There is plenty to ponder about President Donald Trump's impact on global politics, but in the realm of economics, there are grounds to wonder if his administration will make quite as much difference to the rest of the world as either Trump promises or his critics fear.
Trump has pledged to get US GDP growth to 4%, a rate that could raise global growth by as much as 0.5%. But this, his most important economic promise, will be very tough to keep.
In the four quarters to the end of last year, US GDP increased by just under 2%; half the rate Trump seeks. GDP or output growth is generated by increasing numbers of workers and increased productivity by those workers. The US Bureau of Labor Statistics says the US workforce will grow at an annual average of 0.5% over the next decade, compared to 0.6% in the previous ten years. The arithmetic is straightforward. If the workforce grows at 0.5%, then to sustain 4% output growth the US needs labour productivity growth of 3.5%. The US has, briefly, attained annual productivity growth of 3% or more several times in the last 20 years (always when coming out of recession). The average rate during that period, however, is 2%. In the last five years, productivity growth has averaged just 0.6%.
In recent years the US has only been able to attain 2.5% output growth by running down unemployment. But unemployment is now under 5%, and wages growth is already picking up. No doubt if the economy is running hard, many workers who have dropped out of the workforce will be drawn back in, and many part-time workers will take full time jobs. Even so, employment growth can’t sustainably run much faster than the growth of the US workforce. Without a very big rise in productivity, 4% output growth in the US won’t happen.
So what is there in the program promised by the Trump administration that could fire up productivity so substantially in the next three to four years? The short answer is not much.
Even if the President’s proposed infrastructure program makes a material difference to US infrastructure spending – and I doubt it will – it will take years to plan and then build projects. The effect in the first instance is on total demand, which in the US is not really the problem. Once completed, new infrastructure should help productivity, but this would not occur until well into the second term of a Trump administration, assuming re-election in 2020.
Big company tax cuts might make a difference to business investment by increasing expected returns on such investments. But again, the higher investment - if it materialises - will be a long time coming, and it will take more time still for it to lead to higher output per worker. Moreover, the corporate tax plan favoured by House Republicans is intended to be revenue neutral, so there is no reason to expect it would have a net impact on investment.
The Trump administration may introduce personal income tax cuts favouring the rich, but US business investment has been sluggish in recent years, while the rich have got richer. It isn’t sensible to expect business investment to increase now, just because the rich expect to do even better.
Nor, for all the virulent criticism of the Federal Reserve, is the Trump administration likely to make a difference to the trajectory of interest rate increases. The ruling sentiment among Trump’s economic people is that quantitative easing was wicked and very low interest rates are wicked, so it is very hard to see this White House attempting the change the path of gradual tightening, even if it could. A Trump appointee to replace Janet Yellen next year might well want to raise rates more rapidly.
All up, the likely pattern over the next four years is US GDP growth not much faster than 2.5%, higher interest rates, and a higher US dollar.
These conclusions are widely shared. Markets expect the US dollar to continue to strengthen, and US bond rates to continue to firm. With very few exceptions, forecasts expect US growth to remain well under 3%. In its January update the IMF revised up the US 2017 GDP growth forecast to 2.3%, from its earlier forecast of 2.2%. It expects 2.5% in 2018.
It is true that US GDP growth was faster during the Reagan years, and so was productivity growth. Some Trump adherents imagine those good old times will be back. But the Reagan years began with deep recession, a modest and declining budget deficit, high unemployment, idle factories and high interest rates. There was room to dramatically cut interest rates, expand the deficit, and reduce unemployment. President Trump begins with a deficit that is expected to double as a share of GDP over his first term, according to the Congressional Budget Office. Interest rates are rising, and with them the US dollar. His promised programs are designed for an economy with high unemployment, slack demand and plenty of idle resources. This is the economy Trump depicted during the election campaign, but it is not the actual US economy.
Trade and border taxes
What about trade? Trump campaigned on making a difference to the US import/export mix, promising to bring manufacturing home and to renegotiate 'unfair' trade deals. If he succeeds that too would make a big difference to the rest of the world.
Right now, Trump’s threat of higher border taxes on imports from Mexico and China seems to be merging into the House Republicans' ‘border tax adjustment’, part of the proposed rewrite of US corporate taxes. This House version (which preceded the Trump administration) is effectively a 20% tax on imports. It is not a tariff and does not discriminate against particular countries. It works through corporate profits tax. In the House plan, the calculation of taxable corporate profit would exclude revenue from exports, but include the cost of imports. The import component of a business would effectively be taxed at the corporate tax rate (20% in the House proposal), while export revenue would be 20% more remunerative compared to revenue from domestic sales. Since the US runs a trade deficit, the House proponents argue that the gain in revenue from excluding imports from costs would outweigh the loss of revenue from excluding export income from sales. This net gain would enable a cut in the corporate tax rate, with no loss of revenue.
