Trump wishes to see the Americans live a better life, which will be supported by higher GDP growth rate through his economic initiatives – how much higher? At 3%, it is a full percentage higher than what most economists believe is sustainable. While the tax reforms that he has undertaken would instill higher investment by domestic companies, we are not sure if they were needed at this point. The unemployment rate reached 3.8% in May, its lowest level in 18 years.

However, what mystifies most is his trade policy, which seems very haphazard and un-strategic. The biggest flashpoint of Trump’s trade policy is his incessant focus on reducing the deficit with China. He recently announced that he would impose a tariff on $50 billion worth of goods imported from China. However, he hasn’t stopped there and is now gunning for the steel and automobile imports – political sensitive sectors? The affected countries, in this case, are natural allies of the US and spoiling relations with these countries will be a fallout of his vague policies. What are his goals? Is he looking to reduce the deficit with certain countries or looking to increase employment in certain sectors? His responses and priorities change frequently as if he wakes up as a new person every day.

His trade policies only have a downside

The retaliatory global response to the tariff announcement threatens to isolate the US and ruin relationships with its strong allies in Europe and Canada. Below we examine the impact of the ensuing trade war on some important parameters:

• Trade deficit: The tariffs will reduce imports as higher tariffs will make imports less lucrative. However, the retaliatory response will surely lead to a fall in exports as well. The European trade commission has stated that it won’t be returning to the negotiating table and will now look for a united response by Europe. The French president has called the tariffs “illegal” while Mexico and Canada are looking to prepare their own responses. Germany has adopted a somewhat mellow approach so far despite being the EU member to suffer the biggest casualty of a trade war. The overall impact on trade deficit will unfold in the months to come. The US has been running a trade deficit for decades continuously now, which is not a bad thing per se but a structural impact of its economy – Americans typically spend more than they save.
• Economic output: Most economists are of the view that changes in trade policy are unlikely to have a positive effect on employment and GDP. In fact, they believe that liberalizing trade will benefit the economy more. History has been a witness that during times of a trade war, global GDP takes a beating and the US, given its strong linkages to the global economy (the FAANG tech group makes significant money outside the US) will not remain isolated. Also, while steel and aluminum make up for a tiny fraction of the economy stand alone, it goes as a key input into several products. An increase in tariffs will push up raw material cost, which will eat into margins and negatively impact the economy.
• Global investment: Trump does not understand that global trade and investments are based on rules; rules that if become uncertain will make it difficult for investors to commit money to global supply chains. Case in point is Electrolux, which pulled from a planned $250 million investment in a cooking factory in Tennesse. Another example is foreign investment in the UK, and how it dropped considerably once Brexit was announced – uncertainty breeds non-commitment.
• External relations: Trump is not satisfied by reducing the deficit with China alone. He wants to extend tariffs to other major trading partners too. For instance, he wants to proceed with higher tariffs on imported cars (which primarily targets Germany, UK, France). The US imported cars worth $20.2 billion from Germany and $8.6 billion from the UK last year. Then, he wants higher tariffs on imported steel and aluminum, which will curb imports from Mexico, Canada, and the EU. Scrapping NAFTA will also impact car manufacturers with plants in Mexico and Canada. All this is only going to make its biggest allies unite in their fight against the US.
• Inflation: China recently remarked that the trade war the US has begun will have “no winners”. We believe this is especially true for consumers who will likely see higher prices for several items ranging from cars to scotch. By moving production and assembly back to the US, end cost of goods will also increase domestically. When considered in conjunction with the recently announced tax cuts, which should boost investment and spending, inflation seems to be heading upwards.
• Interest rates: Could be higher. There are two things at play here – first, the US interest rates are currently at a very low level and others things remaining same, the Fed will likely increase rates given the 18-year low unemployment rate at 3.8%. Second, tariffs will likely increase prices of several goods both within the US and of imported goods. This should likely lead to higher inflation, putting further pressure on the Fed to raise rates.

What can happen next?

Energy to the rescue. The US has emerged as the largest crude producer in the world. In addition, China continues to remain the largest crude importer. Furthermore, China prefers the sweet variant produced by the US shale industry, thus there is a strong likelihood of it importing more crude from the US. China is also a substantial importer of LNG, a need which is largely met by Australia currently. As it rebalances its import mix to appease the US, we could see the US increasing its exports of both oil and gas to China in the years to come. This may explain why the US Treasury Secretary had earlier announced putting the plan to curb Chinese imports “on-hold”.

China may gain larger clout. By focusing so blindly on the trade deficit, Trump has alienated his closest allies, which are likely to develop stronger ties with China. This may lead to the opposite of what Trump may have intended to do, i.e. it may lead to China gaining a bigger role in global trade. It’s Belt and Roads initiative is a step towards achieving this. It already has an ambitious plan for increasing its share of global trade in Vision 2025 plan, which apparently acted as a blueprint for the US’ plan to curb Chinese dominance!

Global retaliation would lead to an economic calamity. The EU, Canada, China, and Mexico – most affected countries from the higher tariffs will likely respond with a quid-pro-quo tariffs on US exports. This will likely spiral to a trade war, which has the potential to cause a global crisis.

Collapse of rules based system. What started as an exercise by the US to reduce trade deficit through curbing imports from its largest trading partner China, is now threatening to envelop the entire world. Under the vague umbrella of “national security”, the US appears to introduce tariffs on pretty much anything – from steel to scotch and now imported cars.  The actions were taken by the US violate the principles of WTO, a quid-pro-quo trade war may undoubtedly lead to the collapse of the WTO. Even if the US manages to squeeze China and make it sign a definitive import list to curb the deficit, it would still be a violation of WTO principles, which is against “managed trade” and bilateralism. The lack of a regulatory body, such as the WTO, governing trade rules would be disastrous.