Hugo Scott-Gall: Today I’m delighted to have with me, again, Olga Bitel. Olga is our economist strategist on our team, the global team in William Blair Investment Management. Olga is coming back onto the show for the 10,000th time, I think it is. You’re our most frequent guest, but you’re the most frequent guest for a reason. Olga’s back on the show to talk about tariffs, everything you perhaps didn’t know you needed to know, but now you do. Olga, welcome.

Olga Bitel: Thank you, Hugo. Delighted to join you as usual.

Hugo Scott-Gall: Great, let’s talk about tariffs, let’s talk about the theory of tariffs. Why were tariffs ever invented? Why did someone, I don’t know who the first person put a tariff on something, why did they think it was a good idea?

Olga Bitel: Well, the tariffs as an instrument, as an economic instrument, go way, way back. And I suppose in terms of sound economic theory, tariffs first and foremost were used as a way to raise revenue for a sovereign. Whether that sovereign is a knight, a king, a prince, an emir, more recently a democratically elected leader of parliament. Tariffs are used to raise revenue for the treasury, raise taxes.

The attraction of tariffs is that notionally, it’s a tax on foreigners. So, you are protecting your domestic constituency while enabling yourself and your government to have some revenue to affect the changes that you’d like to make.

Up until the very early part of the 20th century, the U.S. Treasury funded itself predominantly through tariffs. In other words, tariffs on foreign companies were, or accounted for, the vast majority of revenues that the U.S. government had at its disposal. Unfortunately, tariffs as a tax raising mechanism have been proven to be highly ineffective. Not least because in order to raise the amount of money that is necessary for a modern government to function, the economic distortions that tariffs bring are too large relative to the benefits of revenue raising. Which is why since arguably the 30s, tariffs have largely been discredited as a tool of macroeconomic policy. More recently, tariffs have come back in vogue as a pushback against globalization, as a pushback against the perceived grievances of lost competitiveness of domestic constituents of industries.

And so, not just in the U.S., but in other parts of the world, companies and select groups have been clamoring for more protection, more protection against foreign competition, more protection against loss of jobs. And tariffs in some circles today are viewed as a viable mechanism to affect those protections

Hugo Scott-Gall: I was going to ask you about comparative advantage.

To the extent that trade didn’t have too many frictions, and you can go back centuries, the notion, theory of comparative advantage worked pretty well. You make this better than I can so I’ll buy it from you, but I make this better than you can, so you’ll buy it from me. That generally, subject to the frictions of transportation and any other trade frictions, that generally worked pretty well. And so that’s been happening for a long time.

Country A is more prosperous, has higher wages, higher labor costs, higher input costs than Country B. So, Country B makes things that Country A can’t make. But Country A also makes things, including services, that Country B can’t make. So, that overall system has had winners, losers, has had bumps and kinks in the road. But it’s worked pretty well if you look at…global GDP or GDP per capita or any measure of human progress.

Olga Bitel: Yes, that’s true. So, Ricardo is famous for a reason. Unfortunately, what has happened in the U.S. in particular, but this is not just a U.S. phenomenon, is that if you look at, and this is really a key chart in terms of, from our vantage point here on the WB’s global strategy team. If you look at the earnings power of the U.S. employment, so take all the people currently in employment and roughly half of them, so this is broadly in manufacturing and vast majority of these people are in services. They now earn relative to prices about 25% less than they did in relative to 1960s.

What it means is not relative in absolute terms, obviously today you’re making much more per hour, even in the lowest income cohorts than you did in the 1960s, but relative to the prices and relative to other people in the economy that then set, whose purchasing power then sets those prices.

And so, what you’ve seen is a real bifurcation of incomes. That started to happen in the 70s, and it really hasn’t adjusted since then. In the last decade or so, we’ve started to see some minor adjustments back toward equilibrium, but they have been very, very slow and very painful. So, when half of your population loses that much purchasing power, you start to look for culprits.