One might suppose that if imports became markedly more expensive Americans would buy fewer of them, and if exports became more profitable they would rise. The trade deficit would then decline - and with it corporate tax revenue. But the proponents say this won’t happen because the US dollar exchange rate will rise making imports cheaper and exports more expensive, and the trade deficit will be as before. Maybe, maybe not.
The House plan is not really worth analysing in detail because it is highly unlikely to be adopted. It’s hard to sell a tax change that, according to its proponents, will drive up prices in Walmart until such time as a US dollar appreciation drives them down again. The opposition from importers will be too ferocious and support from exporters too half hearted. But even if it was adopted and did indeed work the way its proponents say it will, it ought not trouble America’s trade partners. If the Congress and the Trump administration really did create this new corporate tax code, it would be mostly a problem for the United States rather than the rest of the world.
Bilateral trade negotiations likely to take precedence
So it’s possible the 20% import tax won’t discriminate against particular trade partners such as China and Mexico, and may not affect the level of imports overall. More likely it won’t be adopted at all. Instead the Trump administration will concentrate on its promise to pursue bilateral negotiations with trade partners. When the US pursued this in the past, for example during the Reagan administration, it successfully pressed Japan, Taiwan and Korea to increase their exchange rates. It also pressed them to move some of their production for the US market to the US, again successfully. It pressed for 'voluntary restraints' on some exports to the US, including autos and steel. These outcomes perhaps made a bit of a difference to the US but not a discernible difference elsewhere.
I expect the Trump administration will follow this line with Mexico and China though the circumstances relating to each are very different. Mexico is the second biggest markets for US exports. US direct investment in Mexico is twice as big as in China. The US has a trade deficit with Mexico, but not a really big one. Compared to the impact of imports from China since 2000, the impact of Mexican imports on the US is relatively minor. Much of Mexico’s production for the US market is from US firms in Mexico. All these considerations suggest any changes from trade negotiations with Mexico will be cosmetic.
The China story
China is a different, more complicated and much more important story. Depending on the measure, it is now the first or second biggest economy in the world. It is the third biggest market for US exports, but the US trade deficit with China is still very big. US direct investment in China is much less than half its direct investment in Australia, a relatively small economy. China’s direct investment in the US has been increasing while flows the other way have been flat or falling. As Brookings’ David Dollar argues, the obvious path for the US is to demand a bilateral investment agreement that opens more China industries to US investment and increases protections for US intellectual property in brands and technology. If the US is successful, China’s other trade partners will benefit because it is difficult to deny concessions given to one trade partner to others.
But negotiating options are more limited when it comes to goods trade between the US and China. There is a vast range of Chinese manufactured exports to the US which American households depend upon – cheap clothes and shoes, phones and computers. It includes much of what is sold by Walmart and Home Depot. They cannot be replaced by US products, or not in the price range. A big tariff increase to make them more expensive would most hurt the low and medium income voters who got Trump over the line.
And while China will quietly do all it can to accommodate the Trump Administration on trade, it cannot be seen to publicly buckle to a threat of punitive tariffs. The US is China’s largest export market but it still accounts for less than a fifth of its China’s exports. All exports account for around one fifth of China’s output, so China’s direct trade export dependence on the US is less than 4% of China GDP. In a trade negotiation it might voluntarily restrain exports to the US of products the US also makes, such as steel and aluminium. It will take the existing investment talks more seriously if the US insists, though China will probably draw the negotiations out over several years. China may well be willing to do as much as it can to sufficiently placate the Administration to permit it to move to developed country trade status, a change that would set a higher base for figuring if China is dumping steel and other products on world markets. Beyond that, it is not at all clear where a trade negotiation might go, without hurting the US as much as China.
At some point the Trump Administration will have to confront the fact that not only is the US economy is in better shape than Trump depicted during the campaign – so too is US manufacturing. Manufacturing employment is well down, but US manufacturing output has never been higher than it is today. Compared to the year 2000, when China achieved WTO membership and China’s manufactured exports to the US began to rapidly increase, US manufacturing output is nearly one third higher. As a share of GDP US manufacturing output has fallen, but not by much. It accounted for 14% of US GDP in 2000 and accounts for 12% now. Because of the rapid growth of services in developing economies, world manufacturing as a share of world GDP has declined much more than in the US. The implication, of course, is that the US has vastly increased productivity and competitiveness in manufacturing by moving out of labour intensive production. It will never go back. China is now moving to do the same, as highly labour intensive work moves to Vietnam, Cambodia, Bangladesh and other lower cost producers. In the privacy of their offices, Trump administration officials will have to ask themselves what they could possibly achieve by a 40% tariff on China’s exports to the US that could even remotely be in the interests of the US or the voters who elected Trump.
