioned
will continue in the future. Past performance is not indicative of future results.

© Raymond James

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