Trade shocks and demand shocks
Paul Krugman has an excellent piece on the potential effects of an all out trade war. Likely Krugman, I think it unlikely that we actually go that far. My view is that before that happened, Trump would become frightened by a sharp fall in stocks and negotiate some sort of face saving deal where he could claim “victory”. (But when thinking about the stock market as a warning device, beware of the “circularity problem”. The stock market won’t warn Trump if it thinks he would heed their warning.)
Here I’d like to add one additional downside to a trade war, the way trade policy can (and has) interacted with monetary policy. A trade war might be even worse than Krugman estimates, if it leads to tighter monetary policy and falling NGDP.
You might think that Krugman has already factored falling NGDP into his estimate that a trade war could reduce RGDP by 2 to 3 percent. But unless I’m mistaken, he’s using a general equilibrium approach that abstracts from demand shocks. In other words, Krugman is showing that even in a world where the central bank stabilizes AD, a trade war could reduce RGDP by 2 to 3 percent by making the economy less efficient. But what if the central bank does not stabilize AD? In that case you might get an ordinary recession, piled on top of the adverse supply shock produced by a trade war. A recession slows the process of worker re-allocation into non-tradable sectors.
I can see two possible channels by which a trade war could reduce aggregate demand:
1. Imagine the central bank is targeting interest rates. If a trade war occurs, it’s likely that investment demand would fall, reducing the global equilibrium (i.e. “natural”) rate of interest. If the central bank does not reduce the policy rate as quickly as the natural rate is falling, that would lead to (effectively) tighter money and falling NGDP. (Think of this as a channel that operates if I’m wrong about monetary offset, and the Keynesians are right.)
2. Imagine the central bank is targeting inflation. If inflation is kept at 2% while RGDP growth is falling, then NGDP growth will also slow. (Here the problem can occur even if monetary offset is operative, as long as they target inflation, not NGDP.)
Keep in mind that slower NGDP growth is always a problem, even if there are other problems at the same time. Careful readers might recall that this is exactly what went wrong in 2008. The Fed adopted IOR to prevent its liquidity injections aimed at rescuing banking from spilling out into more aggregate demand, out of fear of inflation. They thought the banking crisis was “the real problem” when in fact there were two real problems, banking distress and falling NGDP. The falling NGDP led directly to higher unemployment, and also as a side effect made the other “real problem”, i.e. banking distress, even worse.
In my research on the Great Depression I found that the biggest problem caused by Smoot-Hawley was not that it reduced the efficiency of the US economy (the direct effects were modest), or even the retaliation from abroad. Rather the biggest problem was that Smoot-Hawley led to lower aggregate demand. This occurred either because of a fall in the Wicksellian equilibrium rate (very bad news under a gold standard), or because it reduced the likelihood of international monetary cooperation, or both.
BTW, this is no surprise:
Fears of a looming trade war between the U.S. and China are paradoxically helping to increase the value of the U.S. dollar in global currency markets, analysts say, potentially undercutting a Trump administration policy goal.
This is what happens when you have a president who hires crackpot economists who don’t even know that the current account deficit is a saving/investment issue, not an import/export issue.
HT: Tyler Cowen
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19. June 2018 at 08:39
“This is what happens when you have a president who hires crackpot economists”
I can name only one economist in Trump’s Administration that’s pushing protectionism and that’s Peter Navarro. Secretary of Commerce Wilbur Ross may talk like an economist but his undergraduate degree appears to be in English literature.
Let’s not let congress off the hook.
http://gregmankiw.blogspot.com/2018/05/on-tariffs-blame-congress-too.html
19. June 2018 at 09:23
Europe is full of crackpot economists that insist that the trade deficit is a really big issue. Even the US is full of it. This and “inequality” of course.
Their mumbling about the “trade deficit” and “inequality” might not be exactly the same as Trump’s ideas but it’s somewhat comparable. So many politicians were against TTIP as well (way before Trump), not to mention people like Krugman.
I also got no plausible explanation so far why all those “neo-liberal” politicians like Trudeau, Macron, and Merkel increase their tariffs instead of just lowering them to zero. Well there is one: They aren’t as neoliberal as you say. Abd Trump is not that special.
