tariffs

What Donald Trump Can Learn From Adam Smith

The American President Donald Trump wants to make America great again. At the heart of his plan to make America great again lies the idea of encouraging American manufacturers, Trump wants to implement tariffs on imports into America from other countries. He has already implemented tariffs on steel and aluminium.

This method of trying to make America great again by forcing Americans to buy stuff made in America, goes against basic principles of economics.

One of the most quoted paragraphs in economics was written by Adam Smith in a book called The Wealth of Nations. Steve Pinker writes about this in Enlightenment Now—The Case for Reason, Science, Humanism and Progress: “Smith explained that economic activity was a form of mutually beneficial cooperation: each gets back something that is more valuable to him than what he gives up.”

As Smith put it: “It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own self-interest.”

Hence, exchange is at the heart of any market. Trump is basically trying to clamp down on this exchange, which ultimately makes things cheaper for Americans.

The reason why the United States lost its manufacturing prowess over the years, is simply because other countries produced similar or better goods at a cheaper price. Take the case of China. In 2017, the United States ran a trade deficit of $375 billion (or more than a billion dollars a day) with the country.

Why did the situation come to this? The answer lies in the fact that China produced stuff  that American consumers wanted to buy, at a much more competitive price than the American manufacturers did.

Of course, the American consumer benefited from this because he had to pay a lower price than if he had bought the same thing from an American manufacturer. As Smith had said, “through voluntary exchange, people benefit others by benefitting themselves”.
Americans benefited because of competitive pricing of Chinese goods and the Chinese benefited because they got dollars in return for what they sold. Of course, it needs to be said here that Americans paid paper dollars for tangible goods from China.

These dollars earned by China helped pull many millions  of Chinese out of poverty in a period of around four decades starting in 1978. At the same time, it helped America maintain a lower rate of inflation, though many American jobs were lost due to lack of competitiveness of American firms.

The Chinese companies earned dollars while selling stuff in the United States. But they couldn’t spend these dollars in China because the Chinese currency happens to be the renminbi (also known as the Yuan). They exchanged these dollars with the Chinese central bank, the People’s Bank of China, which gave them renminbi to spend. The Chinese central bank then invested a good portion of these dollars in financial securities issued by the American government and other American institutions.

This flood of dollars from China and other big exporters earning dollars, helped keep interest rates low in America.

Donald Trump is now looking to break this arrangement that has been in place for the past few decades. As economist Ludwig von Mises put it a few centuries after Adam Smith: “If the tailor goes to war against the baker, he must henceforth bake his own bread.”

By imposing tariffs, Trump will force American consumers to buy expensive American goods. And this will not create any jobs. Take the example of steel. Buying American steel will make things more expensive for American car manufacturers.

They will either pass on this increase in cost to the American consumer, who will then have to cut down on expenditure somewhere else. If they don’t do that and decide to maintain the cost, they will have to fire a few employees that they currently employ.
All in all, there are no short-cuts to make America great again. The only way is to be competitive. The sooner Trump understands this, things will be much better.

The column originally appeared in the Bangalore Mirror on March 22, 2018.

Trump’s Trade Wars Will Hurt Dollar’s Exorbitant Privilege

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Dear Reader, we would suggest that before you start reading this column, you read the column published yesterday. In yesterday’s column we saw how the tariffs unleashed by the US President Donald Trump will hurt America, instead of making it great again. Reading this column, before you read today’s column, will give you a complete perspective on the issue. This is the second in a series of three columns on the issue. The third column will appear on Thursday.

The American dollar is at the heart of the global financial system as it has evolved. The reasons for this are historical.

By 1944, it was clear that the Allied forces are going to win the Second World War. In July 1944, they gathered at the Mount Washington Hotel, Bretton Woods, New Hampshire in the US, to design a new financial system for the world. Europe had been totally destroyed during the course of the war and even countries like Britain and France were in a bad shape despite being on the winning side. European countries were in no position to negotiate. And so, the American dollar was placed at the heart of the financial system that evolved at Bretton Woods.

The US was ready to convert dollars into gold at the rate of $35 for one ounce (31.1 grams) of gold. This came to be known as the Bretton Woods Agreement. It made the
American dollar the premier international currency of choice, as it was the only currency that could be converted into gold.

This ensured that over a period of time countries moved to carrying out their international trade primarily in American dollars. It also ensured that countries held their foreign exchange reserves in dollars because dollar was the only currency which could be converted into gold.

