As the trade war escalates, the risk of deflation is also rising.
The recent plunge in the markets has been blamed on the escalating U.S. - China trade dispute and the imposition of fresh tariffs. That sounds logical but the causality is the wrong way round. Social mood in both the U.S. and China has been transitioning to a negative trend from early 2018, as displayed by the fact that the broad NYSE Composite index has declined by 8% and the Shanghai Composite by 19%. Therefore, rather than the markets declining on fresh tariffs, it has been the negative trend in mood (as manifest by declining markets) that has caused this latest escalation in the trade war. Nevertheless, conventional analysis continues to put the egg before the chicken.
Another aspect of trade tariffs where conventional wisdom prevails is that they are inflationary. Again, the logic here sounds reasonable. America slaps a trade tariff on imports of Chinese made televisions. This tax increases the costs of the American merchant who will then pass that increase along to American consumers in the form of a higher price for those televisions. This is what is known as cost-push (price) inflation. In that sense, tariffs can lead to higher prices in the country imposing the tax. However, that's just the start of the process.
U.S. consumers stop buying those high-priced Chinese televisions and start buying the cheaper American-made ones. This helps the American television manufacturing industry and people like the American president, Donald Trump, can boast about tariffs helping American industry. This narrow-minded, mercantilist view, though, spectacularly misses the bigger issue.
The Chinese are no longer selling their televisions to America and so find themselves with a glut of wide-screens sitting in factories. By the law of supply and demand, an oversupply of TVs in China leads to their price falling. There's price INflation in America, but price DEflation in China. That's not all.
In retaliation to the American tariff on televisions, China imposes tariffs on American soybeans. American soybeans become more expensive in China (cost-push price inflation) and so Chinese soybean importers look to other places, like Brazil, to source their beans. Farmers in Iowa can no longer sell their beans and find themselves with a soybean mountain in their warehouse. The price of beans falls in the U.S. so the poor farmer in Iowa is left with a dwindling income and the price of consumer goods, like televisions, going up.
But here's the real killer. The U.S. and China stop doing business with each other, and so importers and exporters in both countries suffer. Revenue goes down and share prices fall. Bankruptcies ensue, and debt-deflation takes hold. People lose their jobs, so spending goes down and the domestic economy suffers. Pretty soon, the deflationary effects of tariffs are felt in the wider economy.
Now, imagine this bilateral example on a global scale. The short-term price inflation aspect of tit-for-tat tariffs will differ between countries but, in aggregate, will even itself out. What the tariff proponents fail to realize is that the decline in international trade and the closing of previously open economies will result in a reversal of the globalization trend that has coincided with rising prosperity over the past 50 years. As the chart below shows, the underperformance of emerging markets since 2010 is probably a sign that globalization and the era of rising prosperity is going into reverse. At the risk of stating the obvious, declining prosperity is deflationary.