Trump, Regime Uncertainty, and Why Rhetoric Matters

Some defenders of President Trump have tried to justify his trade rhetoric as just that: words.  They argue that Trump will never enact the tariffs, or do so at much lower rates, so firms and individuals will not change their behavior.  However, this is a mistake.  We all make choices in an uncertain world and our actions depend, in part, on our internal calculations of the likelihood of different events (not to mention our own risk tolerances).  With these calculations, we make our actions.  If something comes along to change our perceptions, then we also adjust internally.*

Let’s, for the sake of argument, say that Firm X is considering expanding operations in the US. Let’s say they want their annual profits in the US to be $50 million/year.  They need to spend $100 million to enter into the US and set up.  Through various research, the firm concludes that, given current expectations on 1 November 2016, they have a 95% chance of achieving that goal (or a 5% chance of earning nothing and losing their $100 million investment.  The binary nature of this situation, while perhaps unrealistic, is done so the point doesn’t get lost in the math).

So, the expected value of their operation on 1 November is ([95/100]*50)+([05/100]*-100)=$42.5 million.

Now, let’s say that Trump wins the presidency and the likelihood of tariffs has increased. Given that the firm imports some of their material and may wish to import more in the future depending on conditions, they now conclude the likelihood of earning $50 million per year has fallen to, say, 80%. So, now, the expected value of the move is: ([80/100]*50)+([20/100]*-100)=$20 million! That’s a decline of 52.9%!

The firm is now faced with a decision, just as all firms are, based on their assessments of probability. The expected value of the firm’s move has fallen, which means the firm is less likely to enact the move at all. And all this is based off a change in probability, not just the tariffs themselves.

Another important thing to note is this still holds with small changes in probability, too.  Let’s say, for example, the firm’s initial probability of 95% still holds.  However, after the election the firm determines there is still a remote, but still real, possibility of tariffs and thus their probability estimate falls to 94.9%.  Their expected value drops to $42.35 million, a decline of just 0.04%.  But it is still a decline.  What this means is many marginal investments may be cancelled.  These now nonexistent marginal investments, which would have produced jobs and goods for Americans, are weighing on US economic growth.  All because of words.

With rhetoric flying about, it becomes harder and harder for firms to determine their probabilities.  In this sense, it is no different than arbitrary policy changes that causes other forms of regime uncertainty.  In short, rhetoric matters, even if it doesn’t translate into policy.

*For the sake of clarity, I am not saying people walk around and manually calculate probabilities before each and every action they take, but they often act as though they do.  For example, if a person knows a particular part of town has a higher crime rate than another, he may avoid that part altogether.  However, if that part of town becomes more safe, he may venture in there more often.  These decisions are made based on his perception of probabilities, not his actual probability.

3 thoughts on “Trump, Regime Uncertainty, and Why Rhetoric Matters

  1. Well stated. People can’t see the long-term consequences of these arbitrary and protectionist policies, and the jarring rhetoric behind them. They see the visible celebration of the 1,000 “saved” jobs in Indiana, while failing to see the second-order effects of the second company who fails to build in Indiana in the first place, because they know the salvage value may very well be zero if things go sour and they can’t escape. What we don’t see is the $2,000 per job subsidy that the government agreed to to keep those jobs in place that comes from the taxpayer. We don’t see the fact that the finished goods company down the road is teetering on the edge of bankruptcy because their input costs are higher because of protectionist tariffs that protect the steel mill down the street. We don’t see that now that we have shut off trade to protect certain industries or to “punish” certain countries, that we are all needlessly paying $2,000 more a year for our goods. We also don’t see that devoid of global competition, local companies are not forced to innovate or make their products better, faster, cheaper, in near the same amount.

    To paraphrase the old economist Henry George, isn’t it interesting that through protectionist policies that we do to ourselves voluntarily what we do to enemies in times of war?

    Liked by 1 person

  2. Jon Mpurhpy:

    I sense you are a good fellow, a serious econ student, and I note you do not insult me, when I have a different point of view than you.

    This is a serious paper written by staffers at the NY Fed.

    Click to access sr541.pdf

    “The boom-bust in U.S. house prices has been a fundamental determinant of the recent financial crisis. The securitization process that eventually lead the financial sector to the brink of collapse crucially relied on expectations of ever-increasing house prices. Understanding the causes of these house price dynamics is crucial for preventing a repeat of a similar situation in the future.
    Large and widening current account deficits accompanied soaring house prices, especially during the five years before the eruption of the crisis (figure 1). These two variables were perhaps the most discussed indicators of U.S. imbalances (Greenspan, 2005). Interestingly, the negative correlation between house price dynamics and current account balances is not specific to the U.S. but rather a robust global phenomenon, affecting advanced and emerging market economies alike(figure2).1 Countries that witnessed house price boom and substantial external deficits (such as Greece, Iceland, Ireland, Spain and the U.S.) also experienced among the highest degrees of financial turmoil during the crisis.2”

    Fascinating. Run a big trade deficit and boom your house prices….

    Huge trade deficits lead to gigantic and unstable house price booms?

    Who knew? But I think the mechanism still requires property zoning….

    The trigger for higher house prices is limited supply.

    And remember, banks are happy to lend on appreciating property, a asset that cannot run away, and on which there are barriers to entry (property zoning).

    Ergo, I think I stand on solid ground, when I say, “You can accept huge trade deficits, but acknowledge that in the United States huge trade deficits tend to skyrocket house prices, due to ubiquitous property zoning.”


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