ECONOMIC & MARKET COMMENTARY, October 2011

Was the recent signing of the long delayed trade agreements with South Korea, Panama and Colombia a bipartisan success?  Perhaps.  However, with few fiscal and monetary policy options remaining, we may actually see increasing interest in trade protection policies.  The first sign of this development was the US Senate’s bill to allow countervailing duties to be imposed where a foreign country’s “currency misalignment” is subsidizing their imports.  It is no secret that China is the focus of this legislation.

With unemployment likely to remain high through 2012, the bilateral trade deficit with China is an easy target for populist frustration.  That deficit rose to a record high of $29 billion in August, more than what the US ran with all the other countries combined.  Even Republican free trade orthodoxy may not withstand that kind of pressure.  Mitt Romney, a leading candidate for the Presidency, said that if elected President he would declare China a currency manipulator.

The US ran a current account deficit equal to 3.1% of GDP in the second quarter.  Closing that gap could potentially increase GDP by a similar amount.  One way to reduce the current account deficit would be to reduce domestic demand.  That option, however, would only increase unemployment.  Historically, countries deliberately devalued their currencies in order to favor domestically produced goods over foreign products.  One could argue that the Federal Reserve has followed a devaluation strategy though its quantitative easing policies.  Although the dollar has weakened in recent years, China fixes its exchange rate to the dollar and has allowed the renminbi to appreciate in a measured way.  Implementing a trade policy that includes tariffs, export subsidies and/or quotas would close a current account deficit much the same way as a devaluation would.

Of course, no country lives in a vacuum.  Trade policies in one country will beget corresponding policies from others.  Trade wars will have a negative effect on globalization.  The Smoot-Hawley Tariff Act of 1930 contributed to the sharp decline in world trade and exacerbated the Great Depression.  The United States was a big loser because it had a current account surplus.  Since the US is now running a deficit, any reduction in imports and exports would reduce the current account deficit and add to GDP.  Just as restrictive trade policies benefited Great Britain in the 1930s when it was running a trade deficit, so might similar policies accrue to the United States now.

We are following this probable development because of its investment implications.  It is unlikely that the US would target China alone, as production would move to other low cost countries.  All export dependent emerging economies would suffer.  Surplus countries will be slow to adjust (similar to the US in the 1930s and Japan in the late 1980s).  China will continue to aggressively pursue what has worked for them in the recent past and may even resort to devaluing the renminbi.  Germany, which will be hurting from broader European woes, will also be reluctant to stimulate domestic demand as part of its adjustment process.  The unwinding of globalization will be painful for all surplus countries, developed and emerging alike.

There may have been a subliminal reason why President Obama was so discreet in the signing of the recent trade agreements, limiting access to the event to handful of still photographers.  Perhaps it is a signal that the United States is at the end of a liberal trade policy.