Tariffs: Questions to Ponder, Part 1
We pose some questions to ponder as concepts and facts get shredded and game theory is sacrificed to ego.
External Revenue Service: Waiting for all those “seller pays” tariff collections…
The jury of one has weighed in with 25% tariffs on Canada and Mexico and 10% on China with no stated exemptions at this point other than a lower 10% on Canadian energy imports (effective 12:01am on Tuesday, Feb 4). Meanwhile, a blanket statement from Trump was made to the press that the EU is next.
We put together a simple checklist of questions to ponder as this rolls into the US, the North American, and global economy. Some of them are simple and should not even be asked (since the answers are obvious), but we live in strange times.
The apparent (and vague) retaliation threat indicates tariffs could go higher if trade partners retaliate (which they already are). A retaliation cycle could drive trade into a de facto economic embargo in substance on tariff cost dislocations. That would cross from trade war to economic war and a state of emergency in other nations.
The White House Fact Sheet was mostly a replay of the “American Carnage” themes and the immigration and drug crime playbook with minimal economics other than the fact that the US economy is less dependent on trade compared to Mexico, Canada and China. As the #1 economy in the world with the third highest population, that is why trade deficits rise when the economy does well.
What the fact sheet left out was a statement on who pays the tariffs. Apparently no one was on hand from Trump’s new “External Revenue Service” to confirm Trump’s oft-stated view that the selling country pays the tariff.
We have already updated some of the import and export product line details in earlier commentaries as the pain assessment will start in earnest. We include import-export tables in the links below for Canada, Mexico, China, and EU. The final Dec and calendar 2024 trade numbers get reported on Wed this coming week:
Tariff: Target Updates – Canada 11-26-24
Trump, Trade, and Tariffs: Northern Exposure, Canada Risk 10-25-24
Trump at Economic Club of Chicago: Thoughts on Autos 10-17-24
We assume there will be waves of information, disinformation, and purely and easily discernible false statements this week on tariffs with “buyer pays” as a phrase religiously avoided by GOP leaders.
That “buyer pays” fact is a topic added to the loyalty test list along with who won the election in 2020. The hyped creation of the “External Revenue Service” on collection of tariffs from the nations that “treat us horribly” is just in another reality – just not the one that the companies and securities holders live in.
QUESTIONS TO PONDER:
Who pays?
Answer: “The buyer.” This is a broken record complaint about false statements routinely made since Trump 1.0 on “collecting billions and billions from China.” In tariffs, the buyer pays. Not complicated.
This topic is easy for an 18-19 year old intro economics student (unless you want an F), but Senators struggle with asking the simple questions of cabinet nominees:
Does the buyer pay the tariff? Yes or No? (hint: the answer is yes).
Did Trump collect billions and billions of tariffs from China? Yes or No (hint: the answer is No.).
What happens after the buyer pays the tariff?
This is not esoteric economic theory spun by geriatric professors. This is simply “debit and credit” stuff from accounting. The functioning of double entry accounting can be unforgiving and exact in compliance with accounting rules (as a former CPA at Deloitte, it is not always that exciting). In the end, the tariff is a cost to the buyer.
Does the buyer eat the cost?
The easy answer is “not if the buyer can pass it on.” The buyer needs to offset that cost by cutting other costs (often headcount or foregone expansion outlays), eating the cost in profit/loss margin (not great for share value or career planning), or raising prices (Whether you call it inflation or something else, it means less purchasing power for somebody along the chain).
What is the significance of a trade deficit?
Trump pitches the case that a trade deficit means the US is writing a check to the other nation and not getting anything on the other side of that import in terms of US economic multiplier effects (freight and logistics, retail, real estate, financial services, durables retail finance, insurance, credit cards, etc.). Trump’s view is frankly just dumb. The visual is that foreigners are backing up the truck and piling cash from the US into a flatbed pickup made in Mexico. That is all based on one economic event at the border, and he even gets that wrong (i.e. buyer pays).
We have looked at economic theories on comparative advantage and the usual textbook versions in other commentaries along the way since Trump 1.0 and will skip that today. The main issue is that other nations have some comparative advantages (cheap labor and natural resources are the main ones). In some cases, the advantage is subsidies and that is where trouble starts – notably with China. That said, the US comparative advantages are greatest in areas such as tech (intellectual property) and agriculture and various other subsectors such as Defense/Aerospace and Banking. The US is very strong in “guns and butter” and tech and services.
