Investors show Trump, Xi what they think of their trade war

Global financial markets took neither lightly nor especially well the latest breakdown in U.S.-China trade negotiations.

In particular, U.S. stocks (like those in their broadest index, the Russell 3000) have lost more than 10 percent of their value since President TrumpDonald John TrumpEsper sidesteps question on whether he aligns more with Mattis or Trump Warren embraces Thiel label: 'Good' As tensions escalate, US must intensify pressure on Iran and the IAEA MORE's flurry of tweets on May 5 announcing a series of tariff increases on Chinese imports, which was then followed by China's introduction of comparable retaliatory measures on Monday.

European and Asian markets have also declined sharply, in what some commentators are labeling a global "carnage."

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In light of the increasingly acrimonious rhetoric on both sides of the Pacific, which hints at no quick resolution of the stalemate, this sudden (and partly unexpected) decline raises at least two questions worthy of discussion:

  1. Is the carnage on Wall Street a reflection of anticipated pain for Main Street?
  2. Will this global carnage, financial or real, continue?

Unfortunately, answers to both questions are in the affirmative, albeit ones that need to be qualified. To begin with, it goes virtually uncontested among mainstream economists that tariffs on Chinese and American imports will be paid for almost entirely by local consumers (both individuals and firms), especially U.S. consumers, given that they collectively import from China more than they sell to it.

In other words, U.S. tariffs act exactly like taxes on American consumption of foreign goods and services, and those taxes will lower American consumers' real income, discourage some of their consumption and ultimately lower U.S. GDP growth, albeit not in any dramatic fashion.

So, why a global carnage rather than a more modest correction, with cries of more pain to come? For two simple, yet also profoundly complex reasons.

First, financial markets do not like uncertainty because firms and individual consumers do not like uncertainty. As of now, it is reasonable to presume not only that the trade stalemate between the world's two largest economies will continue indefinitely (or at least until the 2020 U.S. presidential elections), but also that it may engulf the European Union, Canada and Japan — with whom the U.S. continues to have a contentious trade relationship since 2017.

Given the dim prospects of the U.S.-Mexico-Canada Agreement's approval by Congress and Brexit still being on the horizon, any such uncertainty will depress individual consumption worldwide, induce firms to put on hold their investments and cause investors to require greater compensation for these risks, which translates into lower stock prices worldwide.

It is therefore not surprising that the CBOE Volatility Index, one of the markets' most popular gauges of fear, was up by more than 20 percent Monday alone.

Second, and perhaps much more important, the uncertainty surrounding this trade war is fueled by what appears to be a fundamental misunderstanding — especially by the U.S. negotiators — of the sources of the country's trade imbalance with China and the rest of the globe.

That imbalance reflects a large gap between U.S. private and public savings (low) and investments (high), which only net capital inflows from abroad (and the accompanying trade deficit) can fill.

Tariffs on trade not only do not remedy that gap but possibly risk its widening, especially since they have been accompanied by a tax reform that generated a wider budget deficit — which means even lower public savings.

A more-targeted focus on unfair trade practices and poor foreign patent protection by China would have likely gathered near universal support (and yielded more favorable outcomes); yet, such a focus does not poll well in an increasingly politicized environment.

Global financial markets recognize that U.S. "trade generals" are fighting the wrong war in the wrong battlefield with the wrong weapons. It is then no surprise that those markets are jittery.

Paolo Pasquariello is a professor at the Ross School of Business at the University of Michigan.