Monday, May 13, 2019

U.S. and China play Trade Chicken, and both are likely to win

Global markets are in the midst of another panic attack that appears to be the direct result of an escalating game of trade-war chicken between the US and China. Who's likely to win? I believe the odds are in favor of the U.S. winning, especially since a trade deal with China to Trump's liking is likely to end up being a win-win for all concerned.

The vast majority of economists would agree that the best trade policy is free trade, with no tariffs, barriers to entry, or subsidies. Free markets and global trade have proven to be the best way to promote global prosperity. Tariffs are best viewed as a tax on imports, with the cost being paid by the consumer, not by the producer. Taxes serve only to reduce private consumption in order to fund public consumption, which in the end is less efficient. The country that taxes its imports least is therefore the country that will benefit most from trade. By the same logic, countries that subsidize their exports only hurt themselves while benefiting those who buy their subsidized goods and services. (We should welcome any country's subsidies!)

The vast majority of economists would also agree that there are second-order effects that stem from tariffs. By making imported goods more expensive, countries that impose tariffs on imported goods give domestic producers a degree of "protection" to the extent domestic producers can charge higher prices and still compete with imports. But this only reinforces the argument that at least part of the cost of tariffs is born by consumers. Protectionists also argue that tariffs save jobs—and to some extent they do, in the "protected" industries—but only at the expense of consumers. Tariffs, in short, benefit a relative few at the expense of the many.

Trump understands this, and said so at the G7 summit meeting last year: "That’s the way it should be, no tariffs, no barriers … and no subsidies. ... that would be the ultimate thing." The only way to understand Trump's apparent love for tariffs today is that they are, as Larry Kudlow noted a few months ago, "a negotiating tool. They are part of his quiver." And tariffs are a policy tool over which Trump has direct control. That makes tariffs irresistible to deal-maker Trump.

A war of escalating tariffs between the US and China would be damaging to both countries. If carried to an extreme, a tariff war with China would most likely endanger the global economy by weakening both the huge U.S. and Chinese economies. Bad! And in that sense Trump is crazy to be engaging in a tariff war with China. Worse, he falsely argues that his tariffs are paid by the Chinese and that the money goes straight to the federal government's coffers. To his credit, Trump's economic advisor (and my good friend) Larry Kudlow yesterday correctly admitted that tariffs are in fact paid by U.S. consumers, not the Chinese. But he also correctly added that higher U.S. tariffs will hurt the Chinese as well. So the question then becomes, Who will suffer the most? Who will likely back off from this game of chicken the first?

Tyler Cowen is a well-respected economist at George Mason University who has a reputation for not having a partisan bias. Today he wrote a column for Bloomberg (which certainly does have a strong liberal bias) in which he argues persuasively that China stands to lose more from a trade war than the U.S. does, even though it is clear that Trump's higher tariffs on Chinese imports impose burdens on U.S. producers and consumers.

Here's Cowen's conclusion (read the whole thing for the important details):

In my numerous visits to China, I’ve found that the Chinese think of themselves as much more vulnerable than Americans to a trade war. I think they are basically correct, mostly because China is a much poorer country with more fragile political institutions.
My argument isn’t about whether Trump’s policy toward China is correct. I am only trying to get the basic economics straight. Next time you hear that the costs of the trade war are simply being borne by Americans, be suspicious. In their zeal to make Trump look completely wrong, on tariffs or other issues, too many commentators pick and choose their arguments. A more fair and complete economic analysis indicates that China is also a big loser from a trade war. Trump’s threats are exerting some very real pressure on the country.

Markets are usually efficient at discounting the future, if only because they reflect the consensus of millions of participants with skin in the game. Right now they are saying that although both the U.S. and Chinese economies are hurting, the Chinese are hurting more.

Chart #1

Chart #1 compares the value of yuan vis a vis the dollar (blue) with the level of China's foreign exchange reserves (red). Here we see that since the beginning of the U.S.-China tariff war (March-April 2018) the yuan has fallen by about 8% vs. the dollar. That means that the amount of yuan that Chinese producers receive for each dollar of sales to the U.S. has fallen by 8%. This chart also shows that China's foreign exchange reserves have been relatively stable for the past 30 months, at just over $3 trillion. China's central bank is apparently targeting a stable level of reserves, and allowing the yuan to fluctuate in value as capital attempts to enter or leave the country (this is a legitimate monetary policy, though one not often used). The weaker yuan thus directly reflects weaker net investment in China and a loss of Chinese purchasing power. Bad!