Even in those areas, we see risks emanating from these tariffs beyond just tariff retaliation. Semiconductor production is offshore (Taiwan, etc.) and we have critical natural resource and materials dependency (China, Africa, Canada etc.), and end market reliance (agriculture). One topic for another day is how many of those 100% tariff threats can be made against countries for removing the dollar as a reserve currency when those same countries provide critical materials.
Where does the trade deficit show up in GDP?
To keep the objective GDP numbers simple, the GDP numbers we see each quarter are rolled up from the Personal Consumption Expenditure line (around 68% of GDP), the Gross Private Domestic Investment line (around 18%) and Government Consumption/Investment (around 17%). That adds to around 103%. The trade deficit is a deduction of -3%, which gets you back to 100%.
Some sub-topic questions on that -3% trade deficit line and what it might mean for the +103%:
Would you prefer less profitable companies that flow into adverse trends in the stock market?
Are you willing to trade off that -3% GDP hit with the +68% in PCE (weaker consumers, fewer jobs, less spending, etc.)?
Would you like less GPDI (lower corporate profits and lower investment and capex)?
Would you prefer a lower tax base and less government spending (Federal, State and Local) that flows into less services? Some would say “yes” for Federal cuts, but “no we want more” for state and local, which is the biggest part of government payrolls and consumption. State and local spending is almost 4x non-Defense Federal.
Why are decisions made to buy (imports) or source offshore?
Answer: It costs less.
This sounds like an especially stupid question to include, but too many have flunked this one in Washington. Low-cost global sourcing has been a wave for decades. Global supplier chains and lean manufacturers caught on as the Japanese autos (notably the Toyota production system) encouraged companies to focus on manufacturing techniques that are way more complex than one can simplify in a tariff policy. Read “The Machine that Changed the World” and you get the idea. It was funded by global auto OEMS and part of a global study run out of MIT.
The US was the driver of global tariff rules and later the WTO. Putting that army of genies back in a single tariff bottle is doomed to fail. It is not untying a knot in your shoe. The global supplier chains are a Gordian Knot, and a tariff binge is not the Sword even if Trump might fancy himself as Alexander the Great. It is net destructive but politically saleable. The latter factor is all some care about. Their constituencies will pay an economic price.
Why would a US buyer buy something outside the US?
Very often it is simply about the “labor arb” and low pay for manual assembly industries. That is notably the case with Mexico, where assembly-intensive operations (from laptops to autos) have seen jobs migrate for decades. That is the same in so many categories of jobs and industries from China to Bangladesh to Indonesia, etc. It is not complicated.
Maybe the rising prices that come with the tariffs can mean a larger increase in the Federal minimum wage to offset the affordability hit? (Not a GOP or Trump thing by any stretch.) At this time, the deportation moves will ship out cheap labor while trying to bring back cheap labor jobs. That is one to ponder.
Does that mean the buyer of the import is “treating us terribly” and not the seller of the product from another nation?
That can be framed as a debating point. However, the rules of the road for the management teams that operate under the traditional Adam Smith Rules (invisible hand, etc.) or as a fiduciary to its shareholders make it a matter of duty and/or job preservation. Those factors all play a role in buying and sourcing decisions.
You can wheel out all kinds of textbook reasons why profit maximization rules, and that is just one more debate to have. Progressive and Conservatives might fight over what is on the priority list, but both at least mouth a focus on the middle class. You can hire more and pay more, but you need to make more on the top line and bottom line. At least if you want to keep shareholders and workers happy. Of course, the worker being happy is just one more debate. One side always likes them unhappy in election years.
Why should we believe these nations are treating us unfairly?
The protectionists like to confuse the issues of imports vs. exports and blur them to win the point. There are two decisions. One is what the US buyer decides and what that buyer has on the menu and the price that comes with it. The other is what the offshore buyers have on their menu for the US export line. We have a hard time figuring out how this can be that wrong in Trump’s USMCA (his deal). They have plenty to complain about with China, but the hammer came down harder on Canada and Mexico. The EU is next.
For imports, the US buyer makes the decision. The EU bureaucracy does not make the decision. Xi does not make the decision on what and where US companies buy. The Canadian provinces don’t make the decision. Profit maximizers in the US are the decision makers. Does that mean that they are “treating us horribly” or meeting their obligations to their shareholders? You don’t blame the US corporate decision makers when you are fundraising for elections.
For exports, that is where unfair trade, etc., comes into play. That is a nation-by-nation analysis. Topic for another day, but it is worth mentioning that the current USMCA was Trump’s deal. He even named it (he was probably listening to his favorite song at the time).
