Trade war will claim innocent victims

This article first appeared in The Edge Financial Daily, on December 6, 2018.
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IN a series of tweets earlier yesterday, US President Donald Trump announced that he was a “Tariff Man,” trumpeting the revenue raised by tariffs and declaring that import taxes would maximise the US’ economic power:

As Paul Krugman pointed out, it’s a fallacy to think that foreigners are the only ones paying the tariff bill. US consumers pay as well. Believing that tariffs are a tax on foreign countries is like believing that sales taxes are a tax on Wal-Mart.

It also makes little sense for Trump to brag about the tax revenue his tariffs are creating, when his own tax cuts have increased the deficit by enormous amounts. So far the tariffs have raised a few billion in revenue, while the tax cuts are expected to cost about US$100 billion (RM415 billion) every year.

Beyond these basic inconsistencies and mistakes, though, Trump’s faith in tariffs as a tool of economic greatness is misplaced. As a mechanism for increasing a country’s strength in global markets, they leave much to be desired.

First of all, the burden of tariffs falls mostly on domestic consumers ­­— in other words, Americans — because the prices of many traded goods are set in world markets. Suppose a Chinese company is selling a washing machine in the US for US$1,000. Trump then sets a tariff of US$200 on the washing machine.

The Chinese company knows that it can go and sell its washing machine somewhere else without the tariff — France, or Japan, or Russia — and still gets about US$1,000 for it. So in order to make it worth the Chinese company’s while to sell the machine in the US, it is going to have to raise the sticker price to US$1,200.

That’s an idealised example, of course — in fact, the US domestic market is large enough where it has some power to affect global prices, so Chinese merchants will pay some small portion of the tariff. But much of the cost of the tax will be borne by the American consumer.

The second reason tariffs are not great is that they don’t take currency movements into account. When the US taxes another country’s goods, it puts downward pressure on that country’s currency. When China’s yuan falls against the US dollar, it makes Chinese goods cheaper, cancelling out some of the effect of the tariff. The yuan was at about 16 cents to the US dollar earlier this year, but as Trump imposed tariffs on Chinese goods and ramped up his trade war rhetoric, it fell to roughly 14 cents — a decline of more than 12%.

That currency drop made all Chinese goods — not just the ones Trump put tariffs on, but all of them — cheaper in the US. That is probably one big reason why Trump’s tariff announcements did not do anything to cut the US trade deficit with China, which has hit record highs this year.

The third reason tariffs are bad is that if done wrong, they can make life harder for US manufacturers and exporters. As Krugman and others (including myself) have repeatedly pointed out, many of the Chinese goods that Trump is taxing are parts, machinery and materials that US manufacturers need to make their products.

By raising production costs, tariffs make US manufacturers less competitive, both at home and abroad — exactly the opposite of what Trump wants to do. A recent report by UBS Group AG found that American companies are starting to shift production overseas in response to Trump’s tariffs.

Raising the competitiveness of US companies is a worthy goal, but tariffs are a bad tool for the job. There is a better one available — export subsidies.

Instead of taxing foreign products in the US market, use tax revenue — from income taxes, which do not distort the economy very much — to help US-based companies sell their wares abroad. Export subsidies are not perfect; they also hurt the US consumer, because they allow companies to raise domestic prices to match the higher prices they can get overseas. But by nudging US companies to get out of the cozy domestic market and compete on the world stage, they probably give productivity a boost.

Trump’s goal of making the US more competitive is not bad, but he needs to stop using bad tools. Tariffs will not, as he said, “max out our economic power”; instead, to the extent that they aren’t cancelled out by currency movements, they will raise costs for American manufacturers and prices for American consumers. Tariff Man needs to cool his jets. — Bloomberg