Another Massive Escalation of the US-China Trade Wars
The White House continues to double down on its aggressive posturing against China in a bid to force the county to yield to its demands at the negotiation table. This approach follows a few patterns in economics, sociology and debate whereby the commitment to escalation persists despite growing risks and diminishing return when or if a compromise is struck – such as the ‘escalation of commitment’ behavior. Late this past week, President Trump himself announced that an additional $300 billion in Chinese imports – essentially the balance of all trade with the country – would be saddled with a 10 percent import tax starting September 1st. He and his representatives – such as economic adviser Larry Kudlow – stated the burden could be avoided if China were to budge on the economic impasses, but the former would also remark that they could be increased further if the situation was seen as not progressing. China does not historically yield to such overt, public tactics; rather it more often responds by retaliating in kind. That is a problem as there is not a like-for-like option for China to respond at this point. It ran out of US imports to slap new or escalated tariffs on with the last volley.
This disproportionate status was a glaring imbalance, but China likely resorted to mere threats as it feared pushing the US to more dramatic retaliations. In diplomatic terms, to not respond now would invite a more emboldened US as it sees no negative consequences for inflicting pain. The next steps from here is where greatest risks reside. If China finds a back channel agreement to halt the pressure, it could suggest an interim turning point. China however would not want the capitulation public for political reasons, but the US would for political reasons. If China retaliates, it will likely take the stalemate off the rails. Without US imports to tax, the country would have to resort to selling private US assets which would not sway the government, restricting rare earth materials which wouldn’t register to the White House until much economic damage is done or they result to a ‘nuclear’ (economic) option. Allowing the Yuan to depreciate sending the USDCNH above the 7.00 mark will offset strictly tariff-based costs, but it will give Trump a platform to claim manipulation – though a currency would naturally depreciate if it is on the short-side of economic pain. Selling US Treasuries would be the most severe option with plenty of pain for China to share as its holdings are enormous, but desperate times can push people to desperate measures.
Side Effects of Trade Wars: More Demand for Stimulus, Other Countries Start Fights
The immediate consequences of an escalating trade war between the world’s largest economies is easy to visualize: economic pain for both that spills over to the global economy as trade inevitably will be impacted for those ‘other’ countries. However, there are other outcomes that can result that have just as disruptive properties on growth or the financial system. One side effect of driving such a destructive fight is that it lowers the boundaries for taking further risks in other avenues, effectively normalizing detrimental decision making. One natural segue is for a country that feels aggrieved to utilize similar tactics with other counterparts for which it feels are taking its partnership for granted. That most threatening spillover for the global community would be for the US and European Union to take active measures against each other. That shouldn’t seem so far fetched now considering the number of reports that suggest the US President has moved forward with China against the suggestion of advisers. Both sides of the Atlantic have laid out lists of tariffs that they are readying against each other and there are obvious flashpoints like the Airbus-Boeing row. Spillover is not just a circumstance for those countries already engaged.
Like nationalism, the tactics of protectionism can be adopted for other countries that feel they are experience circumstances similar to those that spurred the US to action. One example is Japan and South Korea who have gone through a few iterations of retaliation between them as they claim the other is taking advantage of the relationship. Another consequence of trade policy that directly throttles economic activity is outcry for relief through other circumstances. Monetary policy became the go-to aid for any threats to growth over the past decade, so it is natural demands for relief are directed towards groups like the Fed, ECB, BOJ and others. That exact pressure has been raised by the US President to the FOMC for months. The central bank has rejected the pressure for the purpose of its independence, but the group cannot very well ignore tangible risks to economic health that result from international policies. The response is not limited to the countries that are engaged either. While the Fed has cut rates and is expected to do so again next month, the ECB is investigating a return to QE and the PBOC vows to resort to easing in the second half; the markets expect groups like the RBA and RBNZ will have to offer relief of their own as soon as this week when they meet on policy.
A Reminder: The True Tipping Point is Realizing Central Banks Are Powerless
Speaking of the need for monetary policy, one of the greatest financial risks facing the global economy – aside from the excess of leverage at all levels of the financial system (government, businesses, consumer, investor) – is the realization that central banks do not have the tools to stabilize future crises. Rationally, most market participants would recognize this is the case if they were to project the course of future periods of market instability. Yet, after a record decade of bullish markets (in US indices), there is an understandable complacency and even a large pool of investors that have never even experienced a true bear market. When a troubled reality wins out, however, the tools that central banks can use are going to be severely limited. Even in the best of circumstances, rate cuts are not nearly as important for stabilizing the financial system as basic credibility – essentially the market responding to the belief that the deep-pocketed central banks’ efforts will alter the course.
The Fed, among the major central banks, has the most room to maneuver through traditional policy – and that is not much scope with the high end of the range at 2.25 percent (225 basis points). The other major central banks are working with substantially lower yields. Stimulus programs are more directly associated to firefighting in modern times, and key central banks (the ECB and BOJ most prominent) have extremely little margin to add more liquidity to the system with any hope of earning financial return. A thought experiment: if fear started to spread across the global markets and central banks were not a reliable source of emergency stability, where would you expect to find support? If your answer is a coordinated government response in this environment, our precarious state should be obvious. Let’s hope it doesn’t get to that point.