Letter from Dumaguete
December 19, 2024
TARIFFS GALORE
What happens next?
Tariffs and international trade are again in the news. 2025 will begin with a new administration in the United States that has promised its constituents a significant increase in import duties or tariffs. The proposed new tariffs are aimed at Canada, Mexico, and China. Tariff increases are also proposed for other countries that have declared a desire to undermine the role of the US dollar in the world economy.
The impact of tariffs
What do these tariff proposals mean in the short and long run? The long run is a helpful reference point, even if it takes too long. I say this despite a famous admonition by a very important economist (Keynes) that the long run won’t matter because we would be dead by then. It still pays to imagine that there is rhyme and reason, even in economics, when everything we might worry about will have done their ‘entropy’ thing and settled into a steady-state or stable equilibrium.
Let us imagine then the long-run effects of a large country such as the US enacting a substantial hike in import tariffs on its significant trading partners. Canada and Mexico have prospered after entering into free trade agreements with the US in 1974. Many observers view China’s phenomenal economic growth as partly due to its rapid exports since at least the 1990s and more so after China joined the World Trade Organization in 2001. The trade relationships of these three countries with the US give evidence of the benefits of international trade, even if governments attempt to ‘bend’ the rules to their advantage. Such rules cover trade tariffs.
A tariff is a tax. It is levied when goods cross national borders. Since 1945, the international community has negotiated tariff reductions or set up ‘free trade’ zero-tariff areas. This historical move toward liberalization is generally regarded as a good thing because we know that the historical alternative — trade restrictions and trade wars (when countries imposed tariffs and trade embargoes on each other during the interwar period of the 1920s to the 1940s) — was a nightmare. Noteworthy is an observation made in 1933 by an American historian (W. Y. Elliott) who saw in the emergent trade blocs and embargoes “the worst dose of economic nationalism that [the world] has ever seen. Worst because it will be deliberate; because the tools are at hand to make it more absolute than ever before; and because the conditions are present that will probably make the resulting dislocation of existing national economics more painful than ever before.” Sober minds already sensed the deep divisions between countries that resulted in World War II.
A tariff drives a ‘wedge’ between the world market price and the corresponding domestic price. For example, the US presently imposes an import duty of 25 percent on trucks imported from Japan. That means that the $20,000 price of a Japanese-made truck can rise to $25,000 in the US domestic market. The tariff ‘protects’ the American manufacturer from Japanese competition. Of course, such protection can go only so far. The demand for Japanese trucks in the US market also reflects their higher quality. Still, the tariff serves to shift demand toward US-made products.
But is a tariff inherently wrong? Ever since the time of David Ricardo, economists have recognized the desirability of free trade. Tariffs distort the natural incentives for countries to specialize in producing goods in which they have a comparative advantage. The accepted exception to this general rule is when tariffs promote overriding considerations such as national security, the promotion of ‘infant’ industries, or the mitigation of domestic ‘market failures.’ An example of a market failure is when there are large pockets of unemployment that result from free trade.
An interesting aspect of the theory on tariffs is that the size of the tariff-imposing country matters. If large, such a US TARIFFS 3 country can reduce world market prices when its increased domestic production of importables adds to global supply.
It follows from the discussion above that a large country can ‘force’ a fall in the world market price of a good. While this seems to be an argument for imposing tariffs, it carries the risk that similarly large countries would be tempted to impose retaliatory tariffs. The possibility of a resulting downward spiral of world market prices would, however, deter large countries from engaging in such a trade war.
A not-so-funny thing is that tariffs imposed by large countries may benefit small countries that would benefit from a lower price for imported goods. This ‘third-country’ effect may or may not be significant. It depends on how large the tariff increase is and whether the small country benefits from a free global market.
Other economists have come to similar conclusions. For example, a multi-country model employed at the Peterson Institute for International Economics (PIIE) suggests that Asian countries, including the Philippines, will likely benefit from new US tariffs.
The short-run scenarios
The short-run effects of significant tariff increases are difficult to divine.
Initially, US consumers will see price increases for imported goods, representing a one-time blip in inflation in 2025. But, unless tariffs continue to rise in later years, the effect on inflation should be transitory. (And yet, inflation can have a mind of its own. Central banks regard this in part as an insoluble problem of expectations. Inflation persists because the public expects it.)
There will be winners and losers from a new tariff. Domestic producers of goods that compete with imports will gain. Consumers of imported goods will suffer. In an ideal world, society could mitigate these gains and losses. A reduction in their income taxes would compensate the consumers of imported goods. The government could tax the profits of domestic producers.
In my view, such ‘rebalancing’ mechanisms are not likely to work smoothly. Consumers’ confidence will likely be shaken even if their income tax burden is reduced. Because consumption is a large part of aggregate demand, there would be a palpable risk of stagnation or recession following an initial period of stagflation. Indeed, the multi-country model used by the PIIE predicts declines in the trading volumes and national incomes of two countries that impose tariffs on each other.
The effect on the Philippine economy
As noted earlier, Asian countries such as the Philippines stand to gain if they are exempted from the increased US tariffs. This could lead to a surge in demand for goods manufactured in the Philippines, potentially boosting the local economy.
Will the overseas Filipino workers also benefit? Their families in the Philippines can benefit from lower world market prices for Chinese goods.
Summing up and conclusions
The inflationary effects of new tariffs are negligible, especially in the long run, and the size of the US economy suggests that there would be a one-time fall in world trade prices.
A tariff is a tax, a part of ‘fiscal policy.’ What governments take, they can give back. The gains made by domestic producers can be transferred back to consumers through cuts in income taxes. Absent such redistribution mechanisms, a tariff amounts to a tightening of fiscal policy.
There can be severe consequences for the overall economy. A tariff increase can induce stagflation in the short run, depending on how central banks behave and how the public forms its price expectations.
We will likely get trade wars, which, as in the 1930s, will reduce the volume of international trade and usher in a global recession or even depression. A ‘silver lining’ to this grim scenario is that the bubbles in the stock markets and cryptocurrencies are more likely to burst amidst global deflation, which would be the more likely outcome after 2025.
One can almost wonder if tariffs are a modern example of a Faustian bargain. Or perhaps the policy issue can be seen in the saying, “Be careful what you ask for; you just might get it. In spades.”
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