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There's a revealing puzzle in the China tariffs
ON Monday, China announced new tariffs on US$60 billion of US exports, and the United States threatened new tariffs on up to US$300 billion of Chinese goods. These actions were cited as the principle reason for a decline of more than 600 points in the Dow Jones industrial average, or about 2.4 per cent in broader measures of the stock market. With the total value of US stocks around US$30 trillion, this decline represents more than US$700 billion in lost wealth.
This was not an isolated event. Again and again in the past year, markets have gyrated in response to the state of trade negotiations between the United States and China.
Market sensitivity to threats and counter-threats in the trade war is quite remarkable. Monday's announcement by the Chinese, for example, would be expected to raise China's tariffs by about US$10 billion. Much of this will show up as higher prices for Chinese importers, and some of it will be avoided by diverting exports of goods such as liquid natural gas to other markets, so the impact on US corporate profits will be far less than US$10 billion. Meanwhile, US tariffs are likely to raise corporate profits as higher import costs push some business to domestic producers.
There is the further consideration that reasonable market participants should not have entirely discounted the possibility of tariff increases Monday and that there surely remains some chance a trade deal will be reached. So, in fact, the market should not even have moved in full proportion to the change in corporate profitability associated with new tariffs.
There is a revealing puzzle here. Events whose direct impact on corporate profits is a few billion dollars seem to be driving market fluctuations that change the total value of corporations by hundreds of billions of dollars. To be sure, there would be many ways of refining my calculation of the profit impact to recognise various forms of feedback, and certainly the imposition of tariffs increases uncertainty, which in general depresses markets.
But with any plausible calculation of the direct impact of tariff changes on profitability or uncertainty about profitability, it is not possible to justify the kinds of changes in market value we observed on Monday or on many other days when there was news about the status of the US-China trade negotiations.
Part of the answer to the puzzle, I suspect, lies in markets' tendency to sometimes overreact to news, especially in areas where they do not have long experience. This idea is supported by the tendency illustrated by the market's Tuesday rally, which took place without any particularly encouraging US-China developments.
A larger part of the answer probably lies in the idea that the current trade conflict is a possible prelude to a far larger conflict between the two nations with the largest economies and greatest power for as far as can be foreseen. When it appears less likely that a conflict over well-defined and ultimately not-that-difficult commercial issues can be resolved, rational observers conclude that it is also less likely the United States and China can manage issues ranging from 5G wireless technology to North Korea, from the future of Taiwan to global climate change, and from the management of globalisation to the security architecture of the Pacific region.
A world where relations between the United States and China are largely conflictual could involve a breakdown of global supply chains, a splinternet (as separate, non-interoperable Internets compete around the world), greatly increased defence expenditures and, conceivably, even military conflict. All of this would be catastrophic for living standards and would also have huge adverse effects on the value of global companies.
It is, I suspect, the greater risk of catastrophic medium-run outcomes, rather than the proximate impact of trade conflicts, that is driving the outsize market reactions to trade negotiation news.
This carries with it an important lesson for both sides: It is risky to turn the pursuit of even vital national objectives into an existential crusade. Rather, even when nations have objectives that are in conflict, it is important to seek compromise, to avoid inflammatory rhetoric and to confine rather than enlarge the areas where demands are being made. Establishing credibility that promises will be kept and surprises will be avoided is as or more important with adversaries as with friends.
As the Trump administration carries on the trade talks, and as the presidential campaign heats up, Americans should remember that there is no greater threat to the success of our national enterprise over the next quarter-century than mismanagement of the relationship with China. It is not just possible but essential to be strong and resolute without being imprudent and provocative. WASHINGTON POST
- The writer is a professor at and past president of Harvard University. He was Treasury Secretary from 1999 to 2001 and an economic adviser to President Barack Obama from 2009 through 2010