“From this moment on, it’s going to be America First. Every decision on trade, on taxes, on immigration, on foreign affairs, will be made to benefit American workers and American families. We must protect our borders from the ravages of other countries making our products, stealing our companies, and destroying our jobs. Protection will lead to great prosperity and strength.” – From President Trump’s inaugural address on January 20, 2017
President Trump led with trade in his inaugural address. US industry, global markets and America’s trading partners were forewarned that trade policy, and protectionism, would be a top priority in his administration. Yet serious action on trade took a backseat in 2017 to priorities pushed by Congressional Republicans, like health care and taxes, not to mention pushback from pro-trade staffers in the White House. It was perhaps only a matter of time before the administration returned to a long-standing priority and campaign promise.
President Trump announced on March 1st that his administration plans to impose steep new tariffs on steel and aluminum imports into the US – 25% on steel and 10% on aluminum – immediately sending the stock market into the red. The S&P 500 lost 1.33% while the Dow, which includes heavy users of steel (like Ford) dropped 1.68%. At the same time, the stock price of US Steel, which would be expected to benefit from the proposed tariffs, climbed 5.75%.
The reaction from almost every American industry (except steel), and economists , have been overwhelmingly negative, with dire warnings that this would be the beginning of a trade war. Yet the market has recovered amid news that the tariffs would be more limited, excluding Canada and Mexico, and leaving the door open for other carve-outs. At the same time, the President continues to suggest that trade wars are in fact good and America is well positioned to win them.
Small economic impact
In theory, steel and aluminum costs would rise, increasing the price of finished goods for consumers. Or companies will eat the higher cost if they decide that raising prices would reduce demand – for example, if Toyota raises the price of their cars, consumers may buy less Toyotas. In which case profit margins would reduce and investors would take the hit. Toyota could also choose to manufacture their cars outside the US, where the tariffs do not apply, and then ship them in for sales – a scenario that would increase the trade deficit, the opposite of what the administration is seeking.
Another thing to consider from a macroeconomic standpoint is where the US is currently in its business cycle. As we noted in a previous piece , the ultimate goal of new tariffs is to boost GDP growth by reducing the trade deficit. For this to work, American consumers would have to switch from buying foreign-made goods to ones produced domestically. This strategy would work if the US had a lot of supply-side slack, i.e. more idle workers and industrial capacity. However, with unemployment close to 4% it is questionable as to how much slack there is. Straining domestic production could very well result in rising inflation, which in turn would lead to more aggressive monetary policy that eventually sends the economy into a recession.
Now by itself, the proposed tariffs on steel and aluminum would affect less than 2% of US imports and the overall impact on the economy would be small. However, certain industries, like auto manufacturing, oil and gas, brewing and construction, would take a disproportionate share of the economic hit. The Trade Partnership, a consulting firm, estimates that the economy will see a net loss of 146,000 jobs, with employment gains in steel and aluminum sectors more than canceled out by job losses in other manufacturing sectors like fabricated metals and motor vehicles and parts. Declining auto sales (as a result of price increases) could see the auto-industry lose up to 40,000 jobs , which is a third of the entire US steel workforce. These estimates exclude any impact from retaliatory tariffs by trading partners who are subject to the tariffs.
On the other hand, with Canada and Mexico excluded (for now), and wiggle room offered to other US allies, the impact from these tariffs may be even more limited than the estimates cited above. From the point of view of domestic protectionism, providing exemptions does dilute the effectiveness of the tariffs. A non-exempt country, like China or Russia, could potentially export steel and aluminum to an exempt country like Canada, before being re-directed toward the US.
Of course, the economic fallout is not going to happen in one fell swoop. It is more likely to occur over time as other countries absorb the tariffs, and choose to retaliate in ways that create more political pressure than economic pain.
Significant geopolitical impact
Tariffs have been imposed before, though as we pointed out in an earlier piece, they have proven to be ineffective. President George W. Bush imposed a 30% tariff on foreign steel in 2002. However, these were reversed two years prior to scheduled expiration as America’s trading partners filed suit with the World Trade Organization (WTO) and imposed their own retaliatory tariffs. More recently, President Obama imposed tariffs of more than 500% on a specific type of Chinese steel and 30% tariffs on Chinese tires (a move that ended up raising prices for consumers).
The key is that previous administrations have used anti-dumping tariffs. They argued that another country is illegitimately subsidizing their exports to the US to kill off American industry and so by WTO rules, they are allowed to levy a tariff on those exports. Usually, the targeted country takes the issue to WTO and either gets the tariffs ruled illegal or is allowed to impose counter tariffs of their own.
