Donald Trump, America’s president, and JD Vance, his smirking sidekick, berated Volodymyr Zelensky for not playing his cards well (actually claiming he didn’t have the cards) during a shouting match at the White House on February 28th. This begs the question whether Mr. Trump himself is excelling in playing cards. Let’s look at a recent hot topic: tariffs.
King of tariffs…
It is common wisdom, and this goes back to ancient Greek times, that division of labour and voluntary trading of goods are generally beneficial to parties involved in the transaction as higher productivity and output could be achieved by specialization. David Ricardo made the subtle point (in 1817) that comparative and not absolute advantage was important, i.e. even if one country could produce all goods more cheaply than another country it would still make economic sense to divide labour on a relative cost basis. A tariff is a form of tax imposed on purchasing foreign goods (and services although this is less common) and discourages trade between countries. Thus, tariffs prevent a country to specialize in what it does best. This makes everybody worse off, possibly except for the people protected by the tariffs.
Trump nevertheless has fallen deeply in love with tariffs because he believes that tariffs will solve many (perceived) problems. Trade deficits with other countries will disappear, manufacturing activity in the U.S. will be revived (by reshoring, new industrial jobs will be created), revenues for the U.S. government will increase (thereby avoiding the need to raise income taxes) and unfair trade practices will be punished.
Some of these objectives seem contradictory, i.e. if production is successfully reshored, then income from tariffs will drop; even Trump can’t have it both ways. Some objectives are unlikely to be successfully addressed by tariffs. For example, trade deficits. Say the U.S. imports cars from Germany and incurs a trade deficit because of that (imports from Germany are higher than exports to Germany). By prohibiting the imports of German cars (by setting exorbitantly high tariffs), initially net exports (to Germany) rise, all else equal. However, one would expect the real exchange rate to appreciate to offset the increase in net exports attributable to the tariff (imports decline so fewer dollars are needed for global trade). The trade balance is not affected but the amount traded is (both for imports and exports, the latter because the real exchange rate appreciates, i.e. the dollar becomes more expensive). As an aside, Trump’s fascination with bilateral deficits is unintelligible. The U.S. has a trade deficit with Madagascar (which was hit by a frivolously calculated 47% reciprocal tariff, later paused), because Madagascar is the world’s largest grower of vanilla. As long as Americans quaff Starbucks vanilla cream frappuccinos, it is likely that the trade deficit will persist because Madagascar, with a tiny GDP per capita of USD 575, simply can’t afford to buy expensive American products and growing vanilla in the U.S. will be challenging, to say the least. However, there are also countries that have a trade deficit with the U.S. (e.g. the Netherlands, which imports LNG from the U.S.). If Trump believes trade deficits are a problem, he better focus on the overall number (instead of bilaterals) and encourages Americans to save more (consume less), because that is the real reason for the trade deficit. He may start with closing the astronomically high fiscal deficit (raise taxes, unless Elon Musk’s DOGE comes up with meaningful reductions in government expenditure, which seems highly unlikely).
What about the prospects of reshoring, creating new jobs? Tariffs protect industries that can’t compete internationally because they are not efficient or face high costs of doing business (e.g. expensive labour or energy). Indeed, tariffs could lead to companies setting up new plants but especially for industries where there is (domestic and international) overcapacity, like steel and aluminium, this is not a given. Over the last couple of decades, America lost many jobs in low-quality manufacturing sectors. We wonder whether it is feasible to reshore these types of industries. Who wants to work long hours in a sweatshop to knit T-shirts or glue soles onto Nike trainers? A job as a barista (yes, even in Starbucks, brewing frappuccinos) or as a hamburger flipper doesn’t sound so bad in comparison. Does the U.S. have sufficient workers to fill these low-quality jobs, especially when migrants are not welcome anymore? In any case, as consumers have to pay more for products which benefit from tariffs, they can spend less on other items. So, it is questionable whether in aggregate jobs will be created because that depends on whether downscaling of production of non-tariff goods is required. Think of steel. There are fewer than 100,000 steelworkers in the U.S. but millions of manufacturing jobs involve products that use steel as an input; some of these jobs are in jeopardy because of higher production costs caused by higher steel prices. In any case, investments will only materialize when the government’s policies are stable and predictable. This is where Mr. Trump is going horribly wrong. He changes his mind on a whim and says he is ready to do a deal after announcing new tariffs, thereby leaving the market guessing how high the tariffs eventually will be. Certainly for more complex products (like cars or electronics) it takes years and a lot of capital to set up a new plant as well as the required supply chains. Many companies will think twice before committing capital to a project in an environment where the business case of that project can change dramatically in a couple of days on the back of a tweet by the U.S. president. Even if Trump gets his act together and settles for a comprehensive tariff policy, then this does not necessarily translate in more manufacturing jobs. He may have to outlaw automation (robotics) and AI to ensure that a meaningful number of new jobs are created. Given that other countries which used to export these goods to the U.S. are likely to retaliate, U.S. producers are dependent on domestic demand alone. This limits scalability and might result in higher costs. Tariffs tend to stifle innovation and spur lobbying for exemptions (Mr. Trump seems not entirely immune in this respect, as the recent Apple exemption shows).
