Background on US Protectionist Policies
US President Donald Trump won the national election, largely based on the promise to improve the US economy by reducing Free Trade, in general. Over the past year, USA has been imposing higher trade barriers in the form of tariffs on several Chinese imports. In retaliation, to the US policy against Chinese goods, China has introduced retaliatory tariffs, resulting in a series of actions which are now being categorised as a trade war. (Tan, 2018)
The Trump administration has not only been arguing against more trade barriers against China but has also, initiated actions against Free Trade Agreements, in general. The USA, in 2017, abstained from participating in the Trans Pacific Partnership, a Free trade Agreement between over 11 countries ( Sherwood & Iturrieta, 2018). The overall policy of the Trump administration also includes introducing more regulations to discourage the flow of skilled and unskilled migrant workers, especially from countries like India and Mexico. This policy of introducing higher trade barriers and barriers to labour inflow, in order to protect domestic industry and labour is known as “protectionism” and is contrarian to US trade policy in the The protectionist policy of USA does not operate in a vacuum. International Trade, in modern times, has become complex intertwined structure or more “globalized” and the ripple effects of the US policies will be seen all over the world.
Chinese exports to the USA tend to be lower on account of cheap labour available in China. Import demand from USA has, in part, led to a phenomenal economic growth in China, especially, in the past few decades.(Moes, 2018). On the flip side, the United States of America has had trade deficits against China, every year in the last decade, with the exception of the period during the Global Financial Crisis during the year 2008-09.(Federal Reserve Bank of St. Louis, 2017) Since early 2018, the USA has been in the process of imposition of tariffs on a comprehensive list of items imported from China. (Federal Reserve Bank of St. Louis, 2017).Among these items, metals and metal ores are the primary items of concern along with meat items such as bovine meat. (Department of Foreign Affairs and Trade, 2018). Trade barriers would be expected to lead to Chinese imports becoming more expensive to consumers in the USA. this would ideally reduce the quantity of import in USA, which may help the trade deficit become narrower than its current standing. (Mankiw 2018)
Impacts of US Policies on International Trade
China has been able to make a trade surplus by executing currency devaluation, which helps the Chinese imports become cheaper. This makes it very difficult for US products to compete with the Chinese products. (Federal Reserve Bank of St. Louis, 2017)
The Chinese trade deficit reduced during the Global Financial Crisis as the Federal Reserve Bank of USA had to manipulate interest rates to provide a boost to the US economy. A by-product of this manipulation was a devalued US dollar which made Chinese imports relatively more expensive. Trade deficit in USA during this time narrowed down. Hence, there is empirical support for such a protectionist measure. ( Federal Reserve Bank of New York, 2011)
There can be several counter arguments against the policy. Such a protectionist policy is against the larger goal of “globalization” and can raise other concerns. Trade is a narrow part of international co-operation and does not exist in a vacuum, The financial markets, currency markets, asset markets in the two country are also intertwined. There are several areas of the US economy that benefit from a more globalized world. For example, it is easier for Chinese investors to invest in USA due to fewer barriers in investment. As a result, Chinese investors have been investing in assets in USA such as housing, in large numbers.(Richter, 2018) Chinese tourists visit USA in very large number. (Sisson, 2018)
The gains from other sectors of the economy could be eroded as China may introduce barriers to curb activities in other sectors of the economy.
There are several important consequences of globalization in consumers . In the illustration given below, the price of iron ore based products or steel based products are given , in the absence of trade with China and with trade with China. China, steel products importa make reduce the price of steel based goods in the USA markets.
