Tariffs could result in a global recession

Note: This post was first published on Patreon on 31 May 2018

The Trump Administration has decided to impose steel and aluminum tariffs on EU, Canada and Mexico, America’s closest allies. The natural question is: will this lead to a recession? The short answer is yes. I will explain how and what to look for.

First, let’s be clear, the tariffs on steel and aluminum are not big enough to have an appreciable economic impact on the EU, Canada and Mexico. Dani Rodrik gets it right when he says on Twitter, “Wouldn’t it be grand if the EU said instead: ‘Trade restrictions hurt first and foremost countries imposing them. You do not respond to self-destructive policies by aiming to shoot your own foot. So we will not do anything. We will just wait for good sense to return to the U.S.’

If the EU and America’s other trading partners took this approach, the tariffs would become a non-issue economically. But politically, that’s not necessarily a winning strategy. And so, we will have to wait and see what the reaction is. And then we will have to see what the counter-reaction is. Moreover, Trump is also applying tariffs to China. And there will be some political maneuvering there as well.

So, then we have four independent questions to ask:

1. What are the political risks and rewards in the various countries favoring as a course of action?
2. Given the decision tree that this course of action leads to, what is the composite base case economic impact from the host of reasonably possible outcomes? And what are the reasonable best and worst case scenarios?
3. Where is trend growth leading us over the medium-term while this plays out?
4. What is the likely policy response on the fiscal and monetary fronts.

Without formally modeling this, I would say that the risks and rewards suggest some type of tit-for-tat on a multilateral basis that involves all of the US trading partners. And so a base case scenario now shaves a chunk off of expected GDP growth, say 03.-0.5% for example.

Where this gets interesting is under the circumstances where a reasonable worst case scenario approaches a 1% loss of GDP growth or greater, especially given that there is already a marked dichotomy between job growth in the goods-producing industries and the service sector in the US. In Europe, where there is less fiscal space, the variability in economic growth makes countries like France and Italy particularly vulnerable, given the present wrangling over deficits and fiscal stimulus in Europe.

So there are reasonable scenarios in which monetary policy continues to tighten, fiscal policy does not loosen and the economic trajectory slides down into stall speed, even before the full economic impact of tariffs are felt. And in my stasis-shock model of the economy, this jolt would be enough to cause reasonably large inventory purges, production downshifts, job losses and consumption growth declines.

So, yes, a trade war could be the veritable straw that broke the camel’s back, particularly in a world in which a recession in late 2019 or 2020 is already a distinct possibility.

That’s my initial reaction to the Trump tariffs. I am sure I will have much more in due course.