«Trade wars» are a concept long associated more with history than current events. 1930s history, to be exact. But Donald Trump has now made this antiquarian phrase current again by threatening the country’s trade partners with tariffs and vowing to abrogate the North America Free Trade Agreement.
At this point, however, all that we’ve seen are skirmishes, with the U.S. slapping tariffs on imports of aluminum and steel and the affected countries responding in kind. The question is where this initial exchange of fire could lead. Could it be the commercial equivalent of the assassination of Archduke Franz Ferdinand, the incident that sparked World War I?
Analyzing these issues requires one to address in turn three ancillary questions. First, what are Trump’s ultimate goals? Second, what strategy is he likely to pursue in the effort to reach them? Third, is he likely to be successful in achieving his objectives?
More manicurists than steelworkers
The answers are far from clear. On one day (or in one Tweet) Trump’s objective is to achieve a faster rate of U.S. economic growth. The next day the goal is to reduce the U.S. trade deficit, in the aggregate or at least vis-à-vis the countries running the largest bilateral trade surpluses vis-à-vis the U.S.: China, Mexico, Germany and Japan. Some days the objective is to enhance the competitiveness of manufacturing, heavy manufacturing in particular, in the belief that this sector is the source of good blue-collar jobs, or on national security grounds.
It is doubtful that tariffs will have much effect on any of these variables. Steel and aluminum tariffs will have little impact on aggregate output and employment. As former Treasury Secretary Lawrence Summers has observed, the U.S. has more manicurists than steelworkers. In early June, U.S. Steel promised to activate a factory employing 300 additional steelworkers in response to the tariff. That’s just 0.2% of the 223,000 jobs created in the United States in May.
Even an across-the-board tariff on imports would have little impact. If growth and inflation accelerate in response, the Federal Reserve would just raise interest rates a bit faster to offset the effect. (Conversely, if business confidence worsens as a result of the tariff, the Fed would just raise interest rates more slowly, again offsetting the effect.)
The wrong prescription
Where tariffs will have an effect is in altering the composition of production. Trump’s measures will shift employment toward steel, aluminum and motor vehicles, and way from high tech and services. This is precisely the opposite, of course, of what you would want to do if you were concerned with employment creation. High-tech and services are labor intensive; they provide employment for engineers, on the one hand, and home health-care workers, on the other. Manufacturing in 21st century America employs mainly robots – along with a very few workers to tend the machines. This is a reminder that blaming globalization and import competition for the decline in U.S. manufacturing employment is a misdiagnosis, since the real culprit is labor-saving technological change. It follows that tariff production for industry is the wrong prescription.
And shifting resources toward old-line manufacturing industries like aluminum and steel, at the expense of dynamic information-technology and biotech sectors, is precisely the opposite of what you would want to do if you were concerned to stimulate productivity growth and technical progress.
If instead Trump’s objective is to enhance U.S. international competitiveness, then he has three problems. A broad-based tariff may make U.S. goods more competitive relative to now more expensive imports, but that effect will be offset by appreciation of the dollar. The U.S. current account deficit is the difference between domestic investment and domestic saving, as every economist (outside the White House) knows. Since a tariff will have no first-order impact on either investment or saving, it can have no first-order impact on the deficit. This means that the dollar will have to appreciate by 25 per cent to offset the impact on relative prices of a 25 per cent import surcharge, switching the additional domestic spending back toward foreign sources.
Disruption to global supply chains
Second, most of Trump’s tariffs are on intermediate goods; they therefore actually make U.S. producers less competitive. The Peterson Institute of International Economics has estimated that Trump’s prospective auto tariffs will actually reduce U.S. motor vehicle output and employment by 2 per cent by making imported parts and components more expensive.
Similarly, the tariffs Trump proposes to apply under Section 301 of the Trade Act of 1974 may have a sound motivation – they are to be applied in response to China’s abusive intellectual property practices – but they will hit mainly electronic parts and components that are intermediate inputs into U.S. manufacturing.
Third, foreign countries will almost certainly respond tit for tat. In this case there is only the resulting disruption to global supply chains, with devastating consequences for firms and sectors that are especially supply-chain dependent. For example, in a scenario with tit-for-tat retaliation, U.S. employment in the production of motor vehicles falls not by 2 per cent but by more than twice that amount.
But is proportionate tit-for-tat retaliation, meeting tariffs on $3 billion of U.S. imports with tariffs on $3 billion of U.S. exports, the best way for foreign governments to respond? Failing to respond in this manner, it can be argued, is to reward bad behavior on the part of the U.S. president. And failing to respond in this way is also likely to go down badly with a proud domestic citizenry.
Registering a complaint with the WTO
Note, however, that these are political arguments for proportionate retaliation. On strictly economic grounds, it may be better to restrain the temptation to respond in kind and simply do nothing, other than registering a complaint with the WTO. If the U.S. wants to shoot itself in the foot, then the best response may be to let it. There’s no reason to disrupt one’s own supply chains still further by retaliating, or to risk the danger of escalation in which Trump meets the first round of retaliation by imposing even larger tariffs.
Not for the first time, it looks like the politics will trump (as it were) the economics. So the danger of escalation and further disruptions to global supply chains, while unfortunate, are real. And if it is correct that Trump’s initial strategies are unlikely to achieve his fundamental objectives, then there is every likelihood that this president will double down on his failed policies rather than re-thinking them.
Hoping for Congress to intervene
Is there any chance, then, of heading off this impending trade war? One can always hope against hope that President Trump will change his mind. It would not be the first time. Alternatively, the Congress could limit the Executive Branch’s trade-policy-making powers. Senate Republicans are already discussing a bill that would require Congressional approval of any tariff imposed by the president under the provisions of the 1962 Trade Adjustment Act, which Trump invoked to authorize his steel and aluminum levies, packaging that legislation together with Defense Department authorizations to prevent Trump from vetoing it.
But this would require the Republicans in the Congress to show backbone – to stand up to a loose-cannon president who remains immensely popular with his base. This seems like a slim reed on which to hang the future of the global trading system.