Trying to decipher Trump 2.0 using Stephen Miran's paper

Trying to decipher Trump 2.0…some excerpts from Stephen Miran’s paper (these are some excerpts selected from it during my reading, the highlighted portions are my own selections). This is a long read. In my next post, I will try to pick out some of the possible investment opportunities if Trump proceeds with implementing some of these ideas:

The deep unhappiness with the prevailing economic order is rooted in persistent overvaluation of the dollar and asymmetric trade conditions. Such overvaluation makes U.S. exports less competitive, U.S. imports cheaper, and handicaps American manufacturing. Manufacturing employment declines as factories close. Those local economies subside, many working families are unable to support themselves and become addicted to government handouts or opioids or move to more prosperous locations. Infrastructure declines as governments no longer service it, and housing and factories lay abandoned. Communities are “blighted.”

Because America provides reserve assets to the world, there is demand for U.S. dollars (USD) and U.S. Treasury securities (USTs) that is not rooted in balancing trade or in optimizing risk-adjusted returns. These reserve functions serve to facilitate international trade and provide a vehicle for large pools of savings, often held for policy reasons (e.g. reserve or currency management or sovereign wealth funds) rather than return maximization. Much (but not all) of the reserve demand for USDs and USTs is inelastic with respect to economic or investment fundamentals. Treasurys bought to collateralize trade between Micronesia and Polynesia are bought irrespective of the U.S. trade balance with either, the latest jobs report, or the relative return of Treasurys vs. German Bunds.

Such phenomena reflect what can be described as a “Triffin world,” after Belgian economist Robert Triffin. In Triffin world, reserve assets are a form of global money supply, and demand for them is a function of global trade and savings, not the domestic trade balance or return characteristics of the reserve nation.

America runs large current account deficits not because it imports too much, but it imports too much because it must export USTs to provide reserve assets and facilitate global growth. This view has been discussed by prominent policymakers from both the United States (e.g. Feldstein and Volcker, 2013) as well as China (e.g. Zhou, 2009)

According to the World Trade Organization, the United States effective tariff on imports is the lowest any nation in the world imposes at about 3%, while the European Union imposes about 5% and China 10%. These numbers are averages across all imports and not reflective of bilateral tariff rates; bilateral discrepancies can be much larger, for instance the U.S. imposes only 2.5% tariffs on auto imports from the E.U., while Europe imposes a 10% duty on American auto imports. Many developing nations apply much higher rates, and Bangladesh has the world’s highest effective rate at 155%. These tariffs are, in large part, legacies of an era in which the United States wanted to generously open its markets to the rest of the world at advantageous terms to assist with rebuilding after World War II, or in creating alliances during the Cold War.

Reserve nation status comes with three major consequences: somewhat cheaper borrowing, more expensive currency, and the ability pursue security goals via the financial system.

Because nations accumulate reserves in part to stem appreciation pressures in their own currencies, there is a contemporaneous negative correlation between the exchange value of the dollar and the level of global reserves. Reserves tend to go up when the dollar is going down, as accumulators buy dollars to suppress their currencies, and vice versa when the dollar is going up.

The interplay between reserve status and the loss of manufacturing jobs is sharpest during economic downturns. Because the reserve asset is “safe,” the dollar appreciates during recessions. By contrast, other nations’ currencies tend to depreciate when they go through an economic downturn. That means that when aggregate demand suffers a decline, pain in export sectors get compounded by a sharp erosion of competitiveness. Thus employment in manufacturing declines steeply during a recession in the United States, and then fails to recover materially afterward.

Finally, if the reserve asset is the lifeblood of the global trade and financial systems, it means that whoever controls the reserve asset and currency can exert some level of control trade and financial transactions. That allows America to exert its will in foreign and security policy using financial force instead of kinetic force. America can, and does, sanction people all over the globe in a variety of ways. From freezing assets to cutting nations off from SWIFT and restricting access to the U.S. banking and financial system that is critical for any foreign bank doing global business, the U.S. exerts its financial might to achieve foreign policy ends of weakening enemies without having to mobilize a single soldier. Economists cannot evaluate whether America’s national security goals are worthy, only note that it can achieve them far more cheaply because of America’s control of the international trade and financial systems by virtue of our reserve currency status.

The tradeoff is thus between export competitiveness and financial power projection. Because power projection is inextricable from the global security order America underwrites, we need to understand the question of reserve status as intertwined with national security. America provides a global defense shield to liberal democracies, and in exchange, America receives the benefits of reserve status—and, as we are grappling with today, the burdens.

This connection helps explain why President Trump views other nations as taking advantage of America in both defense and trade simultaneously: the defense umbrella and our trade deficits are linked, through the currency.

Tariffs are a familiar tool to President Trump and his team, since they were used—with success—extensively in 2018- 2019 in trade negotiations with China. Those tariffs passed with little discernible macroeconomic consequence— inflation remained stable or even declined, and GDP growth continued to perform quite well despite the Fed’s hiking cycle. It is therefore reasonable to expect tariffs once again to be a primary tool.

