In the Trump era, traders and investors have become increasingly familiar with the phrase “Trade War”. As tensions and rhetoric escalate between the United States and China, now seems the appropriate time to define exactly what a trade war is, so that we may understand the implications of a trade war on the stock market.
Google the phrase “trade war” and the definition that pops up:
“A situation in which countries try to damage each other's trade, typically by the imposition of tariffs or quota restrictions.”
That is a good working definition, but requires further explanation.
A tariff is a tax on imports and can be levied on individual products, all products from a single country, or on imported items across the board. A quota limits the amount a product can be imported from any one foreign country. A tariff’s purpose is usually to protect a domestic industry that is suffering because of competition from overseas -- competition that is usually characterized by those seeking or granting protections as unfair.
That sounds simple, but it really isn’t.
Is it “unfair” that a country has a lower standard of living and therefore lower wages that enable it to produce more cheaply? In that situation is the onus on the wealthier country to come up with innovations that reduce production costs? Is it “unfair” that a country that produces an excess of something take advantage of higher prices elsewhere? Or, should we rely on markets to make the price adjustment that comes with importing inexpensive goods to restore balance?
Go back far enough in history, before travel between nations became easy and commonplace, and these things weren’t issues. Every country lived off its own resources and economies were self-contained. The problem was that wealth production and growth were limited by those inherently limited resources, and wars were the only real way for countries to get richer in the long term. Regulations and restrictions were then needed to protect those hard-won resources.
Then, in 1776, Adam Smith published “The Wealth of Nations” in which he said, to summarize severely, that if we stopped fighting over diverse resources and started selling them to each other we would all benefit. History has shown that he was right. As trade between nations has become freer and easier, wealth creation has accelerated rapidly around the world. You could argue that the system has led to problems in the way that wealth is distributed, but the growth itself is undeniable.
Still, periodically, various countries decide to challenge the free market system and the motive is almost always political. There is no evidence that an isolated country is better off, nor have the attempts to protect dying industries ever worked. That said, “I am trying to help…” is a much more appealing political message than “There is nothing I can do…” whether it comes from the left or right.
That wouldn’t be too bad if the imposition of tariffs and quotas could be done in isolation. Unfortunately, however, isolation is extremely rare. What the googled definition of “trade war” above leaves out is one of its most important characteristics, escalation. What starts out as a political act to buy the votes of workers in a struggling industry, such as tire manufacturing, steel or coal, usually ends up affecting almost every aspect of trade between two countries. We have seen that in the early days of Trump’s trade policy moves. What started as targeted, protectionist tariffs on steel and aluminum have led to barriers on pork, soybeans, aircraft, jeans, motorcycles etc. that, if implemented, would do economic damage to millions on both sides of the dispute.
That damage is not just restricted to shrinking markets and falling prices for those directly affected. The very idea of tariffs is to raise the cost of imports, so everybody on both sides of the dispute end up paying more for things they need and want. Those that characterize trade restrictions as a tax on everyone to benefit a targeted few have a point.
So, a trade war can be defined as being an escalating series of restrictions, either monetary or legal, on trade between nations. If Trump sticks to his trade-related election promises, stories about trade wars will become even more common. Traders and investors should therefore have a working definition of the phrase, and an understanding of the potential effects and why markets tend to react so negatively to this prospect.