The Chief Economist’s Note

Pinning down the costs of the trade war

President Trump may have called off his plan to impose tariffs on Mexico, but a deal with China appears to be further away than ever. This raises two questions. First, to what extent has the president’s trade war with China been responsible for recent weakness in global growth? And second, what would a further escalation from this point mean for the outlook over the next year or so? I’ll deal with the first question in this week’s note and return to the second question next week.

When thinking about the impact of the trade war so far it’s useful to separate the direct effects that tariffs have on output and activity from the indirect effects they have on things like confidence, financial conditions and business investment.

Fleshing out the direct effects has not been helped by President Trump’s claims about who pays the tariffs. In Trump’s view, it is China that is paying the US “billions of dollars in tariffs”. In fact, a tariff is a tax on an imported good that is paid by the importer not the exporter. All else equal, this does two things. First, it represents a form of fiscal tightening in the country imposing the tariff. Second, by raising the cost of imported goods relative to domestically-produced goods, it acts like a devaluation, again for the country imposing the tariff.

Of course, all things aren’t equal. For a start, the US government has so far spent most of the extra tariff revenues (particularly on agricultural subsidies). This can have important distributional consequences but it means that, at an aggregate level, the imposition of tariffs is fiscally neutral. At the same time, currency moves tend to snuff out any “devaluation” benefits. Note that the dollar has appreciated by 3% in trade-weighted terms over the past year and by 8% against the renminbi.

If that’s not complicated enough, we also need to account for behavioural changes that result from increased tariffs. For example, what if the importing country (i.e. the US) responds to the imposition of tariffs by purchasing goods from another country? While the other country gains, the original exporter (China) suffers as demand for its goods falls. But the importer also suffers if the new goods are more expensive than the original imports it was buying pre-tariffs. (In the jargon this is referred to as a “dead-weight loss”.) As our Chief US Economist, Paul Ashworth, has argued, there is some evidence of this happening in the US.

The key point in all of this, however, is to retain a sense of perspective. The US is a relatively closed, service-based, economy. Moreover, despite the common view that China’s economy is “export driven” it has in fact become increasingly domestically driven over the past decade. The direct effects of the trade war are therefore likely to have been relatively modest. We estimate that they may have reduced China’s GDP by 0.3% and US GDP by 0.2%. Global GDP may have been reduced by 0.1%, which is nothing more than a rounding error.

What about the indirect effects? There’s lots to unpack here, and for a detailed analysis clients should refer to a note last week by our Senior Economic Advisor, Vicky Redwood. The short point, however, is that the imposition of tariffs and – more importantly – the threat of further escalation can cause economic damage in several ways, including through tighter credit conditions, reduced business confidence and the deferral of investment decisions. What’s more, these indirect effects can weigh on growth outside of the countries directly engaged in the trade war.

While it’s difficult to be precise, we think that the indirect effects of the trade war have probably had a larger impact on overall global GDP than the direct effects. In particular, while they’re not the whole story, they may help to explain the recent weakness of investment in the euro-zone and parts of Asia. Yet once again, a sense of perspective is required. According to our analysis, the indirect effects of the trade war may have shaved 0.2% off global GDP since the trade war began to escalate at the start of last year.

The bottom line, therefore, is that taking account of both direct and indirect effects, the trade war may have reduced global GDP by around 0.3% over the past 18 months. Given that world GDP growth has dropped from 4% y/y to around 3% y/y over that period, it can explain only a small part of the recent global slowdown. The problem, of course, is that with a deal between the US and China seemingly further away than ever, a continued escalation in the trade war now appears likely. My note next week will examine the implications for the global economy.

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