Marshall Auerback: A Full Employment Economy? What Could Possibly Go Wrong?

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Yves here. With imports representing less than 15% of US GDP, I have trouble seeing the inflationary impact of restructuring trade as being as live a risk as Auerback suggests. However, higher oil prices do make a real difference. However, perhaps all that matters is what the Fed makes of this, since if the Fed finds more reasons to think inflation might finally get going, it will raise rates, denting employment.

By Marshall Auerback, a market analyst and commentator. Produced by the Independent Media Institute

Glance through the business section of any major media outlet, and there is apparently good news to start the autumn: The Bureau of Labor’s September numbers showed measured unemployment hitting a multi-decade low of 3.7 percent. The U.S. secured a revised trade agreement with Canada and Mexico. And wage growth, while rising, still remains a relatively moderate 2.8 percent at an annualized rate. Inflation remains comparatively muted for now, with an annualized one-month gain of 1.4 percent. It seems like the U.S. is experiencing the proverbial “Goldilocks” economy. What could possibly go wrong?

For one thing, there remains the backdrop of America’s expanding trade war with Beijing. On the face of it, the successful conclusion of the new and improved NAFTA 2.0 (henceforth rechristened as the United States-Mexico-Canada Agreement, or USMCA for short) appears to have halted the political tide toward protectionism. Yet paradoxically, it might actually do the opposite: USMCA is designed to give greater weight to regional trade relationships at the expense of global ones, especially the colossal supply chain that has emanated from China. As trade becomes increasingly regionalized, as global supply chains are disrupted, that generally raises the cost of everything, for everyone.

Why is that? Because since the fall of the Soviet Union (and the corresponding end of the Cold War), the expansion of globalization has largely imparted a deflationary bias to the global economyvia “synthetic immigration.” If that term is foreign to you, here’s what it means: a mispriced dollar/yuan exchange rate made the price of labor in China so low for U.S. corporations that the price of American labor looked like a luxury item, and they moved their manufacturing operations to China. China knowingly undervalued its currency to get this process rolling, and over time, it produced a big economic contraction in the U.S. and world economy, the extent of which is literally papered over or hidden by a huge number of bubbles in the world financial markets. Advances in capital mobility, globalization, telecommunications, shipping and low fuel prices made all of this possible.

The rise of a trade battle between Trump and China, plus the long-term outcomes from the reconfigured USMCA, have the potential to reshape long-term trade patterns and the world’s capital and financial markets—and not necessarily smoothly; most of all because the total result could be more politically volatile as well as being more inflationary: a smaller, more divided world economy, competing regional trade blocs, higher prices for consumers. How will they pay for these more expensive things?

To the extent that globalization is impeded by increasing protectionism, that deflationary export channel from China is also disrupted. That could mean higher prices for American consumers, even allowing for the relatively muted pressures reflected in the September CPI. It’s unclear if inflation rates will gobble that up, but on current trends, that remains possible, especially if the trade war persists. Tariffs and other protectionist measures may well produce more domestic jobs, but at the cost of consumers likely having to face higher prices.

This potential turn in the inflation trend is starting to get recognized, notably in the bond markets, which have fallen precipitously in the last few months. Recognition of this inflationary trend may well begin to impede the rise of equity markets as well, although the adverse impact in stocks could be mitigated to the extent that corporations rely less on efficiency gains and more on pricing power (which preserves profit margins). Paradoxically, so long as the Federal Reserve continues with a policy of slow, incremental interest hikes (amply telegraphed in advance to the markets), such gradualism makes it easier for consumers to adjust somewhat, as well as enabling businesses to pass on those higher costs via price increases, which in the first instance, therefore, can be inflationary. At some point in the future, assuming the Fed keeps hiking, real rates will exceed nominal rates and businesses won’t be able to increase prices to offset higher borrowing costs (and will face corresponding consumer resistance to higher prices). At that stage, profit margins will be squeezed, demand will slow, and all bets are off. The risk in the equity markets today is that there is a widespread expectation of rising profits margins.Inflation could upset the apple cart.

The general consensus appears to be that Trump can’t succeed (either politically or economically) via a protectionist trade agenda, even though the president and his advisers themselves argue that the goal of tariffs is a means to an end: namely securing fewer barriers to American exports, particularly to China. That might be the stated objective in favor of deploying tariffs, but it is worth noting that a number of national security experts (in the words of Reihan Salam), “fear that an overreliance on Chinese manufacturing has sapped the American capacity for process innovation, which in turn has created a grave strategic vulnerability.” That creates additional political momentum for sustaining this trade war and disrupting the “Chimerica” nexus once and for all via continued tariffs.

Even while acknowledging that Trump used the tariff “battering ram” successfully to achieve a new revised North American trade deal, Martin Wolf suggests:

China is a different story. Its exports to the US are a substantially larger share of its GDP than vice versa, at 4.1 per cent, against 0.7 per cent, in 2017. China’s bilateral surplus was about 3.1 per cent of its GDP, which is far down from the 10.2 per cent in 2006. Imagine that the US imposed prohibitive tariffs on all its exports. One might think the effect would be to lower China’s GDP by 4.1 per cent. One would be wrong. US exports to China would also fall, as Chinese retaliation bites. Furthermore, a third of the value added in China’s exports is imported. Chinese exporters could also sell their goods elsewhere. In the end, the fall in China’s GDP in such a trade war would be less than 2 per cent, other things equal. This is about four month’s growth.

