Some years ago, I found myself wandering the halls of a high school in Ohio, waiting to make a speech to investors in the auditorium. Earlier in the day, I’d heard about a nearby plant that had closed down a few months earlier. I was a little early for the speech and so, as I pottered around, I looked at the photos of recent graduating classes and realized, sadly, how few of those young faces would ever return to live in that town.
Plant shutdowns, of course, aren’t a new story. U.S. manufacturing employment collapsed in the 2000s, falling from 17.3 million jobs at the start of the decade, to less than 11.5 million by its end. Since then, it has recovered slightly, to almost 12.3 million jobs today. However, the pain of the shutdowns lingers and that pain clearly contributed to the election of the new President. It is also fueling calls for tariffs on imported goods to protect U.S. jobs.
However, as someone born in Ireland, a country well used to economic devastation, I know this is the wrong answer.
In 1841, before the Great Famine, 6.5 million people lived in what is now the Republic of Ireland. However, by the time Ireland achieved its independence in 1921, the population was barely 3 million, with most of the decline being due to emigration.
From the 1930s to the 1960s, Irish governments sought to fix this through tariffs on almost everything imported from shoe-laces to bicycle reflectors. The idea was to protect a wide variety of local industries from foreign competition. However, the result was a disaster. Domestic industries could neither thrive nor become more competitive without foreign markets and domestic consumers, impoverished in part by high import taxes, could not provide the demand to help them grow. As a result, two more generations of Irish children emigrated and the population, in a land of large families, was no higher in 1966 than in 1926.
It was only in the 1960s, that Ireland recognized that tariffs weren’t the answer. The key to Irish growth was not importing less but exporting more and this could only be achieved through free trade and making Ireland as attractive a location for business as was possible. This is the policy that Ireland has pursued ever since and one which has, in my lifetime, transformed it from the poorest country in Western Europe to one of the richest.
In the next few months, the new U.S. Administration will also have to decide whether it wants to be pro-growth or pro-protection. It can’t be both.
A pro-growth policy would start with the kind of corporate tax cut the President elect included in his economic plan: A big cut in the federal corporate tax rate to 15% or 20%, with a lower rate for money repatriated in the short run, would boost both the stock market and investment spending.
However, an alternative tax plan, espoused by some in the House of Representatives, would replace the current corporate tax system with a modified value-added tax or VAT, where corporations could deduct exports but not imports in determining their tax liability. They would also be able to deduct domestic labor costs in calculating their liability. Because of this provision, the U.S. would be at a trade advantage to other countries that use a VAT and so the enactment of such a tax scheme would be seen as being effectively a tariff, in violation of World Trade Organization rules. As such it would invite other countries to impose tariffs on U.S. exports.
While corporate tax reform is badly needed, this particular type would be a spectacularly bad idea for the American economy for many reasons:
–First, tariffs, even if hidden in the corporate tax code, are a tax on American consumers. They would also boost inflation in a way that could trigger further Fed tightening.
–Second, tariffs invite retaliation. Foreign countries would respond to U.S. tariffs with tariffs of their own, hurting U.S. exports.
–Third, unlike Ireland, the U.S. is an enormous player in the global economy. U.S. tariffs, by slowing global trade, could weaken the global economy in a way that further depresses U.S. exports.
–Finally, a cut in the corporate tax rate that turned out to be revenue neutral could do nothing to boost earnings per share. Given the market rally since the election, a policy that undercut economic growth while doing nothing to reduce the average burden of corporate taxes would be a negative for the U.S. stock market.
But if tariffs aren’t the answer, can anything be done about our $500 billion current account trade deficit?
The answer is yes. The U.S. dollar is too high and it has been too high for a long time, making our exports too expensive and our imports too cheap. For decades, the U.S. government has been the only pacifist in a global currency war, with the Federal Reserve deferring to the Treasury on the issue of the exchange rate and successive Treasury Secretaries espousing a belief in “market” forces and the virtue of a “strong dollar”.
But the truth is the “market” in question is mainly driven by currency investors rather than export and import fundamentals. This being the case, it makes sense for the Federal Reserve and Federal Government to switch to a more deliberate attempt to bring the dollar down to more trade-neutral ranges. Simply announcing such a policy change might do the trick. If not, any suggestion by the Fed that it would replace some U.S. Treasuries on its massive balance sheet with foreign sovereign debt, could lay the groundwork for a cheaper dollar.
This should, over time achieve greater trade balance for the United States but do so in a way that allows exports, imports and corporate profits to grow.
In the week ahead, how the new President intends to address this and many other issues will be the main focus of investors.
He has promised a large number of executive actions on his first day in office. In addition, he has made very explicit promises regarding his first 100 days, including working with Congress to introduce legislation on personal tax reform, corporate tax reform, health care reform, child and eldercare assistance, defense spending, VA spending, immigration and tariffs. All of this should shape the U.S. investment environment for 2017 and beyond.
Investors this week will also be absorbing some economic numbers. The December Industrial Production report as well as January numbers from the New York and Philadelphia Federal Reserve banks should paint a relatively bright picture of manufacturing momentum. Meanwhile, Housing Starts should have rebounded in December from a temporary falloff in November. Of most relevance to investors, however, will be the December CPI report, which should show headline CPI moving above 2% year-over-year for the first time in two and a half years.
Investors will also be paying attention to the earnings season. Last week’s strong numbers from the financial sector looked solid and this week’s broader set of reports should be reassuring. Overall, it appears the profits will continue to recover as we enter 2017. However, the strength and sustainability of this improvement depends, to a remarkable extent, on the actions of the new Administration and new Congress and their dedication to pro-growth policies.
Chief Global Strategist