5/17/2019 Weekly Update: Globalization, Deficits and Tariffs

Weekly Recap

S&P 500                -0.75%

10 Year Treasury   +0.57%

Gold                      -0.65%

Volatility              +0.62%

Weekly Update: Globalization, Deficits and Tariffs

The week begin with a strong sell-off in global equities.  The S&P 500 was down 70 points on Monday or 2.5%.  The rest of the week was characterized by a slow, mean-reverting march back to levels we saw intra-day last Friday.  The S&P 500 ended down 0.75% for the week.

As the financial headlines, and Trumps twitter account, have been mostly consumed by our trade dispute with China this week, I wanted to touch the topics of tariffs, deficits and globalization.  Relatedly, I recently discovered the podcast The Knowledge Project, and I highly recommend it.  A recent episode is titled "Luck, Risk and Avoiding Losers" featuring the co-founder of Oaktree Capital, Howard Marks.  Marks covers several interesting topics within the realms of investing and economics, but he very cogently discussed the issues of tariffs, deficits and globalization in the episode at around the 30-minute mark.  I will paraphrase (italics) his remarks on globalization and deficits as I thought he used laymen friendly analogies.  I will add my own thoughts on tariffs specifically.

Globalization:

Let’s say you have two countries: Country A and Country B.  Country A is really good at raising sheep and country B is really good at turning leather into shoes.  Country A raises the sheep and sends the leather to country B to make the shoes and this symbiotic relationship produces 100 shoes per year.  Now let's suppose a politician in country A erects a wall and declares "No more trade in sheep, leather or shoes." Now country A needs to learn to make shoes and country B needs to learn to raise sheep to produce leather.  Now let’s say that in this new paradigm country A can only make 40 pairs of shoes and country B can only make 40 pairs of shoes because they are not only doing what they are good at.  They have to do what they are bad at.

This hypothetical, oversimplified example articulates the benefits of specialization in a global economy.  Everyone is better off from trade.  More goods are produced at cheaper prices. 

Trade Deficits:

The current administration states that the $797 billion trade deficit we are running with China shows that they are winning, and we are losing. They must be cheating us.  They are taking advantage of us and we are going to stop that.  This totally ignores economic reality.  When you go the barber shop and pay the barber $20 you, in effect, run a trade deficit with him.  He adds $20 to his balance sheet surplus will you walk away with a deficit.  On these terms you are worse off on paper, but you are happy because of your fresh new haircut.  We have run a trade deficit with China for decades and our businesses and consumers were not unhappy.  We have bought hundreds of billions more goods from China then they have bought from us, so we are in a deficit.  We would rather buy their goods because they are cheaper, and China is not very motivated to buy our goods because what we manufacture by their standards isn't better/cheaper.  We benefit from our relationship with China through the availability of cheaper goods for all American consumers.  

Tariffs

Trump recently stated that we are seeing such "tremendous economic numbers" because of the "billions and billions" of dollars we are collecting in tariffs.  This doesn't jive with reality.  Tariffs are generally paid by the consumers of goods or importers.  Companies raise prices, when able, to compensate for the higher costs they pay to import products from China.  The companies that can't raise prices have profits squeezed and may need to cut their labor force.  Trump touts that tariffs protect American jobs.  This may be true for a few hundred thousand jobs as importers, in limited cases, switch to more expensive American manufactures who will in turn need to hire more workers.  Are a few hundred thousand jobs a worthy trade-off for higher prices for hundreds of millions of American consumers?  That’s the economic choice we face but isn’t generally discussed.

What does need to change is the asymmetric transference of intellectual property between China and the US.  This has, for the most part, been a one-way street benefiting China and both political parties in Washington agree that something needs to be done.  Perhaps tariffs are the most tractable stick to incentivize change in this regard.

Thanks for reading,

Zach and Dave

Calibrate Wealth
515-371-5316  

https://www.calibratewm.com/blog-01

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