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A few thoughts on Liberation Day:

1. Trump just blew up what was left of the global rules-based trading system. Since the 1940s and the launch of the General Agreement on Tariffs and Trade (GATT), it has been a cardinal principle of the global rules-based trading system that countries should treat all members of the World Trade Organisation equally. America has now shattered this principle of non-discrimination by applying very different tariffs to trading partners, ranging from a baseline 10 percent up to 54 percent on imports from China. The rest of the world may, and indeed should, try to cling on to what remains of the system as a global public good, but the reality is that the trade distortions and diversions of what Trump has just done may be so profound that retaliatory and discriminatory tariffs start cropping up everywhere, leading to chaos.

2. As a result of Trump’s tariffs, America’s average tariff is now estimated to have soared to between 25 and 30 percent, far above the 20 percent level that it reached in the 1930s following the introduction of the infamous Smoot-Hawley tariffs. What’s more, this is a far larger and more rapid hike than the Smoot-Hawley tariffs. They were introduced in two phases and only applied to 20,000 items. In contrast, Trump’s tariffs apply to pretty much everything other than a few metals and other critical resources. Yet the Smoot-Hawley tariffs and the retaliation that they invited were sufficiently damaging to lead to a 60 percent reduction in global trade, deepen the Great Depression and fuel what turned into economic and political disaster in Europe.

   

3. The idea put about by some investment banks that this announcement will draw a line under the uncertainty that has hung over the global economy since Inauguration Day is surely for the birds. For a start, almost of all of Wall Street and the City has been spectacularly wrong-footed by the sheer scale of these tariff hikes. They have consistently misjudged the Trump economic agenda at every stage since his election victory in November, not least in assuming that his tariff threats were all about leverage rather than a profound ideological shift in American economic strategy. The result is that global investors overwhelmingly began this year long US equities and the dollar and short Europe and China. Wealth of Nations readers knew better, and now the financial markets will need to revisit all their assumptions.

4. More importantly, the Trump tariff plan is so half-baked that no one can possibly know what the future may hold. Are these tariffs a floor or a ceiling? The Executive Order announcing the tariffs claims, as if it were some kind of concession, that the new duties have only been set at half the level of the tariffs that the US government calculates other countries apply to the US. But it says that these tariffs could rise if other countries decide to retaliate, or could be lowered if they take action to allow “reciprocal trade”. Yet Trump has calculated these “tariffs” applied by applying a formula which, in effect, divides America’s trade deficit with a country by its total imports from that country. This is such a ridiculous back-of-an-envelope methodology that it hard to know what they are supposed to do to negotiate their rates down.

5. To see the problem, consider Vietnam, one of the countries hit hardest by Trump’s plan. As GaveKal explains: America runs a US$123bn deficit with Vietnam from which it imports US$137bn. So according to Trump, it is deemed to have trade barriers equating to a 90% import tariff. The US formula applies a reciprocal tariff of half that (45%), which should be enough to reduce the bilateral deficit by half. But in reality, Vietnam does not have trade barriers equal to a 90% tariff, so it cannot remove them. It has a strong comparative advantage in manufacturing and a position in global supply chains which means that it can export a lot of goods to the US (although most of the value of those goods is created elsewhere, chiefly China). And it has relatively low income, so it is not yet a good market for most of the things the US has to sell. The result is that “a small, low-income country like Vietnam does not have a lot of options other than to permit a massive depreciation of its currency or suffer a hit to economic growth”.

6. Just how damaging Liberation Day will prove to global growth is impossible to say, even if the finest minds on Wall Street and the City are hard at work trying to come up with an answer. That’s because everything hinges on how the rest of the world responds, particularly the European Union and China. At least they, unlike Vietnam, have options. They will have to decide whether to try to negotiate with Trump, raising the risk that he keeps banking concessions while throwing in fresh demands, not limited to trade, or to retaliate and risk escalation. But they do also have the option to reflate their domestic economies via fiscal and monetary stimulus and structural reforms. That would help contain some of the economic damage. Crucially, China also has the option of allowing further devaluation of the Yuan, albeit at the price of exporting the shock to its own economy the rest of the world.

7. The idea that in this dark global economic environment, Britain is some kind of winner from Trump’s trade war is bizarre. The fact that Britain is only being tariffed at 10 percent, half the level of the EU, is being talked up by Brexiteers as some kind of Brexit bonus. Leave aside the fact that Britain’s supposedly closest ally has just slapped a punitive tariff on the country even though it runs a trade surplus with America, the idea that avoiding a 10 percent additional duty on Britain’s relatively modest exports to America somehow validates an act of national self-harm that cost 15 percent of its trade and four percent of its GDP is absurd. Nonetheless, the danger is that this narrative will further complicate efforts to reset the trading relationship with the EU. Meanwhile, given its precarious fiscal position and broken economic model (in part due to Brexit), Britain is particularly vulnerable to a sharp downturn in global growth - and unlike the EU, the UK has few domestic levers to pull. Morgan Stanley reckons the new tariff regime could knock up to 0.6 percentage points off UK growth.

8. In the near-term, it is hard to see how Trump’s tariff plans can be anything other than negative for US stocks and the dollar. The UBS economics team, for example, believes that US real GDP this year could be down by 1.5-2 percentage points and inflation could rise to close to 5% if these tariffs are not reversed soon. The investment bank suggests that given such damage, the tariffs will have to be reversed. I doubt that very much. Trump has made clear that he sees tariffs as a key part of a complete overhaul of the US tax system. He needs the revenues to pay for income tax cuts. Even if some higher duties are eventually negotiated down, the 10 percent baseline is surely here to stay. Lower growth and higher inflation means that US equity valuations will “inevitably contract”, say Ian Harnett and David Bowers at Absolute Strategy Research since these are historically closely correlated. How far stocks might fall would depend on what happens to corporate earnings, but they also note that earnings are historically closely correlated to global trade growth. Meanwhile slower US growth is likely to mean lower US interest rates, while European and Chinese stimulus could mean higher rates, leading to a weaker dollar.

9. Yet there is a danger that this kind of orthodox analysis risks underestimating the wider consequences of what Trump has just unleashed. Some of those consequences are psychological, not least to confidence in the credibility of US economic policymaking. As George Saravelos at Deutsche Bank notes: “there is a very large disconnect between communication in recent weeks of an in-depth policy assessment of bilateral trade relationships with different countries versus the reality of the policy outcome. We worry this risks lowering the policy credibility of the administration on a forward-looking basis. The market may question the extent to which a sufficiently structured planning process for major economic decisions is taking place. After all, this is the biggest trade policy shift from the US in a century. Crucially, major additional fiscal decisions are lining up over the next two months.” Trust in US economic policymaking once destroyed will be hard to regain.

10. Even more importantly, it is surely naive to think that the consequences of an upending of the global economic order on this scale can be limited to trade. As Harnett and Bowers have noted, few investors recognise how closely global capital flows and global trade are linked. A crucial question now is what happens to capital flows. If it leads to lower cross-border capital flows, that could have consequences both for the dollar and US private lenders, which depend on foreign capital. As Wealth of Nations has been consistently noting since it was first launched, much of the extraordinary performance of US assets in recent years has been fuelled by vast exports of European and Asian capital. Even more consequentially, as trade becomes weaponised, will capital go the same way? After all, if countries are being forced to become more self-sufficient, they will need to be self-sufficient in capital too. The real risk is that Trump triggers a disorderly exit by foreign investors from US assets. History may record that it was not just the global trading system that Trump blew up on Liberation Day but the financial system as we knew it too.

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