President Trump recently announced that the U.S. would be levying a 25% tariff on steel, mainly targeted at China. Many understood it to be the first step in rolling out a more protectionist trade agenda, which caused a great deal of uncertainty in financial markets. In trying to understand the ramifications of these new tariffs and policies there are several angles of approach, and depending on which angle you choose, it can paint a very different picture.
One way to look at the policy is that it was a necessary step to protect domestic producers of steel from the unfair competition of the foreign firms. Some contend that Chinese steel producers are heavily subsidized by the government, allowing them to sell steel in foreign markets below the actual cost for them to make it. When done in large quantities, this is known as “dumping,” which is illegal under the rules of the World Trade Organization (WTO). The problem is that it is difficult to prove dumping, and thus the accusations have not been confirmed through the WTO’s official channels. When viewed in this light it becomes clear why the U.S. would want to impose a tariff to protect against this unfair competition.
On the other side of the coin, whether the tariffs were justly imposed or not, they could catalyze a retaliatory trade war from China. If China passes tariffs on U.S. goods, it will reduce the U.S.’s competitiveness in the Chinese market. Reduced sales or reduced profitability will hurt domestic producers who depend on China for revenue, therefore hurting local economies.
The most complex part about tariffs is that it is not always clear whose pocket the money ultimately comes out of. When we first hear of a tariff we immediately think that it hurts whoever it is levied on, however this is not always the case. The increased cost could ultimately be paid by the consumers who make up the economy you are trying to protect. The cost of a tariff is paid by either the supplier, the consumer, or a combination thereof. Where each tariff lands on the spectrum depends on the domestic price of the good, the foreign price of the good, and the magnitude of the tariff, and these factors ultimately affect the global equilibrium price of the good.
Let’s take the 25% steel tariff for example. We, for argument’s sake, are a U.S. based car manufacturer and we buy all of our steel from China at $100 per ton. The global market price for steel bought from anywhere else is $130 per ton. If there is a 25% tariff put on steel, the producers of the steel in China can just increase their price by 25% to $125. We will still buy from them because they still have a lower price than the global market. In this case the entirety of the tariff expense will be put on domestic manufacturers, hurting our own companies. At the same time the opposite could be true if Chinese steel costs $100 per ton and the global market price is $100.01. Nearly all the tariff expense would be on the Chinese steel producers because they can only raise prices to the global equilibrium. Even this example is a simplification of what actually goes on. It uses an extremely inefficient market to demonstrate a point. Each new good that receives a tariff has different variables and therefore a different mix of who pays the increased cost. With this in mind, it becomes clear that tariffs may or may not be the right answer.
In terms of second and third order effects, we are currently seeing China’s retaliatory tariffs spurring an even greater amount of tariffs from the U.S. If the magnitude of the tariffs continues to rise, it could cause a sudden uptick in the inflation rate. The unforeseen increase in inflation could force the Federal Reserve’s hand, making them increase domestic interest rates quicker than expected. When the Federal Reserve acts in an unexpected way, the market normally does not react favorably; not to mention the slew of affects that increased rates have on the American consumer, as discussed here.
Regardless of whether or not the tariffs are justly imposed, there are both positive and negative consequences when one examines the direct and tertiary effects of the actions. The positive could outweigh the negatives or vice versa, but the true results will only be seen with time. We live in a globalized economy, which is a complex and dynamic system. Certainly, history has shown that protectionist policies can be very effective in spurring an economy, but when one economic lever is pulled, there are first, second, and third order effects that ripple throughout the global economy. While it is easiest to immediately label something as “good” or “bad,” reality is not nearly that simple.
Click here to hear the thoughts of our co-founder and CEO, Dave Clayman regarding tariffs and trade wars.