All true, but as the Great Depression of the 1930s illustrated, the knock-on effects in regard to China’s economy may well go beyond the mere 2 percent of China’s GDP, estimated by Wolf, given the extent to which the country’s export sector is indirectly tied up with its huge capital investment bubble (a leading source of global deflation). This was certainly the case for the U.S. (which was a leading exporter in the 1930s). Much of the capital expenditure emanating from China’s current bubble has been directed toward export industries, and the drive to keep those factories running to sustain domestic Chinese employment has resulted in dumping goods globally (notably bulk commodities, such as steel), which in turn has imparted deflationary pressures. To the extent that Trump’s tariffs impede China’s access to the U.S. market (and replaces its traded goods with domestic product), the opposite is the case: higher prices and correspondingly greater inflation, as the low-cost imports from China are replaced with higher-cost domestic alternatives.

Another factor that may well contribute to an increasing regionalization of trade (and higher inflation) is rising energy prices. Oil prices have almost trebled from their recent lows of early 2016. Heightened tensions in the Middle Eastwill likely ensure that the current upward momentum is maintained for some time (note the recent harsh exchange between Trump and Saudi Crown Prince Mohammed bin Salman), which almost certainly undermines the economic case for extensively globalized supply chains, given higher global transport costs.

For political reasons, Trump may well persist with this “America First” trade strategy. As I’ve written before:

You have what Chris Dialynas of PIMCO has called ‘synthetic immigration.’ As Chris noted to me in a recent correspondence,

Because of technological advances, today’s trade policies are effectively an immigration policy. There are differences to be sure. The U.S. and its municipalities do not benefit from the taxes that would normally fall upon the immigrant workers. Yet, U.S. taxpayers must, like in an old world real immigration, provide benefits for the displaced workers, even as those who remain employed have seen their wage increases “displaced.” Typically low cost labor attracted long-lived capital investment. Synthetic immigration has led to capital investment in the immigrant’s country (China) resulting in a greater capital stock there and increased competitiveness.

Meanwhile, the disinflationary benefits (largely accruing to owners of capital, as well as the country’s banking interests) have proved ephemeral for the working and middle classes, which have seen a steady erosion in their living standards, even as disinflation has reduced the costs of goods. The question for Trump and America’s economic policymakers is: to what extent will this trade-off between potentially higher inflation vs. trade protection be tolerated?

Those who confidently proclaim that China will ultimately be able to wait out America’s attacks on its trade policies without harm to its own economy might begin to question this assumption. Beijing has talked a tough game and suggested that exports could be diverted to other markets. At the same time, the authorities have recently pumped an additional $109bn into the economybecause the trade war with the U.S. has in fact begun to impact on China’s GDP growth adversely. The Guardian has noted that“investment growth has slowed to a record low and net exports have been a drag on growth in the first half of the year.” Beijing is seeking to offset the impact of Trump’s tariffs by allowing its currency to depreciate against the U.S. dollar. If they continue to encourage a further devaluation, Trump may well respond with correspondingly higher tariffs on Chinese goods.

Much like Trump, Beijing also has to make a political calculation here: China’s authorities cannot be seen to kowtow to Trump’s trade demands. By the same token, Trump cannot afford to be seen by his base as soft on China. Hence, the American tariffs might prove more than ephemeral (and could well increase if China continues to devalue its currency against the dollar to offset the impact of said tariffs). The relative permanency of the tariffs would therefore constitute a signal to domestic U.S. producers that the outsourcing game is over and that domestic investment in plants and equipment cannot be easily undermined. The tariffs would likely raise prices, exacerbating rising inflationary pressures.

There is another factor at work, which mitigates against a reduction of inflationary pressures. Trump’s fiscal policy remains relatively expansionary, with the budget deficit still running over 4 percent of GDP, according to the latest estimates. While it is true that much of the current stimulus has been directed toward upper income earners with a much higher propensity to save, the stimulus as a percentage of GDP is still relatively high, when one considers that the official unemployment rate, at 3.7 percent, is the lowest recorded level since 1969. Even allowing for lower labor participation rates (which suggest that there might still be some surplus labor capacity in the U.S. economy), it is unusual to see deficits of this magnitude during a period approaching fuller employment (if not completely full employment). And this doesn’t include the most recent continuing spending resolution reached at the end of September to keep the government open through the midterms.

In essence, the U.S. now has a situation whereby fiscal stimulus is being married to a tariff policy in the U.S., so that the stimulus “leakage” (whereby U.S. spending power is directed toward imports rather than domestic goods) is minimized, and therefore the stimulus absorbed mostly at home. This is more likely to result in inflationary pressures. This is beginning to be intuited by the bond market, where the 10-year Treasury benchmark bond has tumbled to 3.23 percent, the highest yield level since May 2011. Additionally, Financial Advisory reports that:

“the value of the Bloomberg Barclays Multiverse Index, which captures investment-grade and high-yield securities around the world, slumped by $916 billion last week, the most since the aftermath of Donald Trump’s election victory in November 2016. American high-grade obligations are down 2.53 percent in 2018—a Bloomberg Barclays index tracking the debt has dropped in just three years since 1976.”

Keep your eyes on that Index. A lot, to put it mildly, is riding on it.

It’s worth emphasizing the point that the transition from mild deflation to rising inflation does not require a total breakdown in global trade. The mere slowing of globalization trends via tariff impositions and the ending of a shift of production to low-cost emerging market economies, such as China, should be enough to give this trend further momentum. Having been conditioned by decades of disinflation, this could well prove an unexpected and unpleasant shock to American consumers, especially those who are only now deriving the fruits of higher wages so late into the recovery. Against a backdrop where levels of inequality are still as severe as any time in over 100 years, the blowback could be unexpectedly harsh.