Trade: The Most Beautiful Word in the Dictionary

Theme and Background

This chapter is the first part of GMO’s Q1 2025 report, The Most Beautiful Word in the Dictionary, focusing on the economic theory underlying global trade and tariffs. The author notes that the current global trade landscape is highly uncertain, so the analysis begins at a theoretical level to explain why broad-based tariffs are an economically costly approach that is unlikely to effectively achieve the Trump administration’s goals. A second part will follow, specifically analyzing the impact of tariffs on currencies, equities, and credit.

Core Thesis

The author’s core investment argument is that broad-based tariffs are an unnecessary and economically costly approach, which will reduce global trade volumes and suppress economic growth. Counterintuitive judgments include:

• There is no theoretical difference between domestic trade and international trade; historically, it was merely more difficult due to high transportation costs and tariffs.
• Reducing trade frictions (rather than increasing tariffs) is the key driver of improving global living standards.
• Tariffs are essentially a sales tax, the cost of which is ultimately borne by consumers or producers, making economic efficiency losses unavoidable.

Key Arguments and Data

The author supports the thesis through historical comparisons and logical reasoning:

1. Trade as the Bedrock of Modern Society: The report argues that in a modern economy, individuals rely on trade to obtain virtually all goods and services (e.g., housing, bread, childcare), none of which they produce themselves. The essence of economic growth is the occurrence of more trade.

2. Historical Decline in Transportation Costs and Tariffs:

• Before the 18th century, transportation costs were extremely high, and cross-continental or oceanic trade required a risk premium (e.g., merchants like Marco Polo and Columbus became wealthy by surviving).
• High transportation costs partly led to tariffs: trade routes required secure cities (guards, weapons, walls, judicial systems), which needed to be funded by fees.
• Since the 18th century, the significant decline in transportation costs and tariffs has made trade easier, and the world has become wealthier as a result.

3. Economic Benefits of Low Trade Frictions:

• Lower trade frictions = expanded supply of tradable goods and services.
• Supply curve expansion = more production + lower prices (through enhanced competition).
• Final outcome: improved global living standards.

4. Economic Costs of Tariffs:

• Tariffs are essentially a sales tax imposed on imported goods.
• This inevitably leads to: either consumers paying higher prices, or producers cutting costs (reducing investment, wages, or shareholder distributions).
• In either case, it reduces total trade volumes → lowering global economic growth.

Companies/Assets Involved

This chapter does not mention specific companies or assets, focusing instead on theoretical analysis. However, the author hints at a subsequent analysis of tariffs’ impact on the following asset classes:

• Currencies
• Equities
• Credit

Investment Implications

• Bearish on Broad-Based Tariff Policies: The author believes that broad-based tariffs will harm global economic growth, and investors should be wary of systemic risks arising from escalating trade frictions.
• Focus on the Long-Term Trend of Reducing Trade Frictions: Historically, the decline in transportation costs and tariffs has been a core driver of economic growth. Any policy that reverses this trend could have negative economic consequences.
• Await Subsequent Detailed Analysis: The author will release the second part in the coming weeks, specifically quantifying the impact of tariffs on currencies, equities, and credit. Investors should monitor this closely.

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Theme and Background

This chapter delves into the three core arguments supporting broad-based tariffs and systematically refutes their feasibility. The author points out that the "best-case scenario" for tariffs is difficult to achieve in the real world due to exchange rate adjustments, inelastic demand, and trade retaliation. For developed economies like the United States, attempting to revive manufacturing through tariffs would come at a steep economic cost.

Core Thesis

The author's central judgment is that broad-based tariffs cannot create a "win-win-win" outcome, and their economic costs far outweigh the benefits. Counterintuitively, the author argues that the current U.S. pattern of importing physical goods through trade deficits while exporting financial assets (bonds and stocks) is precisely a sign that the U.S. economy is "on the right track," rather than an imbalance that needs correction. Attempting to forcibly revive manufacturing through tariffs would only lead to resource misallocation and output below potential.

