Political Animals: Watch Out! The Macroeconomic Elephant in the Room: How Trade Wars Depress the Economy

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By Reed MacMillan

Last Friday, the macroeconomic elephant in the room stomped on our microeconomic realities. Senator Lindsey Graham’s tweet, on January 26th, saying, “Simply put, any policy proposal which drives up costs of Corona, tequila, or margaritas is a big-time bad idea. Mucho sad!” summarized part of the problem — that trade wars drive up prices on consumer goods. In other words, microeconomics, which looks at the markets where goods and services are bought and sold, is impacted by macroeconomic policies on global trade and tariffs. Within hours of announcing the new policy, President Trump and his administration back-pedaled on the proposed 20% tariff on goods imported from Mexico. If we enter a trade war, there are downsides to consider, not least of which is our own economic growth. Let’s take a deeper dive into 3 top concerns resulting from protectionism.

1. Trade Barriers Depress Growth

In a recent lecture to Sloan alumni, MIT Economics Professor Simon Johnson, provided an overview on the state of today’s economy and the prospects for global economic growth over the next year and decades. In discussing the United States and protectionism, he said “The overwhelming preponderance of evidence suggests that trade wars depress growth.”  He cited a Wall Street Journal (WSJ) analysis of the increases and decreases in trade resulting from freer trade vs. protectionist periods.  The WSJ measured global trade relative to Gross Domestic Product (GDP) using 1947 as the base point of the index. If you take a look at their chart below, you will see several periods of growth. The first occurs between the 1950’s to the 1970’s, as General Agreements on Tariffs and Trade (GATT) nearly doubled the level of trade by 1970. The next bump up occurs after the 1990 Canada U.S. Free Trade Agreement and 1992 North American Free Trade Agreement (NAFTA) took effect. This period of growth continued through 2007, with a severe drop-off due to the financial crisis of 2008. Since that time, there has been slower growth, but it was anticipated that the Transpacific Partnership (TPP) was going to provide another boost.

The period between 1979 and 1990, when the line is relatively flat, was characterized by a period of increasing oil prices which also drove demand for lighter more fuel efficient cars, the kind largely produced in Japan. Students of history, or those who lived it, may recall a moment of crisis in the auto industry. As the industry collapsed, politicians, on behalf of their constituents, tried to pressure other markets to open up and be more fair.

An in-depth analysis of this period can be found in chapter 8 of the National Bureau of Economics Research (NBER) book Politics and Economics in the Eighties.  The author I.M. Destler describes that while Congressional trade activism multiplied, trade protection only increased marginally.  Among the increases in American trade protection were the “voluntary” export restraints (VERs) in steel and automobiles. He further concludes that, “The auto VER remained technically in force through the decade, but it had lost its bite by the late eighties. It had been enlarged by 24 percent, and the combination of the weaker dollar and increased production by Japanese firms on American soil made it increasingly difficult for the quotas to be filled.”

Today, as members of the World Trade Organization, we are bound by preexisting agreements. In a WSJ article by James Bacchus, on January 4th, “Trump’s Challenge to the WTO” the author says that, “Under the WTO treaty, the U.S. is legally bound by the tariff commitments it made on thousands of traded products. These commitments can be renegotiated. But they can’t legally be ignored.” Decisions designed to appease the political base of President Trump, such as in the case of Mexico or with the TPP,  may not take into consideration prior negotiated agreements. No doubt those negotiators also sought to provide certain advantages to the U.S. consumer, or to our own exporters.

For a good source of information on the existing tariffs between Mexico and the United States, visit the World Trade Organization website and refer to the current Schedules of WTO Members. When you open this page, you can scroll to the United States, and download a .pdf file, that contains many details on current tariff rates by product type.

2. Unintended Consequences: Winners and Losers

One downside of tit-for-tat trade policies is calculating the complexities of who might gain and who might lose. At the macro-level, what seems easy, to add a tariff to goods manufactured outside of the United States as a way of encouraging domestic companies to increase their manufacturing in the United States, may have some unintended consequences. A few questions we might ask include:

1) Will these manufacturing plants be located within states that have unions or not? As described in Wikipedia, the UAW has been credited for aiding in the auto industry rebound in the 21st century and blamed for seeking generous benefit packages in the past which in part led to the automotive industry crisis of 2008-2009.  According to Bloomberg, UAW members produced only 54 percent of the cars and trucks made in the United States in 2013. That compares with 85 percent of cars and trucks built in the U.S. in 1999.

2) Assuming the plants are built in non-union states, will there be incentives to help relocate workers to lower paying manufacturing jobs in the South? There is already an unofficial trade war among states in the U.S. who create incentives to lure companies to their state. New protectionism may exacerbate this, as states increasingly compete to provide incentives to automakers to relocate. As long as labor as plentiful and willing to move, this might work. As soon as labor markets tighten, and the dynamics shift in favor of the worker, relocating for cheaper labor will no longer be cost-effective. CEOs who continue to evaluate which is the best economic environment in which to do their manufacturing, will factor in protection of jobs and workers only as long as they can achieve competitive market advantage.

3) How will consumers react to higher prices and less choice? Perhaps, there will be a migration of the displaced union workers from Ohio and Michigan to the South, where they can take advantage of these new non-union job opportunities. Or, if companies choose to build the factories in union states, then we can expect that the increased wages of these union workers might impact to the prices of the automobiles produced. This takes us back to the 1980’s — when the automobiles produced were higher priced than the imports, and potentially less attuned to consumer desires. Thus, two of the benefits of this global competition, more choice and better prices, may decline.

