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

Back in 2016, the Trumpistas told us that the economy was a disaster.  Trump himself talked of economic “carnage” in his inaugural address.  When people pointed out that unemployment had recently fallen from 10% to 4.6%, they said those numbers were meaningless, and that the actual unemployment rate was as high as 30% or more.  We were told that the real issue was the huge trade deficit, which was decimating the American economy.  Those who pointed to “phony unemployment data” and ignored the trade deficit were nothing more than apologists for global neoliberalism.

Today the Trumpistas insist that the economy is in superb shape even though, as Tyler Cowen points out in a recent post, imports are surging and the trade deficit is getting larger.

I actually don’t have any big problem with Trumpistas saying the economy is in good shape, as long as they acknowledge that they have become the loudest apologists for global neoliberalism.  If they aren’t willing to acknowledge that fact, then what basis do they have to insist that the economy is in great shape?  RGDP growth?  It was just as fast around 2014-15.  Unemployment?  It fell from 10% to 4.6% even before Trump was elected.  Stocks?  They soared dramatically higher under Obama.  The big Trump issue is and always has been the trade deficit.  That’s how he wants to be judged, and that’s how I’ll judge him.

So Trumpistas should either take credit for continuing Obama’s policy of selling out to global neoliberalism with a policy of big trade deficits, falling unemployment, and soaring stock prices, or else keep their mouths shut.

PS.  The Financial Times makes the following claim:

Even if Mr Trump were gone tomorrow, nobody today in the US could run for president and win on a “let’s go back to the 1990s” platform. Laissez-faire trade and globalisation in general are under fire in the US (as well as in Europe and any number of developing countries).

Where is the evidence for this claim?  Why can’t we go back to the 1990s?  Polls show that support for free trade agreements is stable over time, and that young people and minorities are far more supportive of free trade than older people.  Why is it assumed that our future is inevitably more protectionist?  Aren’t the young and minorities our future?

After my previous post, Brian McCarthy left the following remarks:

I believe there is a fair bit of empirical evidence that current spot rates are a better predictor of future spot rates than are current forward rates. So a naive “long carry” strategy does generate positive returns over time. The reason this “free money” isn’t arbitraged away, I would imagine, is that the strategy doesn’t have a good sharpe ratio. ie low returns relative to the volatility. In market slang it’s “picking up pennies in front of the steam roller,” involving a significant risk of ruin if done “in size.”

So the market really does “expect” the yen to be at 106 in 30 years, which is where it is today.

This is a good argument, but in the end I favor the alternative view.

Over the past 40 years, the US price level has risen from 1 to 3.975, while the Japanese price level has risen from 1 to 1.556. That means the US price level has risen by 2.555 relative to the Japanese price level.  Over the same period, the yen has appreciated from 241.37 to 106 to the dollar, a ratio of 2.227.  So the appreciation of the yen in the very long run is pretty close to the change predicted by PPP (although over shorter periods there are quite wide discrepancies.)

So here’s how I look at things.  The simplest explanation for the forward yen trading at 50 is that the public expects Japan to continuing having lower inflation than the US, just as has been the case for the past 40 years.  They expect the yen to continue appreciating, just as it has over the past 40 years.

The alternative explanation is possible, but involves more “epicycles”:

1.  Yes, the Japanese yen has been appreciating in the very long run.

2.  Yes, the Japanese inflation rate is consistently lower than in the US.

3.  Yes, the 30-year forward yen is trading at a strong premium, just as you’d expect if these trends were going to continue.

4.  But these facts are actually unrelated.  Starting right now, the Japanese inflation will suddenly rise to US levels, even though the markets don’t seem to expect that.  And starting right now the yen will stop appreciating.  And instead some other “real factor” explains why the forward yen is trading at a strong premium, some real factor that would cause 30-year Japanese real interest rates to be hundreds of basis points lower than American real interest rates.

That’s all theoretically possible, but isn’t the simplest explanation that the forward yen is at a strong premium because investors expect the spot yen to appreciate, and they expect the spot yen to appreciate for the same reason that it’s strongly appreciated over the past 40 years?

PS.  After I wrote this post (a few days ago), I discovered a similar post written earlier by Julius Probst, who has a very nice monetary economics blog.  He anticipates my basic point.  But read his post anyway, as it ends with some interesting remarks on Japanese monetary policy.

Noah Smith has a good post on a topic that’s getting a lot of attention in the blogosphere.  It seems that the recently enacted tax reform is likely to dramatically boost reported exports, without (necessarily) impacting actual exports at all:

Here’s an example adapted from Guvenen et al.’s paper. Suppose that NoahCorp produces the NoahPhone, using research, design and branding done in the U.S., then sells it to people in Japan. Normally, the revenue from that sale would be counted in U.S. exports. But in order to avoid paying corporate tax on the profits from the sale, NoahCorp sells its patents and brands to NoahCorp Ireland for a pittance. It then declares that the profit from the Japanese phone sale actually goes to the Ireland subsidiary, not the U.S. parent company. The parent then doesn’t have to pay U.S. corporate tax. And the phone sale doesn’t get counted in U.S. exports. . . .