As Cowen notes in his column, China's lack of "guarantees against espionage, intellectual property theft and unfair legal treatment ... makes investing in China less desirable for many multinationals, not just U.S. ones." If China were to agree to Trump's demands in these regards, its economy would almost certainly benefit from increased investment and a stronger yuan. Good!

Chart #2

Chart #2 compares the value of the MSCI China Index (in HK dollars) to the value of the S&P 500. Chinese equities have greatly underperformed their US counterparts since China's "opening" to the world in 1995. Moreover, since the US/China tariff war started last year, Chinese equities have fallen by almost 18% relative to US equities. Equity markets are clearly saying that China will be the biggest loser.

Chart #3

Chart #3 shows that Chinese exports to the US and imports from the US have both fallen since the beginning of Trump's tariff war (in dollar terms). This is the result not only of a reduced volume of trade but also the yuan's reduced value. US/China trade represents a far greater share of China's economy than it does of the US economy: China's exports to the US are roughly 4 times greater than China's imports from the US, while the US economy is roughly half again as large as China's. China thus stands to lose much more from any trade disruptions.

Chart #4

Chart #4 quantifies the market's renewed sense of unease over trade relations. Though not yet as acute as what we saw late last year, it's a similar pattern. Rising fears are driving down the value of equities.

Meanwhile, swap spreads and credit spreads remain relatively low. Liquidity conditions have not deteriorated, the Fed is not too tight, the dollar is not collapsing, and the US economy is likely to continue growing. What we see in the markets today is another panic attack which will likely be assuaged once the Chinese figure out a face-saving way of capitulating to Trump's demands. That shouldn't be too hard, since it ultimately will lead to a positive result for both the US and Chinese economies.

Wednesday, May 8, 2019

Bye Bye Misery

This post is a paean to progress. The average person living in the U.S. has never had it so good, by any number of measures.

Chart #1

The Misery Index was invented decades ago by Arthur Okum, and it originally consisted of the CPI inflation rate plus the unemployment rate. A low reading means that inflation is low and unemployment is low, and that brings a measure of stability to the life of the average working person. I've made a minor modification to that in Chart #1, substituting the rate of inflation according to the Core Personal Consumption Deflator (which also happens to be the Fed's preferred measure of inflation. But no matter how you calculate it today, the Misery index as low as it has ever been in my lifetime. Both inflation and unemployment are very low, and that is great news for the average person.

Chart #2

Chart #2 is the result of dividing first-time claims for unemployment by the total number of people working. This is akin to the probability that the average worker will find him or herself unemployed in a given month. Currently that probability is less than 0.2%. It's never been so low, by a long shot.

Chart #3

Chart #3 is a picture of the average worker's nirvana: when there are more job openings than there are people looking for work. This, plus the fact that unemployment is very low makes the current environment the best time in many generations to be looking for a job.

Chart #4

When I was 10 years old, over one-quarter of the average person's annual spending went for food and energy, as shown in Chart #4. Today, thanks to drilling advances, modern agriculture and greatly expanded global trade, that figure has come down to just over 10%. Wow.

Chart #5

Despite our materialistic lifestyles and ever-rising consumer debt, the average household's financial burdens today are no higher than they were 40 years ago, as shown in Chart #5.

Chart #6

Chart #6 illustrates the relative behavior of the prices of services, non-durable and durable goods since 1995, which not coincidentally happens to be the year that China started exporting durable goods to the world in earnest. If you consider that services prices are basically driven by wage and salary income, then one hour's worth of labor today buys about three times more durable goods than it did in 1995 (1.84/0.62). I don't know of any measure of material progress in recent years that is more impressive than this. Is there anyone who can't afford a flat-screen TV or a cellphone these days?

