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REVIEWING THE IMPACT OF TARIFFS

Does Protectionism Work?

Protectionism is a policy of restricting imports from outside countries via various methods. The current tool of choice is tariffs. The theory is the additional cost incurred by foreign producers will limit foreign competition because the additional tax (tariff) raises the cost of foreign goods for domestic consumers. Given the additional cost, consumers will purchase domestic goods. This, in turn, creates demand for domestic goods which creates additional domestic jobs. There is a lot of talk about tariffs given current political discussions. Today, we review:

 

  • What are the short-term and long-term costs (and benefits) of tariffs?
  • Has the U.S. (and other countries) used tariffs (and other tools) in the past?
  • If yes, what were the outcomes? More importantly, what should we consider as the talk of tariffs increase?
  • How would tariffs affect financial plans and investment portfolios?


What is a tariff and to whom does it apply?

A tariff is a “tax” on imports. Foreign producers pay a tax as they bring goods into the country. You may be familiar with the idea of duty. When you bring certain items into a country (alcohol seems to be the most prominent based on duty-free shops), you may be taxed upon entry.

Duties, like tariffs, will vary based on the item and from where you bought it. A common example is a ‘duty-free’ shop located in airports. If you purchase from this store (within limit), you can declare the item without paying duty (simplified version).

The key part of the duty example is that certain items are taxed upon entry while others are not and origination of purchase matters. If you want to limit the amount of Chinese steel entering the United States, you tax steel coming from China at a higher rate than from other origins.

But, according to the International Trade Administration, only 2% of imported steel comes from China; 20% comes from Canada; with 11% coming (each) from Brazil, South Korea, and Mexico.

The emotional side of protectionism

Most ideas have an emotional component. One of the key emotional aspects of the debate is the question of jobs. Theory says that if competitors have an unfair advantage, they cost domestic jobs. Steel production is a good example for this debate.

Steel plants across the country have shuttered and jobs were lost. Pictures of shuttered steel plants raise emotion and emotional people tend to vote. Before we make emotional conclusions, let’s consider how steel tariffs might affect us in both the short term and long term.

If we stop making steel and other products, are we a weaker nation?

If we are reliant on other countries for steel, what happens if those countries stop sending us steel? The extreme scenario would be in the case of war (I suppose). If we relied on others to supply steel would we be susceptible? Maybe…but that also implies a traditional conflict that includes tanks and other traditional tools of war. I am not sure we will fight traditional wars going forward, but who knows, we might.

As someone who tends to think of risk first, I understand this idea, but I consider the unintended consequence of this rationale. Namely, what happens if we become self-reliant and stop trading with other countries?

There is little doubt (my opinion) that the United States could become self-reliant. We could bring the steel mills back to life. We could make the toys and electronics that are “made in China.” We have the “know how.” The short-term effect would create a spike in jobs (both construction and eventually manufacturing). The short-term benefits are emotional. But, what would the long-term picture look like?

Just because we can, doesn’t necessarily mean we should

Let’s consider the scenario where we (as a nation) have become self-reliant. We no longer need and therefore do not trade with other countries. When I consider this scenario, my biggest question surrounds our debt and the need to fund our own liabilities and lifestyle without the benefit of outside investment. As a society, we benefit greatly from outside investment.

Can we give up “Made in China?”

Emotionally, we might like to see more “Made in America” on our labels, but our wallets may not enjoy it. Let’s revisit the self-reliant scenario. There is little doubt (at least in my mind) that we could make all (or at least most) of the products often mentioned in the debate. We could build our own electronic parts. We can make toys. We can sew clothes. In most cases, we could do all these things with equal or higher quality.

If we can use the same resources to provide something of higher value, comparative advantage says we should. Even if the other producer has a greater absolute cost; if the comparative advantage is greater, we should seek it. In a competitive world, both gain from this tradeoff of comparative advantage.

One of the claims against Chinese steel is that they are “dumping” low-cost steel for various reasons. While that debate will be saved for another day, I can’t help but wonder...why not use the “dumped steel” while it remains cheap to accomplish other goals that will also add jobs in the short-term and provide greater security in the future. I am referring to infrastructure updates. If the cost of steel rises, I assume the cost of rebuilding infrastructure rises from both the increased cost of steel and the increased cost of labor (assume some who would be working on rebuilding might be working in the new steel mills).

