Trump's tariff will hurt America - again (Source: here)
Yesterday, US president-elect Donald Trump announced 25% tariffs on US imports from Canada and Mexico as well as 35% tariffs on imports from China. The new trade taxes are due to take effect soon after Trump takes office on 20 January 2025.
Trump said the tariffs are part of his efforts to crack down on illegal immigration and drugs. This is obviously nonsense, but it is clear Trump is both an isolationist and protectionist. After all, we have seen all this before. Trump picked fights with Canada and Mexico over trade in his first term and proceeded to launch an outright trade war against China. His threats therefore carry some credibility.
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One silver-lining is that Trump announced the tariffs nearly two months ahead of actually taking office. His threats may therefore be construed as invitations to negotiation, at least as far as Mexico and Canada are concerned. Last time he was president, Trump launched an early attack on the North American Free Trade Agreement (NAFTA), sparking a renegotiation that eventually led to the United States-Mexico-Canada Agreement (USMCA). While USMCA is now widely regarded as inferior to NAFTA, the damage was not too great. USMCA maintained most of the original features of NAFTA, while updating certain environmental clauses, working regulations, and digital trade provisions. It also produced minor benefits for US dairy and automobile industries, while Canadians got more access to duty-free US goods online.
Trump’s threat against China is a different matter. Trump's last trade war against China turned out to be a costly failure – for the United States. Trump and his protectionist sympathisers failed to grasp the basic macroeconomic truth that trade imbalances reflect broader macroeconomic conditions, not specific relative prices. When countries apply tariffs to imports in order to reduce trade deficits, while at the same time keeping aggregate demand unchanged they merely shift trade to third countries. Thus, the US bilateral trade deficit with China went down in the wake of Trump’s tariffs, but the US went on to import far more goods from third countries (at higher prices), so the overall US trade balance actually worsened.
US and Chinese broad trade balances were unaffected by Trump's tariffs, but trade ended up being diverted via other Asian economies - and American's paid the price (Source: here)
The opposite happened in China. Direct exports to the US declined, but instead Chinese exports went to Asian countries, which then exported to the United States. Result: China’s trade surplus continued to rise. In fact, the only material difference between the pre- and post-tariff situation was that US trade became more inefficient, negatively impacting American welfare and jobs. The Carnagie Endowment estimates the US lost a quarter of a million jobs due to Trump’s tariffs (see here).
So, having unleashed sound and fury signifying nothing in Mexico and Canada and scored a big fat own goal with his China trade war, Trump now wants to do it all again! Good luck, America! I have no doubt whatsoever that Trump’s second attempt will fail as spectacularly as his first. I also have no doubt that the main victims will once again be Americans, not Canadians, Mexicans, or the Chinese.
As an economist, I find protectionists and the wider public’s recurring failure to understand trade policy deeply exasperating. Protectionists are sometimes just plain stupid, but mostly they are operating in the service of some special interest group. They know fully well that protectionism is bad. As such, I find them to be deeply immoral people. As for the ignorance of the wider public, it seems that no matter how many times protectionism is shown not to work, protectionists still manage to find a way to sell the idea to the Great Unwashed. Sigh!
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Economies function best without distortions or barriers to trade. The only exceptions are when there are market failures, such as monopolies, or externalities such as pollution in which case governments are right to adjust prices to ensure that the economy remains efficient. In all other cases, the notion that the world can be made better by imposing taxes on, or entirely banning, some or all forms of trade is simply wrong; protectionism always hurts society in the aggregate and the benefits, if there are any at all, accrue only to small sets of special interests.
The reason tariffs are bad is that they distort markets (for a more comprehensive exposition on tariffs read this). Let me spell out what that means. A tariff is a tax, which is placed on top of the competitive price. It is paid by the consumer, whose income therefore does not stretch as far as it would without the tariff. Having less real income, the consumer consumes less, which reduces the level of economic activity. When tariffs are placed selectively on imports only, foreign firms often direct their sales elsewhere, so domestic consumers end up with less choice.
Tariffs enable domestic firms to sell their goods at a higher price that includes the tariff, which means that the domestic firm gets a de facto windfall at the expense of the consumer, albeit only to the extent that the firm is able to produce at a cost below the market price plus the tariff and that consumer demand does not shrink so much that lower sales volumes completely offset the tariff-augmented price.
Since the domestic firm is obviously quite happy the tariff rigs the market in its favour (at the expense of domestic consumers), it usually starts to lobby to ensure that the government never removes the tariff. Indeed, it is quite common for companies benefitting from tariffs to allocate far more effort to protecting their protection than becoming efficient and competitive. Just think of French farmers! Or the US steel industry, with its chronic dependence on support from Washington D.C.!
In general, the greater the tariff the greater the cost to society. In the extreme case of a prohibitively high tariff, no trade takes place at all. At this point, consumers only have access to goods produced at home, often at far higher costs than goods produced overseas. Many goods are typically also of inferior quality and there is far less choice. All the usual benefits from trade – greater variety, cheaper goods, specialisation, superior quality as well as efficient and competitive domestic industries – are lost. Society is demonstrably worse off.
Incidentally, the logic of free trade applies equally to trade within and between countries. Yet, inter-country trade tends to be far more riven with tariffs, quotas, and non-tariff barriers than intra-country trade. Have you ever heard anyone call for tariffs on trade between New York and Philadelphia? Or between Blooklyn and Queens? Or between England and Wales? The answer, I suspect, is that you have not! Indeed, one of the core strengths of the US economy is precisely that it is a giant free market. The same is true for the European Single Market. Brexit has been such a disaster precisely because it impedes free trade between continental Europe and United Kingdom. Every free trade agreement in operation in the world today was signed out of a wish to reduce trade barriers, because they are so damaging.