This structure that emerged gave the American dollar an exorbitant privilege. While the rest of the world had to earn these dollars by exporting stuff, the United States could simply print them and buy all the stuff that it needed. This has been one of the primary reasons why United States, over the decades, has turned into a big buyer of things. All the American buying drives global demand.

Given that the dollar became the international trading and reserve currency, the oil cartel OPEC (Organization of the Petroleum Exporting Countries), also sold the oil that it produced, in dollars. This was one more reason for the world to buy and sell stuff in dollars. Every country did not produce the total oil it consumed, and in order to import enough oil to fulfil its consumption needs, it needed dollars. The only way to earn these dollars was to price its exports in dollars.

In fact, the Saudi Arabia led OPEC continuing to price oil in dollars, is one of the major reasons why dollar continues to be the major reserve as well as trading currency of the world. Even the Americans recognise this fact.

As Nassim Nicholas Taleb writes in his new book Skin in the Game—Hidden Asymmetries in Daily Life: “It is clear since the attack on the World Trade Center (in which most of the attackers were Saudi citizens) that someone in that nonpartying kingdom had a hand—somehow—in the matter. But no bureaucrat, fearful of oil disruptions, made the right decision—instead, the absurd invasion of Iraq was endorsed because it appeared to be simpler.”

So, dollar due to various reasons is the international currency in which people and countries want to deal with. As George Gilder writes in The Scandal of Money—Why Wall Street Recovers But the Economy Never Does: “Today it [i.e. the dollar] handles more than 60 percent of world trade, denominates more than half the market capitalization of world stocks, and partakes in 87 percent of global currency trades.”

Given this, over the years, countries have accumulated huge dollar reserves. A significant chunk of these reserves have been earned by exporting stuff to the United States.  The United States is the biggest economy in the world. It accounts for nearly one-fourth of the world’s GDP. By virtue of this, it is also the world’s biggest market, where China, Japan and countries from South- East Asia sell their goods and earn dollars in the process.

It is also the world’s biggest consumer of oil and consumes nearly a fourth of the global oil production. This meant that oil-rich states such as Saudi Arabia could sell oil to it and thus earn dollars in the process.

The dollars earned by other countries haven’t stayed in the vaults of their central banks. They have been invested in American treasury securities and other debt securities. Treasury securities are basically financial securities issued by the American government to finance its fiscal deficit, which is the difference between what a government earns and what it spends. Take a look at Figure 1. It basically plots the foreign investment in American treasuries over the last 40 years.

Figure 1:

Source: Board of Governors of the Federal Reserve System (US)

 

The foreigners currently own more than $6 trillion of American government treasury securities. This along with the easy money policy initiated by the Federal Reserve of the United States, in the aftermath of the financial crisis that broke out in September 2008, has ensured that the interest that the US government pays on these securities has been around 2% per year, over the last five years.

The interest paid on the US treasury securities sets the benchmark for other loans in the American financial system (or for that matter any other financial system) because lending to the government is deemed to be the safest form of lending. Over and above this, the foreigners have invested close to $3.3 trillion in other American debt securities.

This inflow of dollars into the United States has kept interest rates low. These low interest rates have kept the American consumption story going to some extent. As the American stand-up comedian George Calrin once said: “Consumption is the new national pastime. People spending money they don’t have on things they don’t need, money they don’t have so they can max out their credit cards… And they didn’t like it when they got it home anyway.”

Donald Trump’s tariff policy will attack at the heart of this model. Countries earn dollars by exporting stuff to the United States and other parts of the world. These dollars then find their way back to the United States where they are invested in treasury and other debt securities, and help maintain low interest rates.

If Trump and America shut out the American market to other countries, the countries exporting stuff to the US (Japan, China, South Korea, Taiwan, and a whole host of other countries), will not earn as many dollars as they currently are. And if they don’t earn enough dollars, the likelihood of them continuing to invest in American debt securities, is very low. This will mean that the interest rates in the United States will start to rise. This is something that the country which is currently going through an early stage of economic recovery, cannot really afford.

Further, the other countries might also start to try and price their exports in currencies other than the dollar, as well. China has been working towards this for quite a while. Trump’s decision to introduce tariffs might just be the final push that the country needs.
If countries start pricing their exports in non-dollar currencies, Trump’s plan to impose tariff will hurt the exorbitant privilege that the dollar has enjoyed over the years.

In fact, in the third and final column in this series, which will appear on Thursday, we will see why Trump’s plan of trying to increase American exports while shrinking its imports, is essentially contradictory in nature.

The column originally appeared on Equitymaster on March 13, 2018.