19. June 2018 at 09:44
https://www.buzzfeed.com/alexspence/boris-johnson-trump-brexit-leaked-recording?utm_term=.unExEjEEK#.leE1R3RRE
————–quote————–
At about 8:30pm, a select group of around 20 people went to a private room for a dinner. Over more than an hour, the foreign secretary [Boris Johnson] took questions from the activists and gave a characteristically ebullient and loose-lipped assessment of the most pressing policy and political matters facing the UK government…..
Asked about Donald Trump, Johnson was positive about the US president and even joked that he wouldn’t mind having him lead the Brexit negotiations.
“I am increasingly admiring of Donald Trump,” Johnson said. “I have become more and more convinced that there is method in his madness.”
“Imagine Trump doing Brexit,” Johnson said. “He’d go in bloody hard… There’d be all sorts of breakdowns, all sorts of chaos. Everyone would think he’d gone mad. But actually you might get somewhere. It’s a very, very good thought.”
————–endquote———–
19. June 2018 at 10:01
Good insight. But does this imply that a more accomadative fed could counteract the effects of a trade war?
19. June 2018 at 10:48
As each countries’ inflation expectation anchored under inflation targeting regimes, I think that global aggregate demand shock will be wilder and more likely happen.
https://www.youtube.com/watch?v=SRgpBDYWGeo
19. June 2018 at 15:21
Patrick, Trump struck such a favorable deal with N. Korea, imagine what he could do with Brexit!
19. June 2018 at 16:21
Good post, not sure about the conclusion.
Does this mean that Beijing and the People’s Bank of China are run by economic crackpots?
Singapore? 7% import tax and 80% of population living in government built apartments. GICs.
The globalists and the nationalists are equally glib on international trade.
19. June 2018 at 18:27
Add on: I would say the chances that some raised tariffs around the world cause a global economic recession are about 1%. And even that presupposes bad monetary policy.
The chances the Fed will cause a global downturn? 30%? And rising? *Remember, David Beckworth has posited about 70% of the global economies are tied to Fed policies).
Strange fact of the day: After Nixon imposed across-the-board 10% import tariffs in March of 1971, the Dow Jones pegged its largest one-day gain ever, up to that day. The NYT sang Nixon’s praises.
19. June 2018 at 19:44
Ben, I already told you that Singapore does not have a 7% import tax, it has a 7% sales tax. Please pay attention.
19. June 2018 at 20:59
There is talk that China would dump US debt on the market. Any predictions on the economic impact of that?
19. June 2018 at 22:37
Can confirm from living in Singapore, no import tax. That’s just the GST.
The government build housing seems a bit silly these days, but seems to work out well in practice. I live in one of the HDB blocks. Most of the flats are privately owned.
The housing regime is probably not perfect, but it beats the NIMBY situation on the American coast (or in Britain or Australia), so I can see why they’d be hesitant to change anything. Historically, fixing the slum-like living conditions was one of the main ways for the then new ruling party to show their competence to the population.
19. June 2018 at 22:39
DonG,
The fed can buy unlimited amounts of American debt the Chinese might want to ‘dump’. So any impact would depend on what the fed’s doing.
But what would the Chinese ‘dump’ the debt for? If it’s USD, that’s not much difference with fed offsetting. If it’s for other currencies or goods, the analysis would be a bit more complicated.
20. June 2018 at 01:02
(continuation of my previous comment)
So do not Trade War, it is very high risky in recently.
(Other real shock also will be amplified.)
20. June 2018 at 06:10
Scott, it could be even worse than what you described. If tariffs on imports go up, we get a temporary rise in some measures of inflation. Not in the GDP deflator (because imports are not produced here) but the CPI and PCE deflator will be affected.
It’s quite likely that the Fed will react to the higher inflation numbers by tightening money, thus compounding the problem. Certainly, they should only tighten in response to positive aggregate demand shocks, which tariffs are not, but they’ve made this mistake before.
20. June 2018 at 08:46
‘Patrick, Trump struck such a favorable deal with N. Korea, imagine what he could do with Brexit!’
https://www.wsj.com/articles/germanys-largest-auto-makers-back-abolition-of-eu-u-s-car-import-tariffs-1529492027?mod=cx_picks&cx_navSource=cx_picks&cx_tag=contextual&cx_artPos=2#cxrecs_s
————-quote———–
BERLIN—When the U.S. ambassador to Germany, Richard Grenell, returns to Washington for consultation with the administration Wednesday, he will be carrying a peace offering for President Donald Trump from Germany’s leading auto makers.
Their proposal, people familiar with the situation say, is simple: Abandon all import tariffs for cars between the European Union and the U.S.
