Trade policy can make for some strange bedfellows. Last week President Trump promised a 25% tariff on steel and 10% on aluminum. The GOP let out a collective gasp while Democrats had manure eating grins spread across their faces.
The stock market reacted negatively to the news. Clients (and a few readers) started asking me what is so bad about a tariff. I pointed them to a post I previously published on the consequences of trade wars, but there are still more questions. I’ll do my best to clear up the issues about why tariffs are a really, really bad idea we need to avoid.
What Really Happens When a New Tariff is Levied?
What is so bad about a tariff? It raises money to pay for the recent tax cuts. It promises to raise prices for steel and aluminum manufacturers. Some laborers stand to benefit from higher wages and with less competition, more job security. At face value it sounds like a good idea!
Of course, it only works if the tariff takes place within a vacuum. The tariffs Trump promises this week are blanket, meaning they hit steel and aluminum from every nation. When such a draconian ax is taken to the playing field there will be a response.
Normally tariffs take a long process to change. Treaties and trade agreements go through a long process of negotiations before each member nation to the agreement presents the details to their legislative branch for approval. Passage isn’t guaranteed. Several safety nets are in place to encourage each nation to honor the terms of all trade agreements.
The General Agreement on Tariffs and Trade (GATT) has been around since shortly after World War II (January 1, 1948). Over the decades there have been additional negotiations to expand and clarify the agreement. GATT has served the world economy well for 70 years.
Trade disputes can end up at the World Trade Organization (WTO). What makes WTO work is all member nations agree to the final decision of the WTO. In reality there is nothing to prevent a nation from thumbing its nose at the WTO, GATT or any other trade agreement or organization.
Trump’s unilateral tariff on steel and aluminum is certain to end up at the WTO. However, in the current political climate the U.S. can send some return international sign language involving the middle finger if it deems the tariffs a matter of national security. Section 232 of the 1962 Trade Expansion Act allows a president to unilaterally, without input or approval from Congress, set a tariff deemed necessary for the sake of national security.
Now that we’ve concluded the president can set a restrictive tariff if it is to protect national security, we can turn to the consequences of such action.
It’s impossible to know if the president will follow through on his threat, but there is nothing to indicate he’ll back down. What we do know is that there will be a serious response from nations around the world. The EU promised to increase tariffs on select U.S. products, including Harley Davidson motorcycles made right in the authors home state of Wisconsin. The gains the steel industry should experience will be felt in job losses in the Milwaukee area where Harley Davidson motorcycles are produced.
Is it Just a Shift, a Gain or are Real Economic Losses Possible?
The next question I get asked involves the ultimate economic gains or losses. Many people mistakenly believe it ends up a zero sum game. It isn’t!
The losses are best illustrated with a simple example. If steel tariffs on imports to the U.S. happen, the cost of steel to all U.S manufacturers increases. The wage gains in one industry pressure wages in other industries purchasing steel. The U.S doesn’t benefit much from the perceived benefit of closing our borders to free trade. However, nations feeling the pain of the tariff will not stand idle while they are gutted economically. These other nations levy tariffs against U.S goods so their domestic producers have an advantage over U.S. producers. And U.S. manufacturers of steel based products have higher input costs and are uncompetitive internationally.
This is where the problems begin. Economic theory is clear about price and demand. If prices increase relative to wages demand will fall. Steel prices will go up so instead of gaining all the benefits of a tariff there is a loss from the higher price. Other nations lose sales of steel to the U.S. while consumers now choose substitute products whenever possible. Regardless, the finite financial resources of consumer’s means they can only buy fewer goods since prices are now higher compared to wages in their industry.
Here is where a good idea gets ugly. Retaliatory tariffs now decrease demand for selected U.S. products. China can buy soybeans elsewhere and goods exclusive to the U.S. (Harley Davidson motorcycles) can be prices out of international markets due to prohibitive retaliatory tariffs. Even Canada could fight back by disrupting the supply chain of auto manufacturers.
