Tariff wars - hysteria and hypocrisy

What can we learn from the wave of hysteria and hypocrisy that has been prompted by President Trump’s Liberation Day announcement of tariffs? As a starting point, the only sensible response is to say: calm down and look at reality – both before the announcements and now.

At the beginning of my academic career, I spent 15 years giving lectures on International Trade and International Economics at Cambridge. David Ricardo’s analysis of the gains from trade was the starting point of my teaching. However, for most of those who have been commenting on Trump’s policies, that appears to have been all they learned about trade policy.

Economics – and particularly economic theory – has a serious problem of public understanding. Modern economic theory proceeds by taking a simple proposition and proving that it may be true under certain, usually rather restricted, conditions. Then, theorists produce increasingly elaborate models under which the proposition is not true without being very precise about the consequences of departing from the strict conditions.

The benefits of free trade are a good example. The classic theorem is extraordinarily constrained. No-one would believe that it has much relevance to real economies. Further, what it does not do is tell us whether lowering – or raising – tariffs is a “good thing”, whatever that means. The answer is always: well, it depends on a long list of factors.

Put aside the rhetoric about free trade. Ask instead: cui bono? Almost without exception major changes in trade policy are driven by concerns about the distribution of income. Yes, free trade may, under some circumstances, increase national income, but more powerfully it affects who gets what.

The repeal of the Corn Laws in the UK was not justified by the theoretical benefits of free trade but to bring down food prices for the rapidly growing urban population. The commentator Victor Davis Hanson has written a piece for The Free Press which highlights the argument that trade liberalisation has had a destabilising impact on US industrial communities and the overall level of inequality.

Some economists might point out that this outcome was not inevitable. There was legislation in place that provided money to fund trade adjustment measures. Mostly this wasn’t used and, in any case, it was sabotaged by lax immigration policies. In the overall scheme of things, trade liberalisation in rich countries implies the transfer of labour and capital from the production of traded goods (usually industrial products) to non-traded items (primarily services).

At the margin, demand for services has been growing much more rapidly than demand for traded goods, so higher real incomes will translate to higher demand and prices for service activities. With a fixed labour force, this would translate to higher wages in service jobs that would, over time, partly or wholly offset the reduction in higher-paying industrial employment.

That was not how things worked out. Neither labour nor capital such as infrastructure are particularly mobile, especially when considering the communities that have grown around industrial plants based on utilising local natural resources. In principle, businesses supplying non-traded services could have moved to such locations, but usually other factors were more important. Instead, the increased demand for labour in non-tradeable activities such as construction and services was filled by immigration, while some service activities moved offshore by outsourcing work to India and the Philippines.

So, let us step away from the absurdities of 24-hour news reporting and focus on some longer-term themes. First, and perhaps worst of all, is the sheer cynicism of commentators, market traders, and politicians. President Trump has been saying for months that he would increase tariffs on industrial goods. Nothing could have been better advertised in advance. In any rational world, the impact of higher tariffs would have been factored into corporate decisions and financial markets for at least 3 or 4 months.

Various tariff announcements have been made since early February. That everyone responded as if the recent announcement was an unforeseen event can only reflect an assumption that no politician will ever do what they say. There is also the element of smugness that no one would be so perverse as to go against conventional wisdom, or, perhaps more accurately, elite opinion.

Second, forget the notion that financial markets provide any reliable guide to developments in the real economy. This is a lazy trope of TV journalists who want images and talking heads to accompany news items that they barely understand. If the level of financial prices really reflected all of the available information, we would not be in the middle of a speculative bubble that can only be warranted by fantastical assumptions about economic policy and the world economy. Thus, set aside the idea that short term market movements tell us anything beyond the collective delusions of market participants.

Third, statements about the end of free trade or the like are pure tosh. We have been through a brief period during which tariff barriers to trade have been relatively low – though only for a narrow range of industrial goods. Even so, the world is awash with what economists call non-tariff barriers. Consider the EU’s infamous phytosanitary standards. These are close to being pure – and deliberate - non-tariff barriers to trade in agricultural and food products. In the UK there is the fuss about chlorine-washed chicken, which entirely ignores the reality that almost every litre of water we drink is “chlorine-washed” (dosed with hypochlorite) – and for good reason.

Such rhetoric ignores the fact that industrial goods comprise a declining share of total consumption and trade. Goods account for barely one-third of US consumer spending, down from more than 60% 50 years ago. Trade in services has increased from about 6% of world GDP to 14% over the same period. Merchandise trade as a percentage of world GDP is much larger but has grown more slowly from 28% to 48% over the same period with no overall change in that share since 2008.

Stepping back to look at trends in trade barriers, it has been clear for nearly a decade that the zeitgeist has been moving against trade liberalisation in industrial economies. Countries differ in how they respond to political and economic stresses caused by changing patterns of trade. The US government has consistently tended to rely on either tariffs or tax credits because those are within its control. The fuss over President Trump’s tariff changes has ignored the fact that the investment and production tax credits offered under the last administration’s Inflation Reduction Act are highly protectionist as they offer generous incentives for the use of equipment and services from domestic producers.

In contrast, the UK government has a longstanding preference for either state ownership or investment grants. To limit the impact of changes in the world steel industry on communities in South Wales and the Humber Region, the UK has first offered large grants to fund modernisation and then resorted to public ownership when that strategy did not work.

In the EU, trade interventions are dressed up in various clothes. Following the US pattern, the EU has imposed tariffs to protect car manufacturers from increasingly successful Chinese manufacturers of electric vehicles. That is unlikely to be sufficient because European manufacturers cannot compete in producing batteries, which are the large component of electric vehicles. In other sectors, Germany, France and other EU countries have preferred to rely upon a variety of non-tariff barriers to protect domestic interests. For example, Germany has long discriminated between large industrial consumers of electricity and other customers in distributing the costs of measures to support renewable electricity generation.