That would mean scrapping the EU’s 10% tax on auto imports from the U.S. and other countries and the 2.5% duty on auto imports in the U.S. As a prerequisite, the Europeans want Mr. Trump’s threat of imposing a 25% border tax on European auto imports off the table.
Over the past few weeks, Mr. Grenell has held closed-door meetings with the chiefs of all major German automotive companies, including bilateral meetings with the CEOs of Daimler AG , BMW AG and Volkswagen AG , which operate plants in the U.S. Overall, Germany’s auto makers and suppliers provide 116,500 jobs in the U.S., according to the Association of German Automotive Manufacturers.
During these talks, which the ambassador initiated, the managers said they would back the scrapping of all import tariffs on trans-Atlantic trade in automotive products as the keystone of a broader deal covering industrial goods. The German government is on board and Mr. Grenell promised to support the idea, according to U.S. and German officials.
————-endquote————-
20. June 2018 at 11:01
Jeff mentioned that “It’s quite likely that the Fed will react to the higher inflation numbers by tightening money, thus compounding the problem. Certainly, they should only tighten in response to positive aggregate demand shocks, which tariffs are not, but they’ve made this mistake before.”
Yep, that was also a contributing factor to 2008. Oil prices surged, put pressure on inflation and played a major role in shaping the Fed’s policies. It also explains in large part why the ECB, and Riksbank tightened in 2011. Luckily for the US–and the world–, the Fed didn’t fall for the same trap twice.
20. June 2018 at 11:06
– The words “Savings” and “Investments” in the context of Trade/Current Account Deficits/Surplusses is actually very confusing for the debate.
– “This is what happens when you have a president who hires crackpot economists who don’t even know that the current account deficit is a saving/investment issue, not an import/export issue.”
The Current Account (deficit/surplus) is predominantly the result of (a) Trade (Deficit/surplus), is trade related.
– But these “crackpots” overlook the Capital Account (CA) as well. That CA is the result of capital flows not related to Trade.
20. June 2018 at 11:19
– In the early 1930s the USD went up in value against other currencies. Making exports more difficult and increasing imports. That’s why Smoot-Hawley was introduced. But US domestic demand was already falling (sharply) as a result of a contraction of credit. Smoot-Hawley only made things worse.
– Bernanke’s IOR wasn’t responsible for the contraction of credit/liquidity. Because when the FED performs QE (or whatever name you want to use) then it increases the banks reserves and those reserves are NEVER lent out. (Never read Steve Keen ?). The australian government did the right thing back in 2008/2009. They sent every taxpayer a check of AUD 1.000. And those taxpayers directly spent the money, helping demand.
20. June 2018 at 13:18
Thanks Matthias, Ben keeps putting out that fake news, I have no idea why.
Jeff and LK, Good point.
Patrick, Most Americans now buy light trucks, not cars. The tariff is 25% on light trucks.
In any case, I doubt that Trump would agree to that deal.
Willy2, Your history is wrong; Smoot-Hawley was not a reaction to a strong dollar.
20. June 2018 at 16:21
About Singapore is the 7% import tax.
True Singapore applies a 7% sales tax on goods and services whether imported or produced domestically.
But we do not know how much of that 7% tax is kicked back to the very domestic companies that paid it.
A government investment corporation for example may make an investment in a domestic company, essentially offsetting the sales tax paid.
All land in Singapore is owned by the government. So sales taxes paid could be easily offset by a cut in rents.
Looking at international trade and trying to determine if it is “fair” in some sense is like watching a World Cup match in the fog.
20. June 2018 at 21:36
‘Patrick, Most Americans now buy light trucks, not cars. The tariff is 25% on light trucks.’
The WSJ article reads: ‘…the Europeans want Mr. Trump’s threat of imposing a 25% border tax on European auto imports off the table.’
So, your comment seems off base. Did you have any further thoughts as to the wisdom of Boris Johnson’s analysis?
21. June 2018 at 01:44
“Japan’s consumption tax should be raised to 15%: IMF official”
—30—
Egads. Is there no pacifying austerity-fixated globalists?
21. June 2018 at 04:43
– It’s not that simple.
– As a result of deleveraging the USD went through the roof in 1929 & the early 1930s. As a result of both the rising USD and falling (worldwide) demand US exports (the US ran a Trade Surplus in the 1920s) shrank dramatically. In order to protect US manufacturing from foreign competition Smoot-Hawley was introduced. Smoot-Hawley was beneficial for US producers but it was detrimental for US consumers. Smoot-Hawley ònly made the bad thing (low consumer demand) even worse.