Chart #7

But what about the supposedly huge increase in income and wealth disparity? Well, the rich may be getting richer than the poor are getting richer, but they are picking up the lion's share of the $3.3 trillion in taxes collected by our federal government in the past 12 months, as Chart #7 shows. According to the Tax Policy Center (a joint venture of the left-leaning Urban Institute and the Brookings Institution) the top 40% of income earners pay 86% of all federal taxes, while the bottom 40% pay only 14%. If you want to narrow that down to the top 20% and the bottom 20%, the tax disparity is even more dramatic: the rich pay over two-thirds of all federal taxes, while the poor pay less than 1%. Politicians have just about run out of room to increase rich people's "fair share" of the total tax burden, which I suppose should be added to the list of things to be grateful for these days.

UPDATE: For more on how things have improved dramatically over the years, I recommend the Cato-sponsored Human Progress site.

Thursday, May 2, 2019

Productivity makes a comeback

Productivity is essential to economic growth and progress, so it's great news that productivity has picked up in the past two years. Productivity happens when an economy produces more from a given level of input, and that in turn usually means that businesses have invested in productivity-enhancing things such as machinery, tools, and computers, all of which allow workers to produce more with a given amount of effort or time. Productivity is also likely to result from a reduction in the costs of running a business, and that in turn usually means less red-tape, and reduced tax and regulatory burdens. Rising confidence can also help, since that helps give people the courage to work harder and take risk. Rising confidence can also make entrepreneurs more inclined to start new businesses and expand existing ones.

Chart #1

Happily, business investment has picked up in recent years, tax and regulatory burdens have declined, and confidence has surged. Even though jobs growth hasn't picked up much, if at all, in recent years, output has (see Chart #1). That's productivity in a nutshell: getting more output from a given amount of input.

Chart #2

Today we learned that first quarter productivity rose at a surprisingly strong 3.6% annual rate. Chart #2 shows the year over year change in productivity, and how the recent pickup coincides with the beginning of the Trump Administration.

Chart #3

However, productivity can be and usually is a volatile statistic on a quarterly and even annual basis, which is why I like to use a 2-yr rolling average (see Chart #3). I've also added recession bars in this chart, since they show how changes in the trend growth of volatility have a lot to do with the business cycle (not surprisingly). Productivity typically picks up after a recession ends, and it usually—but not always—fades as the business cycle matures. The current business cycle got off to a bang with very strong productivity growth in the last three quarters of 2009, but then it quickly faded, only to experience sluggish growth for the next 5+ years. It's picked up meaningfully in the past two years, and we are likely still in the early innings of a great productivity comeback.

Chart #4

Chart #4 reduces the volatility of productivity even more, by using a 5-yr rolling annualized average.  This captures the important growth trends which persist for years. The chart also overlays the many different presidencies we've had in the post-War period. I've color-coded each presidency using red for presidencies that saw productivity fall, and green for those that saw productivity rise. The Reagan and Clinton years stand out for their sustained increases in productivity, while the Bush II and Obama years stand out for their sustained productivity declines. This is very instructive: the pro-growth policies of Reagan and Clinton (mainly in his second term) worked because they incentivized private sector work, investment and risk-taking, and that in turn boosted productivity and living standards. Bush II and Obama policies were anti-growth, characterized by increased tax and regulatory burdens and a more intrusive state.

In Trump's first two years there has been a huge and unprecedented reduction in the number of federal rules with adverse economic impacts put into effect, as documented by the GWU Regulatory Studies Center (see Charts #5, 6, and 7):

Chart #5

Chart #6

Chart #7

Chart #8

As Chart #8 shows, Trump's election marked a sea-change in consumer confidence right around the time that productivity began to turn up. We saw a similar improvement in confidence halfway through Clinton's Administration (1997), and that too saw a big pickup in productivity and economic growth.

Chart #9

As Chart #9 shows, Trump's election coincided with the biggest increase in Small Business Optimism in decades. Small businesses are the biggest source of jobs and innovation.

The productivity stars are aligned: rising confidence and reduced tax and regulatory burdens have created the conditions for a big productivity comeback that could last for years. We're just beginning to see the results, and they are encouraging. This gives the economy plenty of upside potential, which in turn means that living standards for nearly everyone should be improving for the foreseeable future.

Memo to all those would-be socialists eyeing the 2020 elections: income redistribution, higher taxes, increased regulations, mushrooming bureaucracies and handing out freebies (e.g., free college, student loan forgiveness, single-payer healthcare) don't create the conditions for increased productivity and rising living standards. On the contrary, they will only make things worse for everyone.