It is likely that the goods that are still directly exported to the U.S. and therefore subject to the tariffs are the ones over which the Chinese exporters retain the most pricing power and the greatest ability to pass through price increases on Americans. The goods on which Chinese exporters do not have pricing power, and over which they might have to absorb the tariffs, are the ones most likely to be re-exported via a third country. Chinese exporters will not pay the cost of diverting exports if they can push through price increases on purchasers.

If the currency markets adjust, tariffs can have quite modest inflationary impacts, between 0% and 0.6% on consumer prices. Given the inflation volatility of recent years, this is nontrivial, but hardly earthshaking. Clearly, the experience of 2018-2019 was that there were only imperceptible increases on the general price level. Moreover, the totality of tax reform, deregulation, and energy abundance can serve as meaningful disinflation drivers that smother any incipient inflationary impulses; it is quite possible that even with substantial tariffs, Trump Administration policy is overall disinflationary.

In a world of perfect currency offset, the effective price of imported goods doesn’t change, but since the exporter’s currency weakens, its real wealth and purchasing power decline. American consumers’ purchasing power isn’t affected, since the tariff and the currency move cancel each other out, but since the exporters’ citizens became poorer as a result of the currency move, the exporting nation “pays for” or bears the burden of the tax, while the U.S. Treasury collects the revenue.

While the effective price paid by U.S. importers may not change very much with perfect currency offset, U.S. exporters now face a competitiveness challenge insofar as the dollar has become more costly for foreign importers.

President Trump has expressed a desire to take steps to aggressively deregulate portions of the economy. If doing so serves as a boost to growth, it may provide further noninflationary support for the dollar.

The U.S. can proceed to gradually implement tariffs if China does not meet these demands. It might announce a schedule, for instance, a 2% monthly increase in tariffs on China, in perpetuity, until the demands are met.

Such a policy will 1) gradually ramp tariffs at a pace not too different from 2018-2019, which the economy seemed able to easily absorb; 2) put the ball in China’s court for reforming their economic system; 3) allow tariffs to exceed 60% midway through the term, which is something President Trump has expressed wanting (“60% is a starting point”); 4) provide firms with clarity over the path for tariffs, which will help them make plans to deal with supply chain adjustments and moving production outside of China; 5) limit financial market volatility by removing uncertainty regarding implementation.

2018-2019 did not severely hobble China’s economy and bring back all its supply chains to the United States. In part, this is because it was a one-time shock to tariff rates, which was mostly offset by the currency. By contrast, a plan like the one set forth above would result in a perpetually rising tariff rate on a known and gradual path. That would likely instill much greater capital pressures on China and more rearrangement of supply chains.

Scott Bessent, a Trump advisor floated as potential Treasury Secretary, has proposed putting countries into different groups based on their currency policies, the terms of bilateral trade agreements and security agreements, their values and more. Per Bessent (2024), these buckets can bear different tariff rates

Trade terms can be a means of procuring better security outcomes and burden sharing. In Bessent’s words, “more clearly segmenting the international economy into zones based on common security and economic systems would help … highlight the persistence of imbalances and introduce more friction points to deal with them.” Countries that want to be inside the defense umbrella must also be inside the fair trade umbrella.

Such a tool can be used to pressure other nations to join our tariffs against China, creating a multilateral approach toward tariffs.

From America’s perspective, if other nations choose to keep their current policies vis China but accept the higher U.S. tariff, that’s not terrible—because then, in this framework, at least they’re paying revenue to Treasury, and limiting the security obligations of the United States. Joining a tariff wall with a security umbrella is a high-risk strategy, but if it works, it is also high reward.

Investment houses are now projecting that the projected effective rate of the tariffs proposed by President Trump will jump from 2.3% to 17%, just shy of this 20% level.

Moreover, tariffs can address pre-existing distortions due to other nations’ trade policies. The list of China’s abuses of the international trade system is long and storied, and ranges from state subsidies for export-oriented industries to outright theft of intellectual property and corporate sabotage. These distortions interfere with the discovery of comparative advantage and a free and open system of international trade. Applying corrective tariffs to address these distortions may improve overall efficiency.

Because the United States is a large source of consumer demand for the world with robust capital markets, it can withstand tit-for-tat escalation more easily than other nations and is likelier to win a game of chicken. Recall that China’s economy is dependent on capital controls keeping savings invested in increasingly inefficient allocations of capital to unproductive assets like empty apartment buildings. If tit-for-tat escalation causes increasing pressure on those capital controls for money to leave China, their economy can experience far more severe volatility than the American economy. This natural advantage limits the ability of China to respond to tariff increases.

With respect to other nations, if the Trump Administration merges national security and trade policy explicitly, it may provide some incentives against retaliation. For instance, it could declare that it views joint defense obligations and the American defense umbrella as less binding or reliable for nations which implement retaliatory tariffs.

Additionally, it’s not clear whether one should view the failure of this deterrent as a bad outcome. Suppose the U.S. levels tariffs on NATO partners and threatens to weaken its NATO joint defense obligations if it is hit with retaliatory tariffs. If Europe retaliates but dramatically boosts its own defense expenditures and capabilities, alleviating the United States’ burden for global security and threatening less overextension of our capabilities, it will have accom­plished several goals. Europe taking a greater role in its own defense allows the U.S. to concentrate more on China, which is a far greater economic and national security threat to America than Russia is, while generating revenue.