– The story above provides a better understanding of why the US devalued the USD in 1932/1933. It was meant to lower the value of the USD and increase the competitive position of US exports.
21. June 2018 at 04:57
Okay, not to beat a dead horse but…
Singapore applies a 7% tax on all imports, but also the 7% sales tax on domestically produce goods and services.
The tax is not applied to exports, however.
Scott Sumner says that 7% thus is not an import tax.
This raises two questions:
The famously pro-business Singapore government owns all the land in Singapore, and runs government investment corporations that invest in Singapore business.
Then there is this:
“Singapore Government’s Considerations when Allowing Lease Extensions
For all categories of leases, lease extension will be considered only if the proposed use and tenure are aligned with the Government’s planning intention and have the support of the relevant agencies.
For industrial uses, the Government may allow lease extension if there is substantial investment on the land or property and the use is in line with the prevailing economic priorities.
For commercial uses, the Government may allow lease extension if it helps to achieve planning intention – such as substantial intensification in land use – significantly earlier.”
—30—
Oh, sheesh. The Singapore government can give any business a nice lease.
So importers pay a 7% tax, and domestic Singapore businesses pay a 7% tax. Who is to say the government does not merely rebate the 7% sales tax in lease concessions?
https://www.sla.gov.sg/News/articleid/171?category=Press
I will say it again: Trying to determine what are true tariffs, taxes and regulations globally is like watching a World Cup game in a thick fog with myopic and sometimes bribed referees.
Yes, Singapore slaps a 7% tax on all imports. That tax is paid, and no givebacks. That fact stands.
21. June 2018 at 10:26
Ben, You said:
“Yes, Singapore slaps a 7% tax on all imports. That tax is paid, and no givebacks. That fact stands.”
You are in way over your head. I suggest you post on topics you know something about.
21. June 2018 at 10:57
What do you make of the continued out-performance of US small cap stocks in the face of rising trade tensions? Meanwhile, it looks like China’s Shanghai Composite is cracking hard.
21. June 2018 at 20:44
Scott Sumner:
Well, easy for the very tall Scott Sumner to say someone else is on over his head.
Nevertheless, down here at ground level I am reading primary documents from the Singapore Land Authority.
https://www.sla.gov.sg/News/articleid/171?category=Press
It seems clear Singapore (sole landowner in Singapore) can deliver a wide range of favors to domestic enterprise and does, such a “lease extensions” when suitable. How about cut-rate electricity? That too. Or an investment from a government investment corporation?
Scott, no matter how tall you are, when you are watching global trade, you are a World Cup game in a thick fog, and with referees who are myopic or bribed—well, was the final score fair?
Besides, what is not true about this statement:
“Singapore slaps a 7% tax on all imports. That tax is paid, and no givebacks. That fact stands.”
21. June 2018 at 21:33
Scott wrote:
“You might think that Krugman has already factored falling NGDP into his estimate that a trade war could reduce RGDP by 2 to 3 percent. But unless I’m mistaken, he’s using a general equilibrium approach that abstracts from demand shocks. In other words, Krugman is showing that even in a world where the central bank stabilizes AD, a trade war could reduce RGDP by 2 to 3 percent by making the economy less efficient.”
Krugman states that he used a partial equilibrium model and that the results are close enough to using a general equilibrium model.
22. June 2018 at 01:58
http://www.nber.org/papers/w8695
http://worthwhile.typepad.com/worthwhile_canadian_initi/2013/01/the-bank-of-canadas-success-and-failure.html
22. June 2018 at 08:05
BMW exports from the USA
https://www.bmwusfactory.com/bmw_articles/bmw-manufacturing-continues-as-largest-u-s-automotive-exporter/
22. June 2018 at 08:28
Ben, You stubbornly cling to the claim that Singapore has a 7% import tariff. They do not. They are a free trading nation.
Todd, Thanks, I probably should have said “a full employment model”.
22. June 2018 at 17:26
“All goods brought into Singapore (other than exempt imports) are subject to Goods and Services Tax (GST) at the prevailing rate of 7% on the value of goods, which includes the cost, insurance and freight (CIF) plus other chargeable costs and the duty payable (if applicable).Feb 19, 2018”
Okay, Scott Sumner, your position is that domestic companies pay the same 7% tax, ergo it is not an import tax.