In the early 80s with the rise of neoliberalism, the culprit was thought to be terrible economic policies. We needed different antitrust rules, we needed less competition, we needed firmer price support, we needed better corporate profitability. All of these things came into place. So, corporate profitability today as a share of GDP is at record levels, but yet that inequality of income generation for the employees has not been corrected.

And so, one of the proposals and one of the things that is driving the resumption of tariffs as an attractive means to remedy this situation is that it’s foreigners fault. Somebody is subsidizing their production, they’re affecting their competitive advantage in Ricardo’s parlance, they’re changing the relative terms of trade to our disadvantage, therefore we must compensate by imposing tariffs.

Hugo Scott-Gall: So, in your mental model, country A sees a big displacement, it sees a meaningful reduction in the purchasing power, real wages, of a meaningful percentage of its population, which gives rise to, we should impose tariffs. The problem is a real one, which is, the outcomes for a meaningful percentage of the population are worse than they expected.

And therefore, they feel something should be done. The easy thing to do is blame a trading system versus why have we been unable to create jobs, employment, higher wage jobs in other areas of the economy that aren’t being impacted by someone else in another country making things better, cheaper, more conveniently than us. Is that a reasonable framing and therefore there are kind of political tipping points where if more than X percentage of a population feels this way then the groundswell for change becomes really quite powerful.

It’s not necessarily the trading system, it can be a fault in government to create the conditions to compensate for this loss of jobs in one area by making growing other areas. So, there’s an internal how did the government of the country in question deal with a loss of comparative advantage or loss of competitive advantage versus other countries. So, you can either blame the trading system or you can say the government in question should have done more to create alternative growth, sources of growth, opportunities inside a country. Does that make sense?

Olga Bitel: It does, absolutely. As usual, you’re much better at summarizing my arguments than I am. Well put. So look, I think the question is actually even broader than what should a government, A, have done to incentivize growth? The question is really under which conditions, does private sector thrive? And what kind of an economy or a society do we want to have? By we, I don’t mean the United States. I mean that can be applied to any economic or regional jurisdiction. And I think that’s the question that unfortunately hasn’t been asked or certainly hasn’t been asked recently. But you’re quite right. That’s exactly what we should be asking.

And I think if we do that, then the answers to why you’re losing competitiveness and what kinds of jobs do you aspire to have become slightly different, right? So, answers here would be, you want to have more competition in industries and in sectors, not just from international producers, but even within your country, from the domestic producers. You want to have a richer supply chain across all goods and services because that incentivizes innovation that forces companies to invest. It forces them to stay a little bit ahead of the competition rather than to run to a government in question and ask for the next handout or protection or whatever the case may be.

On the labor side, the relevant metrics become education. We don’t need millions more PhDs, but what kinds of jobs are there, not just today, but for tomorrow? What do people want to be doing? Even if you’re in so-called blue collar or more vocational type training, you know, as a plumber or as an electrician, might you need to have some computer skills today such that you can organize your jobs, your procurement, your sales efforts more efficiently? What kind of training does that entail? What kind of elementary and regular education do you need to support the production of that working class?

Similarly in services, the educational attainment of a highly skilled technical society are rising all the time. Are we keeping up? Or is it the case that the sorts of jobs that our companies are producing, we are not able to fill domestically because we’re not producing the right types of engineers, bankers, lawyers, career professionals, whatever you want to call.

Hugo Scott-Gall: I guess the security argument, which is even if country B is the best at making this and it’s a better product and cheaper than we could make ourselves, if we’re not able to access that product, we’ve got a serious problem. Does that justify tariffs to protect a domestic industry, the security considerations, or are there some things where you should protect domestic industries for security purposes?

Olga Bitel: That’s a really, really interesting question. And this is arguably where European answer to the calamities of the first half of the 20th century is really a radical departure from anything we have seen up until that point. And that’s really been the idea behind globalization more broadly. And the idea here is to intertwine every country’s supply chains into an existing global system such that no one jurisdiction would be either interested in or, to your point, capable of starting a military conflict. In practice, it hasn’t worked out this way. And so to the extent that COVID has revealed significant national vulnerabilities in our domestic procurement and supply systems, you’re quite right. National security has been elevated to become an argument against further globalization toward more domestic support with the aim of producing everything you need for your country to function properly within its borders.

