Why Trade Wars Will Unleash Central Banks

There’s been an abundance of coverage surrounding the recent steel and aluminum tariffs. Those measures could hurt more sectors than they help within the U.S. In particular, it could damage businesses that require metals because they’ll have to pay more for raw materials.

Trade wars also escalate geopolitical tensions and economic hardships the world over. They have in the past. When the U.S. imposed tariffs in the 1930’s to try to relieve the Great Depression at home, they achieved the opposite effect.

A global trade war flared, governments became isolated and initiated defensive build-ups. The move ultimately resulted in lower production, reduced global trade and a prolonged international depression that gave rise to WWII.

While the early Great Depression period in which President Hoover invoked harsh trade wars might be different than today, the threat of instability remains. What we saw then was a slowdown in the world economy that lead to regional aggressions and ultimately a world war.

The major differences now are that we have central banks financing markets — and by extension a military buildup.

Countries are better insulated today than they were in those days. By insulating themselves, they now have more choices about who their trading partners are, and what regional or multilateral agreements they enter.

That’s one reason China is championing regional trade agreements throughout Asia and the Pacific Rim, and inked bi-lateral deals with Japan and the EU last year.  Those nations are growing less reliant on U.S. trade and, like good portfolio managers, are diversifying their trade partners.

The U.S. tariffs will likely accelerate this trend.

The tariffs, and super-regional build-ups, will also do something else. Trade wars will morph into an acceleration in global military spending. That’s because the tensions from trade wars have military ramifications.

When government allies are less connected by interdependent economies, they are more likely to act on their own domestic needs.

These divisions are potentially dangerous for the world. As major allies become untethered by mutual economic benefits, the world, from issues ranging from North Korea to Syria, continues to destabilize.

Before President Trump announced his latest tariffs, Mario Draghi, president of the European Central Bank (ECB), was asked about their impact on the global economy.

He noted while the “immediate impact wouldn’t be large” referring to the economic impact, he warned also, “there is a certain worry, or concern, about the state of international relations… because if you put tariffs against what are your allies, one wonders who the enemies are.”

It is true that Trump was targeting tariffs on places like China and South Korea, countries he believes are flooding the U.S. market with low-priced metals backed by government subsidies. Yet the fact remains that China accounts for less than 10% of all U.S. steel imports. That’s well behind U.S. import-heavy countries that are also allies, ranging from Canada and Mexico to NATO allies in the European Union.

Peter Navarro, maybe the White House’s top trade adviser, told CNBC “we come in peace here.” But embedded in the very basic trade principal is a military provocation that cannot be ignored.

The tariffs were characterized as necessary for national security reasons. As President Trump told a White House gathering of metals industry executives before he signed the tariff orders, “You’re going to have protection for the first time in a long time.”

He meant two things by that, the more logical of which was really economic protection, colored in military terms.

That’s why Mario Draghi’s position matters. By examining the real trade numbers among military allies in Europe and even Japan, the tariffs were clearly seen as economic protectionism, not as a security-related action.

The tariffs will also harm U.S. exporters. Besides agricultural products like soybeans, China has announced tariffs against, the U.S. exports a massive amount of products that use steel including aircraft autos, appliances, and industrial machinery. By increasing the cost of metals used, these business will all face the issue of raising prices that hit the consumer.

On the other side of the tariffs argument is the issue of what hitting imports would do domestically. What you would find is that even import taxes aimed at hitting other countries would cause a chain reaction where American metal producers could charge more to U.S. companies like Boeing Co., General Motors Co. and Whirlpool Corp.

That behavior is even worse for smaller firms that could get hit by higher steel prices from both domestic producers and foreign producers.

As trade issues push economies to the brink, central bankers are actively taking notice. While they may not be commenting on specific policy, they are offering a measured response. Trump’s protectionist policy has already caught the eye of his new chairman at the Federal Reserve, Jerome Powell.

In response to the tariffs, Powell said that “a system where goods and services flow freely is a net positive for many countries, though the benefits aren’t spread equally.”

While Powell dodged commenting directly on trade wars, he did say that the “best approach is to deal directly with the people who are directly affected, rather than falling back on tariffs.”

Perhaps that’s because he knows tariffs can have unintended consequences.

If Powell really believed trade wars weren’t a source of concern, he wouldn’t have mentioned them at all. With markets move upwards of 700 points in any given direction on any given day when tariffs are headline news, the Fed can’t just watch as a sideline observer.

You can bet that deep within the halls of the Fed they are developing a game plan to keep the markets from crashing if trade wars escalate.

This is another reason to believe that trade wars will be met with cheap money policy. You can look at this as a financial see-saw of sorts. Trade wars, or even media soundbites about them, will spark negative markets reactions.

That is why the Fed and other central banks will combat this with cheap words and even cheaper money policies.

If the U.S. does jump into a hot trade war it could find itself needing to make up for the costs. The logical place to turn is to the beacon of more money creation from the Fed or to issue more debt.

The Fed would be directly involved in order to keep the cost of debt from rising, again — which is why my analysis forecasts a return to Fed policies that keep rates low. Similarly, other major economies would also unleash their central bank money when needed.

This type of tit-for-tat response is already playing out.

Beijing has used its new wealth to attract friends, deter enemies, modernize its military, and aggressively assert its central bank into nearly any sector it believes requires assistance.

This type of brinksmanship shows that it is only a matter of time before a trade war with China morphs into massive military build-up and competition.

Nomi Prins
The Daily Reckoning

The Daily Reckoning