President Trump is threatening a trade war with Europe. “I’ve had a lot of problems with the European Union, and it may morph into something very big from … a trade standpoint,” Trump said in an interview with British ITV on Sunday. “It’s a very unfair situation, we cannot get our product in. It’s very, very tough, and yet they send their product to us — no taxes, very little taxes.”
Yes, trade in goods and services with Europe is not precisely balanced. But why? Is it because it’s so hard to get products in, and they have a tax advantage? Wasn’t that supposedly taken care of in the recent tax bill?
Like most of what Trump says, the statement is not only wrong, but completely misses the difficult underlying reason why US trade will never be in balance. It’s a major feature of the power we wield around the world through the greatest strength we have – the US Dollar. And messing it up may make us lose far more than we think to in the destruction of a “war.”
Comparing the relative value of currencies is always open to interpretation. There are two basic ways of looking at the exchange between two economies and the medium of exchange that they operate under. One is the bank rate, or what you can get when you go to move value from one system to another. The other way is to look at what that money will buy in the local economy, known as Purchasing Power Parity (PPP).
They are very different things sometimes. A good comparison is hard to make.
In order to see what people can buy with their Pounds, Yuan, Pesos, or Euros we would need to have something which is standard around the world yet made entirely with local products for the local market.
Over 40 years ago, a standard was proposed by the Economist magazine – the Big Mac Standard. Made entirely of fresh (ish) ingredients to specifications kept the same everywhere, the cost of a Big Mac should reflect PPP completely independently of what any exchange bank has to say about it.
The whole thing started as a joke, but it proved to be remarkably useful.
If you average the cost of a Big Mac across the entire Euro area, you find that it comes in at €3.95, which a bank would tell you is $4.84. That’s cheaper than the US average of $5.28 by 8.4%. In other words, the Euro is undervalued by about 8.4% at PPP or what people can buy with it.
The net result is that a Big Mac imported from the US, other than being a bit stale and nasty by the time it gets there, would be 8.4% more expensive than a local one.
Comparing burgers to Buicks may not seem all that useful when talking about the US trade deficit with Europe, but it gives us a baseline for understanding how much more expensive the US Dollar itself is. When you look at Europe, you take away all the effects of comparing a developed versus a developing economy and have a pretty uncooked measure of how expensive the US Dollar is.
Why is the buck more expensive? About 85% of worldwide trade is denoted in Dollars. When Europe buys oil from Qatar, it’s priced in dollars. When China buys aluminum from Brazil it’s priced in dollars. Nearly everything, all over the world, no matter where it comes from or where it is going, is greased with the greenback.
As a result, the demand for US Dollars is higher than it should otherwise be. How much higher? Apparently , about 8.4%.
This figure is important when looking at trade with Europe. Again, we’re talking a bout two developed economies and considerations regarding wages and all that other stuff is largely taken out. In 2016, the last year available, the total value of goods and services traded with Europe was $501 billion in US exports and $592 billion in imports. Over the entire load of about $1.1 trillion the net deficit for the US was $92 billion.
That’s about 8.4%. Notice how that number keeps coming up.
You may see this written up in a lot of different ways, so it’s best to be careful. Total trade in physical goods, $269 billion in US exports, had a deficit of $147 billion, a much nastier looking number. But it was partially made up by the nearly equal volume of services where the US ran a surplus. You have to look at the bottom line because that is the number that should even out between two highly developed economies.
It doesn’t even out, and it won’t. Global traders want US Dollars because they need them to buy everything else.
So why do we have a trade imbalance with everyone, including Europe? Is the whole world terribly unfair to us? Are we losing because, damintall, we just don’t have enough laws and low enough taxes?
The short answer is a solid “No.” We have the trade imbalance we do because currencies, like everything else in a free market, are subject to market forces. The dominance of the US Dollar as the payment method for absolutely everything in the roughly $21 trillion in global trade (27% of world GDP) makes it very valuable.
And it makes everything else in the rest of the world appear cheaper to American consumers holing these valuable greenbacks.
Is Europe treating us unfairly when it comes to trade? Absolutely not. A trade war would not only be pointless, it would cause immense damage. Like every war, there are ultimately no real “winners” and a lot of losers starving in its wake. There is no justification for it at all.
The only way to fire up the manufacturing base in the American heartland is for the world to give up the US Dollar standard and start trading in the same Pounds, Yuan, Pesos, and Euros that they use in their daily life. If that were to happen, just about everything in your local Wal-Mart would cost about 8.4% more, based on my best guess, meaning that it would be paid for by American consumers currently enjoying the cheapest goods from around the world.
What would a trade war do? If anything, it might accelerate the end of the global standard based on the US Dollar which has been in place since the end of World War II – and was indeed one of the main triggers of the glory daze of the 1950s which some people want to bring back.
So perhaps we should all be careful what we wish for, or more accurately be careful how we lash out. Relentless whining about “unfairness” is one thing, but the genuine tantrum of a trade war might just get us something we’re not exactly ready for.