Chekhov’s Gun & the Permanent Threat of Tariffs

The increasing prominence and permanence of trade threats is creating an awkward and complicated world for investors forced to navigate this new reality. What does this latest round mean for us?

Investors are parsing every utterance from Washington and Beijing to calibrate the prospects of an agreement that covers $737 billion of bilateral trade. Talk of bad faith on the other side leads markets lower; mention of the next scheduled meetings delivers a bounce. The consensus remains that a deal is forthcoming, given that it is overwhelmingly in both sides’ interests. (See our next essay for some suggestions on how to keep score.)

What passes unobserved, however, is the fact that the threat of massive punitive tariffs to extract behavioral changes are now part of the global economic landscape. Even if both sides stand down within a month or two, investors will have to assume the possibility that the weapons will be used again.

Like Chekhov’s gun appearing on a theater set in Scene 1, you must now expect it will be fired before Scene 2 ends. Every supply chain should be subjected to a stress test to gauge the impact of tariffs that may come and go anytime in the years ahead. Every analysis of a firm’s addressable market needs to plan for the same kind of shocks.

GLOBAL TARIFF RATE

Note: Average Tariff Rates across 16 countries: Australia, Belgium, Switzerland, Germany, Denmark, Spain, Finland, France, UK, Italy, Japan, Netherlands, Norway, Portugal, Sweden and the US.
Source: Goldman Sachs, Clemens and Williamson (2002), World Bank. As of December 31, 2016.

Moreover, the quiet announcement that the Trump Administration will delay for six months a decision about tariffs on European automotive imports suggests that we should brace for more of the same. Barring unforeseen change, this is Washington-speak that means the tariffs themselves are delayed, but the decision has already been made.

How will other national leaders explain to their constituents they will not resort to their own tariff threats when it has become part of the standard arsenal for the world’s largest economies?

For now, of course, the real drama is over the U.S. and China and the rocky relationship that lies ahead, even if there is a quick deal. These negotiations are still in the early stages of a much larger economic story that will unfold over many decades as everyone adapts to China’s emergence as the world’s largest economy.

U.S., EURO AREA, CHINA GDP AS A % OF WORLD

Source: OECD Long-Term Projections. As July 31, 2018.
Gross domestic product measured as volume in USD, at constant 2010 purchasing power parities

China’s model at this stage benefits both from a centrally-planned system that concentrates resources toward national economic priorities even as it opens market forces that drive dynamism and innovation. This has lifted millions of Chinese out of poverty, while introducing powerful distortions in global markets.

In this context, the Trump Administration’s focus on the bilateral goods deficit looks dated. Early on, a cheap currency fueled export-led growth and a massive Chinese current account surplus. These days, the IMF considers the Chinese currency is fairly valued and the current account is essentially flat. 

Other goals, however, remain very much in line with what presidents of both parties have been trying to achieve for at least three decades: open access to China’s domestic markets and fair competition from Chinese exports abroad. Demands to end government subsidies, forced technology transfer and domestic preferences have long been talking points of U.S. trade delegations.

Previous administrations had also pursued a broader theory that Chinese participation in global markets and institutions would help – some more than others - to coax greater Chinese engagement in a system of genuinely free and fair trade.

So the real test of this brave new world of looming tariffs is whether it delivers lasting change in China’s behavior as the country grows politically and economically stronger. Unhelpfully, the economic conversations will be increasingly confused by cross-talk about North Korea, human rights and the South China Seas.

These complex issues are exemplified in the current standoff over Huawei and ZTE equipment exports. As China expands its role in global telecommunications technology, U.S. concerns about espionage and national security will look increasingly like hypocritical efforts to block a rising commercial competitor. The legitimate concerns on both sides will turn into entrenched animosity.

Already, the grumbling is growing louder that the United States is less interested in fair trade than in keeping China weak. There are patriotic calls in China to eat more tilapia that are now the subject of U.S. tariffs. On the U.S. side, there was a rare flash of bipartisanship as Senate Minority Leader Chuck Schumer joined the president’s Twitter feed to urge him to “Hang tough on China.”

This clash of civilizations may still be avoidable, and the president’s tougher line may still deliver better commercial results than his predecessors. We could get an interim verdict if a substantive agreement emerges this summer.

The issues that separate China and the United States are historical, systematic and unlikely to be resolved with one or more trade deals. It’s also hard to imagine that the permanent threat of tariffs will lead to a more predictable and cooperative world for investors. When new props are inserted into the narrative, we’re forced to follow Chekhov’s advice and expect more shots to be fired.