One of the most important arguments for Free Trade is that it provides consumers with choice: Consumer have a wide variety of goods. Additionally , in case of free Trade, consumers can choose the least expensive good available to them over the more expensive good available from the domestic market. This is known as “consumer surplus”. In the absence of Free Trade, there is a loss of consumer surplus and a “deadweight loss”. In the above diagram, the loss of consumer surplus is depicted by triangle “bcf”. (Cartwright, 2009)
Trade War with China: Causes and Consequences
Firms that import Chinese products will either have to pass on the increased prices to consumers or bear the costs themselves by reducing their profit margins. If the firms bear the costs, then there is a loss of profit for firms. Hence, firms will have to make a variety of changes such as importing goods from other countries or changing theor operations to absorb the costs. In any case, firms face plenty of uncertainty in such an environment and this may affect their business decisions. (Richter, 2018)
The Theory of Comparative advantage, given by David Ricardo, suggests that every country should specialize in the production of that product in the production of which, it has a comparative advantage in.(K?l?, 2002). According to the Theory, even if a country has an absolute advantage (advantage in producing all products), it should still get involved in Free Trade as by doing so, it can focus on production of the product that it is best suited to produce. For example, the two countries United States and China , both produce steel and beef. The price for both goods are given in the table 1. The Marginal Productivity or the number of units of product produced per unit of labour or technology per hour, is given in Table 2
Table 1: Marginal Productivity in USA and China
|
Steel |
Beef |
|
|
USA |
1.25 |
1 |
|
China |
2 |
2 |
Each of these countries will export the good that it has “comparative advantage” in. For example, the USA has better technology, which allows the highly technologically sound beef industry to have higher marginal productivity i.e.e obtain higher for more meat to be obtained from every cow. Similarly, due to abundance of labour in large quantities, (other things remaining same), it is cheaper for China to obtain steel at cheaper prices. Thus, due to technological advancement, the beef industry in USA has higher marginal productivity while The hypothetical price of each unit of steel and each unit of beef sold is given in the table below.
Table 2 Prices (per unit) in USA and China
|
Steel |
Beef |
|
|
Australia |
6 |
3 |
|
China |
3 |
6 |
In this case, the price of each of these products shall be lower in that country in which the for the product that which it has higher marginal productivity in. Hence, it should export that product.
USA is better off with trade with China, even though it can produce both goods. Allowing steel product imports from China, allows the USA to specialize in those products that it has advantage in such as farm products, medical devices etc.
The Effects of Protectionism and Trade Barriers on the Global Economy
According to the Ricardo, even when a country has better terms of trade all all the products it produces. It would still profit from trade as trade would allow it to specialize in the production of the product that it has the most advantage in (for example, China has advantage, in general, in labour intensive industries while USA has a natural advantage in technology based industries). By doing so, both countries will be able to maximize the efficiency in allocation of resources and factors of production within the country.(Feenstra,2015) Hence, both countries shall profit from indulging in Free Trade.
In the current scenario, the USA would be at an advantage in taking it’s gains from technology further. The USA economy is at a highly advanced stage of development. In the near future, the world is moving towards a world of automation which will reduce the requirement for low paid, unskilled workers. The world is moving towards an economy where more creative and skilled jobs are going to be created. This is known as a knowledge economy. Hence, it is more profitable for USA to not specialize in highly specialised, skilled based and technology based products instead of trying to substitute low cost imports from China with domestically produced goods. (OECD, 1996) The USA has high rates of literacy and advantages in the form of greater technology. Hence, the US policy should be oriented towards other industries or creation of technology for manufacturing or design of goods such as aeronautical goods, medical devices, etc. (Bloomberg Markets and Finance, 2018)
USA has already imposed a 25 per cent trade tariff on over USD 34 Billions worth of goods and plans to levy tariffs over more imports. Similarly, China has retaliated by imposing tariffs on goods and services from US, leading both countries to turn to elsewhere to fulfil their needs for commodities and services. (Tan, 2018)On the other hand, the so-called trade war has disrupted complex global supply chains. For example. Australia has suffered collateral damage from President Trump’s policies as a reduced demand for Chinese steel imports will disrupt the demand for iron ore from Australia. Similarly, several supply chains all over the world shall be disrupted as result of such a policy. (Daniels, 2018)
On the other hand, the reduced dependency of the two countries, provides an incentive to both countries to diversify and establish better bilateral trade relationships with other partners, in the world.
The Importance of Free Trade and Ricardo’s Theory of Comparative Advantage
However, in the recent times, this has not been the case. The US Economy has seen an economic boom for 8 years in a row and hence, consumer spending remains high. As a result, the USA has been high. . Hence, it is less likely, that consumers may be willing to spend less money on Chinese imports. Some of the items that are expected to become more expensive are apparel, footwear, toys etc. (Kearns, 2018)
Impact on farmers: US farmers are demographic group that may suffer the greatest from such a policy. Among the items that China has levied retaliatory tariffs are farm products and food based products. Items of exports such as pork, soyabean, fruits etc. are some of the products that will see a reduction in demand. Additionally, agro-based industries such as frozen fruits such as vegetables are the some of the key exports that may suffer in the process. (Daniels, 2018). The cost of production of farm products such as pork is already high in the USA.
