It is no longer news that Trump has suggested that US would raise the import tariffs on steel by 25% and aluminium by 10%. The market reacted in a notable fashion, which I believe was absolutely called-for. Import tariffs could have critical and significant consequences for the world economy.
The way that Trump has implemented this raise on tariffs is also cause for concern. He has tweeted “When a country (USA) is losing many billions of dollars on trade with virtually every country it does business with, trade wars are good, and easy to win. Example, when we are down $100 billion with a certain country and they get cute, don’t trade anymore-we win big. It’s easy!”
In this article, I would like discuss five important aspects of this tariff:
- What is Trump’s goal with the implementation of the tariff?
- Why does Trump believe that this will be an effective policy?
- Who will it benefit the most?
- Who will it hurt the most?
- What are the direct and indirect impacts on the world economy?
Since his campaign in 2016, Trump has not stopped arguing that US loses on foreign trades. He has specifically named two countries that he believes, take advantage of US on foreign trades. Yes, they are the two countries that you hear the most often in Trump’s speeches: Mexico and China (or as he pronounces it, “Gina”).
Trump is correct: China and Mexico represent the no.1 and no.2 deficit partners that the US has. As shown in Table 1, China is largest trade partner that the US has, representing 16.4% of the total trade. In year 2017, China has bought 130 billion from the USA, while sold a whopping 505 billion USD worth of goods and services to the US. This generated a deficit for the US of (505.6-130.4) 375.2 billion dollars. Mexico has made purchases from the US that totalled 243 billion, while the US has bought 314 billion dollars of goods from Mexico. This translates to a 71 billion deficit for the US.
(Table 1: US Exports, Imports, Total Trade, and Percentage of Total Trade in 2017 by Individual Countries, Figures in Billions. )
Now, why is there an imbalance when it comes to trade? Why are some countries selling more to the US than they are buying from the US?
Both China and Mexico share some characteristics in common. Firstly, they are both manufacturing powerhouses. Both countries possess large quantity of cheap labor and have very undeveloped minimum wage regulations. The two countries, therefore, naturally have an advantage at manufacturing goods at a much lower cost, than had those goods been manufactured in the US. This explains why they are major exporters in the world. Secondly, these two countries are still developing economies and have relatively low spending power on a per-capita basis. The implications is that they simply will not be able to buy from the US as much as US buys from them, for they do not have as much money. In a daily-life example, a poor person does not spend as much as a rich person, for the very simple reason that he/she does not have as much money. The same rationale is true with countries on the international stage. However, I must note that, this is changing for China as China has been developing at a mind-boggling rate. The country is poised to surpass the US to become the largest economy in the world. In the recent years, China has imported much more than it used to and taken on a much larger amount of debt to fund the trade deficit. This does not refute our rationale above. Instead, this confirms it: as a country becomes richer, it will start to import more and take more debt to fund the purchases.
The US on the other hand is a developed economy with a high GDP/capita. More importantly, the US is a traditional powerhouse in the world with respect to its economy. The reason this matters is that the US has gotten used to its spending habit and in turn making large amounts of purchases from other countries.
If our analysis is correct thus far, we will logically expect to see the US running large amount of deficit with mainly developing countries, and accruing surpluses with developed economies. Table 2 and 3 rank US trade partners by total deficit or surplus in 2017 from the perspective of the US. As we examine the figures presented in these tables, we see a clear pattern, one that we have been expecting. Among the top 10 US deficit partners, 5 comes from clear developing economies: China, Mexico, Vietnam, Malaysia, and India. Another 2 comes from economies that are not doing well in the recent years: Ireland and Italy. On the surplus side, 7 out of the top 10 surplus partners are clear developed economies, with 3 exceptions being Brazil, Panama and Argentina.
(Table 2: Ranking of US Trade Partners by Total Deficit in 2017; Figures in Billions. )
(Table 3: Ranking of US Trade Partners by Total Surplus in 2017; Figures in Billions. )
If Trump raises on tariffs on steel and aluminum, foreign sellers must raise their prices when they sell in the US to keep the same profit margin. For example, suppose steel is traditionally sold to the US at 100 USD/metric ton, and the foreign miner incurs 80 dollars of cost of mining, shipping, and selling to the US. Therefore, the foreign company makes a profit of 20 USD, or 20% profit margin.