President Trump is going at it in a different way. Based on his Commerce secretary, Wilbur Ross’s suggestion, he is using a rarely used ‘section 232’ tariff, which is based on national security rather than anti-dumping. Formal restrictions based on this justification have been used only twice before – Iranian oil imports in 1979 and Libyan oil imports in 1982.
The logic is that America wants to protect its military might and does not want to be dependent on foreign imports to maintain this. Ironically, the Defense Department is against such across the board tariffs. The US military would be fine with the current capacity of America’s metallurgical industry should it come to a situation when that’s all it had to rely on. Plus, the largest sources of US steel imports (which constitute 30% of overall steel consumed in the US) are from American allies, including Canada, the European Union (EU), Brazil, South Korea and Japan.
The national security approach to tariffs sets a precedent for other countries to use a similar rationale to impose retaliatory measures, and unlike WTO, there would be no framework within which to settle trade disputes. Interestingly, the White House’s own economic report suggests that the US has had most success with WTO’s dispute settlement mechanism.
“The US has won 85.7 percent of the cases it has initiated before the WTO since 1995, compared with a global average of 84.4 percent. In contrast, China’s success rate is just 66.7 percent. Most US WTO cases target China (21) and the European Communities (19). When the United States is the respondent, it still wins 25 percent of the time, a rate that is better than the global average rate of 16.6 percent. In comparison, the EU and Japan have won 0 percent of the cases brought against them, while China has won only 5.3 percent of the time.”
US allies will mostly feel the pinch of new tariffs
The tariffs are ostensibly targeted to fight Chinese over-capacity and dumping of cheap steel on the world market. However, the reality is that China was only the 10th largest supplier of steel to the US in 2017 even though it produces more than half the world’s steel. As economist Chad Bown (Peterson Institute for International Economics) points out, this is because of existing tariffs that target almost 94 percent of imported Chinese steel.
The European Union member countries collectively provide the largest amount of foreign steel to US industry (worth $6.2 billion in 2017), while Canada, Mexico, Brazil and Germany form the top 4 single exporters of steel to the US. Less than 40% of these countries’ steel exports are currently subjected to tariffs but 100% will be under the new tariffs.
The story is similar for aluminum. Trade protection is relatively new for this industry but China is the target of existing tariffs – more than 95% of Chinese aluminum exports to the US are already subject to tariffs. Most other countries currently have no tariffs imposed on their aluminum exports to the US.
Bown estimates that the new tariffs on steel and aluminum would impose losses of $10 billion per year on US trade partners (excluding Canada and Mexico). More than 60 percent of these losses would affect US allies, including the European Union ($2.6 billion), South Korea ($1.1 billion), Brazil ($1.0 billion), Japan ($0.7 billion), Taiwan ($0.5 billion) and Turkey ($0.5 billion). Chinese exports are estimated to hurt less than $700 million.
WTO dispute resolution can take years and so any immediate retaliatory tariffs by trading partners would be along the lines of these estimates. Of course, that is assuming other countries, or blocs like the EU, follow the usual WTO playbook.
Related: Five Macro Questions for 2018 Investors
What happens next
As we mentioned earlier, the political impact of these tariffs is likely to be greater than the economic impact. Trade partners will probably impose retaliatory tariffs specifically targeted to influence the political debate in the US.
At the same time, reports suggest that the President is eyeing further targeted tariffs on up to $60 billion worth of Chinese goods. So the steel and aluminum tariffs may only be the beginning of a more concerted protectionist trade strategy. While this raises the probability a full blown trade war, it is still unlikely to occur over the short-term as countries plan their own retaliation strategy.
We discuss these scenarios below.
President Trump’s initial announcement of the tariffs suggested blanket application to all of America’s trading partners. This was met with significant pushback from the business community and other countries, especially Canada and Mexico. Steel and aluminum form a crucial part of the tight supply chains that connect US, Canada and Mexico, especially for automobiles and parts – several components cross borders multiple times before the finished product is ready for sale.
The administration eventually backed away from imposing the tariffs on Canada and Mexico, instead tying it to successful re-negotiation of NAFTA – though there is no clear definition for success, which only heightens uncertainty. President Trump has gone on to say that other countries that have good trade and security relationships with the US could also be exempt from the tariffs (like Australia). This does provide the administration broad flexibility to pull back from across the board tariffs, especially if it starts to face serious political pressure.