The world supply chain is a complex entity , that is fragmented over several nations. (KPMG, 2016) For example, the steel used in cars for the auto industry in the USA, import steel from China which produces steel from Australia. Similarly, the iphones sold by US company Apple are manufactured in China, that sources the earphones from another firm. In the wake of additional taxes, profit margins of some companies could get eroded. This may result in firms requiring to either sacrifice their profit margins or source materials from other countries. For example, apparel firms could shift their production from China to other neighbouring countries like Bangkok. Electronic firms could shift their production from China to other countries like Vietnam. (Gillespie, 2018) (Daniels, 2018)
The effects of such a policy are felt for business firms all over the world, right from a mining firm in Australia to a consumer product business like whirlpool. One of the direct effects of such a policy is the uncertainty it brings , in terms of uncertainty regarding policies. In some extreme cases, firms could shift production in other countries. Another direct uncertainty is uncertainty that comes from uncertain foreign exchange.(Mu, 2018) It is expected that China may devalue its currency to keep prices the same. This may affect earnings directly. For example, this would directly imports for China expensive, therefore, affecting demand from China. Uncertainty in equities and financial markets in both countries is also expected, which may have a contagion effect all over the world.
Conclusion
The US- China Trade war is a part of a larger theme of protectionism that the Trump administration of US government is oriented towards and may not just bring macroeconomic uncertainty in both countries but all over the world. It may affect businesses by creating uncertainty and disturbing supply chains that span all over the world. Additionally, the trade war may create problems in the financial markets. More importantly, international trade is just one of the concerns in the larger picture of globalisation and no policy should be made without keeping in mind the larger context of politics and economics.
References
Bloomberg Markets and Finance(2018, May 06). Former RBI Governor Rajan on China’s Debt, Economy. Retrieved from https://www.youtube.com/watch?v=LglCBFmaOc4
Cartwright, B. (2016, February 4). “Free Trade and Protectionism Unit: Protectionist Quota Diagram.” . Retrieved from You Tube: www.youtube.com/watch?v=GgqG1ZzoJS4
Daniels, S., (2018, August 21). “US-China Trade War: Australian Economy Risks Getting Caught in Crossfire.” . Retrieved from CNN Money:
Daniels, J. (2018, September 19). Rising US-China trade tensions ‘couldn’t come at a worse time’: Iowa agriculture secretary. Retrieved from https://www.cnbc.com/2018/09/19/escalation-in-trade-war-comes-at-worse-time-says-iowa-ag-official.html
Federal Reserve Bank of St. Louis. (2018) Currency Devaluation and Revaluation. Retrieved from https://www.newyorkfed.org/aboutthefed/fedpoint/fed38.htmlCurrency Devaluation and Revaluation. (n.d.). Retrieved from https://www.newyorkfed.org/aboutthefed/fedpoint/fed38.html
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Feenstra, R. C. (2015). Advanced International Traden Theory and Evidence: Second Edition. Princeton, New Jersey: Princeton University Press.
Gillespie, P., (2018, March 05) A Trump trade war would hit red states hard. Retrieved from https://money.cnn.com/2018/03/05/news/economy/trade-war-red-states/index.html
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Kili¸c, R. (2002). University of Michigan. Retrieved August 23, 2018, from Absolute and Comparative Advantage: Ricardian Model: www.msu.edu
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Sisson, P. (2018, February 02). Soaring Chinese tourism means big money for U.S. cities. Retrieved from Curbed: https://www.curbed.com/2018/2/2/16964908/travel-cities-tourism-china-chinese-los-angeles
Tan, H. (2018, August 22). Beijing retaliates as new US tariffs kick in on $16 billion of Chinese goods. Retrieved from CNBC: https://www.cnbc.com/2018/08/23/us-china-trade-war-new-round-of-american-tariffs-on-chinese-imports.html
KPMG., (2016, September) Taxing complex global supply chain in a post-BEPS world. Retrieved from https://home.kpmg.com/be/en/home/insights/2016/09/taxing-complex-global-supply-chains-post-beps-world.html
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