After the tariffs, if the foreign miner still chooses to sell at 100 USD/metric ton, 25% of the total revenue will now go to the pocket of the US government. Therefore, the miner’s cost has grown from 80 dollars to 80+25=105 dollars. The foreign company now has a loss of 5 dollars per metric ton and will logically choose Not to sell to the US at this price. To keep the same profit margin of 20%, the foreign seller must sell a ton of steel at 132USD. The US buyers now will have to face the price of 132 dollars, instead of 100 dollars. The US buyers will become poorer on a purchasing power basis because the total amount of goods that they can purchase has been reduced.
The direct winners and losers of the tariffs are very clear. It is simple in the study of Economics to predict who will directly benefit or be damaged by a trade policy; however, it is much more difficult, as we will see, to analyze the effect in the long run, for there are many uncertain factors. The US domestic steel and aluminum producers will benefit tremendously. They will now be able to raise their prices to match the now higher foreign prices without being subject to the import tariffs. Therefore, on a per dollar revenue basis, they will be able to expand their profit margin greatly. In addition, they will have more room to undercut the prices of foreign sellers to gain a bigger market share. In either scenario, the benefits that domestic steel and aluminum suppliers will enjoy are major. This is done at the expense of foreign steel and aluminum producers, for the reason that we discussed above. They must either raise prices and be less competitive, or accept a much narrower profit margin.
However, another major loser in the case of an import tariff is the consumers. What tends to happen in global trade is that a tariff is absorbed from two sides: producers and consumers. Producers will raise their prices, but not to the 132 USD that we have calculated in our example. This is because foreign producers typically do not have that much pricing power to dump all the tariffs to the consumers. The producers will be hurt to a certain degree, but the consumers will also be hurt. Often, the line is drawn in the middle. Going back to our example: the producers may decide to sell a ton of steel at 116 dollars. This means the producers did raise the price, but they have conceded 10% of their profit margin and settled with 10% profit margin. The consumers now need to pay 116 USD instead of 100 USD. They still become poorer on a purchasing power basis, but by a less degree than if the producers set their prices at 132 USD.
It works as so theoretically. However, reality is much more complicated, as always. There are many unknowns in this equation:
1. How competitive is the steel and aluminium industry in the US?
This is an important question to answer because depending on the competitiveness of the domestic producers, the foreign producers will then decide how much ground to give in. In the case of a very weak domestic industry, an import tariff will ONLY make the people poorer, and accomplish nothing else, for the foreign producers still possess pricing power after the tariffs and will decide to shoulder 0% of the total tariffs. Therefore, depending on the strength of the domestic industries, the US people will be hurt by a lot, or by not so much.
2. How will other countries respond? Will a trade-war happen?
This is the billion dollar question that Wall Street is interested in. If the US implements a high tariffs to protect its domestic industries. Will China, or Mexico, or Canada, implement a tariff in retaliation on what US is known to sell, such as iPhones, US automobiles, or Microsoft computers, etc.? All those companies reply significantly on their foreign markets, and if other countries choose to retaliate by taxing on the goods that the US sells, they could suffer in a major way even though they had nothing to do with the original tariffs.
3. Will the US win the trade war? Is a trade war easy to win as Trump suggested?
I believe what Trump meant was that the US has so much trade deficit, it is not going to get any worse, as far as the deficit level is concerned. By no means is a trade war easy for anyone. What a trade war implies is uncertainty. In the 21st century capitalism dominated society, uncertainty is the no.1 enemy. Uncertainty makes analysts unable to perform forecasts and makes companies unsure of its production level, inventory level, and so on. China is an upcoming economy and is currently a champion of free trade. If the US closes its door on the world and only encourages buying from domestic sellers, it is not hard to see a world that the living standard of the US people significantly deteriorates, to below the current levels of many Asian rising powers.
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