By now it’s easy to see all the expected benefits of a unilateral tariff regresses to lower economic activity, fewer jobs, lower corporate profits and a difficult stock market. This is why President Reagan was a free trade guy. It’s also why the GOP is so against the tariff. It leads to the nemesis of the 1970s: stagflation, where prices rise while economic activity declines.
But what about the Democrats? Are they idiots thinking the tariff will benefit them? Well, the Democrats aren’t idiots. They’re protecting the interests of their constituents. Unions love the tariff because it helps them (in the short run) even if other industries suffer the ripple effect of the tariff. Many Democratic representatives are from areas with heave steel or aluminum production. They also have major union support. Democrats are engaging survival instincts even at the risk of eventual calamity.
A History Lesson
Tariffs have been with this country since its inception. Tariffs were a major source of federal government revenue before the income tax was instituted. In part, the income tax was needed to provide for an expanded government role in national security (fighting wars) and to allow more open trade between nations, fostering economic growth on both side of the agreement.
The threat of tariffs is also devastating! The real risk President Trump takes by announcing the tariffs is that virtually every nation on the planet will gear up to increase tariffs on exclusive U.S. goods in retaliation. The consequences could be catastrophic!
We can see from a famous real life example how the possibility of increased U.S. tariffs can slow an economy for a decade or more. In 1929, freshly elected President Hoover called a special session of Congress to review tariffs shortly after taking office. Hoover’s idea was to get modest adjustments to tariffs to better manage the economy.
Special interests soon got involved. The special session of Congress dragged on. The vibrant economy of the 1920 started to slow and then decline by the late summer of 1929. The stock market crashed in October of the same year with the economy chasing quick behind.
There is a lot more to the 1929 stock market crash. The economy of 1929 was extended and gold started to leave the country. When money is specie (backed by gold or silver) it’s important to keep enough gold around to back the local currency. Today we have fiat money (issued by decree of the government) so they can print to their heart’s content.
What people often forget is the Tariff Act of 1930 slowed the economy and crashed the stock market before it became law! The blowback was already in force and industries already started adjusting to the advantages or disadvantages. In the end the losers always outnumber the winners. Increased prices always lower demand as consumer’s resources buy less. Less demand means fewer jobs and down you go until the cycle of stupidity is broken.
The Game Plan
Only days into the announcement by the president and its clear there will be retaliatory tariffs if the U.S. carries out the threatened tariff increases on steel and aluminum. The economic ramifications should be felt quickly. The stock market will struggle under the potential for lower earnings. The steel and aluminum tariffs alone could undo all the benefits of the recent tax cuts. It’s that serious.
You can’t predict the future any better than I can. Therefore, a steady as she goes approach is advised. Timing the stock market based on tariffs and counter-tariffs is ill advised.
But you must be ready for some pain! The damage done by the threat alone is meaningful. If the tariffs go into effect and the EU and other trading blocks and nations institute their own tariffs against U.S. goods, it will be a painful time to be fully invested.
An appropriate plan is based upon where you are in your life. If you are young and starting out you need to max out your work retirement program (401(k), 403(b), 457, et cetera). Filling your health savings account and IRAs are also a good idea if you are allowed by the tax code.
Older readers and those near or in retirement should always have a few years of liquid net worth in cash (money market and similar accounts). Any market decline then requires only a modest adjustment to lifestyle as you will have plenty of reserves in cash to draw from, plus dividends.
Something this important and potentially nation-altering requires me to engage in my favorite pastime: predicting the future. It’s all in good fun, understand.
I predict (yes, I am the new Nostradamus!) the next economic savior to ascend to the presidency will kill inflation and spark economic growth by embracing free trade. Reagan’s ideas of supply-side economics have been played out to the nth degree so this time will require different medicine. Once the pain sets in free trade will be the perfect medicine to lower inflation and spark economic growth. Anyone ready to vote for President Accountant?
Remember to vote early and vote often.