What will be the impact of rising impact of protectionism?
I think that we need to go back a step to ask why there is a dollar weakness. We agree that is driven by current account deficit, which I personally think is internally driven as a reflection of private and public negative savings. The private and public negative savings are made in the US. In some sense the monetary policy in the private sector and the fiscal policy in the public sector. Global liquidity effect on paper assets also plays a role. The dollar has been supported by capital inflow which by definition is external driven.
The thought process of trade protectionism is how this may affect the link mentioned.
There is no reason that protectionism will have any significant impact on public saving. It is very hard to imagine the tariff collected from import will be significant in any measure.
On private saving, there are two things to think about. One is the overall level, the other is the substitution. With tariff and if the price actually rose, it is a matter of elasticity whether the US consumers will spend more or less. Indeed, I tend to believe that private business is able to adjust their productions to pass the tariff barrier. Unless there is a global protectionism, I would guess the level impact will not be large. One example is the US has placed a high tariff on wood imported from China for a while. What we see is that a number of furniture firms have switched from wood to leather or metals. The substitution effect may be more important from buying imported goods to domestic goods. I am not sure how big the effect will be, but it is very hard for me to imagine the US has competitive advantage in most consumer goods nowadays. In this sense, the impact on the public and private saving sides will not large.
The other side of the coin is the capital inflow financing. Capital inflow financing is a function of investor’s confidence on the US (yield and investment environment) and the foreign countries’ domestic concern. Protectionism will not be positive on the US investment environment. In the 1980s, when the trade tension between the US and Japan, we saw Japanese companies has put FDI in the US to smooth the relationship. In that sense, it is positive to the dollar. Do we expect this will happen again today when every low labor cost countries are opening up? I could guess the impact will not be as big as in the past decades. By the end, the portfolio flow is much larger than the FDI. For example, net foreign-owned assets in the US in 2006 were 1.76 trillion, while net foreign FDI inflows were $183.6bil, or less than 10% of total capital inflow. (BEA data)
The last thing is what will be the reaction of foreign countries? One reason why the foreign government continues to buy the US treasury is to support domestic employment, as the US government claims it is the exchange rate subsidy. Now, if the tariff is effective to switch employment from EM back to US, what is the motivation to continue buying the treasury? What this implies is that if tariff is effective, trade deficit will be improved, a positive to the dollar. At the same time, capital inflow will slow down, a negative to the dollar. Of course, there is the timing problem. If trade is improving but foreign governments do not act, it will be positive to $, and vice versa. One thing to bear in mind is the foreign governments consist of many players, that they do not coordinate their policies. If the US put a tariff on buy treasury buyers like China, China’s action can affect the market easily, but not the case if the tariff is on Costa Rica for example. So, if tariff is effective in affecting the trade flow, it is likely that the capital account will respond accordingly. Again, this case seems not likely as it is hard to see the competitive advantage of domestic US industry in consumer goods.
The worst case will be the broad protectionism creates a rise in risk aversion, but I am not sure this will benefit the US economy. This will be a loss-loss situation for all.
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