A User’s Guide to Restructuring the Global Trading System

Executive Summary

The desire to reform the global trading system and put American industry on fairer ground vis-à-vis the rest of the world has been a consistent theme for President Trump for decades. We may be on the cusp of generational change in the international trade and financial systems.

The root of the economic imbalances lies in persistent dollar overvaluation that prevents the balancing of international trade, and this overvaluation is driven by inelastic demand for reserve assets. As global GDP grows, it becomes increasingly burdensome for the United States to finance the provision of reserve assets and the defense umbrella, as the manufacturing and tradeable sectors bear the brunt of the costs.

In this essay I attempt to catalogue some of the available tools for reshaping these systems, the tradeoffs that accompany the use of those tools, and policy options for minimizing side effects. This is not policy advocacy, but an attempt to understand the financial market consequences of potential significant changes in trade or financial policy.

Tariffs provide revenue, and if offset by currency adjustments, present minimal inflationary or otherwise adverse side effects, consistent with the experience in 2018-2019. While currency offset can inhibit adjustments to trade flows, it suggests that tariffs are ultimately financed by the tariffed nation, whose real purchasing power and wealth decline, and that the revenue raised improves burden sharing for reserve asset provision. Tariffs will likely be implemented in a manner deeply intertwined with national security concerns, and I discuss a variety of possible implementation schemes. I also discuss optimal tariff rates in the context of the rest of the U.S. taxation system.

Currency policy aimed at correcting the undervaluation of other nations’ currencies brings an entirely different set of tradeoffs and potential implications. Historically, the United States has pursued multilateral approaches to currency adjustments. While many analysts believe there are no tools available to unilaterally address currency misvaluation, that is not true. I describe some potential avenues for both multilateral and unilateral currency adjustment strategies, as well as means of mitigating unwanted side effects.

Finally, I discuss a variety of financial market consequences of these policy tools, and possible sequencing.

Chapter 1: Introduction

Americans’ opinion of how well the international trade and financial systems serve them has deteriorated substantially over the last decade. Among voters if not among economists, the consensus underpinning the international trading system has frayed, and both major parties have taken policies that aim at boosting America’s position within it.

With President Trump winning reelection with a strong democratic mandate, it is reasonable to expect the Trump Administration to undertake a substantial overhaul of the international trade and financial systems. This essay surveys some tools available for doing so. In contrast to much Wall Street and academic discourse, there are powerful tools that can be used by an Administration for affecting the terms of trade, currency values, and the structure of international economic relations.

During his campaign, President Trump proposed to raise tariffs to 60% on China and 10% or higher on the rest of the world, and intertwined national security with international trade. Many argue that tariffs are highly inflationary and can cause significant economic and market volatility, but that need not be the case. Indeed, the 2018-2019 tariffs, a material increase in effective rates, passed with little discernible macroeconomic consequence. The dollar rose by almost the same amount as the effective tariff rate, nullifying much of the macroeconomic impact but resulting in significant revenue. Because Chinese consumers’ purchasing power declined with their weakening currency, China effectively paid for the tariff revenue. Having just seen a major escalation in tariff rates, that experience should inform analysis of future trade conflicts.

President Trump has also discussed adopting substantial changes to dollar policy. Sweeping tariffs and a shift away from strong dollar policy can have some of the broadest ramifications of any policies in decades, fundamentally reshaping the global trade and financial systems.

There is a path by which these policies can be implemented without material adverse consequences, but it is narrow, and will require currency offset for tariffs and either gradualism or coordination with allies or the Federal Reserve on the dollar. Potential for unwelcome economic and market volatility is substantial, but there are steps the Administration can take to minimize it.

From a trade perspective, the dollar is persistently overvalued, in large part because dollar assets function as the world’s reserve currency. This overvaluation has weighed heavily on the American manufacturing sector while benefiting financialized sectors of the economy in manners that benefit wealthy Americans. And yet, President Trump has praised the reserve status of the dollar and threatened to punish countries that stop using the dollar for reserve purposes. I expect these tensions will be resolved by a suite of policies designed to increase burden sharing among trading and security partners: rather than attempting to end the use of the dollar as the global reserve currency, the Trump Administration can attempt to find ways to capture back some of the benefits other nations receive from our reserve provision. Reallocation of aggregate demand from other countries to America, an increase in revenue to the U.S. Treasury, or a combination thereof, can help America bear the increasing cost of providing reserve assets for a growing global economy. The Trump Administration is likely to increasingly intertwine trade policy with security policy, viewing the provision of reserve assets and a security umbrella as linked and approaching burden sharing for them together.

The remainder of this essay is structured as follows: first, I review the underlying economic causes of our economic imbalances. Second, I explore tariff driven approaches to redressing these grievances. Third, I review currency-driven approaches, both multilateral and unilateral. Finally, I discuss market consequences.

This essay is not policy advocacy. I attempt to diagnose the economic disequilibrium in the terms of trade that underlies the nationalists’ critique of the current system, describe a catalogue of tools that can be used to address it, and analyze these tools’ relative advantages or disadvantages and potential consequences. A User’s Guide to Restructuring the Global Trading System 4 My analysis reflects only my own views, not those of anyone on President Trump’s team or Hudson Bay Capital. The goal of the analysis is to understand the range of possible policies that might be implemented, so that our team and clients can evaluate the consequences in the economy and financial markets that might result.

To read the research as it was published by Hudson Bay Capital, click here.