The prospects of a trade war have increased. The second year of the Trump Administration has begun with a serious provocation. Duties and quotas on washing machines and solar panels were consistent with the defenses against dumping and unfair subsidies of previous administrations.

However, the tariffs slapped on aluminum and steel were exceptional. The justification was national security, a rarely used defense. Moreover, in the coming months, the US is expected to take stronger actions against China for violating intellectual property rights.

Nearly every modern US president has put on tariffs. In the recent past, for example, Obama imposed tariffs on vehicle tires and dozens of anti-dumping measures against China. George W. Bush levied a larger tariff on steel that Trump. Fears of a trade war were limited. Europe made some symbolic gestures, but ultimately, the prospects of losing at the World Trade Organization induced the US to drop the steel tariff.

Investors and foreign officials are viewing Trump’s tariffs through the lens of his rhetoric and those of his senior trade advisers. They view trade as a zero-sum game. The distributional rewards of trade have not been accrued to the United States because other countries - and not just enemies - have gamed the system.

The argument is misleadingly simple. Under floating exchange rates and free trade, they argue, the US should not have a large chronic trade deficit. The trade deficit then is the result of measures taken to prevent the foreign exchange market from reaching a clearing price that would bring the trade account into balance.

The accumulation of US Treasuries in reserves is often a way to resist the upward pressure on currencies of trade surplus countries, including Germany and Japan. Also, many countries find ways to game the system through subsidies, low interest rate loans, and other unfair practices.

Further, the key trade officials in the Trump Administration deny the existence of an international community. International relations are characterized by competition between nation-states. It is a permanent and multifaceted struggle for contingent advantages. Ideological differences are for intellectuals, and what ultimately drives policy is the national interest.

The America First that is harkened back to is that which helped block the US from joining the League of Nations after WWI. If the League was extreme idealism, it is not a big leap to think that the post-WWII institutions, including GATT/WTO, are idealism on steroids.

Economists recognize that there are joint gains from trade. The question is how the gains are distributed. The Trump Administration wants more of the joint gains to be accrued to America. They have a multi-pronged strategy. It includes tax changes that ostensibly boost the incentives of investing in the US, and deregulation, which also is thought to reduce the cost of doing business. The infrastructure initiative is also aimed at boosting the attractiveness of doing business in America.

Many if not most officials and economists contend that there are no winners in a trade war. However, because the US runs a large trade deficit, some US officials think that a trade war would reduce the shortfall. That it might reduce the demand for US Treasuries exactly at the same moment when the budget deficit is projected to swell, and the Federal Reserve is reducing its purchases by $420 bln this year and $600 bln in 2019, does not seem to faze them.

To the extent that a trade war would be a headwind for growth, those currencies like the dollar-bloc and Scandis that often benefit from strong growth are vulnerable. Countries with large international net investment positions like Japan, Switzerland, and Norway could see upward pressure on their currencies in extreme scenarios and a return to autarky.

The post-WWII economic order and its subsequent evolution were driven by the United States. A trade war, coupled with a currency war, would be the death knell of Pax Americana, as it were. US prestige would arguably be undermined, though the share size of the US economy, the importance of its consumers, and the depth and transparency of its capital markets, to say nothing of its military might, makes the US – and therefore the dollar – a critical actor in whatever would follow. Still, a look into the abyss is sobering.

Rather than an eye-for-an-eye and a tooth-for-a-tooth frontier justice, which leaves the town blind and unable to eat, US trading partners may be best served by challenging the provocations within the World Trade Organization, and seeing if the US returns to its embrace of the liberal trading order in the next electoral cycle.

Opinions expressed are solely of the author’s, based on current market conditions, and are subject to change without notice. These opinions are not intended to predict or guarantee the future performance of any currencies or markets. This material is for informational purposes only and should not be construed as research or as investment, legal or tax advice, nor should it be considered information sufficient upon which to base an investment decision. Further, this communication should not be deemed as a recommendation to invest or not to invest in any country or to undertake any specific position or transaction in any currency. There are risks associated with foreign currency investing, including but not limited to the use of leverage, which may accelerate the velocity of potential losses. Foreign currencies are subject to rapid price fluctuations due to adverse political, social and economic developments. These risks are greater for currencies in emerging markets than for those in more developed countries. Foreign currency transactions may not be suitable for all investors, depending on their financial sophistication and investment objectives. You should seek the services of an appropriate professional in connection with such matters. The information contained herein has been obtained from sources believed to be reliable, but is not necessarily complete in its accuracy and cannot be guaranteed.

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