Trump Tariffs: A Test of Trade Theory

As the on-and-off-and-on again trade war drama between the US and China unfolds, the President's unflinching continuation with increasingly steeper import tariffs seems to fly strongly in the face of what economists continue to warn about dire consequences from these policies.

On Friday President Trump signaled plans to impose a 10% tariff on $300 billion worth of Chinese goods, most of which are consumption goods, beginning in September. This is an addition to the prior 25% on $250 billion worth of largely industrial products that have been imposed on Chinese imports previously.

The nagging question being asked is, who is right? While economists would point to classical models of trade for guidance, and to the disastrous economic impact of the Smoot-Hawley tariffs of the 1930s as a lurid example of why tariffs and resulting trade wars are bad, there is still confusion in the public over how policies that protect American industries and lead to job creation, as the rhetoric goes, can be bad for us.

To rephrase this question, can it be that the majority of economists who see these policies as bad are naively clinging to theoretical models that offer no real world guidance and Trump on the other hand has come in to save us from our misguided models by showing how, despite his very protectionist policies, and perhaps contrary to the naysayers, the US economy continues to show robust economic growth and the unemployment rate has continued to remain well below the natural rate?

Its all about Context

Many things in the real world are context driven in their outcomes. These contexts are often infinite in their possibilities, which is why economic models are usually depicted with a ceteris paribus clause. The clause has us keep in mind that we are pinning down the context to a familiar one, one where the model's environment is known, predictable and static.

Traditional trade models demonstrate why import tariffs and other protectionist measures including import quotas and local content requirement, hurt the economy imposing these measures, do not create jobs but merely redistribute them, while creating a drag on the economy through the allocation of scarce resources to inefficient industries. This reasoning is often lost on the public, but I have addressed this previously in a few articles. See here, and here and here. In the context of these I have also demonstrated how Trump could actually win on these tariff measures, see here.

What I hope to buttress further is that a lot could be going on to mask or blunt the effects that tariffs have on an economy. The Smoot-Hawley tariffs of the 1930s came against the backdrop of an economy already mired in a Depression so its effects were immediately felt. The current tariffs are being applied in an entirely different economic environment- an ongoing and historically unprecedented expansion.

This environmental difference, along with specific economic policies that seem to be contributing to this outcome, could very well have blunted the negative effects of the tariffs so that it seems to appear that the policies are working well and delivering on the promise of protecting American industry and jobs, when perhaps they are not doing so.

Context Manipulation

This brings up an interesting question then. If the context does matter, does it change the central predictions of the traditional trade models? The importance of the context for prediction of trade policy impact has to do with two things:

First, the theory.

What most principles level exposure to trade analysis tends to leave out could be characterized at least along two dimensions where predictions may not pan out as we have generalized above. One dimension has to do with the size of the country in terms of its demand share of the globally traded product. The second dimension has to do with the market structure within which the globally traded product is being produced.

Size Matters

It can be demonstrated that if an importing country is a large country, in the sense that its demand for some globally traded product represents a sizable fraction of global demand, then imposing a trade restriction such as a tariff on foreign imports of that product could lead to net positive gains for the imposing country through what is called a terms of trade gain. Intuitively, the tariff, by reducing the demand for the imported product, will lead to a fall in the world price of the product, since the imposing country's demand is a significant portion of global demand.

That is, by imposing a tariff, it succeeds in passing on some of the tariff burden to the foreign exporter. This is politically important because the government in the imposing country can actually score political wins by emphasizing the toughness of the policy on foreign imports, even though ultimately it provides very negligible protection to the domestic producers as domestic prices do not rise by much since the foreign exporter shoulders some of the tariff burden. The tariff revenues therefore are in some cases, almost entirely pure transfers from the foreign country, contrary to traditional models that suggest domestic consumers bear the burden of the tariff through higher prices.

One more thing. Even though foreign exporters bear some of the tariff burden on their exports to the tariff imposing country, there is still an efficiency loss associated with the tariff, and while economists tend to make a big deal out of this, it tends to be politically irrelevant because the costs are hidden, and further, any such loss also shrinks as long as imports don't fall by much.

