Last night, President Trump tweeted that the US was going to move toward higher tariffs on Chinese goods. Global stock markets immediately sold off, losing over a trillion dollars in market value. Today, there has been a partial recovery, but stocks are still significantly lower. How should we think about these losses?
One view is that the drop doesn’t matter, as stocks will bounce back after the two sides reach a trade deal. I do believe that it is highly likely that stocks will bounce back after a trade deal is reached, but this does not mean that the market decline is unimportant. A trillion dollars of wealth was destroyed in a short period of time, and that is the best estimate we have of the permanent damage done by Trump’s tweet. So how can I reconcile those two claims?
Consider this admittedly far-fetched thought experiment. A future President, let’s call him “Nero”, is bored with his job. He decides to have the military plant bombs next to $10 trillion worth of infrastructure. Then he puts numbers one through ten in a hat, and pulls one number out at random. If the number is 7, the bombs go off and the infrastructure is destroyed. If any other number is pulled, the bombs are removed and no damage is done.
In that case, both claims would be true:
1. It is much more likely than not that the game will do no permanent damage to the economy.
2. The expected value of the change in wealth from playing this game is a loss of $1 trillion.
The odds are pretty high that there will be no long run damage from the Trump tweet. But stock investors also look at tail risk, and trade wars destroy wealth just as surely as bombs. In the unlikely event that things spiral into a major trade war, then look out below!
PS. This post is not an overall evaluation of Trump’s policies. For instance, it’s likely the corporate tax cut created lots of wealth.
PPS. It was unlikely that the 9/11 terrorist attacks would succeed. Even Bin Laden was surprised. But when it did, it destroyed trillions in wealth (directly and indirectly.)
READER COMMENTS
Thaomas
May 6 2019 at 5:25pm
This analysis assumes both perfect estimation of the damage from the tariffs and of the estimation of the probabilities of their implementation. This is probably not far off for tariffs which have (my guess, anyway) pretty clear economic costs and roughly zero income distribution consequences between stock owners and non-stock owners. I think this would not be the case in a similar event (although there was no such similar event) concerning a tax bill that has much less clear economic costs (or benefits?) and a definitely positive income distribution effect in favor of stock owners.
Scott Sumner
May 6 2019 at 6:26pm
Thaomas, You said:
“This analysis assumes both perfect estimation of the damage from the tariffs and of the estimation of the probabilities of their implementation.”
Not really. I think most readers will understand that I was speaking in round numbers, not that the damage was $1 trillion to the penny.
Phil H
May 7 2019 at 10:38am
I can’t work out if this is correct or not but…
There’s something about financial assets that isn’t like other assets. Like, they can’t all be realized at the same time; many of them represent future value in some way; they are in some sense notional rather than actual.
As such, fluctuations in value on the stock exchange don’t seem to be quite the same sort of thing as fluctuations in, say, the supply of land. Wouldn’t it be more accurate to say that a shock of an unknown size hit the economy, and the stock markets acted like a shock-absorber. Kind of, it took the hit, so we don’t have to? You would then be correct to say that the only relevant measure of the impact to the stock exchange was the actual reaction of the stock exchange; but the real economy hit would be some multiple less?
Scott Sumner
May 7 2019 at 12:17pm
Phil, I think you need more precise terms than “realized”, “notional”, and “actual”. Vague terminology leads to sloppy thinking.
For instance, does “realized” mean “sold”? If so, say so. It’s just as hard to sell all real assets at once as to sell all financial assets at once.
Phil H
May 7 2019 at 6:13pm
Yes, thank you. I was getting worried as I typed it that I seemed to be handwaving… I will go and reconsider these ideas, to try to work out if there is actually any substance there!
Michael Rulle
May 10 2019 at 11:49am
I agree with your point—but not completely. I don’t understand why you left out half the argument, as if only the marginal action by Trump is what matters. Xi’s “non-marginal” actions cost the world a far greater amount than Trump’s marginal actions. Whatever happenned to opportunity costs? The easiest ones to forget for sure. How much did Xi cost the world by not eliminating all tariffs (US is already near the lowest). Yes—“unrealistic”—-but only because we accept the WTO’s development ideas; or that his irrationality is baked in; or he has some 4000 year plan; or he wants “Mao Power”; etc., etc.. So I agree that Trump’s actions hurt us—and I don’t like it at all—but not nearly as much as I dislike Xi’s non-actions.
Michael Pettengill
May 11 2019 at 6:47am
Since circa the meaning of terms like value and wealth have changed in what I consider bizarre ways.
I grew up when the value of a home was it could house a family of four. I live in such a home that would in 1960 house a very wealthy family of four and then cost perhaps $80k. I paid $200k at the peak in 1986, so in 1990 is price was maybe $150k, up to over $300k in 2000, up to over $400k, back down to $300k in 2008.
As iI owned it effectively free and clear by the mid 90s, it represented what in the 60s was wealth. Housing that was secure in its status of “homestead”, ie, protected from tax foreclosure as long as I lived in it. (Such protection has a price limit that has not been indexed to inflation in most places).
I see the value of my house and the wealth it represents as unchanged over the time I’ve owned it, even tho the price has gone up and down, with you arguing I had more wealth destroyed than it original cost to me, possible because you consider inflation to create wealth.
Of course, what was a high living cost house in 1960 is now considered modest living cost today, enabled by much higher labor cost for all workers, but less high since 2000 for computer people like I was.
Personally, I think the actual production aka utility of assets defines value and wealth, not fluctuating prices from capital scarcity and surplus.
mike davis
May 12 2019 at 3:56pm
The Nero story needs more information before we can figure out the impact on wealth. Specifically, we need to know what people thought about Nero before he planted the bombs and what happened after the bomb incident was resolved.
I assume that Scott’s definition of wealth includes the market value of the assets that might have been destroyed. I also assume Scott believes that market value is at least influenced by the expected present value of the income generated by those assets. (He doesn’t have to believe that market value is equal to the expected PV of income—there can be risk aversion and market imperfections—he just has to think that matters.)
Now let’s think about what happens in three different scenarios
Scenario #1: Everyone knew Nero was crazy when he became Emperor and knows he will never change. When Nero announces that the bombs are in place nothing changes. The announcement added no new information and so didn’t change the market value of the assets. Similarly, if Nero picks a number other than 7 and the bombs don’t go off, nothing changes since the results of the lottery don’t add new information. Everyone knows Nero is still crazy and will pull another stunt like this. (Ok, maybe the failure of the bomb to explode increases the market value of assets by a bit if people now think that Nero will have fewer future opportunities to mess things up.)
Scenario #2: No one really thought that Nero was crazy when he became Emperor but after he announces the bombs they realize he his and that he will always be crazy. Here, the announcement of the bomb destroys wealth since this is new information. If the asset owners get lucky and the bomb doesn’t go off, they don’t see much of an increase in asset value since the madness of Nero will be permanently priced into the market.
Scenario #3: Everyone knew Nero was crazy but they think a close call will restore him to sanity. Here, no wealth is destroyed when Nero announces the bombs. But if the bombs don’t go off, wealth goes up since people believe the threat has passed and another will not follow.
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