Reality of tariffs and trade
Donald Trump announced tariffs on steel and aluminium last week. Although the US president feels “trade wars are good, and easy to win” I would suggest they are neither good nor easy.
Although small targeted tariffs may be insignificant in the broad scale of things, broader based, more encompassing and aggressive trade penalties and restrictions would be very detrimental to the market and the world economy in general. The last time this was tried — in 1930 with the Smoott-Hawley Trade Act — global trade collapsed and the world economy essentially shrank by a quarter. I would suggest that the Great Depression was “not easy”.
A Short Narrative on Tariffs
Free trade and the specialisation of labour helps all involved. When companies (countries) focus on what they can produce the most efficiently and productively and trade these goods freely among trade partners the overall level of production and growth is optimised. Creating barriers and walls to trade subverts the efficient allocation of production and capital.
Let's tell a quick story to illustrate. Suppose the government imposes a $5 tariff on the production of widgets because the local producers cannot produce them for $20 like foreign competitors. As a result the domestic company is “saved” and they continue to produce widgets at $25 — (the same as foreign widgets of $20 plus the $5 tariff). People cheer about the jobs saved and rally against evil foreign competition. But we are missing the unseen.
Henry Hazlitt's book Economics in One Lesson introduces us to this concept. Because everyone who needs widgets now has to pay $5 more they actually have $5 less to spend on other things. As a result someone in the economy is now making $5 less. This is the unseen effect.
Ask yourself how many jobs are not made or lost because the other actors in the domestic economy are all earning less by the amount of the tariff? By not optimising how labour could be used, the overall productivity of the nation is actually reduced and productivity is slowed — thus real wages are likely to be reduced.
The consumer who needs to buy widgets has their purchasing power reduced by the additional $5. The protected industry or company benefits at the expense of the broader consumer or nation. We see the jobs saved at the widget factory but we don't see the accumulated smaller attritions building throughout the whole economy and a general depression of aggregate demand.
Trade Deficit Argument
Trade deficits are not necessarily bad. It is difficult to suggest a negative number is not bad but let me use another brief example. Our company runs a trade deficit with Bloomberg. We pay for services provided by Bloomberg which we use in the “production” of investment advice. We are very happy with this arrangement. Of course Bloomberg is too. We both profit from this. If we were forced to pay for information locally we not only may not be able to source this but we would have to surely pay more. In this case we lose and Bloomberg loses.
Companies and people are really the ones that conduct trade — not countries. In my opinion, they should be free to conduct their business with whom they feel best serves them. Governments should have limited to no role to play in this.
I'm pretty confident that we will not get to the point where a broad-based trade war develops but given the rise of populist politics and protectionist rhetoric the risk is far from being zero. I feel this is probably more posturing and strategic positioning to force serious discussions involving Nafta negotiations and other forms of trade globally. This is consistent with Trump's business negotiating tactics. We are already seeing concessions given to US allies but it would be very worrisome to see any further escalation in the rhetoric or scope. A global trade war would likely result in stagflationary conditions — not a good or easy economic outcome.
Economics in One Lesson: The Shortest and Surest Way to Understand Basic Economics by Henry Hazlitt: https://goo.gl/3xAi8V
Nathan Kowalski CPA, CA, CFA, CIM is the Chief Financial Officer of Anchor Investment Management Ltd. and the views expressed are his own. The author can be contacted at email@example.com
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