Tariffs...Such a Lovely Word

With the return of Donald Trump to the White House, the subject of tariffs has once again taken on new meaning.  While the first Trump Administration used tariffs primarily as a means of addressing the U.S. trade deficit with China and as a tool to entice American industry to return manufacturing to the U.S., the current Administration is dramatically ratcheting up its activities surrounding tariffs.

To understand the thinking behind tariffs in general, the objectives of the Trump Administration and the potential impact on the market it is of benefit to begin with a little history lesson.

For those familiar with Adam Smith, author of “The Wealth of Nations”, and still regarded by many as the father of modern economic theory, tariffs are a useful tool capable of being deployed by any nation for strategic purposes.  While Smith was primarily an advocate of free trade, he also recognized that any nation would find it in their best interest to utilize tariffs as a means of protecting critical industry and in helping to nurture value added industries during their early maturation.  To put this in a modern context one can think of key manufacturing capabilities such as steel, pharmaceuticals, chemicals and transportation.  Each of these industries can be viewed as critical to a nation’s national security with loss of such industry or critical disruption to its supply chain having potential catastrophic effects.  For emerging industries one can consider technology, AI, semi-conductor manufacturing, robotics and bio-engineering as industries which to some extent are in their early stages of maturation and therefore would be ideal candidates to protect via tariffs.

Although not an advocate of any potential restrictions on trade, Smith also recognized the impact on employment and overall national wealth resulting from significant trade imbalances, particularly when caused by tariffs.  The historic trade deficits which have been experienced in the United States beginning shortly after World War II are a prime example of such an imbalance.  Such deficits have directly resulted in the hollowing out of American manufacturing and the jobs associated with such industries.  And while these imbalances may have been a means of ultimately propping up the economies of Europe and Japan following the war, there is no reason these economies require subsidization by U.S. consumers today.  Of course, no discussion of trade would be complete without discussing China’s entrance into the World Trade Organization which coupled with an already unlevel playing field, has turned many of America’s former industrial centers into ghost towns.

With this as a backdrop it’s important to understand what the Trump Administration is actually attempting to accomplish through its efforts to reframe America’s international trade policy. 

First and foremost, the Administration recognizes that there are significant risks to the nation’s security given the critical industries that are challenged to compete given historic trade policy following WWII or that have left the country entirely.  Many of the tariffs being put in place, especially those related to China, are specifically designed to level the playing field for those industries that remain.  This along with tax policy are being put forth as incentives for American business to repatriate their operations and for international businesses to invest.

With this in mind, as of the date of this article, we have seen the U.S. announce 25% tariffs on both Mexico and Canada, and an additional 20% on China, (which is on top of tariffs applied during Trump’s first term), and discussion of placing tariffs on Japan and the European Union (EU) equivalent to the tariffs they impose on U.S. imports to their respective countries.  In addition to these actions, the Trump Administration is set to impose reciprocal tariffs on all trading partners beginning on April 2nd.

While Wall Street has reacted negatively to these announcements and actions, one has to recognize that Wall Street is not an indicator of overall economic performance, stability or health.  Also, Wall Street to a large degree has become addicted to the heroine of massive government spending and an America last policy that incentivized the migration of American business overseas to capitalize on cheap and in some cases slave labor.  Bringing some semblance of sanity back to trade policies and domestic manufacturing will ultimately provide greater long-term market stability.

Beyond national security and repatriation objectives, the Administration is also focused on helping to create an environment whereby investment in the U.S. will help to create good paying manufacturing jobs and help to accelerate economic growth.  Both of these objectives are essential as a means of improving the standard of living for the main swath of American citizens and to create the economic engine ultimately capable of generating the tax base required to pay down America’s out of control debt all without the necessity to raise taxes on individual income earners.

With the top 10% of income earners in America consuming nearly 60% of goods and services, the current environment is not only unhealthy, it’s unsustainable.  Through the repatriation of high value manufacturing activities and jobs, American workers will have the ability to experience the same real wage growth experienced during Trump’s first administration.  When this happens, a wider segment of the population will be actively engaged in economic consumption which will ultimately be even better for business and the economy at large.

