The cost of the trade war

The trade war between the US is going into its third year soon and despite the warnings of several economists, we haven’t witnessed a recession in the US or the global economy.

Yet.

Obviously, the trade war is still ongoing and in much of 2018 and 2019 the US economy benefitted from the corporate tax cuts of early 2018 as well as robust consumer demand. The situation is much worse in countries that depend on global exports and did not have the fiscal stimulus that the US experienced. Most notable amongst them is Germany which avoided a technical recession as close as makes no difference in 2018 and is on a direct path to a proper recession at the moment, where it will likely be joined by Italy and potentially France. The UK economy has its very own set of circumstances that are obviously not helpful and that may have pushed the economy close to recession in the second quarter this year.

And meanwhile, China’s economic growth is slowing down quickly despite the fiscal stimulus provided at the beginning of this year. It looks like the People’s Bank of China will have to come to the rescue and engage in monetary stimulus if the economy continues to weaken.

But the question is, how much damage has already been done simply by rising stakes in the trade war which triggered a lot of policy uncertainty? The Federal Reserve has now tried to estimate the impact of trade uncertainty on the world economy and the results are much bigger than I thought they would be.

What the researchers of the Fed did was to simply count the number of times trade uncertainty was covered in newspaper reports and company earnings calls. This sounds easy, but it is technically not straightforward (side note: The Journal of Economic Literature has a great article on textual analysis and its intricacies in its latest edition). This analysis shows that trade policy uncertainty hit new highs in two waves. First, during the first half of 2018 when Donald Trump enacted the first round of import tariffs on Chinese goods and a second wave in the first half of 2019, when additional tariffs were first threatened, then delayed and finally enacted in September. 

The analysis then showed that trade uncertainty leads to lower investments and lower industrial production, which in turn has an adverse effect on economic growth. Note, that in the authors looked at both the trade policy uncertainty as well as actual tariffs implemented and could show that the uncertainty around future tariffs alone has an adverse effect on GDP growth about two quarters later. The discussions about tariffs in the first half of 2018 led to a drag on US GDP of c. 0.4% at the end of 2018. For other advanced economies and emerging markets, the drag was even stronger at an estimated 0.6%.

But with the new wave of trade uncertainty in the first half of this year, we should expect even more adverse effects on the global economy. Our chart below, taken from the Fed research, shows that the impact of the recent trade war escalations will likely only be felt in the first half of 2020 when the drag on the US economy will peak at around 1.0% less output than without the trade uncertainty. Note also that the US economy experiences these adverse effects only with some delay compared to other advanced economies or emerging markets because the US benefitted in 2018 from the above-mentioned fiscal stimulus measures. Now that fiscal stimulus is impossible to enact, Donald Trump needs the Fed to come to his rescue and cut interest rates quickly and decisively to counteract the drag on the economy created from his own trade talk.

Estimated decline in real GDP due to trade policy uncertainty

Source: Caldara et al. (2019).