President Trump’s trade policy is widely criticized by economists but has a silver lining: It is damping down animal spirits in markets that could otherwise lead to the sort of runaway boom that ends horribly.
It might seem odd to regard what is clearly seen by investors as very bad news—the uncertainty of new tariffs—as a sort of good news. But while tariffs are obviously bad news for the economy and corporate profits, by keeping the markets from turning frothy they may do a good job of preventing an unsustainable boom.
As we saw last week with Mexico, trashing important trading relationships pushes investors to run for the hills. The havens of gold, government bonds and the Swiss franc all rose, while stocks touched a three-month low before rebounding. All the havens sold off again on Monday after Mr. Trump suspended the tariffs, while stocks jumped.
But by holding back investment, the trade uncertainty might help to prevent or delay the excesses that so often mark the late stage of the economic cycle.
After a decade of growth, the U.S. is now running at or close to full capacity on most measures. Growth ought to be slow, because there isn’t a lot (perhaps any) slack to be picked up.
History suggests this is one of the times when animal spirits tend to be overly positive. Investors and companies have forgotten the last recession and are eager to recycle their ample profits into new opportunities. Money pours into companies promising to exploit the latest innovations, often with more focus on revenue than profit. Workers, naturally enough, demand higher wages to get their share of the boom. The math doesn’t add up, and eventually it ends either in inflation or a financial bust.
But keep a lid on the optimism, and the boom-bust cycle can be more drawn-out and less damaging. To some extent, this is the history of the past decade, as memories of the greatest financial crisis in generations made banks, investors and chief executives cautious about committing capital. This helped to reduce the market’s normal boom-bust behavior, just as it did after the Great Depression and World War II.
Enter Mr. Trump. His election in 2016 and subsequent tax cuts led to the highest optimism readings among small businesses in history, while the Conference Board’s CEO confidence index reached a post-2008-crisis high. The stock market soared to records, and business investment picked up, although not sharply.
There was a risk of an unsustainable boom, with the stock market reaching its highest valuation in 16 years on price-to-forward earnings at the start of last year. The Federal Reserve used a series of rate increases to try to keep things under control, while worrying in public about the rapid growth of the riskiest forms of corporate debt. But Mr. Trump’s belligerent attitude to trading partners has been far more effective.
Confidence has crumbled, the stock market has pulled back—with valuations down to where they stood at the end of 2014—and companies have reined in expansion plans. It turns out that threats to global trade, and particularly the large and interconnected car industry, are an effective way to stifle a boom.
I am not suggesting that attacking trade is good economics. It isn’t: Trade has made the country richer, while widespread tit-for-tat tariffs could do serious damage to growth. If trade fights hit confidence hard enough, tariffs could even trigger a downward spiral into recession, and if a recession happens for other reasons, trade restrictions would make it worse.
I am not suggesting all investment is bad, either. Corporate investment should in principle help to improve productivity, which allows faster real growth. However, corporate investment toward the end of past booms has often been wasted, going into fancy new headquarters or projects based on shaky financial premises that happen to be fashionable with investors.
So far, the hit to confidence has been just enough to help damp financial excesses, leading to more caution among investors and CEOs. Fewer small businesses are planning capital expenditures, after a trend upward ended in October. The riskiest companies are paying more to borrow than they were last year, and more are having to provide covenants to protect investors. Again this is a change in the trend, if only a small change so far.
In the near term, less corporate borrowing and investment suggests slightly slower growth than would otherwise have happened. In the long run, limiting excesses could help extend both the economic and financial cycle even further, at the cost of missing out on some of the benefits that would have come from higher investment today.
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