“To me, the most beautiful word in the dictionary is tariff….it’s my favorite word.” ~ Donald Trump, October 2024
Americans’ experience with tariffs is mixed. The Smoot-Hawley tariffs of the 1930s prompted retaliatory tariffs and trade barriers from trading partners, causing a collapse in international trade that badly hurt US manufacturers. The tariffs were misguided because, at the time, the US ran large trade surpluses, which made it vulnerable to retaliation.
Now the US runs large trade deficits, of between $60 and $100 billion per month, which makes it far more difficult for trading partners to retaliate effectively.
Stephen Miran, Trump’s nominee for chairman of the Council of Economic Advisers, wrote a 40-page “job application” in October. In it, he praises Trump’s past performance with tariffs in 2018 and proposes restructuring the global trade system. However, misguided use of tariffs could damage the US.
Miran proposes implementing import tariffs, mainly targeting those trade partners that run large trade surpluses with the US, notably China. China’s global trade surplus has expanded to more than $100 billion per month, and a large percentage of this trade is with the US.
Import Tariffs
A tariff on imports will likely provoke two main responses: retaliatory trade barriers and a stronger Dollar.
Retaliation
We can expect trading partners to erect trade barriers to target politically sensitive industries in the US. In the 1930s, Europe responded with import restrictions on US automobiles, hurting the Ford Motor Company. Nowadays, China will likely restrict exports of critical materials in markets it dominates—like germanium, gallium, and rare earth elements—targeting semiconductors, electric batteries, and defense technologies. Another Chinese favorite is tariffs on agricultural imports like soybeans, targeting mid-west farmers. Electric vehicle imports are another obvious target, particularly Tesla because of Elon Musk’s proximity to the president.
Tesla (TSLA) has fallen 39% from its high in December.
The Dollar
The Dollar will likely strengthen if trading partners do not retaliate against increased tariffs. A stronger Dollar will tend to offset the cost of the tariff to consumers, as in 2018-2019, when the Yuan weakened markedly against the Dollar.
The result was that the US current account showed little benefit from the 2018-2019 tariffs.
To the extent that the exchange rate adjusts to absorb the effect of the tariff–so that the Dollar price of the imported goods does not change–the tariff is effectively a tax on the foreign exporter. However, the cost incidence is not that straightforward.
Cost Incidence
A central argument for tariffs is that the exporter, not the US consumer, bears the cost. However, it’s not that simple.
Miran cites a 2019 NBER paper by Cavallo, Gopinath, Neiman and Tang which found that the dollar import price increased by the amount of 2018-2019 tariffs, and that appreciation of the Dollar did little to offset this. “The move in the currency didn’t pass through into import prices.”
While Miran is correct that there may be longer-term adjustments, the study makes an important distinction. US producers responding to retaliatory tariffs on their exports were forced to bear a large percentage of the cost. Export prices for affected goods (red below) fell sharply relative to exports without tariffs (blue).
The difference is that US agricultural exports were a non-differentiated product with ready substitutes. China imposed a tariff on US soybean imports, comfortable in the knowledge that importers would increase orders from alternative suppliers like Brazil. So US farmers were forced to cut prices to compete.
The tariff cost for differentiated products, with no ready substitutes, such as high-level semiconductors and equipment, is far more likely to be borne by the customer.
Weakening the Dollar
Miran recognizes that the strong Dollar will harm exports and speculates that strategies could be employed to weaken the Dollar. However, that would increase the cost incidence on the consumer.
Efforts to weaken the Dollar would likely undermine its role as the global reserve currency and accelerate the migration of foreign central bank reserves to gold bullion as a reserve asset.
There are three likely negative consequences. First, a falling dollar would reduce foreign support for US Treasury markets, driving up long-term interest rates that would hurt financial markets and the economy.
Second, discouraging direct foreign investment in US financial markets—by tearing up tax treaties, for example —would cause an outflow from mega-cap technology stocks, Treasuries, and other key foreign investment targets. The result could crash financial markets and the economy.
Third, printing Dollars to buy assets in a sovereign wealth fund or other strategies that involve increased fiscal spending are likely to fuel an increase in inflation.
Weakening the Dollar may also involve lowering US interest rates vis-a-vis trading partners. However, this assumes that foreign central banks will not respond in kind and that the Fed will cooperate, ignoring the inflation risk.
Re-industrialization
The aim of tariffs is to create a favorable environment for establishing new industry. However, there are many barriers other than the price of competitive imports.
First, you need a skilled workforce with the education and training required to run new factories. Companies establishing semiconductor foundries in the US, for example, under President Joe Biden’s CHIPS and Science Act, have encountered skills shortages. (The Economist)
Then you need infrastructure. ALCOA, the largest aluminum producer in the US, relocated smelters to Canada because of advantageous electricity costs. CEO Bill Oplinger says the increased tariffs would not entice it to return. (Reuters)
You also need to secure the key materials required to support new industries, whether bauxite to supply aluminum smelters, copper for EVs and turbines, or critical materials–like gallium, germanium, and rare earth elements– for high-tech industry. China has spent the last two decades tying up supply contracts, and the US is a late arrival to the party.
Conclusion
Tariffs on imports will likely provoke retaliatory tariffs from trading partners, which could harm international trade and exact a cost on both economies. The US is in a strong position because of its large trade deficit; so it can inflict greater damage on its competitor. However, we should not ignore other forms of retaliation like restricting access to critical materials, where there are no ready substitutes, and erecting other trade barriers that impose a cost on US exporters.
Under no circumstances should tariffs be placed on imports of goods where there is no readily-available substitute. The US consumer will bear the cost.
The Dollar will also likely strengthen in response to US tariffs on imports, which could partially offset the cost of the tariff to consumers. However, a strong Dollar will reduce the competitiveness of US manufacturers in export markets. Miran speculates that the US may be able to offset this by policies to weaken the Dollar. But you can’t have your cake and eat it too.
Efforts to weaken the Dollar could also undermine its role as the global reserve currency, crash financial markets and the economy, or cause a resurgence of inflation. If not all three.
A strategy to re-industrialize the US economy requires a holistic approach. First, ensure that you build up the necessary skills and resources through a comprehensive education and infrastructure program and secure supplies of key materials. Then, progress to the next stage of establishing the groundwork for a new global trade and currency accord. Ignoring the first stage is like putting the cart before the horse.
An impatient president has surrounded himself with a team unlikely to oppose him. Developing a program to re-industrialize the economy will require skill, patience, and meticulous planning. It could take the better part of a decade, but that seems unlikely to happen.
Acknowledgments
- Stephen Miran, Hudson Bay Capital: A User’s Guide to Restructuring the Global Trading System
- Keith Rockwell, East Asia Forum: How China is weaponising its dominance in critical minerals trade
- NBER | Cavallo, Gopinath, Neiman and Tang: TARIFF PASSTHROUGH AT THE BORDER AND AT THE STORE: EVIDENCE FROM US TRADE POLICY
- Carnegie Endowment | Michael Pettis and Erica Hogan: Trade Intervention for Freer Trade
Colin Twiggs is a former investment banker with almost 40 years of experience in financial markets. He co-founded Incredible Charts and writes the popular Trading Diary and Patient Investor newsletters.
Using a top-down approach, Colin identifies key macro trends in the global economy before evaluating selected opportunities using a combination of fundamental and technical analysis.
Focusing on interest rates and financial market liquidity as primary drivers of the economic cycle, he warned of the 2008/2009 and 2020 bear markets well ahead of actual events.
He founded PVT Capital (AFSL No. 546090) in May 2023, which offers investment strategy and advice to wholesale clients.
