On the Road to a Tariff-Led Recession
The highly unorthodox and chaotic way in which President Donald Trump is implementing his import tariff policy is all too likely to produce a US and world economic recession before the year’s end. Tariff policy-induced economic uncertainty is already delaying investment and consumer spending, households are being hit by a tax increase in the form of higher import prices, equity and bond prices are being pummeled by a loss of faith in American economic exceptionalism, and spillover effects to the US economy are to be expected from an upending of the rest of the world economy.
Another unfortunate aspect of Trump’s import tariff policy is that it is being accompanied by a budget-busting tax cut proposal. As occurred in the first Trump administration, that combination of policies is more than likely to cause a widening rather than a narrowing in our trade deficit.
Heightened Economic Uncertainty
If there is one thing that economies and the stock market abhor, it is an environment of great uncertainty. In such circumstances, investors withhold making investment decisions since they cannot gauge their likely costs or the scope of their markets. Similarly, households cut back on their spending as they brace themselves for possible price hikes and the loss of their jobs. Meanwhile, the stock market loses value as it prices in greater risk and as companies have difficulty in offering investors meaningful forward guidance on their prospective profits.
One has to go back as far as 1909 to find American import tariffs as high as they are today.
Yet Trump’s import tariff policy is creating economic uncertainty in spades.
One way it is doing so is by taking the economy into largely uncharted territory. One has to go back as far as 1909 to find American import tariffs as high as they are today. According to the Budget Lab at Yale, as of April 15, even after all of the pauses and exceptions to Trump’s tariff policy, the average effective US import tariff rate stood at around 28 percent. This is a quantum leap from the 2.7 percent average US tariff rate that prevailed last year and is a level that has to raise fears about retaliation from our trade partners.
Trump’s import tariff policy is also generating economic uncertainty because of the highly erratic way in which it is being applied. One day we have a 25 percent import tariff on Canada and Mexico only to be followed two days later by a one-month pause in its application. On April 2, punitive retaliatory tariffs are imposed on some 60 of our trade partners only to be followed one week later by a 90-day pause in their application to give time for trade negotiations. One day we are told that there is to be a 145 percent import tariff on China with no exceptions only to be told one week later that semiconductor imports from China will be excluded after all. As if there were not enough policy uncertainty, we get told that Trump has in mind applying additional import tariffs to key economic items like semiconductors, pharmaceuticals, and lumber.
The Fallout From Uncertainty
As expected, fallout from the heightened degree of economic policy uncertainty has been swift. Surveys from the University of Michigan and the Conference Board show that consumer sentiment has dropped to a four-year low with expectations about the future reaching a 12-year low. At the same time, Wall Street dealmaking has stalled, and business leaders are expressing concern about the increased difficulty of making investment decisions. Meanwhile, in early April the stock market experienced a 10 percent drop that wiped out more than $6 trillion in equity wealth and took the stock market into bear market territory.
Of particular longer-term concern has been the unusual behavior of the US government bond market and the dollar. Normally in times of US and world financial market turbulence, investors flock to the safe-haven of US Treasury bonds and the dollar. This has not been the case this time around. At a time when the stock market was declining, the 10-year Treasury bond yield spiked from less than 4 percent to around 4.5 percent while the dollar dropped to a two-year low against the Euro. The upward movement in 10-year Treasury bond yields is of considerable concern, since those yields are key to setting many interest rates, including long-term mortgage rates. Rising long-term bond yields could also could increase banking system strains since they reduce the value of the banks’ long-term bond holdings.
These unusual moves in the dollar and Treasury bond yields could be suggesting that Trump’s erratic tariff policy is causing strains in the financial system and the loss of faith in American economic exceptionalism. It also could be reflecting growing concerns about the unsustainable path on which our public debt finds itself and the seeming lack of political will to address our public finance problem.
