Why Does Everyone Fear Trade War?

So we have heard that President Donald Trump has threatened to impose tariffs on imports from China, Mexico, Canada and even the EU, in an attempt to encourage consumers to buy Americans to support local. Trump is indeed moving towards his goal to “Make America Great Again”, exactly what he have campaigned for during his presidential election.

Question is, is this move the right way?

Targeted countries have promised to retaliate should the tariffs come into place. And they did.

A 25% tariff on steel and a 10% tariff on aluminium imported into US came into effect on 1 June and affected the EU, Canada, Mexico and other close US allies, including India. In addition, President Donald Trump officially rolled out its tariffs on Chinese products on 15 June which includes aerospace, information and communication technology, robotics, industrial machinery and automobile, all of which are imposed due to China’s use of pressure, intimidation and theft to obtain America’s technology. Chinese imports worth $34 billion will now be subjected to the new 25% tariff as of Jul 6.

Chinese president Xi Jinping’s administration immediately retaliated with a 25% tariff on an equivalent of $34 billion worth of U.S. goods. Tit for tat.

Canada has announced its retaliatory tariffs on C$16.6 billion worth of US exports from 1 July while Mexico has also placed tariffs on $30 billion worth of US goods ranging from steel to pork and bourbon. Even India said that it would raise taxes on 29 products imported from the US – including agricultural goods, steel and iron products. This new duty will come into place on 4 August.

 

What Increasing Trade Tariffs Mean?

Trade tariffs are usually increased to protect domestic industries and similarly in the case of Trump, to encourage households and firms to switch from imports to domestic goods instead. Since the Gross Domestic Product (GDP) comprises of consumption, investments, government expenditure and net exports, here’s how trade tariffs affect economic growth.

Consumer expenditure: Since goods and services from abroad are now deemed as more expensive, consumers are forced to switch to domestic goods, which may or may not increase consumer expenditure depending on whether the demand for the good is elastic or inelastic.

Investment expenditure: As raw materials from abroad are now more expensive, businesses may in turn face higher costs of production where they may push these costs to consumers in terms of higher prices. A country with higher costs of production may also appear unattractive to foreign investors, causing investment expenditure to drop.

Government expenditure: The current U.S. government spending is $4.407 trillion for FY2018, and since tariffs typically bring in revenue for the government, it should bring the gap closer between the budget deficit. Despite knowing that cutting personal taxes, corporate taxes and small business taxes are in a way decreasing revenue, the Joint Committee on Taxation said that these cuts should stimulate growth by 0.7 per cent annually.

Net exports: This is where trade tariffs affect the most. Imported goods and services are now going to be expensive in the U.S., which would most likely decrease imports. As other countries retaliate with new duties imposed on U.S. goods and services, it is going to be equally difficult for U.S. businesses to import their goods and services into other countries without increasing their costs.

Harley Davidson for example, has announced that it would move motorcycles production out of U.S. as the retaliatory duties would result in an incremental cost of approximately $2,200 per average motorcycle exported from the U.S. into the European Union. This is estimated to cost the company an incremental cost of $30-45 million for the rest of the year as they are not intending to raise prices to cover additional EU’s duties.

A one-off trade tariff may indeed bring about positive effects to protect domestic industries, but a trade war from provocation and retaliation is definitely not.

 

Downward Spiral of the Trade War

This is no longer a war between both the U.S. and China’s presidents. There are now actual consequences that people have to pay.

Affected businesses are either going to push rising costs to consumers or absorb them. Should costs be pushed to consumers, demand may decline as the cost of living rises. According to Mark Zandi, chief economist of Moody’s Analytics, all of Trump’s tariffs so far would end up costing the average U.S. family $80 a year. This amount could rise if the trade war continues. When lesser goods and services are demanded, lesser needs to be produced, hence lesser workers needed. Unemployment becomes inevitable.

Should businesses absorb these costs, profit margins will be compromised. Overtime, companies may produce lesser or reduce the labour supply to cut costs. Both of which ends up in a demand-deficient unemployment. (Read here: Three Main Causes of Unemployment).

Banks could lower interest rates to spur spending but that may not happen to the U.S. as they have just risen interest rates last month and have signalled that two more increases are coming. (Read here: How Interest Rates affect Economic Growth)

 

Since the size of an economy is measured by the final amount of goods and services produced, lesser consumer and investment expenditure coupled with a potential fall in exports is definitely going to lead to an output declination. Should a trade war continue, higher inflation is bound to set in, and so is another set of detriments. At the end of the day, does it really still matter who is the ultimate winner?

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