What is clear, however, is that given all these considerations, the Trump team will view tariffs as an effective means of raising taxes on foreigners to pay for retaining low tax rates on Americans.

The disincentive for holding equities is somewhat mitigated, as earnings rise to offset some of the currency losses. A significant portion of sales made by S&P 500 companies come from abroad, and those sales are worth more in dollar terms as the dollar depreciates. Earnings will increase as companies are able to increase selling prices. While higher yields may weigh on multiples, the increase in earnings can mitigate volatility.

As things stand, there is little reason to expect that either Europe or China would agree to a coordinated move to strengthen their currencies. European real GDP growth has been below 1% for almost three years, and the rise of the Chinese auto export industry has Europe so concerned it is implementing its own set of protectionist measures to limit imports. And Chinese domestic growth has been so weak that China has chosen to double down on its mercantilist, export-led model to secure marginal income, much to the rest of the world’s consternation. Indeed, China was basically a non-player in global auto exports just a few years ago, and has now rocketed up to be the world’s biggest auto exporter.Neither Europe nor China will be in the mood to curtail their industrial subsidies and other market interventions that would reallocate tradeable manufacturing demand away from themselves and toward the United States.

Japan, the U.K., and potentially Canada and Mexico, might prove more amenable to currency intervention, but aren’t large enough in today’s global economy to accomplish the desired end.

Instead, recall that President Trump views tariffs as generating negotiating leverage for making deals. It is easier to imagine that after a series of punitive tariffs, trading partners like Europe and China become more receptive to some manner of currency accord in exchange for a reduction of tariffs.

President Trump will want foreigners to help pay for the security zone provided by the United States. A reduction in the value of the dollar helps create manufacturing jobs in America and reallocates aggregate demand from the rest of the world to the U.S. The term-out of reserve debt helps prevent financial market volatility and the economic damage that would ensue. Multiple goals are accomplished with one agreement.

With President Trump unable to run for another term, he can focus on his legacy and achieving some of his core goals of reindustrialization, manufacturing revitalization, and improved international competitiveness.

Moreover, because reducing inflation is critical to helping alleviate bond market concerns as well as allowing the Fed to pursue a deeper cutting cycle, a Trump Administration is likely to prioritize structural policies that reduce inflation via supply side liberalization. That means aggressive deregulation, and a concentrated effort to reduce energy prices. This combination is probably bearish oil prices, but ambiguous for energy producers, and quite bullish for equities and growth. If deregulation boosts potential growth and reduces inflation—as this contributed to the noninflationary growth experienced in the first Trump Administration—that will help support both the bond and equity markets.

An agreement whereby our trading partners term out their reserve holdings into ultra-long duration UST securities will a) alleviate funding pressure on the Treasury and reduce the amount of duration Treasury needs to sell into the market; b) improve debt sustainability by reducing the amount of debt that will need to be rolled over at higher rates as the budget deteriorates over time; and c) solidify that our provision of a defense umbrella and reserve assets are intertwined. There may even be arguments for selling perpetuals rather than century bonds, in this eventuality.

In All Cases

There are some common consequences across all these possible scenarios, if the Administration pursues any of them.

First, a much stronger demarcation between friend, foe and neutral trading partner. Friends are inside the security and economic umbrella, but there is more burden sharing.

Second, the threat of withdrawal of the security umbrella without burden sharing will have its own, potentially volatile, consequences. Will it spur nations around the world to invest more in defense? Will it encourage more aggressive action by bad actors against those now outside the defense umbrella?

Third, a structural increase in implied volatility in currency markets. The scope for monumental, once-every-few-decades level of shifts in policy ought to significantly heighten expectations for volatility.

Fourth, these policies may supercharge efforts of those looking to minimize exposure to the United States. Efforts to find alternatives to the dollar and dollar assets will intensify. There remain significant structural challenges with internationalizing the renminbi or inventing any sort of “BRICS currency,” so any such efforts will likely continue to fail, but alternative reserve assets like gold or cryptocurrencies will likely benefit.

Conclusion

Wall Street consensus that an Administration has no means by which to affect the foreign exchange value of the dollar, should it desire to do so, is wrong. Government has many means of doing so, both multilaterally and unilaterally. No matter what approach it takes, however, attention must be paid to steps to minimize volatility. Assistance from trading partners or the Federal Reserve can be helpful in doing so.

In any case, because President Trump has shown tariffs are a means by which he can successfully extract negotiating leverage—and revenue—from trading partners, it is quite likely that tariffs are used prior to any currency tools. Because tariffs are USD-positive, it will be important for investors to understand the sequencing of reforms to the international trading system. The dollar is likely to strengthen before it reverses, if it does so.

There is a path by which the Trump Administration can reconfigure the global trading and financial systems to America’s benefit, but it is narrow, and will require careful planning, precise execution, and attention to steps to minimize adverse consequences.