Trump’s Trade Levers Test Long-Term U.S. Alliances

President’s threats against Mexico and others can work in the short run, but global rules could be strained

President Trump’s threat to hit Mexico with tariffs over immigration is the latest and most dramatic step in the weaponization of international economic levers.

In the short run, these moves may serve the U.S. interest. But in the long run, they could do the opposite, by emboldening everyone to ignore international conventions and rules that reserved tariffs and sanctions for specific purposes. The U.S. may also find its “soft power,” the ability to get other countries to cooperate out of shared mutual interest rather than threat, diminished.

Mr. Trump is not the first president to use trade levers to achieve unrelated goals. Congress has granted the president authority to do so in successive statutes, starting with the Trading with the Enemy Act of 1917. These laws enabled Presidents Roosevelt to declare a bank holiday in 1933, Nixon to impose a 10% tariff on foreign imports and Reagan to sanction Nicaragua.

But Mr. Trump’s trade maneuvers have been different in several ways. First, the extent is unprecedented: Last year, he used national-security justifications to impose tariffs on steel and aluminum imports, even from allies, and is threatening the same with autos. He then doubled tariffs on Turkish steel to force that country to release an American pastor. He has imposed new sanctions that would severely penalize any foreign or U.S. company that does business with Iran. A new order barring U.S. companies from doing business with China’s Huawei Technologies Co. because it could be a conduit for spying is ensnaring foreign companies as well.

“There’s nobody like this in the last century,” said Gary Hufbauer, a trade expert at the Peterson Institute for International Economics.

Second, the president has used these powers to achieve narrow goals with little connection to the economic imbalances or national-security threats for which they were intended. In 1985, Mr. Reagan imposed sanctions on Nicaragua using the International Emergency Economic Powers Act of 1977, the same authority Mr. Trump invoked for his tariffs on Mexico. But the U.S. regarded Nicaragua as a hostile client-state of the Soviet Union. Similarly, Mr. Reagan imposed sanctions on construction of a natural-gas pipeline from the Soviet Union to Western Europe for fear it would make American allies vulnerable to Soviet economic blackmail.

Mr. Trump’s actions don’t flow from an overarching geostrategic vision: His tariffs on imports of steel, aluminum and, potentially, autos are designed primarily to shore up favored domestic industries. His threat toward Mexico came because he says it hasn’t done enough to stem the flow of Central American asylum seekers traveling north to the U.S. border. And while his tariffs on China and his sanctions on Huawei superficially resemble Mr. Reagan’s efforts to contain the Soviet Union, Mr. Trump’s calculus is more transactional. He has suggested, for example, that the case against Huawei, which U.S. officials say is motivated by national security, might be dropped as part of a trade deal.

In the near term, these tactics can work. His assumption that other countries will prioritize retaining access to the U.S. market has generally proved correct. Mexico has so far been restrained in responding to his tariff threat. Though U.S. allies haven’t joined its sanctions on Iran—designed to halt all its nuclear activity and support for Syria’s government and groups the U.S. considers terrorists—the threat of American penalties has dissuaded their companies from resuming business there. As a result, Iran’s economy is cratering. Similarly, several Western European companies have suspended business with Huawei even as their governments don’t view it as the threat the U.S. does.

Yet in the long term, these actions, with other trends, likely will weaken ties between the U.S. and its allies and the security and leverage all derive from acting together.

The Pew Research Center has found a growing share of Republican voters, like Mr. Trump, are skeptical that openness to the world or deference to allies serve U.S. interests. And many countries are moving in a similar direction. Nationalists now govern India, Israel, Brazil, the Philippines, Poland, Hungary and Italy, and Chinese President Xi Jinping espouses a more bellicose, China-first agenda than his predecessors. Because they define national interest in the same transactional terms as Mr. Trump, they are more likely to defy the U.S. if it suits their immediate needs. The Philippines, for example, has courted Chinese investment, and Italy has welcomed Huawei. Despite Mr. Trump’s personal fondness for Indian Prime Minister Narendra Modi, India has sought to circumvent the U.S. crackdown on trade with Iran, while the U.S., unhappy with Indian protectionism, has withdrawn tariff preferences from India.

Even countries still ideologically allied with the U.S. will question the value of doing deals if, as with Mexico, they fail to prevent unilateral punishment for nontrade matters.

“As Trump shreds international trust in the U.S., friendly countries have to start preparing Plan Bs: alternatives to relying on America,” said Robert Zoellick, the U.S. trade representative under George W. Bush and later World Bank president. “This shift won’t occur overnight, but the erosion is increasing rapidly, and the negative dynamic weakens U.S. influence.”

The Iran sanctions are an early sign of this diminished leverage. Other countries, tired of how the U.S. uses the dollar’s role in global payments to enforce unilateral sanctions, are devising workarounds. The U.K., Germany and France are building an alternative payments system for dealing with Iran, which has meanwhile begun expanding its stockpile of enriched uranium.

The political trends weakening U.S. leverage with the world are compounded by economic trends. Since 1985, the U.S. share of global gross domestic product has shrunk to 24% from 35%, while China’s has grown to 16% from 3%. This means other countries have less to gain by cooperating with the U.S. and more to lose from antagonizing China.

If U.S. tariffs, real and threatened, shrink trade and investment flows, that would further diminish economic incentives to cooperate, while also weakening the constituencies in other countries favoring openness and integration with the U.S.

But that argument can’t be applied to other countries targeted by Mr. Trump. Aaron Tornell, a Mexican-born economist at the University of California, Los Angeles, noted that since the 1980s, Mexico has turned away from left-wing isolationism toward liberalized markets and closer cooperation with the U.S. on trade and security issues such as narcotics. Advocates in Mexico of this integration argued American presidents and big business would prevent the U.S. from using its enhanced leverage to punish Mexico.

Mr. Trump’s policies could “destroy the political foundations of a country that has been following liberal economic policies for the last 30 years and give more power to those who want to be like Venezuela,” Mr. Tornell said.

The Risks in Overusing America’s Big Economic Weapon

Alienated nations will be moved over time to establish alternatives to the U.S.’s systems and markets

But there is a real underlying risk that by deploying and using its economic weaponry so frequently the U.S. will, in the long run, drive others, friend and foe alike, away from its economic orbit. “These are not zero-cost options,” says Robert Hormats, former under secretary of state for economic affairs and an adviser on international economics for presidents going back to Richard Nixon.

Imposing tariffs on China and other nations trying to send their goods to the U.S. not only raises the prices of those products for Americans, it also gives targeted nations an incentive to develop markets, and long-term trade ties, in other countries.

At the same time, those foreign nations can retaliate by cutting purchases of American goods, or by slapping retaliatory tariffs of their own on American products, making them less competitive, as China has just announced it will do. The Chinese may find other countries to provide, say, wheat and soybeans, and in doing so develop lasting, non-American trade ties.

If the U.S. develops a reputation as an unreliable supplier, countries will turn to our competitors, and, when sanctions end, earlier supply chains will be difficult to restore,” says Mr. Hormats.

.. Similarly, there is a danger the U.S. is providing both allies and adversaries an incentive to find ways around using the American financial system as the wiring for international commerce.

For now, there are few alternatives to using American banks for clearing international transactions. As a result, enemies find they can be shut out of much international commerce by crossing the U.S. and being slapped with American sanctions.

But it isn’t just enemies. Friends also know their companies can be isolated if they don’t heed American wishes to shut down commerce in countries on the American black list. The risk of losing access to the financial system is a powerful motivator.

Yet overuse of this threat could compel other counties—including the very allies whose cooperation the U.S. seeks in applying financial pressure to the bad guys—to find alternatives to using dollars and American banks. Mr. Hormats notes that this “is not easy to do now, given the dollar’s pre-eminent role, but over time such overuse could eat away at the dollar’s role and hence U.S. leverage.

Indeed, there are signs that others are seeking alternatives to the dollar and the American-led financial network. The European Union is trying to set up its own payment system to allow oil companies and businesses to continue trading with Iran despite American sanctions. China has made clear it would be happy to lead a different international finance system and use its currency as an alternative to the dollar.

Similarly, 11 Pacific Rim allies have moved ahead with their own new trade bloc after the U.S. pulled out of the Trans Pacific Partnership trade deal.

America remains the big kid on the economic block, but it isn’t the only one. The danger is that it could come to be seen as the bully who tries to intimidate the other kids once too often, persuading them to join together to find ways around him.

 

The Fed and the Professor Standard

The central bank needs new voices that will speak up for a stable dollar, which leads to prosperity.

Real income for America’s bottom 90% reached an all-time high in 1999, and at the time Pew Research found that 81% of Americans agreed that free enterprise was a major reason for the country’s success in the 20th century. By June 2015, however, Gallup reported 47% would vote for a socialist.

What happened? Real income for the bottom 90%, as measured for the World Top Incomes Database, declined after 1999 and never rebounded. Two terms each of Republican and Democratic administrations failed to end this stagnation, which says all you need to know about why Donald Trump was elected president. Now wages are rising at robust rates—above 3% a year—thanks to cuts in taxes and regulation, with the largest wage increases going to low-wage workers. And the Federal Reserve has been itching to raise interest rates.

The Fed still operates on the “professor standard,” enshrined with Bill Clinton’s nominations of pure academics. Their textbooks say strong economic growth, particularly strong wage growth, causes inflation, which Fed policy should temper. Both the Bush and Obama administrations perpetuated the professor standard, and both presided over incom

Ending that stagnation is one goal that unites the political spectrum. But do we really expect that to happen under the professor standard? The academics’ favorite tool, the Phillips curve, tells them wage growth that is too strong can cause an outbreak of 1970s-style inflation, as former Fed Chair Janet Yellen alluded in her 2010 Senate confirmation hearing.

I have a different perspective. The professor standard doesn’t work, and the Fed needs new voices to argue for an approach that does.

The 1980s and 1990s brought prosperity across the board. This success was driven by a voting bloc of Fed governors, such as Wayne Angell and Manley Johnson, who favored a stable dollar and were able to swing the consensus. The dollar is a unit of measure—like the foot or the ounce—and keeping units of measure stable is critical to the functioning of a complex economy. The result of their stable-dollar policy was prosperity.

.. Since the Federal Reserve Act of 1913, there have been three distinct periods of sustained dollar stability:

  • 1922-29,
  • 1947-70 and
  • 1983-99.

During these periods, real growth of gross domestic product averaged 3.9% a year and real income growth for the bottom 90% averaged 2.2%, according to calculations done by Rich Lowrie, senior economic adviser to my 2012 presidential campaign. During distinct periods of sustained dollar volatility—in 1913-21, 1930-46, 1971-82 and 2000-15, real GDP growth averaged only 1.9% and real income for the bottom 90% declined by an average of 1.3% annually.

The prosperity of the 1980s and 1990s gave way to stagnation precisely because dollar stability gave way to volatility. Blame the professor standard. Demand for dollars is determined globally on a real-time basis, but the Fed has preferred to look largely at domestic lagging indicators in determining supply. The frequent resulting mismatches cause dollar volatility, which the professor standard then dismisses as transitory.

America’s future prosperity, and especially the end to income stagnation, depends on getting this distinction right. The Fed has the tools to stabilize the dollar. The open-market desk can buy bonds to counter a downward trend in commodity prices and sell bonds to arrest an upward trend, resulting in ongoing stability in the dollar’s commodity value. The only thing missing are voices like Messrs. Angell’s and Johnson’s to advocate for it. If confirmed by the Senate as a Fed governor, I will speak up for dollar stability.

Last September the professor standard led Fed governors to pick up the pace of quantitative tightening and stick to its plan of rate hikes. Never mind that commodity prices were falling, meaning the dollar’s commodity value was rising, a market signal of deflationary pressure. Meanwhile, the forward outlook for industrial production and retail sales indicated signs of slowing rates of growth. This combination of slowing growth and a rising dollar is a deflationary slowdown. These are the worst conditions under which to raise interest rates, yet that’s what happened, not once but twice, presumably because wage growth was deemed “too strong.”

Markets rightly sent the Fed a strong signal to back off, prompting three subsequent dovish pivots. If the Fed listens to markets after the fact, why not listen to them before?

This mistake is not new. Had the Fed responded appropriately to the dollar’s commodity value at the turn of this century, it wouldn’t have tightened the U.S. economy into the 2000 deflationary slowdown, and technology speculation would have resolved itself without taking down the entire economy.

Had the Fed reacted to the dollar’s commodity value coming out of that recession, it wouldn’t have inflated the real-estate bubble, which led to the 2008 financial crisis. After June 2008, the dollar’s skyrocketing commodity value was screaming that there was a sudden, huge, global scramble for dollar-based liquidity. Unfortunately, the market’s cry fell on deaf ears, apparently because the signal hadn’t yet registered in the Fed’s lagging employment and consumer-price indicators. This deflationary pressure ignited the financial inferno that began in September 2008, yet the Fed didn’t begin quantitative easing to put out their fire until that December.

If Congress responds only after a crisis, the Fed’s record indicates it listens to markets only after enough damage has already been inflicted. The results of that policy look even worse in contrast: Show me a financial crisis that happened in America while the dollar’s commodity value was stable.

We need new voices at the Fed that understand stable money and know how to interpret important market signals—and that means breaking the professor standard. Monocultures tend to be fragile, but is the Fed so closed off that it can’t handle challenges to its models or the assumptions that feed them? So fragile it can’t consider that the economy is driven by production, not consumption, and that the dollar’s commodity value is important to the real investment that fuels production? I hope not.

The best way to achieve full employment, price stability, economic growth strong enough to solve our fiscal problems, and sustained income growth for the striving majority is for the Fed to stabilize the dollar. The professor standard will not challenge itself—that much has been proved. That’s why my voice is needed at the Fed.

Which Nation Does the World Trust Most? (Hint: Follow the Dollar)

When businesses in two countries — say, India and Argentina — want to conduct a deal, they almost always arrange payment not in rupees or pesos but in dollars. Everyone wants to hold the world’s most trusted and liquid currency. Nearly 90 percent of bank-financed international transactions are conducted in dollars, a share that is close to all-time highs.

.. History also suggests that economic size alone will not be enough to propel China to financial superpower status. From 1450 through the late 1700s, the leading reserve currency was held by smaller countries — first Portugal, followed by Spain, the Netherlands and France. These nations were all major trading and military powers with credible financial systems, but not one was the world’s largest economy.
.. Throughout those centuries, the leading economy was primarily China. It never gained the advantages of having the leading reserve currency because, then as now, its financial system lacked credibility.