Notes from the trade war

In light of recent events, just wanted to add a further word on Trump’s trade policies and their likely effect on continued dollar dominance. There are two schools of thought regarding Trump’s latest acrimony with traditional American allies. At last week’s G7 meeting, Trump had a stare-down with Germany’s Merkel and was “stabbed in the back” by Canada’s Justin Trudeau. The latter’s sole offense was to say, in public, that Canadians are polite and practical, but will not be pushed around. If you don’t understand Trump’s subsequent rage, you might be sane. It may be further dog-whistle phrasing for Trump’s white nationalist base that Canadians supposedly do to him what Jews did to Hitler. Steve Bannon believes (or says he believes) that this is a signal to China and strengthens Trump’s hand: if I think of my closest “friend” and neighbor like Hitler thought of Jews, just imagine how crazy I would go on actual rivals like you! The second interpretation is that Trump’s latest round of histrionics and tariffs is a display of weakness that further weakens his already weak hand: Trump is a classic schoolyard bully who psyched himself up to fight China, lost his nerve and now settles for pushing around Canadian-like kids who won’t fight back (he thinks). If and when Trump actually fights China, he will be tired and friendless. But, meanwhile, he blustered about tariffs for months (mainly against China) and, damn it, he’s going to get tariffs (against anyone)!   
The second scenario seems likelier. The second scenario seems likelier. Bannon has an open desire to curry favor with Trump and the Bannon-termed “hobbits” (I prefer the phonetically similar “bigots”) who support him. who support him. Moreover, Trump’s record in school and business was that of someone who liked to fight (literally and figuratively) but didn’t know how to choose his fights and underperformed his average peers. Were Trump the master of brinksmanship and controlled risk that Bannon posits, he would not have been a borderline juvenile delinquent who got shipped off to military school, he would not have gone bankrupt six times and his lifetime returns would not lag all major American indices. Trump was a New York real estate mogul whose returns trailed the New York real estate index. Had he randomly bought local properties, or simply dumped his money into an index fund, he would have accomplished more than all his braggadocio, bile and bankruptcies. Psychologists say that the best predictor of future behavior is past behavior. That may be even truer of the mentally ill who are especially captive to their pathologies. A few years ago, Trump, in his seventies, barged onto a global political stage that, by his own admission, is even more complex and difficult than New York real estate. There is no reason to think that a sick, old dog has since learned new tricks. 
Trump hates trade deficits. His misanthropy and paranoia make him think like an eighteenth century mercantilist. When continent-spanning wars are a regular occurrence, trade cannot reliably supplement domestic deficiencies. One’s trade partners today will be military opponents tomorrow. Therefore every nation must become as independent as possible, by seizing control of as many material resources as possible – which leads to more wars. There has not been such a trade-disrupting conflict since World War II. Since then, weapons grew deadlier while global supply chains deepened. We have more to fear from war and more to enjoy during peace, which makes another such conflict increasingly unlikely. Unless Trump himself triggers World War III, his hatred of trade deficits is a prejudice without modern factual basis.  
The larger question is whether Trump is right to hate trade deficits (albeit for the wrong reasons). 
What are trade deficits? What are the roots of America’s trade deficits? Examining those questions sheds light on the effects of our deficits and suggests probable long-term outcomes (assuming Trump refrains from blowing up the system and/or world). Tactically, Trump picks simultaneous fights with China, Canada, Mexico, the European Union, Japan and just about everyone else with whom America runs a deficit. He remains the same belligerent moron he was when he assaulted his teacher. But even if an abler, saner leader picked only winnable fights, the more interesting and important question is whether trade deficits merit picking fights at all. 
Any meaningful answer hinges on the nature of a trade deficit. If I give you an IOU in exchange for a good or service, I receive a specific good or service from you, while you receive a (hopefully) redeemable token of value from me. Therefore I run a trade deficit with you. If everyone trusts me and I give IOUs to everyone, they will likely trade those IOUs among themselves, because they trust I will redeem my IOUs to whomever presents them to me. The same principle applies to international trade. Trade deficit countries get more goods and services. Trade surplus countries get money (IOUs) in the denomination of their trade partners. The bigger a country’s trade deficit, the more of its money circulates abroad. America runs the world’s largest trade deficit, which means more dollars circulate abroad than any other currency. 
The dollar’s role as global reserve happened in two phases. After World War II, the dollar was the only safe currency and also flooded the world via the Marshall Plan and similar aid packages. After the early 1970s, another wave of dollars flooded the world as America started to run large trade deficits. In 1945, America produced more than half of global GDP. In absolute terms, America was the only winner of World War II. For reasons both altruistic and anti-Communist, America sent billions in money and material to help Europe and Asia rebuild. America was the world’s most creditworthy country and its aid flooded the world with dollars. Dollar-denominated assets, already the world’s most trusted, became the world’s most liquid, which made America the only political and financial game in town. 
