A Protracted Trade War? Not Necessarily

President Trump aims to significantly reduce bilateral U.S. trade deficits with the E.U., Asia, Mexico, and Canada principally through reducing tariffs on U.S. exports.  To achieve this, he is prepared to impose a series of retaliatory tariff increases on imports to the U.S. to pressure trade partners to cooperate.  In particular, his trade policy targets the excess trade advantage that past agreements ceded to U.S. trade partners beyond what free trade would warrant based principally on competitive advantage.  This injustice is like finding out one's phone bill was overcharged for forty years and now an adjustment is demanded, at least prospectively.  That U.S. autos exported to Germany are subject to a tariff that is four times what Germany incurs on its auto exports to the U.S. is an example of the inequity Trump challenges.  What's more, some U.S. trade partners, especially China, are significantly subsidized by their governments as to create overcapacity that depresses prices such that U.S. producers cannot produce profitably.  As such, fair trade calls for so-called anti-dumping provisions in trade agreements, as well as substantially lower tariffs on U.S. exports.

However, U.S. protectionism aimed at upholding inflated domestic prices resulting from government subsidies, as well as uncompetitive regulatory, labor and tax costs, goes beyond fair trade as to constitute managed trade.  In a free market, those anti-competitive factors should be resolved through the political process and union discussions, not trade negotiation.  Unfortunately, Trump does not agree.

The extra trade concessions accorded U.S. trade partners over time were politically motivated to benefit the competitive position of special industry groups, and perhaps to provide surreptitious foreign aid and wealth redistribution in response to leftist globalist influences in Washington.  In some instances, companies are indifferent to tariffs just to secure a foothold in what is a lucrative market regardless.  Another unfair advantage results from suspiciously acquiescing to trade agreement violations.  Indeed, the U.S. has been a patsy in international trade for far too long.

Economic Impact of Unfair Trade

According to the Federal Reserve Bank of Atlanta, from 1980 through 2015, the U.S. incurred more than a $10-trillion cumulative trade deficit, an indeterminate percentage of which derives from one-sided inflated tariffs, or unfair trade.  In 2015, the goods deficit was $762 billion, about half of which was with China.  These examples suggest that if 10% of the respective deficits were attributed to unfair trade, the loss to the economy was about $30 billion a year over the 35-year period, and some $75 billion in 2015 alone.  A 30% share of the deficit yields a $90-billion and $225-billion annual cost, respectively.  Trump wants to correct this largess, but also impose some misguided protectionist measures to save certain companies and jobs, that would together reduce the aggregate trade deficit by $200 billion a year.  That deficit reduction would accrue to the U.S. economy in the form of lower import costs, higher export revenues, and lower prices.  This translates into higher business profits and consumer savings equivalent to an additional annual GDP growth of about 1% ($200 billion/$20 trillion).

The Corrective Calculus

Consider the dynamic below for correcting unfair trade imbalances through U.S.-imposed tariffs that are painful enough for trade partners to make serious concessions.

U.S. raises tariffs on imports (the proceeds of which are retained by the Treasury):

  • Domestic manufacturers are protected from import competition, allowing them to preserve jobs and profit margin.
  • U.S. businesses and consumers pay higher domestic prices as lower-priced imports are no longer competitive because of tariffs.
  • Importers incur higher materials costs that reduce profit margin, which lead to layoffs, plant closures, and less hiring.
  • Importers may reduce purchases to compensate for tariffs to the dismay of trade partners.
  • Importers may purchase from other sources to avoid tariffs, but this requires costly and time-consuming reconfiguration of supply chains; materials may be more costly and possibly inferior.
  • Importers may bypass tariffs by investing directly in overseas markets; domestic jobs are lost; investor may receive government subsidy to finance this investment, which may in turn face tariffs on materials imported to overseas production facilities.
  • Trade partners impose retaliatory tariffs on various U.S. exports that make that product less competitive in target markets; exporter layoffs and plant closures may ensue because of lost revenue.

The Incentive for Trade Relief

On balance, tariff increases are a net drag on the economy, principally because businesses and consumers burdened by higher prices and less selection far outnumber manufacturers and workers who benefit from import protection.  This means that trade partners who impose retaliatory tariffs are similarly affected (allowing for certain structural differences between the respective economies).  As mentioned, importing from alternative sources may involve a costly and protracted reconfiguration of supply chains that is viable only if new product is of comparable price and quality.  Importer agreements to increase purchases from U.S. exporters may not be a viable substitute for tariff reduction because productive capacity to meet the added demand may not be in place.

As such, the incentive on both sides is to avoid a protracted impasse.  For this reason, U.S. trade partners might be disposed to capitulate eventually in the form of tariff and non-tariff relief that significantly reduces the aggregate deficit, notwithstanding a period of saber-rattling.  But it takes a persistent hard line by the U.S. amid temporary economic disruptions and political pressure.  In addition, enforcement must be optimally executed as there is no limit to the potential chicanery of trade partners.

Nonetheless, legitimate national security considerations have to take precedence over fair trade.  As such, the U.S. must guard against genuine security threats by prohibiting intellectual property transfers, restricting certain foreign acquisitions, and imposing sanctions where necessary.  Even invoking national security with respect to allies may be appropriate considering third-party enemies imbedded in their companies can intercept American intellectual property.

U.S. Leverage on Trade Partners

The U.S. has greater tolerance for the short-term disruption inherent in rectifying unfair trade flows because of the size and diversity of its economy.  Therefore, Trump should use this leverage to play the long game and force concessions, notwithstanding the economic, electoral, and geopolitical risks.  This advantage did not exist in 1930 when the protectionist Smoot-Hawley Tariff engendered the Great Depression.  Then the U.S. operated in the absence of today's dominant manufacturing base, developed infrastructure, and technological efficiencies that make the country more self-sufficient and resistant to economic shocks.  Ironically, that U.S. exceptionalism and attendant altruism may be a reason for the nation's long concessionary trade stance, such that trading partners expect it.  Is there a place for noblesse oblige in America's trade policy on the order of possibly $200 billion a year?

Revised bilateral trade agreements must substantially eliminate the excessive concessions that have weighed on the economy over the years.  If so, U.S. companies will benefit significantly from greater profitability with all the implications for jobs, income, and economic growth.  Natural trade deficits founded on the principle of comparative advantage are benign, regardless of size.  But trade gaps resulting from giving away the store to partners are unfair, and even suspect.  The U.S. must insist on substantial trade relief, impose punitive tariffs as an inducement, and bear the pain from retaliation.  Trade partners will suffer even more and will likely relent as result.

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