Voodoo Trade Policy Comes to America

What to expect when you’re expecting tariffs

OK, I’m going to take a break from the death of democracy to talk about bad economic policies instead. Warning: lots of numbers ahead. That will happen sometimes.

So: if you ask me, what’s going on in financial markets right now — which have, if anything, been behaving as if the danger of a Trumpian trade war has receded — looks like a self-defeating prophecy.

True, Donald Trump didn’t impose tariffs on day one. But he did say, more or less unambiguously, that he plans to impose 25 percent tariffs on Canada and Mexico on Feb. 1 unless they stop massive flows of migrants and drugs across their borders. This will be a hard demand to meet, because to a large extent those massive flows exist only in Trump’s imagination. Canada in particular will find it hard to “stop” massive border violations because they aren’t happening; both illegal crossings and drug smuggling across our northern border are in fact trivial.

Still, so far markets have shrugged Trump’s tariff threat off, apparently in the belief that he won’t follow through. But why not? Economists would, if he asked, tell him that high tariffs on neighboring nations closely integrated with the United States will do major damage; businesspeople would say the same thing. But if Trump wants your opinion, he’ll tell you what he wants it to be.

I believe that the only thing that might dissuade him from destructive policies would be a severely adverse market reaction — which means that the lack of such a reaction, based on the belief that he won’t really do it, greatly increases the probability that he really will.

So what happens if he does? Let me make four points about tariffs.

1. 25 percent tariffs would be really, really high — and destructive

2. Consumers would pay a heavy price

3. The tariffs would raise far less revenue than Trump imagines

4. While some industries might gain, tariffs at this level would destroy many jobs

On the first point, the numbers Trump are now talking about are much higher than the numbers most people have been using when making guesstimates about the effects of his trade policy. For example, last month the Congressional Budget Office did an estimate of the effects of “illustrative policies” that would increase tariffs; their version of Trumponomics involved only a 10 percent tariff on nations other than China.

So should we just multiply CBO’s numbers by 2.5? No, it’s much worse than that. The damage done by tariffs isn’t proportional to the tariff rate; 20 percent is something like 4 times as bad as 10 percent, 25 percent something like 6 times as bad.

Why? I’ll do a longer-form explainer at some point, but maybe this will help readers’ intuition. Any tariff causes consumers to shift from imported goods to domestically produced alternatives that are more expensive, inferior in quality, or just not quite what they want. But with a low tariff domestic alternatives will be only a little bit worse than the imports they replace; with a high tariff many of the domestic goods consumers buy will be a lot worse than the imports they replace. (Some readers may know that I’m talking about Harberger triangles; never mind.)

Whew! The second point is easier. Imports of goods are about 11 percent of GDP. While you can tell stories under which import prices wouldn’t rise by the full amount of the tariff, they’re weak and poorly supported by evidence. So a first-pass estimate would be that tariffs on the scale Trump is threatening would be a 25 percent sales tax on goods that account for 11 percent of consumer spending, raising the cost of living by almost 3 percent — well over 3 percent if, as he says he intends, he puts much higher tariffs on imports from China.

Since median household income is more than $80k, that’s around $2500 a year for the typical household. People who voted for Trump because they believed he would bring prices down are in for a rude shock.

How much revenue could these sales taxes — because that’s what they are — raise? Imports are around $3 trillion a year, so you might think that a 25 percent tariff would raise 25 percent of $3 trillion, or $750 billion. But this ignores the fact that a tariff would reduce imports — which is the whole point, in Trump’s mind — so the revenue raised would be much less. When I plug in estimates of the effect of import prices on demand, I get Trump’s tariffs reducing imports by about a third, so they raise only around $500 billion.

This is a lot less than the $1 trillion Trump has reportedly been telling Republican senators his tariffs will raise, and only about 10 percent of total federal revenue. Trump’s fantasy that he can replace income taxes with tariffs is, as my headline suggested, the trade policy version of voodoo economics.

Yes, back in the days of William McKinley the federal government was funded almost entirely by tariffs — but government was vastly smaller then:

Finally, about jobs: if and when Trump makes his big tariff proclamation, he will surely claim that tariffs will create millions of jobs. They won’t. In fact, they can’t, because we’re currently more or less at full employment. What tariffs will do is disrupt the economy, causing job gains in some places but large job losses in others. And as I said when writing about China’s trade surplus, disruption itself is a cost; unavoidable in an ever-changing economy, but this disruption would be gratuitous, caused by nothing but Trump’s tariff obsession.

What would be disrupted? U.S. tariffs would lead to a stronger dollar, hurting exporters (very much including farmers) except to the extent that other countries retaliate, which would also hurt exporters in a different way.

The threat of retaliation is very real. Goldman Sachs recently examined the effects of foreign retaliation to the much more limited tariffs Trump imposed during his first term:

Foreign retaliation led to large declines in US exports of targeted products to China and a roughly 20% decline in targeted exports to other retaliating countries over the next year … Retaliatory tariffs hit exports of homogenous goods such as agricultural and natural resource products especially hard … Other economic research has found that foreign retaliation led to lower US export prices as well as volumes, lower manufacturing employment, and fewer job openings.

That’s not all. These days, U.S. manufacturing is closely integrated with manufacturing in Canada and Mexico; auto production, in particular, typically involves shipping many car components back and forth across our northern and southern borders, sometimes multiple times. Trump’s proposed tariffs would throw a lot of sand in the gears of that system, raising costs and reducing employment.

The bottom line is that what Trump is saying he’ll do would do a lot of damage to U.S. families and producers, without delivering the benefits he thinks it will. But he doesn’t know that. And market complacency makes it likely that he’ll go through with his tariffs and only discover the consequences when it’s too late.

MUSICAL CODA

Nothing to do with this newsletter’s topic, but I needed some uplift.