And in an extreme, it’s quite dangerous in the sense that nobody has a ministry of offense. Everybody only has a ministry of defense. So, if we’re all busy defending ourselves, who’s attacking whom? And if we are building up domestic defense capabilities and national supply chain resilience, what are we going to do with all of those capabilities five, 10 years down the road? Those companies and industries and products are going to need a market and a market for defense capabilities is usually a war. That’s the challenge with that line of thinking. But you’re quite right. COVID has raised national supply chain resilience as a key concern and to an extent it is being addressed.

Hugo Scott-Gall: Okay, let’s talk about the impact of tariffs. It’s not just the U.S., but it’s the U.S. that has instigated this round of tariff increases. Now, some countries have responded or threatened to respond. But let’s just talk about the mechanical impacts of tariffs. If a country, so in this case, the USA says, we’re going to impose tariffs on imported goods, who pays that?

Olga Bitel: If the U.S. imposes tariffs on country B’s goods, U.S. consumers and largely U.S. producers, so those two cohorts, will end up paying that tax. So, we already have empirical evidence of this. We’ve had a first round of tariffs in 2018–2019-time frame.

There are pretty isolated examples relative to the more broad-based tariff structure that we seem to be putting in place today. But nevertheless, I think those examples are informative. For example, we introduced a tax on washing machines. What ended up happening is that the U.S. consumers paid a higher price for washing machines. The demand for washing machines had plateaued. So, before it was rising at roughly the rate of nominal GDP growth and post the tariff introduction that demand growth plateaued. What’s also interesting is that the price of dryers also went up, even though dryers weren’t taxed or tariffed rather explicitly. So because washing machines and dryers are sold in combination, the combo units went up in price. What this episode tells you is several things. The first is that when you increase tariffs on foreign producers, domestic producers will adjust their prices to just below the rate of the new price with tariff. This makes sense if you’re looking to improve their domestic producer’s profitability, you want them to achieve that through higher prices. Higher prices then will eat into the purchasing power of domestic consumers such that it will ultimately result in some marginal or significant demand destruction. So, that’s what we mean when we say, or that’s rather what the economists mean when they say that domestic consumers and producers pay for tariffs. Incidentally, if you look at the price, stock price, not that it’s everything, but also profitability, of the U.S. washing and dryer machine producers, you will notice that there has not been an improvement in profitability for these businesses. Now we can dig into why that is and why they have failed to produce better products that are cheaper and more efficient and arguably even more durable. And that’s why we go back to the original argument, which is that tariffs are not really an effective way to incentivize domestic investment and innovation and improvement when used in isolation. So, I don’t think it will be different this time. I think the U.S. consumers will end up largely paying the brunt of the tariff increases and to a lesser extent U.S. producers, but mostly U.S. consumers.

Hugo Scott-Gall: Therefore, when tariffs take effect, and we don’t know exactly, it’s a negotiation, but assuming that there are going to be increased tariffs year over year on many goods coming to the U.S., the economic consequence and impact of that is to depress demand, therefore economic activity, therefore a weaker economy, potentially it could be higher unemployment, certainly it could be lower corporate profitability. Is that a logical thread that makes sense.

Olga Bitel: It is indeed. This is why we’re kind of thinking about the next six to 12 months as an air pocket in growth.

So, we expect growth to decelerate pretty meaningfully in the U.S., but other jurisdictions will also take a hit. To the extent that exporters from other countries will see reduced domestic demand or U.S. demand for their goods, that will be a headwind to their growth as well. Hence the air pocket. The biggest uncertainty at this point is the first and second round effects and the timing of each of these. What I mean here explicitly is whether the bumpiness, so the volatility and arguably the rise in inflation that tariffs will produce will be more than offset by weaker U.S. consumption, weaker demand such that prices over time will have to come down. We think that inflation becomes volatile and goes up first.

