How Trump's tariffs could actually work

The Hill

2 days ago

Economists prefer free trade because it is the best policy for global welfare. But what the debate around tariffs often fails to recognize is that there is an economic rationale for U.S. tariffs of 15 to 20 percent.
Large countries like the U.S. have market power, which means U.S. demand affects global prices. Tariffs depress U.S. demand, pushing global prices down. As a result of tariffs, the U.S. imports goods at lower prices and also obtains revenue in the process.
Most economists estimate that the optimal tariff for the U.S. is between 15 and 20 percent but could be as high as 60 percent.
The major problem with imposing high tariffs is that if our trade partners retaliate with similarly high tariffs on imports from the U.S., the U.S. will be worse off. So, the U.S. wants a tariff if it can act alone, but cooperation on low tariffs is the best policy for all — and better for the U.S. — if the alternative is a trade war.
To get a sense of the magnitudes, a recent study estimates that 19 percent tariffs could expand U.S. income by roughly 2 percent and boost employment if other countries don't retaliate. However, the effects on income and employment become negative when other countries also impose tariffs.
The basic intuition for the tariff is that foreign sellers want access to the huge U.S. market and are willing to pay a fee for that access.
Consider a German auto firm, say BMW, that sells lots of cars in the U.S. If the U.S. places a tariff on German cars, Americans will shift to buying more GMs and fewer BMWs. But the U.S. consumer is hard to replace, so BMW will lower the pre-tariff price of its cars to maintain competitiveness.
U.S. consumers face somewhat higher prices on BMWs with the tariff, but the tariff revenue that the U.S. government collects more than compensates for the consumer loss, so the U.S. as a country is better off. Put differently, because the U.S. is large, some of the tariff is paid by BMW.
The ability to pressure BMW and other German producers to lower prices only works because of the extraordinary buying power of the U.S. consumer.
If, for example, a small country, say Ghana, puts a tariff on BMWs, it would negligibly affect total sales, so this effect would be absent. This market power is similar to the leverage that companies like Amazon and Walmart have to push down the prices of their suppliers because they control such a large share of the market.
The problem with using market size to push down import prices is that the U.S. is not the only large country. If other large markets, like the European Union and China, also raise tariffs then everyone is worse off.
In a trade war, U.S. exporters will also have a hard time selling abroad, while U.S. consumers will have fewer varieties to choose from and face higher prices. The biggest risk Trump took when he reversed decades of low, predictable tariffs was starting a trade war with tariffs spiraling out of control around the world.
Given the recent news of U.S. bilateral trade deals with the United Kingdom, Indonesia, Vietnam, the Philippines, Japan, Korea and the EU, as well as a preliminary accord with China, the gamble may have paid off.
One after another, our most important trade partners are accepting significantly higher U.S. tariffs without raising their own tariffs on imports from the U.S. Moreover, in addition to accepting higher tariffs on their exports to the U.S., Europe, Japan and Korea are committing to increased investment in the United States.
Why are countries caving? The large market is part of it, but the gaping U.S. trade deficit with these markets also matters.
It gives the U.S. additional leverage since American consumers are needed to buy foreign goods to a greater extent than American businesses need foreigners to buy U.S. goods. The U.S. military might also factor in, as many of the countries making deals depend on the U.S. for security.
The unpredictability introduced may already be depressing investment and hiring, as investors and firms have no idea what policy will be tomorrow. Similarly, companies that rely heavily on imported parts and components may be unable to survive in the U.S., leading to job loss in import-dependent industries.
Already high, U.S. inequality could get worse if care is not taken since low-income families spend more of their income on goods, making them more vulnerable to price increases.
There are also major global threats. The bullying that was part of achieving these trade deals could lead to backlash against the U.S. and its brand with real consequences of sustained loss of U.S. leadership and power in all global matters.
The unpredictability introduced may depress investment, as investors have no idea what policy will be tomorrow. Domestic political blowback in our trade partners against the U.S. could ultimately create pressure for higher tariffs on imports from the U.S., resulting in a trade war.
Variable U.S. tariffs across trade partners — already ranging from 15 to 55 percent — will create trade diversion and administrative costs. Countries could look to other markets and make deals that exclude the U.S., reducing our global leverage. And the list goes on.
But if the U.S. government moves on from these trade wins, facilitating a return to predictable policy, and shows more openness to global cooperation in other critical areas, Trump's trade policy could boost U.S. income without major damage to our global standing or global investment.
Perhaps this is the hope that has been driving the stock market up.
The risks are many and great. But given the (surprisingly) flexible response abroad to date, the policy is not guaranteed to fail as many assumed. One big bullet may have been dodged.
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