Bank for International Settlements tackles protectionism

This speech by Agustin Carstens, General Manager of the Bank for International Settlements,  is well worth reading.  Speaking at the Kansas City Fed's Jackson Hole conference, Carstens spelled out the reasons why recent trends in international trade alarm him, "as they no doubt alarm many of you":

"Reversing globalisation puts at risk the real economic gains that have come about through closer trade and investment links. This could increase prices, raise unemployment and crimp growth. Retreating into protectionism also risks unravelling the financial interdependencies that enable and encourage trade and investment links. This threatens to unsettle financial markets and put a drag on firms’ capital spending, as investors take fright and financial conditions tighten. Finally, these real and financial risks could amplify each other, creating a perfect storm and exacting an even higher price."

Following Carstens' example, let's take inflation first:

"The globalisation of firms and markets has no doubt contributed to the persistently low level of inflation in recent years. Low inflation has been driven by two long-term forces: trade and technology. Fostered by liberalisation, increased trade openness and, in particular, competition from imports produced in countries with lower wages, drove down prices in advanced economies......"

"...technological advances, especially automation in manufacturing, have brought down global production costs. These two forces go hand in hand. Innovation and more open markets have radically reshaped global production, replacing locally segmented manufacturing with global value chains. These depend on financial openness. They have put downward pressure on firms’ production costs and market power, keeping in check both prices and, ultimately, aggregate inflation....."

".... Seeking to turn back the clock and to retreat to a simpler world of local production may undermine the market discipline that helped curb inflation."

Carstens argues that US tariffs will push inflation higher, forcing the Fed to tighten monetary policy in response.  That in turn would cause the US dollar to strengthen, leaving US manufacturers facing a double whammy in the form of an uncompetitive exchange rate and the retaliatory tariffs imposed by US trading partners. Trump's criticisms of Fed rate hikes may mean that he is dimly aware of this, but rather than admitting the main cause of the problem -- the tariffs -- he seems more likely to attempt to browbeat the Fed.

As regards the impact of tariffs on growth and incomes, Carstens makes reference both to investment and income inequality:

"The uncertainties of turning back the clock imperil investment in advanced economies too, as companies put on hold plans for new or expanded production. Orders for capital goods, although volatile, are showing signs of a distinct deceleration this year from last year’s brisk growth in the United States, Germany and Japan..."

"...Retreating into protectionism, by raising tariffs and ripping up trade agreements, will not fix inequality. For example, as a just-released BIS working paper finds,  revoking the North American Free Trade Agreement (NAFTA) would create only losers, certainly at the national level in Canada, Mexico and the United States, but also generally across North American regions. While higher trade barriers would shield some domestic industries from import competition, the resulting wage gains would be more than offset by the damaging effects of reduced export opportunities and the increased cost of imported inputs for manufacturing firms..." 

A remarkable graph in Carstens' paper shows that of 435 US Congressional districts, only THREE would not see a decline in real wages if NAFTA were revoked.  The graph also shows that Canada and Mexico would, unsurprisingly, suffer somewhat worse than the US in that event. Given Trump's indifference to inequality and to the fate of his neighbours, it is unlikely that this will carry much weight in the White House.

Lastly, the risks to financial markets:

"....Trade in commodities and finished goods requires only simple financial services, such as cross-border payments and foreign exchange. But complex trading relationships....need complex financial services to glue production processes together.  The far-flung operations of multinational firms, which account for an increasing share of trade, require lots of working capital and entail lots of exposure to foreign currency risk.  More complexity is added by the financial transactions needed to manage these positions, including derivatives and hedging strategies to offset currency risk. 

All these links rely on the dollar, which remains dominant in trade transactions or bank loans for working capital, and in international banking or securities markets more generally.  Indeed, in currency markets, the dollar prevails even more in the swap and forward markets than in the spot market." 

Carstens offers examples of financial risks taken directly from recent headlines: the gyrations of the Mexican peso in response to trade developments, and the impact of tariff-induced commodity price rises on the share price of General Motors.

Having laid out these risks, Carstens closes with two short summary sections. The first, titled "A perfect storm?", warns of the risk that trade tensions could trigger all-out currency wars, with "implications for everybody".  And even if the worst case is avoided, Carstens is in no doubt that the net impact of the trade war that the Trump administration seems bent on causing will be negative.  His final section, titled simply "Pain not gain", ends with an unequivocal forecast:

".... in the long term, protectionism will bring not gain, but only pain. Not just for the United States, but for us all."

It's a short paper -- just nine pages, with lots of pretty pictures -- but sadly, that probably won't help it to gain any attention in the Oval Office.