Why is a Trade War Bad Anyway?

Over the last few months, the escalating trade rhetoric might have you wondering why were are concerned with a trade war at all, especially when the markets are approaching all time highs again.

To understand the concern we have to get into some economic theory. The whole reason free trade has been promoted by economist and capitalists is the benefits that are expected from theory – free trade creates benefits for all participants. And we’ve seen this in reality – as tariffs dropped over the last hundred years, global trade has increased and all economies and people have benefited.

There are two main concepts that need to be understood to see why everyone is so concerned with President’s Trumps tariffs and the retaliatory tariffs being implemented by the target countries.

The first is a concept that most people understand – the law of supply and demand. It is a comprehensive concept but to understand tariffs the important part is that as price goes down, demand goes up and vice versa. This is easy to understand from our everyday experience – if a pair of shoes goes on sale, you are more likely to buy them. If they get more expensive, then you are less likely to buy them. When you combine your behavior with that of everyone else, we see that as price drops, consumption increases and vice versa.

The second important concept is specialization – where a country focuses on producing where it has a competitive advantage and trades with other countries where it is not as competitive. For example, Canada is rich in resources such as oil and lumber, and because of our high cost of labor, we are not competitive in products that require lots of manual labor, such as textiles (clothes). Japan, by contrast, has few natural resources and therefore imports much of its raw materials. Japan has been successful at specializing in electronics and exporting those products to other countries that are specialized in other areas. The point is that if all countries made everything it would be far less efficient than if they focused on items where they had advantages and imported where they were relatively disadvantaged.

So, what happens with tariffs? Tariffs add to the cost of products. So, let’s take steel, the subject of recent tariffs. To make the math easier, we’ll make the normal price of steel $500/ton. Now, Trump has imposed 25% tariffs on steel imported from a number of countries including Canada and Europe. That means the new price for a company that uses steel (building construction or auto manufacturing) would be $625/ton, assuming that the exporter doesn’t drop their price.

So, now going back to the first concept – supply and demand, it is easy to see that with the price increased, demand for the product will drop and less steel will be purchased and used. Domestic production of steel in the US will increase as they can get more for their products – the tariffs will help and industry where the US is disadvantaged, destroying the benefits of specialization.

Now take this one example and apply to all the goods where tariffs have ben applied recently. These tariffs will mean that prices will rise, consumption will fall and the overall global economy will be negatively impacted. That’s why economists worry so much about the impact of these tariffs and while the markets have been swinging widely with all the news. If the tariffs remain or expand, then the overall global economy will shrink.

So, why are the markets approaching all time highs? Good question. Markets are valued based on expectations of the future. Most people believe that the Trump tariffs are just short-term tactics to extract concessions from other countries. For example, Trump is trying to eliminate some objectionable China policies (such as requiring companies that sell in China to partner with a Chinese company and pass over intellectual property) and also get China to import more US goods. Many believe that when he gets concessions from China and other countries, the tariffs will be removed and the economy won’t have lasting effects. In fact, some of the concessions expected will be good for the US economy and those benefits might also be factored in.

If these tariffs turn out to be long lasting, then expect the markets to adjust appropriately to reflect the decrease in global trade and global consumption. We are all hoping that doesn't happen.