In addition to the key tariff objectives outlined above, one must also consider the negotiating leverage provided by such actions.  Given the might of the American market, tariffs are capable of being used as a negotiating tactic to aide America in obtaining other benefits.  A perfect example is using the threat of tariffs to cause Mexico and Canada to take more definitive action to stop the flow of fentanyl into the country.  The same can be said for potentially using tariffs as a means to motivate European allies to more aggressively fund their own defense.

For those countries who truly desire free trade, tariffs may ultimately be a means to engage in discussions to remove all market barriers between themselves and America.  While today the idea of ‘free trade’ is totally phony, maybe we will someday see a true free trading partner emerge.

And finally, it would appear that the Trump Administration views the American market as one that is worthy of a premium for those countries and businesses that want to participate.  In some ways, tariffs can be used as the ‘price of entry’ ultimately permitting access to the largest and most stable market in the world.  This is an interesting way of viewing the U.S. marketplace and certainly it would be hard to argue that the U.S. market doesn’t possess more intrinsic value for its participants than virtually any other market in the world.  The Trump Administration, through tariffs appears to be poised to monetize this value, thereby establishing a revenue source capable of funding a large percentage of government spending and as a result, lessen the overall tax burden on American citizens.

So, what do tariffs mean for the market and businesses in general?  Unlike Trump’s first term where Chinese manufactured goods were largely impacted, it is to be expected that virtually all of America’s trading partners will be impacted by at least reciprocal tariffs.

An immediate reaction to hearing the word tariff is to think inflation.  While it would seem logical that any increase in cost (i.e. the establishment of a tariff) would ultimately be passed on to the consumer in the form of higher pricing.  Interestingly, tariffs don’t always work in this manner.  In fact, during Trump’s first administration, increased tariffs on Chinese imports had no appreciable impact on consumer pricing.  The same can be said with respect to pricing during much of the 19th century when the majority of government spending was funded by tariffs and America experienced one of its most prosperous times in its history.

There are many factors that ultimately contribute to pricing of any product and generally, tariffs represent a small component.  First, it must be remembered that tariffs are imposed not on the retail price of a product but on its cost.  With layers of distribution in many supply chains, tariffs imposed on a product’s cost tend to be minimal when compared to the mark ups across the distribution chain.  Of greater significance is the impact of the market itself on pricing.  While many businesses might desire to pass along any cost increase to their retail product pricing, it is the marketplace that ultimately dictates price.  As a result, businesses with products competing in mature markets, commoditized products or products in highly competitive markets may not be capable of supporting additional cost or run the risk of losing sales.  In addition to the factors outlined above, it must also be remembered that product pricing is made up of many facets that go well beyond tariffs.  These include costs related to raw materials, labor, manufacturing efficiency, and energy to name a few.  While tariffs may be well beyond the capability for a business to control, many other facets of pricing are within their influence.  As a result, businesses have many ways in which they can adapt to the impact tariffs may have thereby avoiding the necessity of raising prices.

And adapt businesses will.  It is already clear from the number of large companies including the likes of Apple, Honda, Siemens, Taiwan Semi-Conductor, Softbank, Oracle, OpenAI, GE, Nvidia, Johnson & Johnson and many others who have committed to invest in U.S. based manufacturing (to the tune of nearly $4 trillion thus far) that the Trump Administration’s policy is having the desired effect.  While the total impact of these investments won’t likely be felt in the economy for another 18-24 months, nobody can dispute that the impact on American jobs and the tax base, not to mention national security, will be significant when these operations go live.

It is of significance to point out that the level of investment associated with just the organizations mentioned above has been garnered within the first 60 days of Trump’s second term.  With additional tariffs on select nations and reciprocal tariffs set to kick in on April 2nd, it is highly likely we will see other big names make the business decision that manufacturing in the United States is a proposition capable of delivering long-term value.

With tariffs set to make up a considerable component of Federal government funding, who knows, maybe America can revert back to the days prior to 1913 and eliminate the burden of federal income tax once and for all.