In the next six to 12 months, what we’re likely to see is reduction in domestic demand together with a higher and more volatile inflation, which may ultimately prove more transitory. But as we learned from the 21, 22 episode, transitory can last several years and several years can feel like a lifetime. And more importantly, even than that, the purchasing power loss.

This is associated with higher bouts of inflation which tends to be pretty permanent in that it takes a very long time for wages to recover to compensate for higher prices. For example, here in the U.S., we’re still a long way, 10-plus percent maybe from recovering pre-COVID wage to price ratios, so to speak. So, the purchasing power that you had prior to COVID, which largely explains why the incumbent was voted out of office, because whoever is in the Oval Office at the time of a higher period of inflation will tend to be viewed pretty unfavorably because people lose purchasing power, and nobody likes to lose purchasing power. Hence the air pocket that we fear is coming.

Hugo Scott-Gall: Great, okay, so that’s a pretty clear view around downside risk to the U.S. economy. Let’s sort of finish off and discuss how do other countries respond to the U.S. imposing tariffs?

Do they get even leaner, reduced costs of their goods kind of cost the same, it’s cheaper good but it’s tariff, it’s maybe the same price as it was before, you can do that through lower costs or can do that through your exchange rate. But are there other things that countries can do including more trade between themselves so it becomes a sort self-fulfilling thing for the U.S., the U.S. becomes more isolated because tariffs increase the probability of isolation? So I’m interested in your view, I guess really around the U.S.’s tariff policy, but maybe also some other policies about how countries are responding to a different current government in the U.S.

Olga Bitel: That is a brilliant question. Your questions are always pretty good, but this one is a particularly good one. And if there is a silver lining to the change in macroeconomic policies from the current U.S. administration and specifically tariffs this arguably would be it, should other countries choose to embark on it. So, the question becomes, what can other countries do to mitigate the negative impact of tariffs on their economies? And the answer is those that have the means.

So, financial resources and administrative capacity to improve the functioning of their domestic economies, arguably will choose to do so. What do we mean by that? And that’s the big silver lining that ultimately if other countries respond in the way that we think they should and there are some, there’s already mounting evidence that they’re moving in that direction, and I’ll touch on that in a minute, that will be a big positive for global growth ultimately.

So, where are we seeing these silver linings and what do we mean? Let’s start with our three demand centers. We’ve covered U.S. extensively. Let’s move to Europe and China. First in Europe. Yes, Europeans have embarked on building a common market, a single market. That project is multiple decades in the making. It’s a democratically driven process, which means it’s inherently very, very inefficient. So, the Europeans have to exhaust every other possible solution before they embark on the correct one, which is to further reduce trade barriers and economic barriers within the single market so as to prop growth. One of the reasons why export growth in Europe has been so strong is because arguably domestic demand has been so weak. So, if a company in question can’t find a good source for its products domestically, it will try to sell them abroad. If you remove internal barriers to trade and I think Draghi’s recent report that was released last September pointed to about 100% worth of tariffs equivalence in terms of reduction of internal trade barriers in Europe and that’s entirely within Europeans’ control. That could be a big boost to domestic growth in Europe.

Another has been a massive fiscal break in Germany that has been in place for several decades now going on to the end of the second decade, which has resulted in massive underinvestment in physical and digital infrastructure in Germany. That break has now been removed. Germany is re-engaging in its macroeconomic policy. German government is. Money is starting to flow where it’s very needed.

And that arguably will pave the way for other European governments to do the same and ultimately for EU at the EU level to begin to focus more on energy infrastructure, banking union, collective resources in capital markets, and a whole host of other things. So, building out joint infrastructure, which is cheaper and more efficient. And of course, not least, the topic that we’ve already touched on is European defense capabilities. All of that means more growth emanating from Europe and from European domestic companies and European exporters.

The next jurisdiction then is China. In China, the problem of domestic demand is a little bit different. So, post COVID, China has really suffered from a dramatic step down in its consumption. Why has that happened? Partly as a response to COVID. So, Chinese government, unlike all the other governments in the West, did not support households to nearly the same extent that we did here and in Europe.