Under WTO rules, proportionate retaliatory action, called ‘safeguards’, must be implemented within 90 days of US trade measures being implemented. So countries, especially US allies, will be seeking exemptions from Washington over the next three months, before they move forward with their own measures.
There is also the chance that the administration is using the threat of tariffs solely as a negotiating ploy around other issues. For example, NAFTA or assistance from China on the North Korea issue. In which case the tariffs will eventually be scaled down and further exemptions provided. However this is unlikely given the President’s, and his advisors, long-standing belief that the US is getting a raw deal from its trading partners.
Scenario: Proportional tit-for-tat
The EU is America’s largest trade partner and will clearly see the biggest impact under new tariffs (now that Canada has been exempted). They do have some leverage because they trade with the rest of the world as a bloc, under a single trade policy. So Washington cannot deal directly with member countries – even the UK is not allowed to do so until it formally exits. However, with Europe’s economy finally on the mend, and exports forming a big part of the recovery, the bloc will probably try to push back hard on the Trump administration while also trying to avoid a full-blown trade war.
European commission officials have already presented EU member states with a $3.5 billion list of more than 100 US products that could be subjected to reverse tariffs. These numbers are not that meaningful in an $18 trillion economy but the EU is targeting exports from states that will have a political impact, including bourbon (Kentucky – Senate Majority Leader Mitch McConnell), Harley-Davidson motorcycles and cranberries (Wisconsin – House Speaker Paul Ryan) and blue jeans (California – House Majority Leader Kevin McCarthy). They have successfully used this approach in the past, when they targeted Florida orange juice and other swing state products in retaliation to the Bush steel tariffs of 2002.
So if the EU is not exempted, expect to see retaliatory measures that are proportional to expected losses, under the auspices of WTO.
The other big question is how China will retaliate. For now, the steel and aluminum tariffs have only limited impact on China. However, if the administration imposes a host of new targeted tariffs on Chinese goods, there will be more pressure on their government to respond. They do have a significant trade surplus with the US, which means they are as reliant on exporting cheap goods to the US as Americans are on consuming those goods. So the US has some leverage against China.
At the same time, China can exert political pressure with targeted measures against coal and electronics, or even reversing aircraft orders from Boeing – America’s largest manufacturing exporter. This would be especially painful at a time when China is expected to become the largest aviation market by 2022 .
The ultimate goal of imposing retaliatory tariffs that are proportional in nature would be to get Washington to back down – essentially going back to the Pullback scenario we laid out above. This would perhaps be the most ideal situation for the existing global trading regime and we would see minimal disruption to the global economy.
Scenario: No-rules trade war
One big risk with the Proportional tit-for-tat scenario is a possible escalation by the Trump administration, especially if they feel that America’s trading partners have not ceded enough ground on trade (or other matters). A collapse of NAFTA talks, and unilateral withdrawal by the US, would be the most immediate risk under this scenario.
An all-out trade war would deal a serious blow to the global economy, and not simply because every country will lose out under such a scenario. As we discussed earlier, the Trump administration is using the national security argument to impose new tariffs, as opposed to the more typical anti-dumping duties. The global trade regime that exists today is ultimately based on trust and long-established rules via WTO. It would also hurt any US action taken against Chinese intellectual property practices – which would be a lot more effective if it were coordinated with Canada, the EU and Japan. Going outside existing norms would lower the scale of cooperation across nations on multiple issues, beyond just trade.
In fact, the Trump administration’s exclusion of Canada and Mexico from the new tariffs – tying them to progress in NAFTA negotiations – and offering other countries a chance to negotiate away the tariffs on a bilateral, and ad-hoc, basis that circumvents WTO. This further undermines the existing multilateral global trading order that the US played a big role in setting up.
The administration’s latest decision to kill Singapore-based Broadcomm’s takeover of Qualcomm, the chip-maker, also adds a new front in a potential trade war. This decision to protect a domestic firm could be justified on national security grounds but it does increase uncertainty around further foreign direct investments (FDI) in the US – a key source of funds for the US since domestic savings is currently insufficient to fund domestic investment. Since 2010, the US has seen more than $4.8 trillion worth of FDI flow into the country.
A full blown trade war where countries respond to each other outside WTO is obviously the worst case scenario, though we are some ways away from it at this point. We are far more likely to see several iterations of the Proportional tit-for-tat and Pullback scenarios before getting to a No-rules trade war scenario.
However, the probability of the worst-case scenario has clearly increased and it is no longer an outside tail risk.