Another aspect of this story is how our politicians respond. In 1991, The National Bureau of Economic Research’s published volume of conference proceedings includes a chapter titled: “U.S Trade Policy-making in the Eighties.” One interesting finding concerns the role politicians played during this time: essentially embracing protectionist views to appeal to their constituents without taking specific concrete protectionist actions. Generally, the article finds that in spite of protectionist rhetoric during this period, the measures taken were weaker than the rhetoric espoused.

Economist Anne O. Krueger offers the following insights on this topic: “In this light, one can adopt a demand-and-supply framework. There is a “demand for protection,” which is presumably a function of voter concerns, lobbyist pressures, and other considerations. Simultaneously, there is a “supply of protection,” which is a function of the economic and political costs of providing protection. The demand for protection is higher the less well informed voters are about economic policy, the less economic knowledge supports a free-trade stance, and the larger the negative net trade balance in individual economic activities. The supply of protection is greater the smaller the negative impact on other producers (and hence greater for consumer goods than producer goods and greater for activities in which domestic firms do not have overseas operations from which they supply part of the domestic market) and the smaller the negative side effects (such as foreign policy considerations) of protection. In this framework, the 1980s experience could be interpreted differently. Clearly, the demand for protection increased. It increased because negative net trade balances emerged and/or increased for a large number of economic activities. It increased because the economics profession was willing to give more credence to considerations of “strategic protection” than it had earlier, thus undermining the professional consensus that had stood as a partial barrier to protectionist measures. ”

Put simply, it is our own non-specific demand for general protectionism which may cause the most harm. Blanket policies may help some, but these will also likely hurt others. Swapping Mexican tequila for American-made bourbon may be palatable, but will it be palatable to pay more for domestically produced automobiles? Furthermore, will a global company such as Ford, which sold 1.27 million vehicles in China in 2016 (Melissa Burden, The Detroit News, January 6, 2017) face retaliation on the world stage that causes a decline in their growth? If that happens, will the impact on their value and evaluation as measured by indicators such as the stock market face downward pressure? Will other countries with less cumbersome trade policies fare better on the global stage?

3. Fair Labor Practices and Environmental Standards may Erode

While some manufacturing jobs may return, they are no guarantees that they will be at the former UAW compensation levels. Michelle Maynard, a contributor to Forbes, writes in “The UAW Is Losing Its Grip On Auto Industry Labor” about how the increase in foreign automotive manufacturing plants has caused a decline in UAW influence. She says that “While many of the older foreign plants pay wages similar to those earned by senior UAW members, the newer companies have been paying less, especially those located in the Deep South, from Texas to Georgia. Meanwhile, the UAW has agreed to more-significant differences in wages for new hires at the Detroit companies in recent contract negotiations, moving it farther away from its vow that workers will be treated equally. These two-tier wage systems have helped create new jobs, but mean that newer workers earn substantially less than their veteran counterparts.”

Without delving into climate change, and whether it exists, it is not hard for Americans to remember times when companies and factories were freer to pollute than they are today. Among the checks and balances that we take for granted today, are the measurement of toxic releases by these companies. The EPA produces something known as the Toxics Release Inventory which offers analyses and interactive maps showing data at a state, county, city, and zip code level. The EPA describes the purpose as follows:

“We all have the right to know about the chemicals we may be exposed to in our daily lives. The Emergency Planning and Community Right-to-Know Act of 1986 and the Pollution Prevention Act of 1990 require certain industrial facilities across the country to report annually to EPA’s Toxics Release Inventory (TRI) about toxic chemicals they release* and what they’re doing to prevent or reduce pollution. TRI includes data about more than 22,000 facilities across the country and covers more than 675 toxic chemicals.”

Simply by inputting my zip-code, 06489, I was able to generate a snapshot of what is going on in my own backyard. The EPA is vitally important to our country and to its citizens. We have paid with our tax dollars to gather rich and important data which can be used by all US Citizens to learn about what is being done to their environment in their backyards and farther afield. If you think that this impact is only domestic, I know first-hand that many countries also analyze these data to assess what kind of neighbor the company might be, when/if they move in.

But, let’s not assume that American companies take with them all of the good practices that are required here by the EPA when they locate internationally. In fact, they may relocate precisely to avoid regulation and reduce costs, which also allows US consumers to benefit from cheaper goods manufactured with less environmentally friendly practices, while also removing job opportunities.

As we ponder how to make America great again, maybe we can figure out how we can afford to purchase goods which are manufactured in accordance with the best environmental practices required here in the United States, whether produced here or off-shore. Environmentally sustainable production may decrease the advantages of relocating to avoid regulation, but we will not be trading our values for lower priced goods that harm our own economic prospects.  If we are really are so concerned about Chinese pollution, perhaps we might want to export our environmental practices as a way of protecting our workers. If we gut our own environmental protections as a cost saving measure to encourage manufacturing at home, we may face our own pollution crisis. It is not coincidental that a climate change denier will soon lead the EPA, industries will be de-regulated, and we will seek to shore up U.S. industry by putting up trade barriers. We should therefore expect, higher-priced products, more polluted environments, and less economic growth. If those are the goals we have, then we are on the right path.

Additional Sources of Interest on this Topic: