Tariffs and Currency Games 9-30-2009

September 30, 2009 Edition, Volume III

Inside Signature Update

- 2nd Quarter GDP Revision and More to Come
- Tariffs and Currency Games
- Protectionism and Mistakes of the Past: the ‘Swedish System’ and Chinese Fortunes


2nd Quarter GDP Revision and More to Come

Wednesday morning’s announcement of 2nd Quarter GDP revisions to a decline of .7% from a previously reported -1% may seem slight, but it reveals important corroboration for economist’s expectations of positive growth of 3-4% for the 2nd half of 2009. Domestic output is growing, if ever-so-slightly, and the improvement supports the US equity market’s continued gains for the month of September and the 2nd Quarter as a whole.

The DOW Industrials closed September with a 220 point gain on the month capping a 1,265 gain for the quarter. Market pessimists first called for a lackluster summer and then hoped for a meaningful correction in September; neither of which materialized. Now Bears are positioning themselves for weak October stock market performance and may be disappointed as unemployment levels continue to moderate and a weak dollar continues to add strength to US export activity. Even the beleaguered housing and transportation sectors continue to benefit from current economic trends.

Market expectations of 11,000 on the DOW before the end of 2009 are becoming more status quo than brave projections as we turn to the 4th Quarter. Perhaps more than ever, investor and trader eyes are focused on manufacturing reports, employment levels and retail activity as a ‘tell’ of 2010’s developing market trends.


Tariffs and Currency Games

Throughout history, tariffs have been used as effective tools to aid businesses within developing economies while they mature sufficiently to compete in global or regional markets. When used by fully developed economies, tariffs are most commonly employed as political tools to make a point to foreign governments seeking to gain trade advantage.

Early in US history, the application of a tariff to an imported product was one of the few ways the federal government had to create much needed revenue. In addition, it was a relatively effective way to equalize pricing between products made in fledgling domestic factories versus more efficiently produced products manufactured predominantly in Western Europe. They were used as a means whereby US businesses could compete against foreign growers and manufacturers whilst maturing to the point where they could compete on their own. Often times the revenues garnered from tariffs were used to support the growth and maturation of domestic businesses in an effort to help them compete in foreign markets and at home.

In simple terms, a tariff is a tax on imported goods. Depending on the structure of the tariff, the tax may be paid by the importer or exporter, but in either event it has the effect of increasing the price of the good in the import market. In some cases the exporting country will subsidize the manufacturer of the good in the amount of the tariff, but in most cases the cost of the tariff is added to the cost of the good, making it less attractive to buyers in the import market; thus discouraging the importation of the good.

For small, less mature nations, tariffs on manufacturing and agricultural products can be beneficial as a means to level the playing field while the home team develops in talent, strategy and capital. For highly developed nations, tariffs are used as a way to get around global competitive forces, or as in the case of the newly imposed tariff on Chinese manufactured tires, they can help domestic businesses offset the effects of dumping by foreign manufacturers and counteract the impact of nationalized support sometimes offered foreign manufacturers by their own governments.

In modern times, the use of tariffs has become a game for trade delegations to play while seeking advantage over one another; for consumers, manufacturers and others it can become a very costly game with few winners. A central government can increase the price of imported goods in a number of ways and may choose to do so for a variety of reasons; not all of which are as obvious as one might expect. Applying a tariff is a way of focusing on a particular product, manufacturer or exporting nation – it is targeted and tactical.

A less obvious strategy may be what occurs when a currency decreases in strength relative to one or many foreign currencies. Most think of the weakened US dollar only as a sign of declining US financial strength around the globe, but in reality it is a major means of strengthening US export business as foreign buyers are able to purchase US made goods more cheaply than they can those manufactured in some other nations. In the near term it bolsters US manufacturing and employment at the expense of the foreign manufacturing; in the long run the impact may be much more complex.

A senior Chinese trade delegate recently referred to the US Treasury and Federal Reserve’s willingness to allow the dollar to sink to lower levels as an act of financial terrorism. The comment garnered eager press attention in the midst of a verbal fist fight between Treasury Secretary Geithner and his Chinese counterpart. Most of the coverage seemed to disregard the fact that the Chinese have artificially kept their currency from rising against the US dollar for decades in an effort to continue their new role as exporter to the world of inexpensively manufactured consumer goods.

Many argue that the US consumer has benefited greatly from the availability of lower cost goods, but US manufacturing has paid much of the price tag. Though it is likely that the breadth of the US economy has benefited more than the collective burden born by employees of US manufacturers, many of whom are now unemployed consumers, it’s hard to argue that lower prices for imported goods have benefited everyone.

Likewise, a weak dollar aids in the increase in the price of oil and gold and can stimulate inflationary pressures or even signal a coming recession. Oil, regardless of where it is produced, is priced based upon international supply and demand adjusted for currency exchange rates. The escalation in oil’s trading price in mid-2008 equated to higher costs in transportation, manufacturing, and utilities and negatively impacted the US economy in the midst of a real estate and credit crisis.


Protectionism and Mistakes of the Past: the ‘Swedish System’ and Chinese Fortunes

Protectionism is a short-sighted game for mature governments to play. It can have immediate, and sometimes popular benefit, but games played at the level of global financial giants often have unintended consequences.

The ‘Swedish System’

The Swedish government pursued an aggressively protectionist stance for decades as it developed the ‘Swedish System’. From the 1950’s through the early 1970’s Sweden created a social system like none other. Swedish manufacturing and export thrived and the lifestyle of Sweden’s citizens became one of the most stable and comfortable in Europe. Sweden’s central bank artificially kept the value of its currency stable and the federal government actively subsidized large manufacturing concerns focused on export goods. In an effort to support the expanding welfare state, taxes on corporate income, invested capital and above average personal incomes eventually soared. As a result, in the 1980’s and 1990’s many of Sweden’s most profitable corporations and talented leaders migrated to other parts of Europe, leaving a trail of higher unemployment and lower tax revenues in their wake.

As Germany impacted the economics of Western Europe through its reunification plan, most European currencies first faltered and then declined sharply. Sweden’s currency had been so weakened through federal manipulation that even the enticement of 500% interest rate offered by Sweden’s central bank wasn’t enough to attract needed capital. Then, as the dot com bubble burst in the early 2000’s and the real estate and credit crisis hit less than a decade later, Sweden was ill-prepared to face another round of difficult financial times.

Consequently, the Swedish economy has been hit harder than most, her corporations and citizens have suffered, and the much touted ‘Swedish System’ is no longer able to offer the social welfare and support it once promised. Some estimates show Sweden’s real unemployment rate as high as 26% and Anders Borg, Sweden’s Finance Minister reports the economy at a 30 year low with GDP growth expectations pushed to 2011.

Chinese Fortunes

China, the current star of the international economic stage, is following Sweden’s playbook and some suggest the Chinese economy could suffer a similar outcome. Even with China’s impressive GDP growth in recent years, the infrastructure challenges and social welfare needs of a country coming out of generations of economic malaise are daunting. Like Sweden in decades past, China enjoys a net trade surplus and now owns some $1.3 trillion in US debt. Where China differs is in the breadth of her economy, the still untapped labor productivity gains that will be realized as almost one billion Chinese citizens migrate from poverty level agrarian existences towards middle-class lifestyles, and the riches of her natural resources.

China suffered during the Asian financial crisis of the late 1990’s, as did all of Asia, but her choice to maintain an artificially stable currency later helped the country to capitalize on weakness in regional trading partners. In recent years the Chinese have allowed the Yuan to float upward by as much as 10% against the US dollar to assure Chinese manufacturing an advantage against foreign competition, but increasing pressure from other developed economies such as the UK, Germany, France and the US may finally force China to value the Yuan more aggressively. If the exchange value increase occurs naturally it could damage the Chinese economy, and along with it the rest of the region.

These are but a few examples of the potentially damaging effects of a national protectionist policy. While facing the grim realities of the depression, US policy makers adopted a sharply protectionist stance to no avail. The depression deepened as the policy, coupled with other fiscal and monetary policy decisions drove unemployment to 25%.

Bernanke and company are acutely aware of the mistakes of the past, as well as those of other nations. The Fed’s continued aggressive monetary policy is evidence of their ongoing concerns, even though the costs of current policy may include continued weakening of the dollar and future inflationary pressures. Though there are risks to be avoided as the Fed now seeks a more temperate monetary stance, the unprecedented creativity shown by policy makers in the face of the recent has served us well.

Now, as we appear to be on the leading edge of emerging from one of the most economically troublesome periods in the last 100 years of US history, the Obama administration and Democrat controlled House and Senate are beginning to play the tariff game; as though our weak dollar, trade deficit and soaring federal debt isn’t providing sufficient pressure on our foreign trading partners.

From protectionist language included in the stimulus plan to trade barriers now offered Chinese tire manufacturers, current fiscal policy makers risk offsetting economic recovery trends. This simply isn’t the time for such games – there are more important issues to which the administration and congress should be attending.





Signature Update is offered by Richard Haskell, Managing Director of Signature Wealth Management and CEO of Signature Management, LLC