Tariffs and trade wars

Written by multiforte on . Posted in News

Tariff announcements from the US and tit-for-tat retaliations from China have dominated the headlines for quite a few weeks.

While the evidence suggests that geopolitical events have no lasting negative impact on global financial markets, it is still worth understanding the nature of these events and keeping an eye on them.

This note takes a look at tariffs and trade wars, discusses the current state of play, and considers the views of key economists on how the recent developments could play out.

What is a tariff?

A tariff is a tax on goods that enter a country. While tariffs can provide a revenue stream for the government, they are essentially a protectionist measure – designed to stem the flow of competing products being imported by making the cost of those imported goods more expensive for the consumer.

Many countries have some tariffs in place – usually on a few goods, and generally not that significant.

Did you know that Australia still has a tariff on imported cars, even though we no longer have a car manufacturing industry? And we have a 25% tariff on bed sheets. Can you imagine a bed sheet incited trade war!

Which reminds us that just because a country has tariffs in place doesn’t mean that a trade war will emerge.

What is a trade war?

A trade war is where two or more countries impose barriers to trade with each other – through import tariffs or quotas – which escalates into a tit-for-tat.

As you would imagine, in a trade war, the barriers imposed are sufficiently large in terms of their size and the proportion of imports covered to create a costly impost on the trade partner.

Do tariffs work?

No, is the short answer. The consensus among economists is that over time, the costs outweigh the benefits.

According to Megan Greene, Global Chief Economist at UK-based Manulife Asset Management, “a cardinal rule in economics says that, while tariffs create winners and losers in any economy, the latter outweigh the former. The gap is known as ‘deadweight losses’.”

At the fundamental consumer level, tariffs and trade barriers increase the prices of goods and decrease living standards.

Here’s a great snippet on this from Shane Oliver, Chief Economist AMP Capital:

“A basic concept in economics is comparative advantage: that if Country A and B are both equally good at making Product X but Country B is best at making Product Y then they will be best off if A makes X and B makes Y. Put simply, free trade leads to higher living standards and lower prices whereas restrictions on trade lead to lower living standards and higher prices.”

If we consider the broader economic impacts, tariffs still don’t stack up. Here’s a few key reasons why:

  • A tariff cannot be a targeted strike. If you impose a tariff on one product in one country, you never know where the impact will pop up. We’re seeing right now how tariffs can cause chain reactions around the globe. You can’t just put a tariff on something and expect other countries to sit back and let it happen. There will be counter-tariffs.
  • While a tariff may be designed to help specific sectors of an economy for a period – chances are, it will simultaneously hurt other parts. According to US economist and author, Tyler Cowan, “the changing nature and greater complexity of international supply chains makes effective protectionism hard to pull off”. He cites the example of foreign steel – which is an input into many American products sold abroad, such as cars:

“If tariffs or quotas restrict the importation of foreign steel, American automakers will face higher costs, and they will find it harder to export.”

The US car makers are already protesting. Toyota argues that more than 90 per cent of the steel and aluminium used in its US-built cars is sourced in the US. It told Reuters: “The administration’s decision to impose substantial steel and aluminium tariffs will adversely impact automakers, the automotive supplier community and consumers.”

Policy makers might like to think that tariffs can target foreign interests with precision, but argues Cowan, that has never been less the case than now.

  • Tariffs stifle industry innovation and efficiency – why bother to innovate or drive efficiency when you are protected from global competition? Professor Tony Makin of Griffith University argues in The Conversation that ironically, the American manufacturing sector could suffer greater damage from lost international competitiveness than from cheap steel and aluminium imports.

Shane Oliver agrees – and reminds us that this was a serious issue for Australia in the 1960s and 70s:

“The experience of heavily protecting Australian industry in the post WWII period was that it was just leading to higher costs and prices and lower quality products and Australians’ were voting with their wallets to buy better value foreign made goods. We might have protected lots of manufacturing jobs if we stayed at the levels of protection of 45 years ago, but we would have become a museum piece.“

Fortunately, he argues, the tariffs came down. And despite the loss of manufacturing jobs, new jobs emerged in the services sector where Australia’s relatively highly-skilled and highly-paid workforce have a comparative advantage compared to workers in less developed countries.

“In short”, says Shane Oliver, “if you want to support your country’s products buy them, but trade barriers don’t work.”

What should investors do?

Periods of heightened uncertainty can create turmoil in markets. This can be unsettling – so it’s valuable to remember three key principles of successful long-term investing:

  • Setbacks in share markets are normal. We don’t know when they will occur – nor how deep they may be. What we know is that over the long run, shares provide higher returns than more stable assets.
  • Selling out of shares – or moving to a more conservative investment strategy – after a correction can be the worst possible move, as it can lock in losses. Your best bet is to stay focused on your investment plan and ‘stay the course’.
  • Finally, turn down the noise. In periods of market turmoil, the flow of negative news reaches fever pitch – making it hard to stay calm. Again, a well-considered plan should help you to reduce the noise and focus on the things you can control.

Conclusion

So far, much of what we’ve heard is sound and fury. While the war of words marks an escalation, many commentators believe that an all-out conflict is in neither the US nor China’s interests. This is too important a relationship for the two countries and for the world to be taken lightly.

In the words of US economist Tyler Cowan: “The good news… lies outside the realm of politics: The long-run trend is one of greater interconnectedness, at least for traditional goods and services… In the broader sweep of world history, we’re probably not going to remember this era for its temporary uptick in steel tariffs.”

Sources: Cowan, “Trump Tariffs Are Just a Blip in the March of Free Trade” Bloomberg (8 June 2018); Greene “Forecasts of the impact of a US-China trade war fool markets” Financial Times (12 June 2018); Letts “Donald Trump’s tariffs not great for Australia, but terrible for the US” ABC News (2 March 2018); Makin “Why Trump’s tariffs will have little impact on Australia and a trade war is unlikely” The Conversation (12 March 2018); Oliver “Oliver’s Insights” (27 March 2018; 12 April 2018).