The biggest story of the day appears to be the incipient stages of a trade war between the US, Mexico, and Canada (I don’t believe any tariffs are being planned between Canada and Mexico, though). Trump is allegedly imposing these tariffs in response to excess drug/opiate smuggling and illegal immigration. Assuming this is justified, I don’t particularly see why Canada finds itself at Trump’s mercy. From what I understand, many of the intermediate inputs of dangerous drugs like opioids are legally imported from East Asia to Mexico, assembled there, and then illegally smuggled across the border. This is a problem. I ought to do more research into how this issue could be solved. What can US Customs & Border Patrol do? What about Mexican authorities? Chinese authorities (assuming East Asia = China)? Regardless, it doesn’t seem to be Canada’s fault.
If actually imposed (slated for Tuesday, the 4th), these tariffs will have a couple of domestic economic effects. First, US imports from both countries will become more expensive. A first-order effect would imply that 25% tariffs across the board should raise prices by around 25%. I don’t know if this will actually hold true. Consider this example:
Suppose exporting firms in Canada and Mexico have some degree of price-setting power. That is, they are currently charging above their marginal cost and can lower their price, or they can lower their price below marginal cost because they expect future rewards with increased market share. Then, these firms may lower the sticker prices of their goods and services to sell more. That is, if prices are 100% sticker with 0% tax ex-ante, ex-post prices may be 90% sticker with 25% tax for a total of 115%. A 15% increase (which, conspicuously, is lower than 25%). This depends on how much market power these firms have and the perceived importance of market share (which goes hand-in-hand with the perceived duration of tariffs. If a firm believes tariffs are short-lived, they may want to lower prices for more market share to benefit when tariffs evaporate and would be willing to operate at a loss).
Another domestic effect (and the seeming economic rationale) is protectionism. By taxing firms that are exporting to the US and increasing their prices, domestic firms in competition with foreign firms benefit. Suppose we go from a 0% tax on Canadian cars to a 25% tax. We likely see a price increase for the reasons listed above. Purchases of domestic cars, on the other hand, are not ~25% more expensive. Thus, domestic cars seem much more attractive, people buy more, and these firms are better off. These firms pay their employees income, so domestic income increases. As incomes increase, spending increases. And, since one person’s spending is another’s income, incomes across the board increase (this income effect may be relatively small, but overall good for Americans).
However, this assumes that we are only taxing final goods. I don’t know the exact details of these tariffs – maybe it is the case that 25% across the board refers to final goods (probably not, though). Let’s strip away this assumption. 25% means 25%. We aren’t just taxing Canadian cars at 25%. We’re taxing their steel, aluminum, electronics, microchips, and all the other intermediate goods that we use to construct a car. In this scenario, the price of domestic cars rises as well! The price probably won’t rise as much as foreign cars (because I’m assuming every factor of production in car assembly isn’t imported and taxed. If every part was imported and taxed, labor costs aside, prices should rise in tandem). Nonetheless, Domestic prices still probably rise. Then, the effects on domestic firms are ambiguous. On the one hand, they capture more demand from foreign firms because foreign firms now have higher prices. On the other hand, production is now more costly as intermediate inputs are taxed and more expensive, raising the price, and reducing demand for these domestic firms. This probably nets positive for the domestic firms, but perhaps that’s just me spitballing.
Everything I just mentioned is a first-order effect. We tax Mexico and Canada, they don’t tax us. In reality, it only seems logical that Canada and Mexico would respond with tariffs in turn. And, it seems that these countries are already planning retaliatory targeted tariffs. So, suppose Mexico and Canada levy 25% tariffs on American goods and services. Then, flip all the effects I previously laid out and add them. American goods become more expensive for foreign consumers. We lose their business. Domestic firms lose money, pay less income to employees, they spend less, resulting in less spending/income in the US. This doesn’t seem great for the US. It is this retaliatory effect that appears to have so many economists concerned about a destabilizing trade war.
I’m glossing over much of the nuance involved in these tariffs. I failed to account for three main forces: game theory, foreign exchange effects, and budget deficit effects. Game theory applies because it could be the case that tariffs are being used to ‘bully’ other nations into submission. And, if successful, America could accomplish other economic and non-economic goals with the threat of tariffs alone. These goals include limiting immigration and drugs, the purchase of Greenland, renaming the Gulf of Mexico, etc. Also, if Trump can implement relatively smaller tariffs and prevent retaliation (which seems unlikely), these tariffs could truly help the American people. I have also ignored the foreign exchange rate in this analysis. In short, USD should appreciate as relative demand for peso and Canadian Dollar fall. Demand for these currencies fall because exports to US account for more of MEX and CAN economy than exports from US to MEX and CAN matter for the American economy. Thus, a greater proportion of MEX and CAN’s output is slapped with tariffs and see reduced demand for their currency. This is corroborated by Bloomberg’s report that USD and oil jumped. Further, I have ignored the effect on the budget deficit (increased tax revenue should decrease the deficit).
Although I could enrich my prior analysis with these omitted variables, I think the general effect remains the same: unless Trump forces heavy concessions and prevents retaliation, these tariffs will hurt the American people. At this moment, it seems unlikely Trump can accomplish that. Maybe that changes, and if so I’ll write about it. It also seems very likely that America’s trading partners will suffer from these tariffs.
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