Lots of the households in China are busy repairing their balance sheets. So, if your purchasing power today is 80% or even 70% of what it was five years ago, your consumption will be as well. And so, it just takes time to repair those balance sheets to get back to work. A lot of the services jobs went away as closures in China were even more dramatic and lasted longer than we saw here in the West. And so, that repair process left to its own devices is taking a very long time. There’s a lot that the Chinese government can do to accelerate that process and arguably we’re starting to see offshoots in that direction. So, primary and secondary properties could be offered at lower mortgage rates. There could be more incentives for durable goods purchases. More fundamentally there could be more support both vocal and at the policy level for domestic private companies which are driving 90% of China’s growth and consumption and innovation and employment. So, they’re the growth engine of that economy and has been for decades now. And I think that leadership is starting to recognize their importance.

And so, to the extent that China can elevate its consumer demand on the near to medium term, I think that will provide a meaningful and durable offset to the headwinds that their export sector is facing, given the tariffs that are being imposed by the U.S. and arguably maybe others will follow as well. So, if there is a silver lining here, it is a big one.

Yet these economies really need to demonstrate that they’re capable of delivering the changes that I just highlighted but if they do and we see stronger growth stronger domestic growth in China and stronger domestic investment and consumption growth out of Europe that will be a very, very meaningful tailwind to economic growth and lasting tailwind to economic growth outside of the U.S. and lastly of course the one area that you touched on in your question which is global trade deals outside of the U.S. so EU has been and remains very active in that area. We’re seeing a number of trade deals not quite ready to be signed, but certainly the negotiations are accelerating. So, EU-India is one EU-China is another, the UK is busy penning pending deals so bilateral and multilateral trade deals are happening and are arguably likely to accelerate. But the evidence here is still a little bit more patchy. It requires a lot of external and multimodal cooperation, so these tend to be a little bit slower.

Hugo Scott-Gall: So, the difference in growth rates between different parts of the world, so Europe versus U.S., China versus U.S., other parts of Asia versus U.S., might look different in the next five years than the last five years or even last 10 years where the U.S. has been so powerful, this expansion of nominal GDP, improvement in GDP per capita have been driving part of the narrative around U.S. exceptionalism.

Now I don’t think we need to discuss whether that is an accurate description or not, but I think what you’re saying, central to your thesis, is that the difference in relative growth rates is going to be narrower versus the U.S. for other parts of the world next five years than in the previous five, previous ten.

Olga Bitel: That’s exactly right. That’s kind of our working thesis. And that’s why we on the global team are pretty excited about that opportunity. Because if growth differentials narrow, and if those other jurisdictions that we talked about, Europe, China, other parts of Asia, are able to step up to the plate and improve their growth rates, then we’re going to see stronger global growth as well. That is a really exciting backdrop for international investors, especially vis-a-vis the prior decade where you could have been forgiven for only paying attention to U.S. assets. I think we’re going into a period where that won’t be the case.

Like I said, this is a big silver lining indeed growth differentials across jurisdictions we think are likely to compress. And that provides a lot of exciting opportunities for growth outside of the U.S. And so for international investing, this is a very exciting time.

Hugo Scott-Gall: And history doesn’t repeat it, it rhymes. That’s probably one of my least favorite cliches. But the period, say 2000 to 2007/2008, the U.S. economy did pretty well. Obviously expanded debt levels to GDP, not so much in the government sector, but not so much in the public sector, but more in the private sector. But the rest of the world did.

Equally well if not better and in that period, we saw a week of dollars so we lower differentials in growth and normal GDP China was fully awakened and booming in the early 2000s that had lots of spillover effects. Do you think the next whatever period of time could look more like that? 2000 to 2008 period now obviously not how that period ended that’s different, but the relative the differential and growth rates was much narrower. You had a weaker dollar not a stronger dollar that was pretty good for the performance of non-dollar assets back into dollars.