Key Arguments and Data

The author systematically deconstructs the three supporting arguments for tariffs (Argument #1, #2, #3) and identifies the conditions under which they fail:

1. Conditions for Failure of Argument #1 (Tariffs are borne by foreign producers):

• Exchange Rate Adjustment: Broad-based tariffs immediately trigger domestic currency appreciation, offsetting some of the impact on consumers but severely harming exporters.
• Inelastic Demand: When imported goods are essential for production (e.g., steel for automakers) or survival (e.g., natural gas in New England), consumers cannot reduce purchases, and the full cost of tariffs is passed on to the domestic economy.
• Trade Retaliation: Unilateral tariffs are perceived as unfair. Both historical and social science research indicates that people are willing to sacrifice their own welfare to retaliate, harming domestic exporters and producers.

2. Conditions for Failure of Argument #3 (Tariffs stimulate domestic manufacturing):

• Resource Reallocation: Reviving manufacturing requires drawing labor and capital from other sectors (e.g., knowledge industries, services). The economy only improves if the value of newly produced goods exceeds that of the displaced goods. However, in a competitive capitalist system, resources are already near optimal allocation, making it difficult for government intervention to boost output.
• Insufficient Idle Resources: The U.S. does not have an abundance of idle labor. Data shows that the employment-to-population ratio for Americans aged 25 and over is above the 85th percentile across all age groups. Moreover, idle workers are unlikely to be attracted to manufacturing jobs that pay less than competitive positions.

3. Limitations of Non-Economic Rationales:

• Tariffs can be a tool for national security or social cohesion, but they must be as limited and targeted as possible to minimize economic costs. Broad-based tariffs would cause damage far exceeding necessary levels.

Key Data Comparison:

Indicator	Data/Status	Implication
U.S. Employment-to-Population Ratio (Aged 25+)	Above 85th Percentile	Idle labor is scarce; reviving manufacturing requires poaching workers from other sectors
U.S. Dollar Purchasing Power Parity	Near All-Time High	Foreign exporters receive extremely low purchasing power for their dollars; terms of trade are highly favorable for the U.S.
U.S. Equity Valuation Premium	At All-Time High vs. Non-U.S. Stocks	Foreign investors buy U.S. assets at high prices, benefiting the U.S.
U.S. Credit Spreads	Near All-Time Lows	Foreign investors purchase U.S. credit at extremely low risk premiums, further evidence of strong capital inflows

Companies/Assets Involved

This chapter does not mention specific companies but covers the following macro asset classes:

• U.S. Dollar: The author believes the dollar is at a historical high, making terms of trade extremely favorable for the U.S.
• U.S. Equities: Valuations are at an all-time premium relative to non-U.S. stocks.
• U.S. Credit: Spreads are near their narrowest historical levels.
• Non-U.S. Stocks/Bonds: Valuations are more attractive relative to U.S. assets.

Investment Implications

1. Bearish on Broad-Based Tariff Policies: The author clearly believes that broad-based tariffs will harm overall U.S. economic output and could trigger a global trade war. Investors should be wary of risks in sectors highly correlated with such policies (e.g., manufacturing reliant on imported raw materials, export-oriented companies).

2. Focus on Exchange Rates and Capital Flows: The report emphasizes that broad-based tariffs would cause the dollar to appreciate, which, while buffering imported inflation, would severely hurt exporters. Meanwhile, the current U.S. model of relying on capital inflows (foreign purchases of U.S. Treasuries and stocks) to finance trade deficits is "extremely favorable for the U.S." Any policy that disrupts this capital flow (such as tariffs) could trigger sharp adjustments in the dollar and asset prices.

3. Beware of Investment Traps in the "Reshoring" Narrative: The author argues that in a context of full employment and efficient resource allocation, forcibly pushing for manufacturing reshoring carries high economic costs. Investors should not blindly chase the "U.S. manufacturing renaissance" theme but instead focus on sectors with genuine comparative advantages in the existing global division of labor (e.g., knowledge-intensive industries, high-value-added services).