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By Steve Butler, Founder & CEO (sbutler@pensiondynamics.com)

With the trade war soon escalating to include a total of $520 billion worth of Chinese products, it is impossible to know where this will end.  So many moving parts and potential for unintended consequences.  Wilbur Ross, our Commerce Secretary, earlier said as much when he confronted a group of Congressmen from the farm belt whose were largely corn and soybean farmers who are losing  their farms.  Secretary Ross said, “We can’t anticipate how the Chinese will respond to our tariffs.”

An educated guess might have predicted that we would soon be paying those farmers $28 billion a year of taxpayer money to give them a lifeline. Meanwhile, reviewing some basic economic theory can help us appreciate the complex intertwining of international trade, tariffs and currency exchange rates. 

First, a concept known as “comparative advantage” is at the heart of international trade.  It basically recognizes that some countries can make a product or offer a service more efficiently and competitively than other countries.  We buy flat screen TV’s made in other countries for a fraction of what we would be paying if we were still buying them from Magnavox or Zenith. Foreign auto manufacturers eclipsed our auto industry, beginning in the 1970’s by offering a level of quality and price that no U.S. manufacturer could match.  At the same time, we were selling products overseas that other countries couldn’t match.  Eighty -five percent of Microsoft’s sales are overseas and for Caterpillar, it’s 65%.  In fact, 35% of the sales of the S&P 500 are to foreign countries.  We sell roughly 40% of our farm products overseas…or we did until the tariff war began.  Comparative advantage makes the world go around, but tariffs throw sand in the works. And, by the way, tariffs are not “easy to end if they don’t work.”    

Meanwhile, the fact that we can purchase goods cheaper than we could make them ourselves gives us more money to spend on products and services that are, in fact, made in the USA.  This is the point that Gary Cohn, former Director of the national Economic Council, was trying to make.

Tariffs are viewed by some as being a solution to balance of payments concerns.  A company like China selling more to us than we sell to them starts piling up dollars relative to their own currency, and this oversupply makes dollars drop in value when priced in their currency.  Supply and demand for currencies of various countries relative to each other determines its value in “the other guy’s currency.”  Fundamentally it is the international currency market’s perceived strength of a country’s economy that determines currency values --- at least in a perfect world.

So. currency valuations between the two countries are supposed to act as a shock absorber of sorts as follows:  the country with dollars piling up, compared with their own currency, finds that their currency becomes more valuable (in dollars) because its own money is becoming scarce in comparison. So, dollars go down in value and the exporter’s currency goes up.  This makes their exported products more expensive (in dollars) for Americans to buy ---while making U.S.  products cheaper (in their currency) for them to buy. The net effect is that they can buy more from us and we can afford less of what they want to sell.  Over time, the trade imbalance reaches a form of equilibrium. But it’s not that simple.  

What complicates matters is that our dollars go down in value relative to foreign currencies, the U.S. fixed income debt looks more attractive to foreign investors.  Overseas investors are buying our debt because it’s a better deal for them, but also (and this is the “x factor”) because it reflects the “flight to safety.” This demand for our dollars that has little to do with balance of payments factors makes our dollar strong even if they are piling up overseas.  American government debt is the safest investment in the world. Under these circumstances, nothing the Federal Reserve can do will weaken the dollar to any great extent.  World wide bond and currency markets trump artificial attempts to tilt the playing field. 

All this turbulence and uncertainty should not prompt anyone to bail out of stocks, After all, the market earlier this year dropped by 18 percent from late last year’s high and has pretty much recovered. To sleep better, however, some may recall that the “sweet spot” pf minimizing risk while give up the least amount of potential gain a 33/67 bond/stock allocation --- used by most balanced funds. For retirees --- or anyone who totally wants to sleep in --- a 50/50 mix can do the job to perpetuity with expected historical annual returns of around 7 percent and half the risk of the equities market. 

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