“Problems worthy of attacks prove their worth by hitting back.”—Adam Smith
This past Thursday, President Trump met with CEOs of major U.S. airlines and promised them a “phenomenal” tax policy that would be rolled out in a few weeks. With this statement, stocks, which had been limping a bit as some investors began to doubt the future of “the Trump rally”, caught a nice bid, along with the U.S. dollar (USD), at the expense of Treasury notes, as the ten-year rose from 2.33% to 2.44%. When the new president focuses on the economy, he focuses like a laser beam on global trade, looking to significantly reduce trade deficits with our major trading partners. With this in mind, many believe that the Trump administration will introduce a corporate tax policy that incorporates a “border adjustment tax” (BAT), where corporations are taxed at a higher rate for domestic sales and imports and not taxed on exports or sales made in overseas operations.
In theory, this would make U.S. exports more competitive at the expense of foreign competition, both abroad as well as at home. Additionally, this would provide relief for corporations with tremendous cash hoards overseas, allowing them to repatriate this cash without being taxed at their current U.S. marginal tax rate.
Assuming that this is the path the administration wishes to take, we have to first ask ourselves if a mercantilist tax policy would make it through the Senate. I have strong doubts, considering that very powerful companies, like the oil refining industry, will be vehemently opposed. Not to mention, I am sure many senators enjoy the generous support of these companies and may not be inclined to say yes to such a policy. However, for sake of argument, let’s assume that a BAT policy could make it through the Senate.
If the intent of the administration is to use tax policy to improve our trade balance, then I would presume we would need to initiate the policy when the U.S. dollar (USD) is significantly lower than its current level. Currently, the USD, on a trade-weighted basis, is near its all-time high. All else being equal, the USD will only appreciate more should we adopt a fiscal policy that works to balance our trade deficit. This is why we have heard President Trump and his economic advisors (including Steve Munchin, who as of this writing has not yet been confirmed as Treasury Secretary) complain of the overvaluation of the USD on many occasions. Perhaps in normal times, it would be perfectly reasonable to wonder why, with our trade deficit running at about an annual $500 billion the past few years, the USD is so high (on a trade-weighted basis).
However, these are not ordinary times. Since the U.S. has recovered more quickly from the Great Recession than many of our trading partners, combined with the Federal Reserve (Fed) increasing its policy rate (while other major central banks are keeping policy rates extraordinarily low or negative), monetary policy, not the balance of trade, controls the valuation of the USD. The Fed’s monetary policy draws global cash flows to the USD like a magnet. A president, or a high government official, can talk a currency down for a day or two, but in the longer run, it is a futile effort because the investment flows are just too big to be influenced for a meaningful period of time.
Therefore, I think a tax policy that aims to improve the U.S. balance of trade, coupled with the divergence of monetary policy between the Federal Reserve and other major central banks (or the divergence of the U.S. economy with major trading partners), will just add more fuel to the USD rocket ship, thus working against the aim of improving our trade balance. Additionally, an abnormally high USD hurts emerging markets who owe debt denominated in USD, hurts commodity prices, and destabilizes China, who, contrary to President Trump’s belief, is fighting to keep its currency from weakening further against the USD to staunch domestic capital outflows.
Eventually, this will become another point of contention between the Fed and the President in 2017. It is a fight I don’t see the Fed losing. The only thing that would circumvent this clash would be if monetary policy between the U.S. and the other major central banks of the world converged either by the U.S. economy slowing down or the growth of the European, Japanese, and Chinese economies speeding up. Until that time, I am afraid if the risk markets are rallying over the promise of a tax plan that takes aim at improving the trade balance, they are going to end up disappointed.
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