Unfortunately, trade is not a black and white matter. Its omnipresence with everyday life often leads to complicated externalities when changes to policies are made. For decades, economists have argued over the pros and cons of what is most optimal for global growth; free trade or high barriers? A mainstay of many of these arguments is the topic of tariffs. Put simply, a tariff is a tax that is placed on imported goods. Tariffs attempt to promote a domestic nation’s industries through disincentivizing households and firms from buying and importing goods from foreign nations. Trump has already imposed tariffs on $50 billion of Chinese goods and has threatened them on an additional $200 billion, on top of the tariffs already placed on Canadian steel and aluminium. Although the uses of tariffs are congruent with President Trump’s protectionist agenda, is the potential “trade war” that this may catalyze really a net positive situation for the USA?

The benefit accrued to domestic producers is unfortunately only one side of an equation that must balance. Given this, an appraisal of the potential hardships that may accrue to the economy, firms and consumers of the USA is imperative in understanding this trade-off.

National Level Impacts – Global Trade Tension and Uncertainty

Thus far, both Trump’s threats and actions have catalyzed a wave of global economic uncertainty. It is evident that in the long run, trade relations have the potential to be compromised through potential retaliation from tariff-subject nations. The EU, Canada and China have already prompted the possibility of this behaviour through threatening tariffs on American exports ranging from bourbon to blue jeans. Any levies placed on the nation have the potential to lead to millions in lost exports. If prevalent enough, it would not be surprising to see layoffs from such a drop in demand. It is therefore evident that any retaliatory measures have a potential hindrance to American business interests and comparative advantages that may ultimately negate the benefits of such protectionism to domestic producers.

It is also vital to comprehend the “second round” impacts of these trade decisions. For instance, the US economy being close to full capacity with a strong labour market and US dollar exacerbates the risks of these tariffs. With this being said, a sudden influx of demand may not be able to be handled by the current American infrastructure, causing prices to reach levels that may spur inflationary pressure. If so, this has the potential to catalyze a chain reaction of counterproductive events, as rate hikes to combat such pressure will lead to the dollar value rising and ultimately reducing the competitiveness of US exports. Hence, any desired demand enhancement may be muted through constraints in both capacity and alternatives, ultimately impacting business confidence.   

Firm Level Impacts – Disruptions to Supply Chains and Productivity

Globalization has helped in transforming many once local businesses into multinational titans. Economies are now more intertwined than ever, hence an American firm is not necessarily going to have its entire supply chain operating domestically. Marketplace competition now requires firms to walk the fine line between trading off quality and costs, with any disruptions to this balancing act posing substantial risks.

For American firms whose products require those goods impacted by tariffs as a factor of production, margins will of course shrink as the costs of production rise. These firms have the option of following the intended goal of tariffs and turning to the domestic market to purchase inputs (often at a higher relative price), or continue to import and pay these tariffs through higher costs. A third alternative is to import from a foreign exporter that is not levied with American tariffs. The problem with this, however, is that large firms often have multi-year contracts in place with suppliers, and any renegotiation would be costly and albeit impossible in certain instances. The supply chain impacts of this are immense, as producer prices are already up 3.4% YOY. Uncertainty regarding global free trade complicates the scenario planning of firms that lack robust contingency plans. Indirectly, as firms spend more time realigning their supply chains rather than their product offerings, innovation suffers at the expense of future competitiveness. Therefore, situations like this have the potential to undermine economic efficiency given the diversion of American firm’s time and attention away from more productive practices.

Consumer Level – Switching Costs and Sticky Prices

In the long-run, higher costs of production will eventually be passed onto consumers. On the individual level, price increases may be immaterial; however, once scaled across the entirety of the American economy, consumers will start to see their purchasing power erode. For instance, tariffs already placed on washing machines and solar cells have trigger prices on these goods pushing upwards 16.4% since January. Adding to this is that historically, price increases have been sticky. Once prices rise, there is an inclination to keep them there and reluctance for them to fall in the event that tariffs are lifted. Consumers would already be used to higher price levels, which ultimately would pad the margins of producers.

On top these price hikes are the switching cost that Americans will face. Consumer prices have hit their highest level since February of 2012, increasing 2.9% YOY. Tariffs on steel and aluminum have also led to automotive prices rising at their fastest speed in seven years (0.8% over that last two months), while also helping contribute to the 6.5% YOY increase in construction material costs, a 9-year high. The microeconomic decisions of households will eventually adjust to their lower levels of disposable income available, impacting their propensity to invest and purchase other American goods

Final Thoughts

There is no free lunch within the world of finance; you cannot gain without having to give something up. Tariff threats are leading to global economic uncertainty, highlighted already by June’s -1.1% fall in the University of Michigan’s Consumer Sentiment survey. The near-full capacity state of the American economy adds to these worries, and firms are now seeing the recent tax-cuts be slapped back on through these tariffs. Retaliatory measures can spiral into a vicious loop, dragging consumers into the mess of the aforementioned externalities and proving that Trump’s tariff threats can truly be tarrifying.

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Writer: Matthew Leonelli

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