Protectionism is a clear and present danger. The talk of “currency wars” could escalate into something more serious. As the political dust settles after the election next month, Washington will be under increasing pressure to increase jobs. Current evidence indicates that the economic recovery is slowing. While it is unusual for a slowing economy to slip into a recession, it is possible. Usually, some kind of shock triggers a recession. With slow economic growth, the economy is easily susceptible to shocks. With the outlook for continued slow growth, we are likely to see shorter business cycles in the years ahead.
Even without a recession, our estimate of 2% trend growth will not be sufficient to accommodate new entrants into the work force, let alone reduce the number of people currently unemployed. With short-term interest rates near zero, an additional round of quantitative easing may buy some time. We do not expect substantive results from a new round. It appears that the Federal Reserve is running out of ammunition to stimulate the economy to fulfill one of its important political mandates – full employment.
Although the United States is about to embark on a national debate on tax policy, there is little likelihood of any improvement in the Federal deficit any time soon. To the contrary, federal spending on entitlements is scheduled to increase significantly in coming years. As the national debt climbs, there is no enthusiasm in Congress for further fiscal stimulus. With pressure mounting, and the Government running out of options, we may see a willingness to undertake desperate measures.
Although protectionism has been tried before – Smoot Hawley in 1930 with disastrous results, we are seeing increasing dissatisfaction with our trade deficit, particularly with China. The American consumer, who financed global growth, is tapped out. Politicians, feeling responsible for solving the economic crisis, are running out of patience with a slow recovery that fails to produce adequate jobs. The rhetoric to influence the Chinese to revalue the Yuan is moving down a path to increasing protectionism. The United States put a tariff on Chinese tires. The Chinese responded by placing tariffs on American chicken. Frustrated with the pace of revaluation and the growing trade deficit with China, the House of Representatives overwhelmingly passed a bill authorizing a broad range of duties on Chinese imports.
A Yuan revaluation is a simplistic solution to a complex issue (and, by itself, will not meaningfully change trade flows with China). Certainly, the Chinese have serious concerns, too. They want to prevent speculation in their currency that would have unintended and unfortunate consequences. Ironically, the United States is one of the few countries that could withstand a period of increased economic isolation. Manufacturing would benefit somewhat. There would be no favorable impact on services. But, it certainly would not have the desired result of increasing exports.
It is a dangerous path. Smoot-Hawley started benignly in 1929 to assist some farmers. By the time it was signed into law in 1930, it was a comprehensive bill that protected not only the then large agricultural sector, but a broad swath of industry, as well. All of our major trading partners retaliated, with adverse consequences. The stock market continued to fall, as did exports, which declined by more than 75% by 1933. In an even more interdependent world, countries will act again to protect their national interests.
Currency tensions, if not wars, are spawning imbalances in some asset classes. In particular, the weak dollar is creating some interesting trading opportunities. Astute investors can benefit by timely action. Nonetheless, everyone should be aware of the risks of increasing political focus on trade policy.