Strategy plays a role

Another important aspect of this discussion that often only gets treated in advanced trade coverage, but which is nonetheless very important, is the market structure within which the product is being produced or/ and sold.

When, for example, a foreign exporter operates with market power, it may exercise its ability to price discriminate across its possible markets, but its profit-maximizing calculus is affected when it faces a tariff in its export market. The foreign exporter may then find it more profitable to simply change its export price in order to avoid the tariff.

The bottom line here is that the threat of a tariff could actually make the foreign exporter re-evaluate its pricing policy and bring it closer to conformity to what the importing country wants. This is a form of what is called a strategic trade policy.

President Trump has towed this line with threats of particular tariffs being applied to particular range of products if specific actions are not being undertaken by say China or Mexico. The goal here is for the exporting firms (countries) to evaluate how these tariffs would affect their profits and to see if taking an alternative approach, such as raising their export prices and ceding market share away to US import competing firms, would be more profitable for them than a post-tariff reaction.

Second, the political maneuvering.

This aspect I have addressed somewhat previously in an article I have linked above, where I talked about how President Trump could win a trade war. The point of that article, and which I have already stated above, is to highlight the fact that even if a particular trade policy does come with negative effects, those effects can be cushioned through policies that have changed the environment.

When you have an environment already awash with cheap credit and you are putting continuous pressure on the monetary authorities to maintain that environment, when you have passed tax reform that effectively reduces tax liabilities for households and businesses, the latter rather very generously; the negative impacts of protectionist policies, even when they escalate to include retaliation from the other country on our exports, will be negligibly felt, especially when there is provision being made to support exporting firms through subsidies to ameliorate their suffering from reduced exports.

So while it appears to the casual observer that these protectionist policies are doing a number on traditional trade models, what is actually happening is the classic political business cycle, the 2.0 version. These policies simply trade off outcomes between the short run and the long run. We have a continued economic expansion in the short run, but at a steep cost through higher debt and drag on economic growth in the long run:

An accommodative economic environment persisting during an economic expansion means that the continued increase in money supply will ultimately find its outlet in the economy through inflation. The tax reform has been projected to accelerate the growth of the federal budget deficit significantly leading to faster climbing federal debt, now over $22 trillion dollars, for years to come. The inefficiencies in our production from the tariff policies will eventually come back to haunt us as we find scarce resources tied down in senile industries. These are long term outcomes that will only be felt long after the immediate electoral objectives of incumbents have been met.

Trump the Trade Genius?

Political economic models of government tell us that politicians are also rational beings just as those who participate in markets are. The older economic models of government assumed government to be a benevolent monolith of some sort, seeking to maximize the economic wellbeing of society. The more modern models take into account both the fact that government is made up of many individuals with idiosyncratic preferences - whether it be ideological imposition or reelection or both as their primary objective, as well as the political institutions within which they have to navigate in order to achieve their objectives.

In this context, yes Trump is the ultimate trade genius. His ideological disposition is to the right of the US political spectrum, but it seems this is subject to a more overarching goal of reelection. If elections are won solely on the basis of the economy, then he has used both a mix of supply side economics and aggressive mercantilist policies to secure apparent short term beneficial outcomes. These outcomes were aided strongly by an ongoing economic expansion and where the Fed has, with a few exceptions, continued with dovish accommodative policies.

However being politically astute and achieving a political objective is one thing. Sacrificing the long run economic health and wellbeing of the country is another.

Traditional economic models of trade are still alive and well. The more realistic versions that take into account country size (of which it can be argued that the US could be conceived for many global products as a large country) and market structure, simply let us know that because those tariffs are zero sum- we benefit, while the foreign country bears the cost - they will retaliate as well on our exports, leading to a reverse zero sum outcome. We are currently mired in such a trade war with China.

We are worse off as a result because any measures we take to mitigate the impact from this trade war will mean a misallocation of scarce resources to supporting inefficient domestic production. It will also mean either higher taxes or higher debt burden from borrowing to make this possible. Either of these comes with additional waste and a drag on our long term economic growth. Politically though these costs will largely be hidden and not immediately apparent, that's a political win for a reelection-focused incumbent.