A Tax on the American Public
At a time when our economy is already slowing and households have taken a big hit to their 401(k) accounts, Trump’s import tariffs are delivering a large tax increase on American households. It is generally estimated that Trump’s tariffs will result in almost a 3 percent increase in overall consumer prices. That in turn could cost American households more than $3,000 a year. It would seem that consumers are expecting such a price shock, as indicated by a rise in household one-year inflation expectations as measured by the Michigan University Consumer Survey to 6.7 percent.
The prospective rise in inflation and the increase in inflation expectations to well above the Federal Reserve’s 2 percent inflation target puts the Fed in a most unenviable position. Even though it might anticipate a marked slowing in the economy as a result of the tariffs, it will not be able to respond in an anticipatory manner to such a prospective slowing with interest rate cuts for fear of un-anchoring inflationary expectations. This would seem to be especially true in a world where Trump could either roll back or intensify the trade war on a whim. In a recent speech, Fed Chair Jerome Powell emphasized that the level of the tariff increases announced so far is significantly larger than anticipated and that the lingering uncertainty around tariffs could inflict lasting economic damage.
Spillover Effects from Abroad
Trump’s trade war comes at a time of great economic vulnerability for the world economy. China, the world’s second largest economy, is presently in the midst of the bursting of its epic housing and credit market bubble. Germany, Europe’s largest economy, has been in recession for the past two years, and France and Italy have public debt levels that are higher than they were at the time of the 2010 European sovereign debt crisis. Meanwhile, the export-intensive Canadian and Mexican economies have around 80 percent of their exports going to the US market.
A marked slowing in overseas economic growth could cast a long shadow over our economic recovery prospects in a number of ways.
In these circumstances, a 145 percent import tariff on the exports to one of its largest export markets could deal a major body blow to the Chinese economy. Similarly, the last thing that a German economy needs is a 10 percent tariff on all of its non-automobile exports to the United States and a 25 percent tariff on its automobile exports. The same can be said of the 25 percent overall tariff on all US imports from Canada and Mexico not covered by the Canada-America-Mexico Trade Agreement.
A marked slowing in overseas economic growth could cast a long shadow over our economic recovery prospects in a number of ways. Weaker economic growth abroad, coupled with retaliatory trade measures by our trade partners, could limit our export sector’s growth prospects and create supply chain problems for our manufacturers. At the same time, poor economic growth abroad could have a material impact on the bottom line of our companies. This would seem to be especially the case considering that the S&P 500 companies derive more than 30 percent of their revenues from abroad. In turn that could be the basis for another leg down in the stock market.
A Widening Trade Deficit
Making Trump’s tariff policy doubly regrettable is that there is little prospect that it will succeed in reducing the country’s gaping trade deficit for very much the same reason that it failed to do so in his first term. Between 2016 and 2019, the US trade deficit on goods and services widened by 40 percent from $480 billion to $680 billion. It grew despite import tariffs on $350 billions of imports from China as well as tariffs on steel and aluminum imports. The main reason was that the tariffs were accompanied by the 2017 Tax Cut and Jobs Act, which incentivized investment and blew out the budget deficit. In turn, that worsened the country’s saving and investment balance, which is the basic driver of our trade deficit.
If import tariffs were accompanied by tax cuts in Trump’s first term, they are planned to be accompanied by tax cuts on steroids in his second term. According to the Committee for a Responsible Budget, over the coming decade Trump’s tax cuts could add over $5 trillion to the budget deficit. This has to beg the question why tax cuts on a larger scale this time around than the time before will not exacerbate the country’s already serious twin budget deficit and trade deficit problem.
The discussion above suggests that absent an early change in tariff policy direction, there are all too many reasons to expect a recession later this year. Tariff policy-induced economic uncertainty now delays investment and consumer spending, households are being hit by a tax increase in the form of higher import prices, equity and bond prices are being pummeled by a loss of faith in American economic exceptionalism, and spillover effects to the US economy are to be expected from an upending of the rest of the world economy. For all of these reasons, we have to hope that Trump makes an early and fundamental tariff policy U-turn. However, I would not suggest holding your breath for that to happen anytime soon.