Getting a bit yippy…
There are cases where tariffs can play a positive role. For example, a temporary protection of infant industries from foreign competition to achieve a minimum required scale and move down the learning curve could be justified (and has been ubiquitously used by Emerging Markets). Another example could be to retain manufacturing capability in an industrial sector that is deemed of strategic importance (“national security”) to the country (e.g. food production, essential pharmaceuticals or maybe even semiconductors), although this could also be achieved by subsidies (think of Joe Biden’s Inflation Reduction Act) or quota. However, tariffs are then only one component in a set of comprehensive industrial policies to achieve the objective. And this comes at a cost (distortion of capital allocation); there is no free lunch here, just look at China.
Trump also says he wants to impose tariffs to offset unfair trade practices (according to him, China and the EU are ripping off America). Question then is how to define “unfair” and specify for whom it is unfair. “Unfair” is typically meant to be selling goods at very low prices (dumping). Is it unfair when China sells cheap clothes to U.S. consumers? Ask shoppers at Temu and Shein who eagerly buy their junk. For many households in lower income brackets electronics are only affordable because they are sold on the cheap by Chinese manufacturers. An iPhone made in the U.S. would reportedly cost more than three times its current price, out of reach for many Americans. Clearly, China has overcapacity in many industries and is exporting goods, that cannot be sold domestically, at very low prices. But in aggregate the U.S. has not become poorer as a result of China’s trade practices. Lost manufacturing jobs have been replaced by service jobs and the value added for the manufacturing jobs that remained have increased substantially over the past two decades. In case of the EU, Mr. Trump argues that VAT is causing a disadvantage for U.S. producers because exports from the EU are VAT-exempt. However, VAT is akin to a sales tax, thus a tax on consumers irrespective of where the good is produced. A car produced in the U.S. has the same VAT as a car produced in Germany if sold within the EU. Likewise, a European producer faces the same sales tax (but no VAT) as an American producer if the car is sold in the U.S. The important difference between VAT and sales tax is that VAT calculates the tax on the incremental value added and thus prevents cascading whereas a sales tax could (but theoretically should not) be applied at successive stages of production. The solution actually is in Mr. Trump’s hands; he should replace sales taxes with VAT which is more efficient.
Other Trump policies also impact U.S. manufacturing. The clampdown on elite universities will prove to be a negative for innovation, and thus economic growth, in the longer term. Also, Trump’s geopolitical discourse is negative. For example, Mr. Trump rightly demands that Europe increases defence spending (5% may be unachievable in the short-term but 3.0% should be realistic). This would be good for the U.S. economy as Europe’s defence industry is not as developed as that of the U.S. so higher spending would increase demand for U.S.-made kit. But by threatening to leave NATO and bashing Ukraine, he spurred Europeans into action to build their own defence industry and to reduce reliance on U.S. suppliers. In any case, would the U.S. economy really benefit from further Russian incursions into European territory? Russia’s economy is wholly dependent on fossil fuels. By normalizing (economic) relations with Russia (Vladimir Putin is Trump’s BFF, which possible explains why no tariffs were imposed on Russia), Mr. Trump fosters competition for production and sale of oil and LNG, exactly the products he wants other countries to buy from the U.S.
The summary is simple; tariffs are bad for the U.S. economy (with an increased likelihood of triggering a recession) and Trump’s bullying will get him nowhere, especially with China. Trump slapped tariffs of 145% on China but this will hit back as a boomerang. First, U.S. consumer prices for many essential goods will rise substantially or those goods may even not be available (resulting in unhappy voters). Second, if China decides to focus on domestic demand (instead of flooding South-East Asia and the EU), its trade surplus will reduce but its need to buy U.S. Treasuries will also diminish, eventually resulting in higher risk premiums unless the U.S. substantially reduces its fiscal deficit and debt pile (which is not in Trump’s playbook). Trump’s incoherent and erratic behaviour already has damaged the status of the dollar. It may be too much to ask Mr. Trump to undo his liberation day tariff onslaught but he must realize that the one who is paying for all this is the U.S. consumer. That dims Trump’s prospect for an unprecedented (and unlawful) third term as POTUS. Maybe he should try his hand at bluff poker when playing cards…