That American world order continued until the Bretton Woods agreement dissolved under the stagflation pressures of the early 1970s. Since then, America has partly compensated its declining political power by flooding the world with even more dollars. Running large trade deficits erodes the dollar’s long-term credibility even as it increases the dollar’s current utility as global reserve. As long as people trust me, the more IOUs I issue, the more my influence grows – until people stop trusting me. Since the dollar was already the global reserve and exchangeable with everyone for anything, other countries willingly shipped more goods and services to America for more American IOUs (dollars). Decades into our current era of free markets, free-floating currencies and huge American trade deficits, dollar assets and transactions maintain a shrinking global lead. Dollar dominance is ending but not ended. 
Dollar-denominated assets are no longer the world’s most trusted. Japan, Switzerland, Germany, Sweden and Denmark, among others, have notably lower borrowing costs. But dollar-denominated assets remain *among* the world’s most trusted. Among this general class of most trusted nations, only America runs a large trade deficit. Only America floods foreign markets with its currency and is the most liquid by far. That gives America powers, including political leverage, that even the slightly more productive and populous eurozone lack. If everyone trusts me and everyone circulates my IOUs among themselves, I can control from whom I accept my IOUs. To a lesser extent, I can control how my IOUs are traded. I can refuse to redeem IOUs presented to me by, say, Iran and North Korea. I can also pressure others to not take IOUs from them (“If I find you accepting my IOUs with those guys, I won’t accept IOUs from you”). When I am mad at Iran and North Korea, I can freeze their Peter-denominated assets and also give others a lesson to stay on my good side. 
Trade surplus countries lack such leverage (critical caveat: assuming they do not make large politically targeted investments abroad. The eurozone and Japan do not. However, China does, using its trade surplus with America, and consequent wealth of dollars, to buy influence over other countries, as with its One Belt One Road infrastructure program and various African investments). Japan runs one of the world’s largest trade surpluses. Everyone has lots of electronics from Japan. Conversely, no one has a big stack of IOUs from Japan. When Japan is angry with North Korea; even when North Korea kidnaps Japanese citizens or lobs test missiles over Japanese airspace, Japan cannot freeze North Korean assets, because North Korea has no Japanese IOUs to redeem. If no one trusts me, I will not be allowed to run a trade deficit (developing nations tend toward trade surpluses). If I am trusted but frugal, I do not turn my good reputation into economic leverage over others (most other developed nations). America is both trusted and, in part through trade deficits, influential.
Trade deficits are not quite the one-sided utopia they might seem so far. I consume more goods and services from others than I produce for them. I also gain influence by controlling from whom and how my IOUs are redeemed. In the short term, I indeed gain goods, services and influence in tandem: the more, the merrier! But in the long term, even those who trust me now will begin to look askance at my penchant for writing IOUs for everything. If someone suddenly calls me a lazy parasite and refuses to accept my IOUs henceforth, that might trigger a crash that hurts everyone who holds my IOUs, which hurts everyone except possibly Iran and North Korea. A chaotic unwind of my IOUs seems less than likely because everyone knows and fears the downside risks. But even gradual erosion of trust in me erodes the value of my IOUs, even as everyone continues to trade them. As my IOUs devalue, that limits to buy goods and services from others. I then must either produce more or live with less. In some cases, I must remake rusted tools and relearn forgotten skills. During that transition, parts of my living standard might dip below the last level before I outsourced production in return for writing IOUs. If I depend on China for rare earths and active pharmaceutical ingredients (as America does), the transition could even become an industrial and medical crisis. Even as I gained goods, services and influence from others, I also became dependent on their goods, services and good will. If I come to hate everyone (as Trump does), I cannot freeze everyone’s assets or slap everyone with tariffs. The universality of my IOUs lets me punish individuals selectively. But if I try to simultaneously punish everyone who trades my IOUs (as Trump is trying to do), I overplay my hand. If I hate everyone and everyone hates me, I ruin my own creditworthiness, at which point the one who consumes too much is more vulnerable than the ones who produce too much.      
Trump’s term is that we “lose” money to countries with whom we have a deficit, as if deficits bleed wealth and jobs from our economy. He may genuinely believe a $100 billion trade deficit is the same as having one’s pocket picked of the same amount. In any event, he talks constantly of countries with trade surpluses “winning” and those with trade deficits “losing.” His mercantilist ideal is for America to run surpluses and presumably drain others of their wealth. This is nonsense. A trade deficit means we receive tangible goods and services for fiat money. In terms of actual material wealth, we win. As for the sustainability of this system, America is the world’s largest national economy (although the politically fractious eurozone is the world’s largest currency union). America also remains elevated by its post-World War II role as issuer of the global reserve and final guarantor of global markets. Given America’s credibility and systematic importance to the world economy, it is natural that other countries want to hold dollars for a rainy day. It is therefore natural that we run a trade deficit with almost everyone. The question is not whether America should run a trade deficit, but how much that deficit should be: big enough to preserve the dollar’s utility as global reserve, small enough to preserve our credibility.  