Olga Bitel: That’s exactly right. And in fact, the recent dollar depreciation is one of the KPIs that we’re keeping a close eye on. There is a lot of discussion about the weaponization of the dollar of foreigners moving out of the U.S. dollar assets, and that’s what’s causing the weakness.

And these trends tend to play out over very long periods of time. There’s no arguing that some of that is playing out. But what I think is really playing out in real time is this compression in growth differentials, at least certainly in the more foreseeable future. And so to that extent, you’re quite right. The period of the early 2000s is arguably more similar to where we think we’re going than where we have been in the recent past. So, depreciating dollars, stronger growth outside of the U.S., together with reasonably good growth in the U.S., should the administration choose to pivot and adjust to lower growth, which we think they will be forced to do eventually.

It is a good way to describe where we think we’re heading so to the extent that there’s a silver lining here again it’s stronger global growth in the context of Depreciation depreciating U.S. dollar is a good  way to think about it.

Hugo Scott-Gall: Okay, I’ve one more philosophical question for you before we finish, which is most mature, most say developed world economies have struggled with this question of how to grow. Once you get pretty mature, go back to where we started, you’ve lost market share in industries where input cost can be a source of commercial advantage, where scale can be a source of commercial advantage. Someone is making what used to make either better or meaningfully cheaper and you see substitution away from what you do. And that’s fine if you keep improving your economy and you create higher value add jobs, services. But most developed world economies, I’m thinking many here, Europe, less so U.S., have struggled for growth.

Do you think that combination of COVID, the end of COVID, combined with the U.S. making some policy changes to address the loss of purchasing power of a meaningful percentage of its population. That we’re maybe through this, what we used to call secular stagnation phase, and we’re moving into something a bit different where governments have been forced to seize the mantle of growth again, whether that is a response to something like tariffs, whether that’s a response to say change in defense policy, military policy from the U.S., whether it’s a response from rising political pressure for some of the things we talked about in the U.S. Do you think that period of secular stagnation where it was a problem, but it didn’t really get addressed head on, know, the Mario Draghi paper, you know, here are Europe’s problems, here are solutions to them. Do you think we’re now at the end of that secular stagnation phase with governments experimenting, being bolder about how to achieve growth in a mature developed economy?

Olga Bitel: As I think I’ve said before, you are at your usual best when you summarize these arguments so well. The end of secular stagnation, especially in Europe, is I think the best summary of our thesis for the next decade. Obviously, the question remains whether they are capable of achieving that outcome or if, you know, the moves in that direction won’t come fast enough, won’t be aggressive enough. You know, there are all sorts of implementation pitfalls that can come out of nowhere.

But that’s the direction of travel as best we can see from here. So, the end of secular stagnation is I think the best way to summarize what I think the world’s response to some of the policy changes that are emanating from the U.S. and also to your point, you know, being felt domestically. Whether it’s the rise of populism or, you know, lack of proper infrastructure, you know, German trains are no longer running on time.

That’s not something that you and I thought that we would ever say in our lifetime.

Hugo Scott-Gall: Yes.

Olga Bitel: So, these changes are real, people are rebelling against them, they’re voicing their discontent, and so governments need to move forward in figuring out how to address these issues. And there are signs that they are pivoting back towards sustainable growth, pivoting back to structural growth, and figuring out what they need to improve in their policy mix to enable the private sector to begin to grow, or rather resume growing sustainably. Not to mention the fact that we need growth to solve, you know, the next leg of our problems, whether it’s climate change, whether it’s declining fertility rates, meaning there will be, you know, fewer consumers supporting the retirees.

You know, this all points to the need for innovation, the need for better efficiencies. How do we produce more with less? How do we allow for better purchasing power, for better living standards? How do we raise the education attainment of our populations? These are all real questions that demand resources and ultimately that underpin growth and that require growth to answer. So the lack of secular stagnation I think is a brilliant way to summarize where we think we’re heading, or at least where we hope we might be heading.

Hugo Scott-Gall: Olga, thank you for coming on the show again. Always a pleasure.

Olga Bitel: Pleasure is mine. Thanks, Hugo.