Trade Trumps Protectionism

Contrary to Presidential candidates' and pundits' claims, a trade war likely would wreak economic havoc.

Alright friends, we're going to talk about a touchy subject today: free trade. This topic has set off strong emotions and harsh rhetoric in both US political parties' primary debates, with candidates on both sides preaching fire and brimstone over trade deficits and job losses. We're told repeatedly that freer trade has hollowed out US industry, displaced workers, whacked wages and made everyone worse off. We're also told, from people in both parties, that high tariffs will restore factories, jobs and prosperity. When brave souls dare suggest tariffs could cause a crushing trade war, hurting far more than they help, they're bullied out of the building-sometimes by candidates promising to offset trade wars with strong central planning, sometimes by pundits claiming trade wars aren't calamitous because reduced imports boost GDP. While that is mathematically true, it errs in presuming GDP math accurately reflects economic well-being, ignoring imports' many contributions to actual economic activity. Trade is not about winners and losers. Supply chains are way too global for that. Markets will likely be happiest if this bellicose trade talk ends up being a load of hot air.

Now, when those for and against free trade make their case, they usually say something like "well this is impossible to prove with data since there are so many other variables, but..." When discussing things like displaced or added jobs, that's mostly true. While some jobs have been lost to trade, many others were victims of automation. US manufacturing output is at all-time highs and climbing. Our factories just do more with less labor, as robots do the heavy lifting. Trade and technology are impossible variables to isolate. Similarly, while imports create jobs in retail, logistics, services and-yes-factories, it's impossible to say how much job creation comes from trade versus normal cyclical drivers. So both cases end up being largely rhetorical, based on anecdotal evidence alone.

But thanks to the fine folks at the Organisation for Economic Cooperation and Development and the World Trade Organization (OECD and WTO), we have a compelling dataset to make the case for free trade. I refer to the Trade in Value Added database, or TiVA for short. The OECD and WTO worked with national statistics agencies in 61 countries to create a series showing how much foreign countries contribute to a given nation's exports. Few goods are manufactured start to finish in one country with 100% locally sourced materials. Firms import raw materials and components all the time. In one famous infographic, The Economist showed the geographic breakdown of an iPhone . While the final gadget is pounded together in China, the components hail from South Korea, Taiwan, Japan, Italy, the US and others. Yes, China imports American flash memory, touchscreen and audio components, mashes them with other things, and re-exports the whole shebang as a finished smartphone. This sort of thing happens all the time, and thanks to the OECD and WTO, we can measure the economic impact.

Study the database for any length of time, and it becomes abundantly clear that any country trading internationally has a symbiotic relationship with every last one of its trade partners. For example, politicians repeatedly whine that China has beaten us up and stolen our lunch money. And yet:

  • In 2011 (the latest year available), the US added more value to China's exports than any single country except Japan.
  • On a percentage basis and in dollar terms, the US added more value to China's exports than China did to US exports.

Does that really sound like a trade relationship that's killing us?

The global economy is far more interconnected than the protectionistas would have you believe. A picture is worth a thousand words, so here are some charts.

Exhibit 1: Foreign Value Added as a Share of Gross Exports, 2011

Source: OECD and WTO, as of 3/11/2016.

Exhibit 2: Breakdown of Value Added to US Exports, 2011

Source: OECD and WTO, as of 3/11/2016.

Exhibit 3: Breakdown of Value Added to Chinese Exports, 2011

Source: OECD and WTO, as of 3/11/2016.

Exhibit 4: Breakdown of Value Added to UK Exports, 2011

Source: OECD and WTO, as of 3/11/2016.

Exhibit 5: Breakdown of Value Added to Mexican Exports, 2011

Source: OECD and WTO, as of 3/11/2016.

Exhibit 6: Re-Exported Intermediate Imports as a Percentage of Intermediate Imports, 2011

Source: OECD and WTO, as of 3/11/2016.

From these charts, it should be fairly obvious that jacking up tariffs against China, Mexico, Japan or whoever else wouldn't just result in higher prices for all of us at Wal-Mart or Target. It would also severely threaten the many US firms that re-export foreign products. Their input costs would soar. Plus, rare is the country that takes a tariff lying down. It's fairly normal to respond in kind, raising retaliatory tariffs, adding administrative customs burdens or cutting import quotas. That would limit all firms' access to end markets. Mathematically it might not register in GDP, but it would hurt like the dickens for the actual companies.

The freer trade is, the better global supply chains function. When parts move cheaply and quickly from link to link, we all benefit. Consumers get cheaper goods, logistics firms get more business, factories find it easier to plan and expand, businesses are more willing to take risk, and more folks ultimately find work. The more barriers there are, the more commerce gets interrupted, and the more global production breaks down. Smoot-Hawley didn't cause the Great Depression, but the trade war it triggered caused shortages and sky-high prices while demand was down, exacerbating the downturn. The world was a lot less interconnected back then. A trade war now could set off even bigger chain reactions globally, creating a negative feedback loop.

Now, the simplistic argument against this line of logic goes something like "Yah, but if we just make everything here at home, then we're totally insulated!" In a world where central planning actually works and can effect change in an instant, perhaps that is true. But we don't live in some Communist utopia nightmare/fantasyland. We live in the real world, where things take time, life is messy and the private sector generates most economic activity. Russia learned this the hard way in 2014, when Vladimir Putin responded to economic sanctions by cutting off all food imports from the US, EU, Norway and Australia. He and Prime Minister Dmitry Medvedev promised Russians they'd be fine, because Russia could either import what it needed from Brazil and China or just produce more food. Neither of those hopes worked out, and Russians still face empty supermarket shelves. Moreover, 20th century history is littered with isolationist, centrally planned Communist nations that tried and failed to be self-sufficient. To say living standards and technology lagged is an understatement. Glasnost and Perestroika-less central planning and more trade-were the answer.

America's economic system relies on trade. So does most of the rest of the world. Imports and exports alike boost local manufacturing. They both create jobs, too. Trade policy that punishes imports would be like asking our economy to cut off a limb. Why would we ever want to handicap ourselves like that?

I don't want to panic you, so I'll leave this on a positive note. Candidates have a long, long, long history of saying radical things on the campaign trail and abandoning those pledges once in office. Several recent Presidents have run as loud protectionists, only to moderate and sign or shepherd free-trade deals once in office. Take, for example, the 2008 campaign. 2012's Republican primaries were twinged with protectionist notes from many candidates, including eventual nominee Mitt Romney. Talk this time is louder than four or possibly eight years ago, but volume doesn't make policy a post-election reality. (And remember, major trade hiccups like overturning NAFTA require passing a law.) Don't take any candidate's proclamations at face value. Keep an ear on what they say, as that impacts sentiment and the market's expectations, but what they do-and how that squares with expectations-is what will ultimately move stocks over time.

If you would like to contact the editors responsible for this article, please click here.

*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.