Economics

The Major Effects Of The Trade War With China So Far Little

Ben Strubel’s letter to investors for the month of August 2019, titled, The Effect Of Trade War With China Heats Up Again.”

Effect Of The Trade War
christels / Pixabay

Dear Investors,

No sooner had I returned from vacation than Trump fired off another salvo in his trade war with China. This time the economy is facing a 10% tariff on the remaining $300B or so of goods currently unaffected by tariffs. The longer this tit-for-tat escalation goes on, the harder it will be to reach a deal. With tariff announcements seemingly coming out of the blue on Twitter, the Chinese will find it hard to trust anyone that a deal can be made. Likewise, China apparently had backtracked on large portions of a previous deal agreement. Perhaps it was also dragging its feet about agricultural goods purchases. It matters little who is “right” or “wrong.” The result is a widening gulf between China and the US and no deal in sight. But, that probably isn’t the end of the world.

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The most pronounced effect of the trade war with China has simply been a shift in the flow of goods. Imports from China into the US have dropped, while imports from countries like Mexico and Vietnam have risen. Through the first half of 2019, compared to the first half of 2018, imports from China have dropped $31B, while imports from Mexico jumped almost $11B and imports from Vietnam rose almost $8B.

This is due, in part, to real shifts in trade. For instance, we’ve read numerous articles that say apparel manufacturing has shifted out of China and into Vietnam to such a degree that Vietnam is now “full” and its apparel manufacturing industry is at 100% capacity. Other shifts in trade are due to cheating and mislabeling the true country of origin. Something manufactured in China can be shipped to Mexico where there are no tariffs, labeled as made in Mexico, and then sent to the US. (It takes some effort to hide the true origins but it can be done.)

The second major effect of the trade war has been to slow business capital investment. Over the long term capital investment is driven by demand from consumers, but there is short term variability.

Here is an example of what I mean. Suppose ABC Company manufacturers widgets. Its plant is currently operating at 70% capacity. Consumers love widgets, and sales of its widgets increase each year. The company knows that soon they will need to build another plant to keep up with demand. The current trade war makes company executives feel uncertain about taking the big risk to build a new plant now. Instead, they decide they can run the plant up to 80%, 90%, or even 100% utilization. That will buy them time to wait till the effect of the trade war stops and the economic climate stabilizes.

The tariffs are making companies uncertain about  their future costs of production. What if they decide to build a new plant in Mexico instead of China even though it’s more expensive because they think the trade war with China will keep going, but then Trump strikes a deal and the tariffs are lifted? Now the company is stuck with an expensive new plant in Mexico. What if the opposite occurs? Maybe the company thinks China and the US will eventually reach a deal, so they build a new plant in China. What happens if no deal is reached and the tariffs stay, and even increase? Now the company is stuck paying huge taxes to import goods from their new factory in China.

The cost of inaction for companies is very low. They can run plants up to higher utilization even though it might be inefficient. They can add extra production lines or another shift. Then when there is more certainty about costs (it doesn’t matter which way things go so long as there is certainty) they will know the most cost effective way to expand. On the other hand, the cost of action is high. If you spend millions or billions on new facilities only to have guessed wrong on which way the effect of the trade war will end, you lose.

What’s interesting is that we have not seen much inflation (at least passed on to consumers). Although the washing machine tariffs that were passed on to consumers has taken up most of the headlines, there is very little overall inflation. Interestingly, it seems washing machine prices now may be beginning to decline. Both corporations and consumers are able to adapt their behavior enough to mitigate most of the effects of the tariffs. Companies either relocate production or cheat their way out of tariffs while consumers alter their buying behavior, such as waiting to buy a new machine later. (While the price of washing machines went up, sales fell.) There is some inflation to be sure but the longer things drag on the more ways businesses and consumers find to avoid tariffs.

It’s important to remember that business investment is only around 16% or so of the economy. Government spending makes up about 20% (30% to 35% if you count Social Security, Medicare, Medicaid, and other pass through programs.) of the economy. Consumer spending makes almost 70% (55% to 60% if you subtract Social Security, Medicare, Medicaid, etc.) of the economy. (The total is greater than 100% because foreign trade is negative.)

For 2019, federal government spending is up 8% compared to last year. This number includes Social Security spending, Medicare, Medicaid, and so forth, so that means about 20% of the economy is seeing an 8% financial boost.

The labor market remains good. Jobs pace has slowed, but the economy continues to add jobs faster than population growth. More people are working and earning wages, meaning more consumers have more money to spend. That means the 55% of the economy that centers on consumers is doing well.

It’s hard to see how we would get a recession with the consumer and the federal government sectors of the economy doing so well. We continue to think consumers will change their behavior to adapt to tariffs, and businesses will continue to adapt or cheat their way around most of the worst effects. Yes, some costs will go up and some corporate profits will go down, but we don’t see that being bad enough to cause a recession.

We’ve already had tariffs enacted on steel and aluminum, and 25% tariffs on about half of the goods imported from China. Those haven’t had drastic impacts on consumer spending or inflation. The original tranche of tariffs were designed to be minimally disruptive to consumers (they targeted so called “intermediate goods” that were used in the production of other final goods). The next tranche of goods facing the 10% tariff are finished goods. The effect of the trade war with China will likely be greater than what we’ve experienced in the past but not enough to tip the economy into a recession based on previous experience.


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