In early March President Trump announced tariffs on steel and aluminum from China and South Korea who purportedly flood the U.S. market with the metals are artificially low prices:

Trump’s stated targets are countries such as China and South Korea that allegedly flood the U.S. market with metal goods sold at artificially low prices. Even many pro-free-trade economists agree with the White House that this is a real problem. But, as I wrote the other day, China accounts for less than ten per cent of all steel imports, which places it behind Canada, Mexico, and the European Union. These countries could be among the biggest victims of Trump’s tariffs.

I originally thought any sign of tariffs would drive up prices for aluminum and steel. Over the past month (since tariffs were imposed) aluminum prices have fallen about 3% while carbon steel prices have been practically flat. Financial markets, on the other hand, have experienced turbulence. Markets are bracing themselves for the potential damage reciprocal tariffs from China could cause.

The general thesis is that nations or entities should engage in trade when they have a comparable advantage or lower opportunity cost. Let’s assume a Vice President in a buy-side M&A department could generate $3 million per year in fee income by prospecting for new deals. The Vice President could run spreadsheets analyzing new deals, valuing companies and performing market research, but it would cut into his/her time prospecting and bringing in new deals. If the V.P. could [i] pay an analyst $75 thousand per year to do run spreadsheets and perform research which [ii] could free up the V.P. to bring in new business then the two should enter into a trade. The V.P. could be more efficient at doing analyst-type work, but the firm would generate less revenue if the V.P. performed these tasks.

The more resources the U.S. uses to produce steel or aluminum would imply less manpower or resources to produce technology or perform other services. Trade with China and South Korea could create a symbiotic relationship. In my opinion, if President Trump wanted China to stop pirating U.S. software then taking the case to the World Trade Organization (“WTO”) would be a better tact than engaging in a trade war.

Trump And The Global Economy Illustrates The Folly Of Protectionism

Last year I started Trump And The Global Economy town hall to discuss President Trump’s policies and describe their impact on the economy. The October 2017 town hall all included economics professor and Seeking Alpha contributor Lance Brofman. The following link provides a video from the event. At the 49 minute mark Professor Brogman explains the follow of trade wars and protectionism. His analysis was spot on and gave historical examples of the follies of protectionism:

Free trade always helps everybody … Mahatma Ghandi was a great statesman but really bad economist. He thought in 1947 … Indians who make three cents per day (or whatever it was) that they shouldn’t have to compete against Americans and Europeans who have fancy machines,  so he adopted protectionism. At that time India and South Korea had the same per capita income. By 1970 South Korea and Taiwan (per capita income) were 10 times that of India. What made it so bad it was illegal to import computers [into India] …

The most famous protectionism was the Smoot-Hawley Taft … which really made the recession of 1930 into a depression because that really cut off free trade. David Ricardo in 1917 demonstrated the concept of comparative advantage which means that if you have trade even if some country has an absolute advantage it still makes sense as long as there is a comparative advantage.

Say China can make television sets for $100 and they can make trucks using $10,000 worth of resources … the United States can make the same television sets using $500 in resources and the same truck for $20,000 in resources. China has an absolute advantage … lower cost in both. For the Chinese to make one truck they would have to give up 100 television sets sets. For the United States to make one truck they would only have to give up 40 television sets. It makes sense for the Chinese to make the television sets and the Americans to make the trucks and both people are better off.

The concept of comparative advantage could currently be in play between the U.S., China and South Korea. The bombastic statements from both sides bring attention to the trade imbalance between the countries and shines a light on the importance of protecting our technology.

Where Next For The Trade War?

So far there has not been much economic damage from tariffs between the U.S. and China. My guess is that President Trump wants to start with an aggressive position (threat of a trade war), come to a landing on technology transfer and make China think it got something by avoiding a full-blown trade war. I also believe China will offer an olive branch like opening their financial markets to Wall Street or some other concession. However, I doubt it will promise to stop pirating software since the practice has been going on for so long.

If Trump’s end game is to grab headlines and gain certain trade concessions then Trump will be victorious. However, getting China to stop pirating our software could be more elusive and more protracted.

Conclusion

Financial markets have been volatile amid trade war rhetoric. Neither country wants a trade war but the rhetoric could last for months or even lead to the WTO getting involved. The Dow Jones (DIA) is off about 5% since the trade spat began. I envision more volatility for financial markets. Investors should avoid financial markets amid a trade spat with China and expected rate hikes from the Fed.

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