How do companies that actually make the purchasing decisions best serve shareholders from here?
The easiest way to reward shareholders after these latest, onerous tariffs may be to raise prices ASAP (or in a respectable staged process as higher costs roll in). Buy back shares and make some tactical acquisitions? Eliminating offshore competition will increase pricing power for domestic competitors. Do you think they will use this pricing power? If not, then you must believe in the Easter Bunny.
For those companies that are hurt by the tariffs and see their supplier costs spiking (think retailers, small business manufacturers, auto OEMs, etc.), their bottom line may require aggressive cost-cutting. Restructuring programs are as old as the secular shifts that the tariffs are looking to fix. Plant closings are an option. Hiring freezes, bonus cuts, and more radical steps such capacity downsizing in the US and abroad is on the short list.
Downstream buyers cannot simply build their own supplier chains in reshoring. For many, the decision to pause (wait them out since this will be a disaster), retrench, take the near-term hits and optimize working capital are on the short list of activities in regrouping.
We assume exemptions will be coming in time as influence peddlers get caffeinated (or start courting Musk) and checkbooks get pulled out.
What is next for those who rely on global sourcing?
The companies will be making their own decisions on next steps just as they did in their purchasing decisions in the first place. Some multinationals will focus on their non-US operations where they sell into local or other regional markets where they will not face such challenges. They may cut back US operations and diversify their markets and supplier chains. It is a case-by-case product decision and operation specific. They also need to sort through the retaliation decisions and impacts.
Right now, Canada and Mexico are clearly on a trade war footing. China is playing it close to the vest since they may assume Trump’s long game is an alliance with China and Russia while undermining the EU bloc (next on the agenda for Trump is crushing Ukraine, owning Greenland, undermining or leaving NATO). The Senate is cowed and is blindly following the Trump loyalty rules. The tariff revenue line also factors into the reconciliation process for his tax bill. That is another reason to keep the tariff revenue forecast high. They need to get around the filibuster as they did for the Dec 2017 tax bill as did the Democrats for Biden’s stimulus bill.
The list of questions and digging will continue…
The trade issues as they are unfolding do not open a can of worms. It is more like multiple warehouses of canned worms. The questions will keep on coming and the retaliation and “retaliation to the retaliation” will continue. The EU gets sucked into this next.
Here are some other questions we need to think through (more to come):
What does the US trade surplus with Canada ex-oil mean in this? Embargo oil and just call it a goods surplus? (That is too dumb to think about.)
Could a Trump tantrum on proportionate retaliation lead to a situation where economic viability is no longer relevant and the tariffs function like an embargo? Would that be when the exemption process starts?
Could Canada actually select exports to cut off supply and undermine entire production chains in the US? Same with Mexico?
Will Canada take aggressive actions to impair supply-demand balances in the US by targeting critical narrow components/materials to assigned quotas or exit taxes? For example, oil country goods needed to expand upstream US drilling?
What will happen to US auto prices and dealers with so many light trucks made in Mexico?
What happens to the substantial steel trade surplus that the US has with Mexico? Does Trump even know that?
How will the indirect effects of the possible meltdown in Mexico assembly line operations undermine high value-added automotive steel exports?
How will supplier chains in Mexico undermine the transplant operations of Japanese, Korean, and European OEMs operating in the US?
How brutal will the tariffs fall on the Canadian OEM assembly plants serving the US markets? Those facilities use US and Mexico components and materials.
What will the tariffs mean for assembly of tech equipment in Mexico such as laptops? (Note: computers and laptops are #2 behind autos on the Mexico import list.)
And the list will continue from the macro to the micro level…
Tariff links:
US-Canada: Tariffs Now More than a Negotiating Tactic 1-9-25
Trade: Oct 2024 Flows, Tariff Countdown 12-5-24
Mexico: Tariffs as the Economic Alamo 11-26-24
Tariff: Target Updates – Canada 11-26-24
Tariffs: The EU Meets the New World…Again…Maybe 10-29-24
Trump, Trade, and Tariffs: Northern Exposure, Canada Risk 10-25-24
Trump at Economic Club of Chicago: Thoughts on Autos 10-17-24
Facts Matter: China Syndrome on Trade 9-10-24
Trade Flows: More Clarity Needed to Handicap Major Trade Risks 6-12-24
Trade Flows 2023: Trade Partners, Imports/Exports, and Deficits in a Troubled World 2-10-24
Trade Flows: Deficits, Tariffs, and China Risk 10-11-23