Why is a Trade War Bad for Business?

When President Trump announced the renegotiation of NAFTA, tariffs on steel and most recently tariffs targeted at China to reduce the trade deficits, the markets plunged, generally recovering as, each time, Trumped backed off this initial pronouncement and as analysts began to understand that even if the tariffs went through, the impact on the economy would be small. But why do the threat of tariffs and protectionism cause this negative impact in the market?

While understanding this fully would take a full course at University, our goal here at Smart Invest Canada is to simplify things for the beginning investor. The explanation is, quite simply, that almost every Economist believes and every business and economics student is taught that tariffs make global economies less efficient, dropping overall growth. An overall decline in growth is means that the companies that make up the overall economy are seeing a decline in growth. This usually translates to lower than expected earnings. This is turn drives stock prices lower as stock prices reflect future earning potential of companies.

The example most often given in textbooks has two fictitious countries and two fictitious products but it should be easier to understand if we use the latest example – the US and China; and two important trade products - steel and agricultural products (let’s pick wheat). The US imports a lot of steel from China and China imports a lot of wheat from the US. Both countries have their own production in both those products (US makes steel and China grows wheat)

Let’s use real numbers to understand the reason most Economists think tariffs are bad for business. Let’s say that American companies can sell steel at $800/tonne. In China, because of lower labor and other lower costs, that number is $750/tonne. For wheat, the situation is reversed where American companies can sell wheat for $7.50/bushel and Chinese companies can sell wheat for $8.00/bushel. In both cases, the more demand, the higher the cost in both countries. So, while the Chinese can produce steel at $750/tonne for the next tonne, to produce another 1,000,000 tonnes (for example), that price might go up to say - $800/tonne, matching the American price and making the Americans competitive again (this increase in cost of production with increasing volumes is typical).

With free trade, the most efficient thing to do is to buy steel from China and buy wheat from the US until the price paid for the steel/wheat matches the cost in the less efficient country. And that’s what has happened – China’s steel production has increased rapidly and America’s has dropped off (Trump would argue that there has been no offsetting benefit for America – but we’ll leave out the political discussion).

Now, Trump is proposing a tariff of 15% on steel. Let’s say China responds (trade war) with a 15% tariff on wheat. Then, a tonne of China steel now costs American companies $750 X 115% = $862/tonne and a bushel of American wheat now costs Chinese companies $75 X 115% = $8.60/bushel. So, now American companies are more likely to buy steel from American producers (which is the intended consequence). Chinese companies are likewise more likely to buy wheat from Chinese producers (which is the unintended consequence).

But here is why it is bad for everyone. Now the input costs for companies in both countries (steel to make cars and wheat to make bread), goes up and consumer prices go up as a result. We all know that as price goes up, demand goes down and that means that there are fewer products built from these two materials. The overall economy drops even through the steel industry in the US and the wheat industry in China improve (and the wheat industry in the US and the steel industry in China suffer).

The economist would say that each country should focus on where it has competitive advantage. That’s why the US produces wheat (and software, services and many other products where it has a competitive advantage) and China produces steel (and textiles, consumer products and many other products where it has a competitive advantage). Now that means that the uncompetitive industries tend to shrink in both countries but the overall global economy grows, prices stay as low as possible and companies make as much money as possible (and stock markets go up).

This elimination of tariffs, free trade and global specialization has been the norm since World War II with America leading the push to open markets and reduce tariffs (since America was a low cost producer in many products). But with Trump talking about tariffs, analysts are starting to wonder if the application of tariffs is going to be more than bluster and a few narrow tariffs that are meaningless to the economy as a whole, or if the implementation of tariffs is going to spread globally (a global trade war) and reduce corporate profits based on the mechanism described above. With the fear of lower corporate profits comes a decline in the market that we’ve seen recently whenever tariff fears are heightened.

Trump is clearly trying to threaten the rest of the world with a trade war to extract some trade concessions. Time will tell if his brinksmanship policy works and how much damage it will do to the world economy.