Jefferies

Economics and Strategy

Are Fortune Cookies and Sauerkraut Next?

— David Zervos, Chief Market Strategist

Well, it had to happen at some point. We all knew Trump had the power to set tariffs unilaterally as long as he invoked national security concerns. And steel and aluminum were certainly natural candidates. The questions now of course center on international escalation and congressional backlash, since these specific trade protections are not particularly meaningful for U.S. or global economic activity on their own.
Before tackling those two questions, though, let’s take a step back and remind ourselves of ALL the new Trump policy levers. Just after the election I put forth the idea that the financial markets would need to weigh the effects from four new Trump policy changes: fiscal, regulatory, trade, and immigration. And looking through the lens of real rates (or more specifically expected real rates of return on capital), I claimed the first two would have a positive impact while the second two would have a negative impact. It’s been almost a year and a half now of watching the good stuff evolve (i.e. tax cuts and deregulation), so I suppose it’s only natural that we have to have a little of the bad stuff, too. And rest assured, watching Pete Navarro on the Sunday morning talk shows is a highly unpleasant experience for me. I would certainly rather see Randy Quarles touting the unwind of the more draconian portions of Dodd-Frank. But as with everything in life, we always have to take a little of the bad stuff to get the good stuff.
Now, turning to the two questions above, I fully expect this trade brouhaha to be much more about bluster, game theory, and politics than anything else. The most sensible of Trump’s advisors, as well as the core folks in his party, know all too well that escalated trade wars are terrible for business. But if he can convince our trading partners that he is crazy enough to start a battle, then maybe they back down from some of their current unfair practices. There is no doubt that WTO rules are being violated behind the scenes by many of our trading partners. There is also no doubt that many foreign industries are subsidized through their governments when they engage in mercantilist activity. And there is no doubt that many foreign markets are protected from U.S. competition via a multitude of trade barriers.

Trump is executing a classic tit-for-tat game theory strategy in a repeated prisoner’s dilemma trade game in which the U.S. has been more cooperative than its partners. The only question is which equilibrium we head toward: the one where everyone defects, or the one where everyone cooperates. John Nash would tell us it’s the former, but Trump is playing for some form of the latter. More subtly, I suspect Trump is just trying to move the needle ever so slightly toward a more cooperative outcome – one that involves less defection by our partners. If he is successful it is actually a positive sum improvement in the game (and a huge improvement for the U.S. economy). However, if this moves us towards a more uncooperative outcome, then of course it’s a negative sum outcome all around.

Actually, all things considered, I would argue it is probably a reasonable risk/reward strategy for Trump, especially when one considers his political motives in the heartland. He can gracefully back away by having Congress gazump him with their own trade legislation if this escalates negatively. And alternatively, he may just get the Chinese and the Germans to play a slightly fairer game so as not to risk some messiness at home. The easiest win is no doubt in China, as their game is more transparent. The Germans have hidden very well behind the weak euro, and it will be hard to tease out concessions from such a well-crafted mercantilist structure.

In the end, I do not expect to see this game move to the point where we start placing tariffs and quotas on everything from fortune cookies to sauerkraut. More than likely the players fall into line and the global trading game becomes slightly more cooperative. Good luck trading.