Tariffs: The end-game

It is unlikely President Trump knows where he wants the US tariff regime to end up. Nor can I suggest a logical ending place because the whole thing is illogical. It is a big policy mistake. Period. But it may be possible to identify a kind of ‘equilibrium’ place where competing political pressures will tend to take it.

These pressures include corporate lobbying, the threat of retaliation and Trump’s likely reluctance to accept too much of a lift in inflation or too great a threat of recession. Trump will get some of what he wants while the disruption to US business and the economy is not as great as it might be.

So what does Trump want? Four things, I suggest. Significant revenue (to finance income tax cuts), protection for US manufacturing at home, the reduction of tariffs and barriers abroad to open up export opportunities and a reduction in the trade deficit.

The fact that he wants revenue means that tariffs will not go away. So, my guess is that the ‘equilibrium’ end-game might be something like 10% all round on allies and neutral countries, with 25% on China. At these levels some people would breathe a sigh of relief, though they are still damaging to efficiency. In addition, there are likely to be higher tariffs on finished vehicles, steel, aluminium and pharmaceuticals. At the same time there will be plenty of exemptions as US firms lobby for advantage.

I also think that in an ‘equilibrium’ Trump will come to accept that the tariff regime needs to be more stable, rather than changing with every tweet. Though that stability may still be many months away.

The current high tariffs on China and threat of high reciprocal tariffs on Europe and other countries are being used to gain concessions. I expect countries will promise to buy more US goods while reducing specific tariffs (eg Europe’s 10% tariff on US cars which it has already offered to cut). Countries which reduce their own tariffs will benefit of course from lower prices and greater competition to a varying extent, which may be particularly useful for those with high tariffs such as India. However, if tariffs on Europe settle at 10%, Europe can be expected to levy higher tariffs too.

The outcome for Mexico and Canada also has a logical ending point where Trump acknowledges that the USMCA enables US manufacturing to access cheap labour in Mexico and cheap resources in Canada (such as energy) with no threat to national security. I am sure the car companies are explaining that making simple parts in Mexico and even making small cars there is beneficial to the US if it wants to be competitive and keep inflation down. So, the USMCA will be renegotiated with the emphasis on raising and enforcing North American content requirements and, in some cases US content requirements.

If I am right that China will end up with a higher tariff, the US will need to work hard to ensure that China does not simply route exports via other countries. But to the extent that Chinese companies continue to move actual production to other countries, particularly in south-east Asia, this will be good for those countries. Chinese companies producing in Mexico may face a tougher time. To the extent Trump allows, it will benefit Mexico (via helping with development) and the US (through low prices and competition).

Short-term implications

The biggest problem is getting to the end-game, with China playing hard-ball on negotiations and the risk of a recession due to all the uncertainty. Once we get to it, the US average tariff would be in the 12-14% range, up from about 2% previously, but lower than the 23% threatened. Exporters and importers would absorb some of the tariffs so the policy might raise $100-200bn in revenues annually. This is not to be sneezed at but makes only a small contribution against a $2 trillion deficit.

There would be a one-off jump in US prices of around 0.5-1% and a direct hit to US GDP of 0.5-1%. This wouldn’t be enough to cause a recession on its own given that GDP growth would likely have run at least 2% without Trump. But the uncertainty surrounding the tariff regime, which is likely to persist for many more months, could still do that. For other countries, the hit to GDP is much less, since the tariffs affect 100% of US trade and only a limited chunk of other countries’ trade.

Long-term implications

The tariffs will accelerate the division of world supply chains into two – North America and Eurasia. Multinationals will increasingly develop parallel supply chains. To some extent Eurasia will also be split though Europe is likely to continue to source significantly from China and other Asian countries even while tariffing some goods. US services companies, including technology companies, may face increasing foreign push-back.

This retreat from globalization to regionalization is costly and inefficient and will raise prices and lower competition, particularly in north America. The US-based supply chain cluster is likely to be the least efficient of the two if it limits itself to Mexico for production of cheap labour-intensive goods. US exports of manufactures may find it harder to compete globally, though of course US companies will do fine with goods they produce outside the US in their alternative supply chain. It is doubtful if US manufacturing production and jobs will rise very much, if at all, though there could be gains in some sectors.

Impact on markets

A tariff regime as described is a pointless cost to the world and especially the US economy. It is not the end of the world though, particularly if it settles down with minimal further meddling. Markets would welcome it compared to the current chaos and it would imply ‘risk on’ for investors. If it begins to emerge in coming weeks, market attention may well shift to the budget negotiations, to see whether the government will make any attempt to reduce the large deficit.

Meanwhile we have to navigate the current trade chaos, which is set to last well into the summer. Institutional investors are questioning their long-term view that investments in the US offer reliably good prospects with low policy and political risk. They are looking elsewhere (though US small investors are buying the dip). So the dollar, equity markets and Treasury bonds are down and are likely to continue with higher risk premiums than before. Investments in non-US stocks, Swiss Francs, TIPS and gold look more attractive to some.

Have we seen the worst in terms of policy? Not necessarily. The tariff regime described above may be too sanguine. To boost revenue Trump may insist on higher tariffs than I suggest. Or he may meddle indefinitely. China and the US could escalate the trade dispute into a wider confrontation potentially extending to a blockade of Taiwan. But the ‘equilibrium’ forces I have described do suggest that things will settle down over time as Trump realizes the limits of radical policies.