There is another dimension that most commentators neglect. In the past US governments have focused on exchange rates, suggesting that other countries have deliberately maintained undervalued exchange rates with respect to the US dollar to promote exports and discourage imports. China has certainly followed that course at times, and it is arguable that the operation of the Euro-zone has benefitted Germany in a similar way. That belief led to the Nixon shock in 1971, when the US government suspended convertibility of the US dollar to gold at a fixed price, as well as the Plaza Accord of 1985 when the US attempted to weaken the dollar relative to other major currencies.

While depreciation of the US dollar may reduce trade deficits, it is also likely to increase the interest rate on US Treasury bills and bonds as well other US dollar debt. The financial cost to the US government of high debt service might more than offset the tax and other revenues from higher domestic production.

These points highlight an even more important macroeconomic issue. Standard national income accounting tells us that the US balance of payments deficit is the mirror image of an imbalance between US investment and savings. From one viewpoint, the fundamental issue is that collectively the US saves too little or spends too much – not just the US government but also US corporations and households. An alternative way of describing the same outcome is that foreign demand for US dollars drives the US dollar up to a level at which the gap between saving and investment is just offset by foreign demand for dollars.

If, and this is a large “if”, the revenue generated by tariffs is used to reduce the federal deficit, the macroeconomic logic works in a more positive direction. The deficit between saving and investment will fall along with the requirement to borrow from abroad. A reduction in capital inflows will lessen upward pressure on the dollar

This is very much “on the one hand, on the other hand” stuff. That is correct, but is it equivocation or reality? The ultimate impact of the shift to higher US tariffs on industrial goods will take years to emerge and is quite uncertain because it is contingent on future developments. We should heed W B Yeats’ lines from his poem The Second Coming:

                                    The best lack all conviction, while the worst
                                              Are full of passionate intensity

The poem is one of the great works of 20^th century poetry. It should warn us that that the certainties expressed by those who have commented on the increase in US tariffs mostly rest on foundations of sand.

If we return to cui bono, the cost of iPhones, laptops, TVs, imported cars, and similar consumer goods will certainly rise. By how much is unclear, because some of the extra cost will be absorbed by reductions in profit margins and changes in the source of supply.

On a very generous basis, the total weight in the US CPI of categories likely to be affected by the tariff increases is 5.8%, excluding new cars and trucks. The average price increase for these categories is unlikely to be more than 25% after allowing for domestic production and distribution margins. Hence, the overall impact on the US CPI over the next year may be between 1% and 1.5%.

New vehicles, including leased vehicles, separately account for 4.8% of the CPI. Since purchases can easily be delayed or redirected to less expensive or domestic vehicles, the impact of the new tariffs on the prices paid by consumers is likely to be felt over several years.

Overall, the price shock due to the tariff changes is unlikely to exceed 2% and may be closer to 1%, holding macroeconomic factors constant. That is significant but considerably lower than the impact of the post-pandemic recovery on US inflation.

Macro changes in the value of the dollar and world commodity prices have been much more important factors in determining US price rises in the past. Since the tariff policy is likely to increase the value of the dollar and lower commodity prices over the next year, it is quite likely that the overall impact on the US CPI will be an increase that is close to 1%.

What we have is a policy whose costs are widely spread across the population, but whose benefits are quite concentrated. The beneficiaries will include communities in the Mid-West and South that might expect to gain either directly or indirectly from a boost to domestic production.

The industrial economy of the 1950s and 1960s with large factories paying high union wages will not return. That does not preclude a more dispersed growth in skilled industrial employment in small and medium enterprises. The famed supply chains in Japan and China do not just consist of large assembly plants run by Foxconn and others. There are thousands of smaller enterprises with the skills, experience and technology needed to supply sophisticated components for modern industrial products.

That prompts a related question. To what extent is what I will call the Apple model of industrial production – the separation of IP from production plus, in turn, extreme decentralisation of component supply in the search for the lowest production costs – a sustainable model for rich industrial economies? The last five years have highlighted the risks of supply disruptions, financial stress at component suppliers, and adverse changes in trade barriers (not just higher tariffs).

There is also the strategic concern that such arrangements may encourage imitation and eventually serious competition from erstwhile suppliers, something that has clearly happened in the car industry. Many companies may have good reason to reconsider the balance between domestic and offshore manufacturing. The Apple case illustrates the complicated nature of such decisions as China is such an important market for Apple products.

In a year or 18 months, after things have settled down, the result of President Trump’s tariff increases is likely to be (i) a reduction in operating profits as a share of total revenues for US-based companies that were heavily reliant on offshore manufacturing, plus (ii) an increase in total value-added – i.e. direct and indirect labour costs plus operating profits, rents and taxes – generated within the US. In less formal terms what this means is that companies will make lower profits, but a larger share of the value-chain will be accrue to workers, other companies and governments in the US.

In view of the widespread concerns about widening inequality in the US associated with the rising share of profits in GDP, it is hard to argue that such a shift in the distribution of income is necessarily a bad thing. Many might wish that the same outcome could be achieved in some other way. However, the US political and legal system has proved extremely resistant to alternative policies such as reducing the market power of corporations. Measures such as wealth taxes, even if they were feasible, are almost certainly worse in their wider impacts than tariffs.

Perhaps the best parallel in thinking about President Trump’s policies is the decisive shift against corporate power and the era of robber barons associated with the Progressive Movement under President Theodore Roosevelt. Even though Theodore Roosevelt was a New York Republican, it is far from clear that President Trump would welcome the comparison but major changes in economic policy often produce strange alliances.