Since Brexit, there has been a growing debate about the usefulness of current economic thinking. The basic story seems to be that the economics community broadly failed to forecast the 2008 financial crisis and the subsequent global recession. They were wrong to predict such bearish outcomes if the UK did indeed vote to exit Europe. They are completely out of touch with Main Street and simply don’t understand the economics behind the rise in populist/nationalist politicians. Why should we trust anything they say? Well, as one economist retorted (and I paraphrase here), “we may not be able to predict the future, but we know the facts”.
What follows is a rather dry look at what Trump’s trade policies may mean for both the US and the rest of the world but we believe that this is one of the most important issues for investors to understand. In fact, we think that Trump’s trade policies may well signal the end of the easy credit era that was born out of the US decision to abandon the gold standard in 1971, and which has enabled an unparalleled period of prosperity for most post the 1970’s economic troubles. So, with apologies for a more technical commentary, yet potentially of the upmost importance, let’s crack on.
As we sit here in the fog of policy uncertainty (the details of where the Fed and Trump administration are headed), we do know where we are today in terms of the state of the economy and we can make educated guesses on various potential outcomes once we know the details of important policy areas. Of course, the economy is an incredibly complex beast. Many economists rely on complex models to help predict outcomes, and yet perhaps economies are simply too complex to model.
There are, however, some simple economic truths that must hold at any given time, and these are known as accounting identities. To be clear, building economic models around these identities will not yield great results, because they are not dynamic; they are simply a fact at any moment in time. So, what are we on about here?
We have spent a lot of time in the last few days reading and thinking about the potential outcome from Trump’s trade and protectionist policies (we will reference here the work of both Michael Pettis and Charles Gave and provide links to recent research for those that are interested in more detail). Simply put, he wants to eliminate the trade deficit as his team believe that the trade deficit is a drag on economic growth. So, eliminate the deficit and the economy will by definition be bigger and will most likely have created more jobs; Bingo! The accounting identity Trump’s team are implicitly linking their policy to is;
GDP = Consumption + Investment + Government Spending + Net Exports
When net exports are negative (I.E. a trade deficit; and for the purposes of this note, we’ll simply assume the trade deficit and current account deficit as being the same), this reduces GDP and when they are in surplus, they add to GDP. Let’s consider another accounting identity;
Current account deficit = Capital account surplus, OR
Exports – Imports = Savings – Investment
In the case of the United States, because they have a current account deficit, their capital account must be in surplus so that the shortfall between savings and investment is filled. In terms of numbers, the US current account deficit is somewhere in the region of US$500 billion which in effect means that US domestic investment is US$500 billion more than US savings and the gap is filled by foreign capital coming into the United States.
If we assume that Trump gets his way, and the US eliminates their current account deficit, what has to happen from an accounting identity perspective, using the above example of a deficit of US$500 billion? Well, the current account deficit shrinks from US$500 billion to zero, which means that the excess of US Investment over US Saving has to fall by US$500 billion. This can be achieved by US Investment falling, US Savings rising or both. Although there are a number of ways that this can be achieved, there are four likely options;
- Productive Investment falls (surely impacting productivity further)
- Non-productive investment falls (non-productive investment being inventory or misallocated capital into speculative ventures)
- Unemployment falls, resulting in higher savings
- Households reduce debt, consume less and therefore save more.
Of the four likely options noted, surely the only palatable outcome for Trump is that unemployment falls and US Savings rise as a result. A fall in productive investment would be a significant disappointment from a structural perspective given how poor US productivity has been in the last decade or so. And a fall in non-productive investment and/or Household debt are inherently deflationary.
We would also proffer that the only way that Trump can reasonably increase employment sufficiently to raise US Savings without any decline in productive investment is for millions of so-called disaffected workers to re-enter the workforce. And even if this were to occur, can corporate America afford to pay these people without a significant decline in profit margins or boost to productivity?
As well as having a potentially profound impact on the US economy, if the US economy moves to a current account surplus, this will have very significant implications for the global economic order that has existed for the past 40 years or so. We have written before about the importance of the US current account deficit in supplying US Dollars to the rest of the World. In his note, Charles Gave goes into great detail about the importance of the US current account deficit, and how this has allowed both the US and the rest of the World to benefit from a “double pyramid of credit”. In short, after the US’ abandonment of the gold standard in 1971, the world moved to fiat currencies which allowed both the US and its trading partners to create almost unlimited credit.
We know this to be true as global debt was not only part of the problem that almost brought the system crashing down in 2008, it has continued to grow unhindered since. In fact, central banks have actively encouraged further debt addiction with their extraordinary policies of recent years. Simply put, if the US does not have a current account deficit, they will not supply the World with US Dollars and the World will not reinvest said Dollars back into the US via the Capital account.
As we have written about before, the rest of the World needs Dollars to engage in global trade, and without a consistent and growing supply of Dollars via the current account, global trade will stagnate or decline (we have seen a foretaste of this in recent years). Furthermore, there is an offshore pile of US Dollar denominated debt of about US$10 trillion. These non US borrowers need access to US Dollars to both service and potentially repay these borrowings. Without a current account deficit, the cost of access to US Dollar will increase markedly.
From where we sit, although there seems to be an obvious win for the Trump team from eliminating the US current account deficit, it will make life extremely difficult for the rest of the World and is not even guaranteed to make life easier in the US.
- As noted above, economists may have a very patchy forecasting record, but they do know facts, for example;
- Globally, debt levels have never been higher and are significantly higher than they were on the eve of the Global Financial Crisis.
- Demographically, working age populations are growing very slowly (declining in some advanced economies) and ageing (in some cases rapidly).
- Financial assets have rarely been more expensive than they are today and a future global recession could be devastating.
Central banks have already gone to extreme lengths and the outcome was that the rich got richer and the poor did not benefit much.
We don’t think we are dealing in hyperbole when we say that a Trump policy of moving to a current account deficit could end the incredibly prosperous era that has been seen since the 1980s. We think that Trump’s trade policies will be THE most important of his economic plan (accepting they are all important) and we are simply unsure as to whether he understands the true implications of what he is proposing.
We also believe that the global economy is already struggling with structural headwinds and it not in a strong position to withstand the ending of such a prosperous era and with little visibility of what the new order will look like. Financially, markets at near record valuations are closer to pricing in perfection that the risks of the end of the prosperous era described.
From where we sit, although we accept that that economies are incredibly complex and may well adapt to a new era very well and disruptions will be minimal, we worry that the opposite will happen. Government and private institutions are geared to what has worked well in the last four or so decades and change does not come easily – in fact, many are incentivised to cling onto what has worked well for them in the past. We fear that many investors have become very myopic as central banks have soothed away any concerns with unprecedented liquidity.
For those that have already read the note from Charles Gave, they will know that he offers a potential policy to overcome the current account issue. The US Federal Reserve could choose to flood the World with US Dollars until the global economy has adjusted to the new equilibrium. Of course, this may not be politically palatable for the Trump administration, and nor the voters that voted him in.
We’ll end this week here. We will write about this subject again and in more detail once we have more details from the new administration. 2017 really is shaping up to be a year of change, and change with it brings opportunities which we hope to take full advantage of.