The Truth About Tariffs
As seen on Forbes.com
Tariffs have a horrible economic reputation. Since the Great Depression, economists have told us that trade barriers made that economic collapse much worse. Not surprisingly, therefore, the recent trade war has sparked fears of recession. For several reasons, however, recession does not seem likely.
Unlike the broad way monetary policy affects economic demand, tariffs target a much narrower segment of the economy. And businesses also have ways to limit the shorter-term loss of sales. Although tariffs can damage the economy, the real damage occurs gradually over time.
Monetary Policy Versus Tariffs
Consider how monetary policy slows economies. Monetary tightening reduces demand by broadly constraining how much consumers and businesses can borrow to spend. Together, those areas contribute approximately 82% of U.S. economic activity, and much of that spending is sensitive to the cost and availability of credit. Thus, restrictive monetary policy often pushes the economy into recession.
Tariffs, on the other hand, affect a much narrower segment of the economy. U.S. exports contribute less than 14% of total gross domestic product (GDP). And only 5% of that goes to China. Accordingly, the loss of all export sales to China would put a meaningful dent in U.S. economic growth but should not cause a recession by itself.
By raising the price of goods, tariffs reduce the total consumption of some goods and can shift sales to countries that are not targeted by tariffs. Typically, however, there should be relatively little immediate impact on a country’s total economic activity.
Responding to Tariffs
Sometimes buyers have little choice but to purchase a product—whatever the cost. For example, Chinese suppliers are reportedly the dominant source of disposable medical gloves for U.S. healthcare. When there is no competition, suppliers simply pass the entire tariff cost along to buyers. The resulting price increases add to inflationary pressure, but overall economic activity remains largely constant. That is particularly true when the cost of the item, like surgical gloves, is a small part of the total cost of goods sold or services provided.
Shorter term, too, suppliers exempt from tariffs may not have the capacity to satisfy demand. When international supply and demand are largely balanced, sellers subject to tariffs may be able to retain most of their market share even if they pass the entire tariff cost along.
Switching costs also keep businesses from changing suppliers quickly. It can take considerable time, effort and money to change vendors. Until buyers can identify suitable vendor replacements and execute necessary contracts, they often simply pay higher prices.
Even in cases where a broad range of suitable product substitutes are available, tariff-stricken companies do not always lose sales. Absorbing the cost of a tariff is never a seller’s first choice, but it can avoid the loss of major business relationships, especially when tariffs are not expected to last. That reduces profits but selling firms and the larger economy retain the sales. Producers of highly specialized machinery and other products with large profit margins can use this defensive strategy.
Some products do not have enough profit to fully absorb large tariffs. For example, most agricultural products would sell at a loss if producers lowered prices enough to offset sizeable tariffs. Sometimes, however, short-term losses avoid even larger losses—for instance, it makes more sense for farmers to sell existing crops at a loss than let them rot in the ground. Likewise, losses on manufactured goods make sense whenever goods can be sold for more than the out-of-pocket costs of production. Whenever producers can generate positive cash flow, they should make sales that create accounting losses.
Recessions create a significant contraction of demand over a short period of time. Tariffs seem unlikely to produce that sort of short-term damage. But there are reasons to believe that a protracted trade war with China would increase the damage to the U.S. economy. U.S. production will gradually be replaced over time. Long trade wars give buyers both time and incentive to find other suppliers. And time also gives producers more opportunity to avoid tariffs by relocating facilities.
Additionally, while China accounts for a relatively small proportion of current exports, it accounts for a very large share of the growth of U.S. exports. Sales are hard to recover once buyers change suppliers. Consequently, while the shorter-risk of recession does not seem large, the potential impact on longer-term economic growth would be much greater.
About Bruce McCain, Ph.D., CFA®
Bruce McCain is the Chief Investment Strategist for Key Private Bank, where he monitors the economy and the financial markets and serves as part of the team that formulates investment strategies for clients. He supplies frequent insights to media throughout the region and around the country. His comments and interviews have been featured in such publications as The New York Times, The Wall Street Journal, Investor’s Business Daily, and Business Week, as well as on television outlets such as CNBC and Bloomberg TV. He is also a regular source for wire services such as the Associated Press and Reuters and is a Contributor on Forbes.com.