At current levels, a reduced deficit would help America. America continues to grow, but the rest of the world grows faster. America comprises a shrinking share of global GDP. The decline of America’s institutional importance erodes the dollar’s importance as a global reserve. That erodes international tolerance for America consuming more goods and services than it produces. If our trade deficits continue at this rate, and particularly if the euro survives without (further) major mishaps, it will hasten the decline of the dollar’s value. Other things equal, a reduced trade deficit would at least stem America and the dollar’s long-term decline.  
Trump’s preferred method of reducing America’s trade deficit guarantees that other things will not be equal. Slapping tariffs on foreign goods reduces America’s deficit by reducing American demand. Other countries will retaliate by slapping tariffs on American goods. But since America runs trade deficits, even reducing both our imports (American-imposed tariffs) and exports (retaliatory tariffs from other countries) will probably reduce America’s absolute deficit. In terms of bringing American consumption closer to production levels, that might appear to make America more creditworthy. But it would reduce America’s demand for foreign goods, reduce foreign demand for American goods and reduce the amount and general liquidity of dollars circulating abroad. In a worst case scenario, there is little point for foreigners to hold dollars if America buys nothing from the world and the world buys nothing from America. America’s current trade deficit is big enough to undermine long-term dollar value. But an overly large deficit is preferable to shrinking the deficit by shrinking America’s importance in global markets. 
If everyone trusts me enough to accept my IOUs, my proper goal is to manage the amount of IOUs in circulation, rather than to eliminate them completely or even have a role-reversing “positive” balance wherein I hold IOUs from others in exchange for my goods and services. If all my IOUs are redeemed, I can no longer freeze the assets of my enemies. I no longer have a trade deficit, but I lose my soft power over others and, barring a personal production boom, have fewer material things. But if I write too many IOUs, I flood the market and erode their value. I want enough of my IOUs to circulate that they remain an important vehicle of trade. But I do not want so many to circulate that others question why I seem incapable of doing anything for myself. Nor do I want to make doing business with me difficult. If I habitually complain, threaten and delay, I hurt myself by undermining the value of my word and the desire of others to business with me. If others cannot be certain that I will do business with them (or anyone) tomorrow, they have less reason to accept my IOUs today, even if I otherwise make myself more creditworthy and productive. 
Trump wants to alienate America’s trade partners even as he concurrently makes America less creditworthy by increasing our national debt and less productive by cutting education and investing in unproductive and antiquated industries (e.g., the military and coal, respectively). Trump wants to reduce America’s trade deficit by reducing dollar liquidity and American creditworthiness, productivity and soft power. If he fails, he will be an ineffectually incompetent historical asterisk. If he succeeds, he will be a failure of epochal magnitude. Trump is a steroid-mad sprinter running a race to the bottom. If he is lucky, he will only fall and be unable to get up. 
If America reduces trade deficits by reducing trade (the only possible outcome if Trump’s tariffs and foreign counter-tariffs come to pass), the dollar will rise in the short to medium term (on improved sentiment toward American creditworthiness) but weaken in the long term (on the reduced supply and utility of dollars). If America maintains its current trade deficit, the dollar will weaken in the medium term (on cynicism toward Americans piggybacking global productivity) but be underpinned by institutional demand in the long term (on the dollar remaining the global reserve). In the very long term, and albeit with different timing and to different degrees, both protectionist and globalist scenarios point to dollar weakness. Unless the rest of the world is devastated by world wars every generation, as occurred between 1914 to 1945, America and its currency will not maintain their historical prominence. At some point, fathers lose to their sons at basketball, soccer or whatever sport constitutes their bonding forum/Oedipal arena, no matter how well the fathers eat, exercise and rest. It does not help that America may be the world’s most mismanaged developed nation (only Britain comes close: their government is corrupt to our crazy, equally stupid and prone to viciousness, but with better healthcare and environmental policies). But barring material cataclysms (at the early twentieth century rate, we should be wrapping up World War V), the broad narrative of American and dollar decline is inevitable. If Trump fails badly enough, he may even help transition our national focus from power politics to living standards. Or we may elect a *competent* fascist demagogue who backs his verbal bile with bite. When the center does not hold, both upsides and downsides expand. 

Notes from the trade war
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