No doubt the Trump administration will huff and puff on China’s exchange rate – though it is interesting that the new administration has not declared China a currency manipulator 'from day one', as it promised. But if the US dollar is rising against most other currencies, as it has been for the last two years and will likely continue to do for a while yet, it is unreasonable to insist the Chinese Yuan keep up. In the IMF’s view, the Chinese Yuan is no longer undervalued. As state and private businesses in China increasingly invest in the rest of the world, Chinese authorities have had to sell US dollar reserves to prevent the exchange rate falling. Were China to move to a clean float, unlikely soon but the eventual goal of policy, the exchange rate would at least for a time likely be lower rather than higher than today.
So long as these trade bilateral trade negotiations don’t get completely out of hand, China’s other trade partners will quietly cheer the US on. Under existing trade arrangements, there is formal and informal pressure for both the China and the US to extend trade concessions agreed with one partner to its other partners. This is part of the domino process of trade agreements.
Time to move on from the TPP
President Trump’s disavowal of the Trans Pacific Partnership was loudly lamented by its 11 other participants, including Australia and Japan. The TPP was touted as the third biggest trade bloc in the global economy, after NAFTA and the European Community. Australia’s Turnbull government was particularly bothered by the US exit, though total Australian exports to all 11 putative TPP members is markedly less than Australia’s exports to China and Hong Kong. On the most cheerful estimate (the World Bank’s), the TPP would have increased the GDP of its members in 15 years' time by an average of 1.1%. That sounds useful, except that, even in a comparatively slow-growing economy like Australia’s, GDP will in the ordinary course of things will be at least 40% bigger in 15 years than it is today. Vietnam’s output may have doubled. The extra one 1.1%, if indeed one thinks the models can sensibly predict the impact so far ahead, would not be noticed.
For Australia the TPP was always a sideline trade deal which had the unfortunate effect of diverting Australian trade attention away from the far more important long term issue of economic integration into the rapidly growing economies of Asia. Its collapse gives Australia an opportunity to switch the focus back to where it ought to be, which is basically China. Far and away the biggest gains to regional trade can be achieved through a regional trade agreement, the clumsily named proposal for Free Trade Area of the Asia Pacific (FTAAP).
The proposal for an APEC region preferential free trade area originated in the US. While not vigorously pursued, it was endorsed by both the Bush and Clinton administrations. It is now supported by China, though also not vigorously pursued.
The one country in the region with the capacity and repute to drive negotiations on a regional free trade agreement is Australia. China, the US and Japan are too big. They view each other with deep suspicion as trade rivals, and the smaller economies are suspicious of all three. Trade bureaucracies in the ASEAN economies do not usually have the necessary range, depth, experience and access to government authority to create the architecture and schedule for a major regional trade negotiation. Australia took the initiative with APEC, and can again with an Asia Pacific free trade negotiation.
Given the views of the Trump administration, the US will not be part of an early round of talks. But if the talks continue the US will have no choice but to join, a very useful by product of a regional negotiation. There is an opportunity for Australia and like-minded countries to get busy on a regional FTA, one which would be a serious enhancement to the economies which account for well over half of global GDP.
The big cloud on the horizon
The one economic policy aspect of the Trump administration (and it is one favoured by the Republican-controlled Congress) that does present very serious risks is the intention to undo much of the financial reregulation enacted since the 2008 financial crisis, including the constraints on investment and commercial bank speculation, higher capital requirements and so forth. It may remove the Volcker rule which discourages banks from running large speculative positions. In yet unspecified ways, it plans to undo much of the rest of the 2010 Dodd-Frank legislation. This legislation imposes stress tests on banks, and discourages proprietary trading.
During the crisis Goldman Sachs and others like it became insured banks. Merrill Lynch merged with Bank of America, an insured bank. To now weaken or remove the constraints on leverage and on speculating using the house book pretty well guarantees another global financial meltdown, sooner or later. Asked about the plans Trump said he planned to 'do a big number' on Dodd-Frank. 'The American dream is back,' he said, worryingly. On Friday he signed an executive order to begin removing regulatory constraints.