The result of all this profit-shifting is that the U.S. trade deficit seems wider than it really is, while U.S. income on foreign investments gets overstated. It looks like the U.S. is really bad at selling things overseas, but very good at choosing its foreign investments. For many years, pundits believed that wise U.S. investing was partially making up for uncompetitive manufacturing — now, it turns out that both of those stories might be different aspects of the same illusion.

With the new and lower corporate tax rate, companies will now be willing to declare this revenue as income from US exports.  And that could have political implications for an administration that is all about smoke and mirrors and marketing:

Nothing real will be changing, of course. The same phones will still be sold, and the same intellectual property will be created. But it will look like a huge win for the Donald Trump administration, which pledged to cut trade deficits.

I’m a bit skeptical that this will work.  Unless I’m mistaken, any gain in the trade account will be offset by deterioration in the services account as investment income declines, leaving the current account unaffected.  (Someone tell me if I’ve made a mistake here.)  And it’s the current account that pundits focus on, not the trade account.

On the other hand, this would tend to boost reported GDP, without boosting actual GDP.  It will be interesting to see how large the effect will be, and how durable.  My hunch is that any boost to growth would be modest (below 1%) and temporary.

I don’t worry at all about the President taking credit for things that are not real, as the public sees through the phony data.  When Trump took office he claimed the the unemployment rate almost immediately fell from the 30% to 40% range, down to about 4.1%.  But nobody took this seriously.  (Ditto for his recent claim to have repealed Obamacare).  Trump has made so many absurd claims that even his supporters don’t take anything he says seriously.  All that matters in 2020 is how the American people feel they are doing, not what the data show.

HT:  David Levey

Here is the Treasury’s list of the three criteria it uses to identify “currency manipulators”:

Pursuant to Section 701 of the Trade Facilitation and Trade Enforcement Act of 2015, this section seeks to identify any major trading partner of the United States that has: (1) a significant bilateral trade surplus with the United States, (2) a material current account surplus, and (3) engaged in persistent one-sided intervention in the foreign exchange market. Section 701 requires data on each major trading partner’s bilateral trade balance with the United States, its current account balance as a percentage of GDP, the three-year change in the current account balance as a percentage of GDP, foreign exchange reserves as a percentage of short-term debt, and foreign exchange reserves as a percentage of GDP. Data for the most recent four-quarter period (January to December 2016, unless otherwise noted) are provided in Table 1 (on p. 13) and Table 2 (below).

This is obviously beyond stupid.  (Since when do bilateral trade deficits mean anything?)  But at least the Treasury doesn’t try to read minds, and interpret the intentions of other countries.

Matthew McOsker sent me an article from the Economist, which nicely illustrates the confusion surrounding the concept of currency manipulation:

Awkwardly for America, two of its friends in Asia have recently scored more highly than China: South Korea and, most clearly, Taiwan. But the highest score of all goes to Switzerland, by dint of its whopping current-account surplus and its hefty foreign-currency purchases. This illustrates one of the method’s flaws: in terms of the goods and services that it can actually buy, the Swiss franc is in fact among the world’s most overvalued currencies.

This is why it’s so important to have a clear definition of currency manipulation.  The Economist clearly thinks the concept is related to undervalued currencies, and most people probably agree.  But whether a currency is “undervalued” is completely unrelated to whether some of the other criteria are met, such as large purchases of foreign exchange and/or a current account surplus.  If you really believe that large purchases of foreign exchange and a big current account surplus constitute currency manipulation, then you should have the courage of your convictions and label Switzerland as one of the world’s worst villains.  After all, it is among the world’s leaders in both categories.

And this leads to another irony.  I frequently point out that the more conservative the central bank, the bigger the balance sheet as a share of GDP. Thus in the future we may end up seeing more and more countries like Switzerland, with huge purchases of foreign assets in a futile attempt to prevent their currency from appreciating.

To avoid being labeled a currency manipulator, they may instead choose to buy domestic assets (as in Japan).  This will also boost domestic saving, depreciate the currency and increase the current account.  But since they won’t be buying “foreign exchange”, they just might fool the US Treasury.  (It’s not hard, when the Treasury is hamstrung by the silly mandate given to it by Congress.)

Here’s another irony.  Some people seem to think that fixed exchange rate regimes are evidence of currency manipulation.  But in the 1990s the EU had a fixed exchange rate system with the express purpose of preventing currency manipulation.  In fact, fixed exchange rate regimes determine the path of the nominal exchange rate.  But if currency manipulation happens at all (I doubt it), then it surely relates to real exchange rates. Thus if currency manipulation happens, it is equally likely to occur with a fixed or floating exchange rate regime.  Indeed you don’t even need your own currency to “manipulate” your real exchange rate.  Germany depreciated its real exchange rate in the 2000s.  If Wisconsin wanted to depreciate its real exchange rate it could do so.

But why would they want to?