The Damage of a Trade War

In a fast moving, world, it is two days since I wrote this and already, it appears tariffs has been paused. But, it is still all very relevant as who knows what could happen next.

Damaging Trade War Begins – 25% Tariffs

On the campaign trail, President Trump threatened the highest level of tariffs since the Smoot-Hawley tariffs of the Great Depression. Business largely assumed he was bluffing, surely, a President wouldn’t choose to inflict, higher prices, lower growth and increased uncertainty on his own economy? But, the news of 25% tariffs on Canada and Mexico last Friday is unprecedented. During Trump’s first presidency, tariffs on China applied to around $370bn worth of Chinese imports. His new round of tarrifs covers roughly $900bn on imports from Canada and Mexico. And it sounds like this is just the start, with more tariffs on Europe and China likely to be coming soon.

Mr Trump is correct in saying that America has leverage in trade disputes. Exports to the US are worth 20% of Canadian GDP and 30% of Mexican GDP. By contrast, American exports to Canada and Mexico are worth just 3% of US GDP. The Economist reports these tariffs could shrink the Canada and Mexican economy 1-2% over the next few years. However, faced with this threat, Canada has responded with unusual force, with Justin Trudeau revealing $155bn counter-tariffs on US goods could limit US access to critical minerals. Mexico has offered similar retaliation. The concern is that as tariffs and retaliation become the norm, and the trade war escalates, nobody wants to be the one to back down.

One undeniable fact of this trade war is that the consumer will pay higher prices. Tariffs are effectively a regressive, distortionary tax on consumer goods imported from abroad. By targeting Mexico, Canada and China, 50% of US consumer imports will become more expensive. A 25% tariff is effectively like a 25% sales tax. Given imports are 11% of GDP, a blanket 25% tariff on all imports could raise the cost of living 3%. For an average household income of $80k, what would be $2,500 a year? Now, at the moment it is not a blanket tariff, but it gives an idea of what could be coming.

It will lead to higher food prices from avocados to tomatoes. It will also lead to higher prices for cars and crude oil. Despite being a net exporter of oil, the US still imports refined oil from Canada for use in agriculture in the mid-west. The trade war will hit deep red states with higher costs a bedrock of Trump support. On the presidential trail, Trump promised to reduce prices, but at least for these imported goods, prices are likely to rise. The last time, the US placed tariffs on China, the dollar rose and this offset a degree of the tariffs. So you may get a short-term rise in dollar too. But, this will reduce the competitiveness of US exporters. Come Monday, you are likely to see markets take fright at the now very real dangers of a global trade war. Markets have been largely complacent at this prospect, hoping it would be like 2016, when tariffs were almost largely symbolic. For example, it is estimated the last trade war reduced US GDP only 0.4% – not really visible to anyone. But the second Trump term has seen within 2 weeks tariffs escalated to a level which will have a real economic impact.

Will Manufacturing Jobs Return to US?

One argument for tariffs is that it will bring manufacturing jobs back to the US. Arguably NAFTA played a role in deindustrialisation which caused job losses in the rust belt of America. However, since the 1990s, the North American economy has become highly integrated. The three economies each have a speciality – US high tech, high skills, Canada rich vein of materials, Mexico low labour costs. The result is that even when cars are made in the US, supply chains rely heavily on Mexico for parts and Canada for raw materials. It would be very expensive and disruptive to end this supply-side integration and try to bring everything back to the US. Even with this first round of tariffs, US consumers could be paying $3,000 more for a new car. You can’t easily turn the economy back to the 1960s when there were millions more manufacturing jobs in the US.

Some may argue the trade war may peter out, and after only a few days, that appears to have happened with Canada and Mexico. Trump’s threat of tariffs on Colombia leads to Colombia backing down and accepting extradition flights. But, the larger point is the executives of multinational companies will be genuinely worried by this uncertainty and threat of upending current production. At the very least it will reduce investment and hold back economic growth. A good question is that if the US goes after its close neighbour and most reliable ally – Who can trust America as a reliable trading partner?

Revenue Raising

Another argument for tariffs is that it will raise revenue. In the early days of America, tariffs were the main source of federal tax revenue. But, in those days, federal spending was very limited – mainly a very small armed forces. The Tax Foundation think tank state the new tariffs on China, Mexico and Canada may bring in just $110bn or 2% of federal tax revenues. Don’t forget that an effective tax of 25% will significantly reduce demand for imports, so the actual revenue will be less than the assumption. But, given prices will rise and costs for farmers rise, it is quite likely the US will try to limit the damage of the tariffs by offering subsidies to farmers, like last time. Overall the tariffs are going to make the average consumer worse, and they will hit low-income consumers proportionately more.

Some domestic US industries will benefit from tariffs. But, don’t forget because consumers face higher prices, and disposable income reduces, overall demand will decline. Some US firms will see less demand because of the tariff effect

The last time, the US imposed major global tariffs, it contributed to a deepening of the Great Depression. GDP in the US fell 25% and unemployment rose close to 25%. Now, the situation is very different. The Great Depression wasn’t caused by tariffs, it just made the depression worse and longer lasting. But, it also gives an insight how protectionism can make everyone worse off and in difficult times hard to end. Would tariffs cause a recession on their own? That’s a difficult one there are so many moving parts in the economy, it is possible the strong growing US economy could shrug it off. But, if other aspects of the economy start to falter. Consumer debt has been soaring, housing costs are very high, the US budget deficit has been soaring. A knock to consumer and business confidence could start to hit economic sentiment which turns strong growth lower. It is speculative to say tariffs will lead to recession, but it is not going to help the economy.

 

NY Times

Economist

Krugman – substack

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