1. Let us posit that the government of Singapore explicitly, and in public documents, rebates the 7% sales tax to domestic companies through rent concessions. Then the tax is effectively only applied to imports. It becomes, effectively an import tax.
2. Of course, the government of Singapore is not stupid, quite the contrary. They do not make such a statement publicly. But they own all the land in Singapore, and they grant rent concessions as a matter of business, commercial and industrial development policy.
Conclusion: We are peering through a thick fog, and someone took away our glasses. In many cases, no doubt the 7% sales tax applied at the border to imports is in fact effectively an import tax, since domestic competitors are receiving offsetting rent concessions to the sales tax.
22. June 2018 at 17:31
I think I am banned at EconLog again.
If anyone can bear it, here is a comment on Singapore and economic nationalism.
—30—
Well, I do not know if anyone is reading anymore, as this blog is old in blog-years, and I have told by Scott Sumner I do not know what I am talking about.
Nevertheless undaunted, I offer the following—
What is economic nationalism?
Is it not Sino state-planning and mercantilism economic nationalism? What about Beijing capital controls? Sino belt-and-road initiatives also appear to be geared to funneling commerce through China. Increasing Han hegemony over Tibet appears to be nationalistic, as well as Sino imperialism in the South China Sea.
Okay, I think we can posit China practices economic nationalism (very intelligently, in many cases). If not, then I do not know what the term means, and we get deep into the semantics woods.
Okay, trickier case: How about Singapore?
Singapore at ground level is nearly unrecognizable from popular myth-making.
The government owns all the land. More than 80% of population lives in government-built housing. Singapore operates government investment corporations.
And much more.
Here is an interesting headline from yesterday:
ExxonMobil starts up world’s largest resin plant in Singapore
The Business Times-Jun 20, 2561 BE
These two new plants fall under a multi-billion dollar expansion project atExxonMobil’s integrated manufacturing complex in Singapore.
Why are there giant petrochemical plants in Singapore, on government land?
There is an entity entitled The Singapore Economic Development Board.
https://www.edb.gov.sg/en/how-we-help/incentives-and-schemes.html
They offer everything under the sun to entic businesses to locate in Singapore…including—-
“[Singapore]Land Intensification Allowance (LIA) The Land Intensification Allowance (LIA) aims to promote the intensification of industrial land use towards more land-efficient and higher value-added activities.”
Then also:
“[Singapore] Tax Incentives
Pioneer Certificate Incentive (PC) & Development and Expansion Incentive (DEI) The Pioneer Certificate Incentive (PC) and the Development and Expansion Incentive (DEI) aim to encourage companies to grow capabilities and conduct new or expanded economic activities in Singapore. Companies that carry out global or regional headquarters (HQ) activities of managing, coordinating and controlling business activities for a group of companies may also apply for the PC or DEI for the HQ activities.
—-30—
Free job training too, and much more.
Okay, so let’s ask the question: Why did Singapore induce the building of giant petrochemical plants on government land?
The city-state is smart, and does not over-tax businesses. So it wanted tax revenues, but that was probably a wash in terms of what they gave up to get the plants. Think Wisconsin and Foxconn.
The answer: Singapore wanted the good-paying jobs, for its residents, and the other income for its contracting firms.
The key: At bottom, Singapore wanted the income associated with plant location. Duh.
When Trump says he wants industry to move to the US, he is saying as much. Trump is an economic nationalist.
Singapore is not?
25. June 2018 at 01:41
The below point of view may be a bit rough around the edges…but is US 2018 re China just a rehash of US re Japan circa 1985 (Ronald Reagan redux)?
JUN 24, 2018 @ 10:37 AM 47,017 2 Free Issues of Forbes
What Is America Doing To China? The Same Things It Did To Japan
Panos Mourdoukoutas , CONTRIBUTOR
Washington has sent a clear and loud message to China in recent months: you can no longer take the American market for granted. You must develop your own market, so as to balance the trade books.
That’s why Washington has announced a host of tariffs on products imported from China.
This message isn’t new. It echoes a similar message America sent to Japan back on September 22, 1985, at the Plaza Accord.
—30—
The dollar was mechanically cut in half, exchange-wise, after the Plaza Accords….the Reganauts played hardball, Ty Cobb-style.
(The baseball Ty Cobb not the handlebar lawyer….)