Show me the money

As I was researching this topic, I asked myself…” where does the tariff money go?” Will it help pay down debt? That might be a positive. It might be used to subsidize the industries hurt as countries add their own tariffs. That is not beneficial to the economy. I haven’t seen much talk about how tariff proceeds would be used.

We might need time to grow...and compete.

While competition benefits most economies, there are times when industries need to be protected from competition. Sometimes we need to protect industries and provide the time needed for them to mature without the threat of competition that may offer products at unreasonably low costs to prevent maturation.

Perhaps the most successful was the protection Japan provided its automakers after World War II. With high tariffs, Japanese car companies learned and matured which ultimately taught U.S. automakers how to build better cars. The Japanese auto scenario reveals another weakness of protectionism. If domestic producers are protected from competition for too long, they might become lazy. South Korea also hid behind a high tariff wall in the 1960s. This allowed the country the ability to gain knowledge of technology without fear of competition.

The Smoot-Hawley Tariff of 1930

In 1929, Reed Smoot and Willis Hawley co-sponsored legislation that kept foreign goods out of America. They promised a boost in domestic employment while protecting the living standard of the ordinary working-class family. It was originally designed to protect farmers from agricultural imports from Europe as they increased farming production after World War I.

 Economists at the time shared the opinion that the bill would hurt, not help the domestic economy. By the time the bill was enacted, tariffs were added to more than agricultural products. But, Herbert Hoover campaigned on a “protectionist ticket” and signed the bill into law. The result...a trade war based on the retaliation of other countries. The bill is said to have extended the severity of the Great Depression.

Steph thinks emotionally…at first

One thing I try to consistently do with Steph is asking rather than tell. This can be extremely frustrating in the short-term but creates better long-term outcomes (I hope).

She is set on taking the next step at the horse ranch (leasing a horse). But, I wanted to check in on the actual lessons rather than the emotional impact of having a horse she could call her own (well sort of). I asked if she was still learning. Her emotional and quick answer was yes. A week later, she reconsidered. She told me… “I was thinking about your question. I am not sure if I am learning as much as I would like.” This raises two new options. First, we can discuss her progress with her trainer. Second, we could test new barns.

 Sam (her trainer) was out of town the past two weeks so we haven’t had a chance to address step one. Last week, we addressed step two and tried a new barn. We’ll see how that goes. So far...she says she likes it, but of course...that may be another emotional answer because any horse is a good horse in her eyes.

How will tariffs affect portfolios and financial plans?

If the tariffs are enacted, we should expect some sort of trade war. This will likely raise prices in the short-term. This would likely also put pressure on employment income as companies struggle with higher costs for some goods. We will begin to see the impact as companies provide guidance for earnings.

Inflation without income compensation has the potential to slow the economy as people and corporations struggle to maintain the current standard of living and profitability. If the trade wars increase, the pain could increase. This would not be good in the short-term, but would we benefit in the long-term?

I heard an interview that questioned if this process is part of making the deal? Are we showing a bad scenario with the real goal of wanting attention is drawn and progress made on something less invasive to our economy? Interesting viewpoint and I suppose a possibility.

Stocks have for the most part shrugged off trade war threats. Perhaps participants don’t believe this will come to fruition or maybe they believe protectionism will ultimately benefit us in the long run.

Because we haven’t really dealt with tariffs for a long time, it was interesting to research the topic. It was interesting to consider various outcomes and review history. It was also an important reminder to look at all the data before making a decision. The emotional response is to have more domestic jobs. The question is at what cost and is this the right time as we consider the current unemployment rate.

As I researched the topic, I was reminded of another protectionism tool…the use of subsidies. As I considered how subsidies have been used, I thought about the two current domestic scenarios. The first is the public funding of sports arenas and the second being tax breaks for large companies as they enter a city. When I considered where we look for help, I considered our debt and highly educated professionals.

 I believe the most expensive and desired “product” will be known. Are we subsidizing the right “products?” Sounds like a potential future post.