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So why do nations still engage in protectionism? An important part of the answer is, as always, culture. Citizens and businesses in one country tend to ignorant of, prejudiced about, and suspicious of citizens and businesses and business practices in other countries. At the same time, they are usually extremely familiar with citizens and businesses and business practices within their own country. This asymmetry is easily exploited for political purposes. In fact, what Trump is really saying when he announces tariffs on America’s trading partners is that evil foreigners are hurting “our” industries. His reference to "our"industries is subtle, but powerful rhetoric, which voters tend to fall for over and over again. You may not work in the affected industry, you may not own its shares, you may not even a customer, but you are likely to be sympathetic to the industry the moment a politician says it is one of “our” industries and it needs protection from foreigners. The politician is exploiting our cultural bias: by simply labelling a home industry “ours” governments will more often than not succeed in pushing through measures that ultimately end up costing voters money and restricting their choices as consumers.
A slightly more sophisticated argument in favour of tariffs is that they are necessary to offset broader types of industry protection abroad. China, it is alleged, has protected its industries for years in multiple ways, including government subsidies and directed credit. These measures supposedly amount to beggar-thy-neighbour policies in response to which some people see tariffs as targeted, efficient, and proportional.
There are two problems with this argument.
First, tariffs easily provoke reciprocal tariffs, thus triggering trade wars. Trade wars are unambiguously bad, because they simply destroy trade. A world with less trade is hugely sub-optimal in macroeconomic terms. It is bad for all countries. The world largely avoided a broader trade war in response to Trump's first round of tariffs on China, because China showed great restraint.
The other and more significant problem with the argument in favour of tariffs on beggar-thy-neighbour grounds is that China’s industrial policies, while successful in expanding China’s influence within certain sectors, such as electric vehicles, have clearly not benefitted China in macro terms – nor have they evidently damaged the United States.
Take the US economy. Not only is the US economy the strongest in the developed world, it is also highly diverse and therefore extremely resilient to shocks. Moreover, it has been strong and resilient throughout the last three decades despite China’s rapid rise as a global economic superpower. The reason why the US economy is so strong and so resilient is precisely because the US government generally does not distort its economy through interventions in multiple markets. In fact, if there is one reason Americans should worry about Trump’s tariffs it is that tariffs just might undo the very thing that has kept the American economy so strong for so long.
Tariffs and protectionism in all its forms may feel good, but they are in fact ineffective and damaging policies. Take China. China’s rise from economic isolation to global superpower was achieved despite protectionism, not because of it. The four core drivers of China’s economic ‘miracle’ were: (a) the opening of the economy to international trade; (b) high savings and investment rates; (c) sound macroeconomic management; and, (d) a relentless focus on long-term policy objectives.
Protectionism has generally worked against China’s economy. China’s current pronounced economic downturn is directly attributable to government intervention in the house market. By subsidising capital for the real estate sector for far too long, China ended up building too many houses, leading to an eventual collapse in the building sector and years of painful macroeconomic adjustment. The housing sector may have grown radidly for a period of time, but ultimately the misallocation of capital brought down the sector and now China’s macroeconomy is paying the price. The same may well happen in other sectors of the Chinese economy unless market forces are given a greater role in resource allocation.
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What should a country do if its industries compete in sectors in which foreign competitors benefit from government protection? First, the country should rejoice that its consumers have access to more choice and cheaper goods than in protectionist countries. This is basically the case of the United States over the past three decades. Second, home industries should focus on areas where they have a genuine competitive edge, taking world prices as given and letting resources find their most optimal allocation accordingly. Remember there is always a competitive edge, because trade depends on comparative, not absolute advantage. Comparative advantage means home industries can be competitive even if all the goods they produce cost more than those produced in cheaper countries. Each country’s industries ends up specialising in the goods in which they are better relative to the other goods they produce. Each country ends up producing a sub-set of goods rather than all of them.
What countries should avoid at all cost is acting like King Canute trying in vain to stop the unstoppable. Take world prices as given. Take China as given. Do not guide precious resources down some blind alley artificially created by trade distortions. Resources, if thus misallocated, never deliver genuinely competitive firms, only rent-seeking, corrupt and inefficient firms, and fiscal problems, without in any way improving external balances.
If a government really wants to help an industry, it can provide temporary financial assistance to the industry to help it adjust swiftly and easily to changing global conditions. Even more importantly, the government can maintain sound, sustainable macroeconomic policies, including a commitment to free and undistorted international trade. By removing itself as determinant of relative prices, the government ensures the most stable economic environment, which in turn provides the best possible conditions for investment.
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When viewed against these time-honoured economic principles, it is extremely worrying that protectionism is now once more rearing its ugly head. It is particularly concerning that the US – hitherto the world’s most stalwart opponent of protectionism – is abandoning its commitment to free trade. You can now be sure other countries will follow suit. We may be entering a new dark age in which protectionism ultimately turns out to be the least of our worries.
Tariffs, you see, are rightly viewed as hostile actions, i.e. ways to attack other countries (even though the perpetrators often get more damaged than the intended targets). Trump’s draconian tariffs will be seen as pure aggression, a clear step towards conflict. They will provoke anger, possible retaliation. The last time the world descended into wholesale protectionism was in the 1930s, when nationalism was on the rise in Europe and the US had withdrawn into isolationism. With hindsight, the protectionism of the 1930s was an excellent early indicator of future global war. It may yet prove to be so again. This would certanly be consistent with my thesis (see here) that the West is being sucked ever deeper into a downwards economic and political spiral that began with the Global Financial Crisis in 2008/2009.
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