US Tariffs unleashed

The United States announced on 1 and 2 February that it would impose broad-ranging tariffs of 25% on Mexico and Canada, and 10% on China. Within 24 hours, the tariffs on Mexico and Canada were put on hold for a month pending further negotiations. And President Donald Trump also announced that tariffs would “soon” hit the European Union. The tariffs follow on from President Trump’s pronouncements during the election campaign, when he alluded to an intention to impose tariffs on all imports coming into the United States. President Trump availed himself of powers under International Emergency Economic Powers Act of 1977 to levy the tariffs on the grounds that they would compel countries to take action on various matters from the flow of migrants to the flow of drugs that he deemed to imperil the security of the United States.

The political economy factors behind rising protectionism in the United States and elsewhere would be the subject of an entire article. Here we focus on how to think through the effects of tariffs on world trade and on economic activity.

It’s all relative

Tariffs change relative prices: they raise the price of tariffed goods in the country imposing tariffs. They affect relative trade costs by making tariffed products more expensive to trade across borders than non-tariffed ones. Producers and consumers respond to these changes by changing their choices of what markets to supply and/ or what goods to produce; and consumers may also choose to switch what they buy and from whom they buy. Pulling these ideas together helps us think through the effects of tariffs and their implications.

To see this, we consider a scenario in which the United States imposes 60% tariffs on China, and 20% tariffs on the EU, Canada, Mexico and Brazil, but not the United Kingdom. This is in line with some of the pronouncements made by President Trump during his presidential campaign. The idea here is to present a stylized example, not to model every particular pronouncement (which would be a vain exercise, a chasing after the wind).

Figure 1 shows the effects on total exports to all countries from the UK and EU member states, with the left hand set of charts showing percentage changes and the right hand set showing changes in dollar terms

We see that industrial and agricultural goods exports fall from the EU. This reflect the direct hit from US tariffs and lost opportunities in the US markets. They may also reflect lost opportunities in other markets where EU exports have to compete with Chinese exports that are diverted from the US.

We also observe that the UK increases its exports. Its exports are not subject to tariffs in the US, but the EU’s are: the change in relative trade costs brought around by the tariffs favours the UK.

We also observe that services exports from the UK and  the EU both increase, and this mitigates the effects of US tariffs. Again, this is because of the relative effects of tariffs. For exporting countries, tariffs make mean that trade costs for goods have increased relative to those of services, making exports of services (which cannot be tariffed) more attractive, and resources reallocate away from goods to services. Meanwhile, in the United States, tariffs cause a switch in domestic goods consumption from imported to domestically produced sources, and draws resources to goods from services. At the same time, US demand for services needs to be met, and this is done though imports, which provides opportunities for services exporters in the UK and the EU.

And then what?

Economists sometimes speak of tariffs as “tariff experiments” because they allow us to trace how the effects of these interventions vary across sectors and countries depending on whether or not they are “terrified”. The results above are one such example and highlight the need to for policymakers to think through the effects by using modelling techniques that can capture the various interdependencies that exist between countries and sectors.

There are also various policy implications. One of these is to remember that tariffs are a subset of trade costs. There are a variety of others, including transport and connectivity issues, access to finance, costs associated with regulatory divergence, customs and border inefficiencies, and so forth. Some of these are due to internal policy failures in exporting regions affected by tariffs, and may be compounded by more deep seated issues. For example, in both Canada and the EU, the threat of tariffs has shed light on internal barriers to trade and economic activity, which can constrain the international competitiveness of businesses .

The results for services also suggest that for economies like the UK and those of the EU, which are heavily services-based (and in the case of the UK, have a trade structure dominated by services), that measures to enhance services markets would be beneficial. This is especially true in digital trade, the fastest growing area of services trade, where frameworks on data and regulatory cooperation, and mobility of skilled workers, would play an important part in lowering trade costs. And because services are an important input into goods, services policy measures can also reduce trade costs affecting goods.

None of this should detract from the fact that tariffs are in overall terms a bad idea. By reducing overall trade intensity in both the US and in tariffed partners, they lower rates of growth in the longer run. Estimates suggest that every percentage point decrease in trade openness reduces national income by 0.5% to 0.7%. Moreover, for the US, tariffs will likely have inflationary pressures. A combination of these factors explains why modelling suggests that blanket tariffs of the sort envisioned by Mr. Trump would leave the average American household worse off by between $1000 and $2000 dollars per year.

Moreover, the modelled effects of tariffs do not take into account the broader systemic change  in international economic governance that seems to be heralded by unilateral tariff pronouncements of the sort made by President Trump. For most of the post-war era, the guiding principle behind trade, and economic governance more generally, has been to develop frameworks of rules to keep markets open, and when there are upswings in protectionist sentiment, to channel these in a way that could keep an upper bound on how bad things could get. It is that framework that has been abandoned. In imposing tariffs, or threatening to impose them, on relatively flimsy ground of national security, the United States has breached treaty commitments at the global and regional level. These include those of the US-Mexico-Canada agreement, which was painstakingly negotiated under the first Trump presidency after President Trump had threatened to withdraw its predecessor, the North American Free Trade Agreement. Inevitably, opportunistic behaviour of this sort will invite retaliation, and more generally a level of mistrust and uncertainty that will cast a pall over trade and economic activity.