Tariffs are worse than you were told

I'm starting to think that the financial journalists working today are hired based only on their ability to pump out stories quickly rather than to understand an issue and explain the financial and economic impact to you. Or, maybe AI is writing the stories, and it can't summarize an issue from different angles.

The reporting on the broad tariffs enacted earlier this year focused on who would pay the cost. Some reporting said a tariff is a "sales tax". Others said it's a duty collected at the border, so it's up to the supplier and importer to decide who will pay what portion. Some say that a company may choose to "eat" the tariff, without explaining that anything eaten off one plate is less food to go around. A tariff is an import duty, or a tax, if you will, paid on a product as it enters the country. A tariff of a few percent gets little notice, is paid to customs, and results in not much impact on anyone. If the tariff is larger, say 25%, the supplier may decide to "eat" some of it, reducing the price of their product to make the impact smaller on the customer. What they "ate" was profit for themselves. And, sure, maybe they'll accept that profit reduction for a while to keep the factory running at 100%. But then, they'll start looking to sell into other countries that don't have a steep tariff.  Once they secure enough new business to keep the factory at 100%, they'll tell the country with the 25% tariff, essentially, your price is now higher because I don't need your business anymore. The point is, there is no "eating" of the tariff. Anything eaten is profit lost, either by the exporter or importer, and no business will continue to lose money if it can avoid it.

The next thing that happens is that those faced with paying the tariffs look for ways to get around that 25% tax. When the tariff was 1 or 2% it wasn't worth it. Now, if the product or supply chain can be redesigned, maybe the tariff can be avoided. The first thing they might consider is moving production to a country with a lower tariff. Put a high tariff on China? Then, China sets up a factory in Mexico, problem solved. Or, China changes production to do most of it in China, using one key part from a country with a low tariff, and then they claim the item is produced in that country. Or, a company engineers a product made in the U.S. to not use steel or aluminum in the case because of the tariffs on steel and aluminum, and instead uses plastic. All of these workarounds cost money (and time). Depending on the makeup and extent of their business, subject to tariffs, they may or may not decide to do them (or they think the tariffs will be removed later, so they won't spend the money now). Thus, it's likely that under broad-based tariffs, over time, they will bring in less and less tariff revenue because products will no longer be sourced from the highly tariffed countries. Thus, the new costs to re-engineer or re-source will be paid, which is paid by someone; either here or somewhere else, as a cost that increases prices or lowers profits.

Then there is the fallacy that high tariffs will bring jobs back to the U.S. Besides the obvious cost of labor issue (U.S. labor is much more expensive than that in Asia), there is investment—similar argument as previously discussed. The high tariff is forcing businesses to do business in a different way, or the supplier will live with lower sales or less profit. So, they'll do the math to move production to the U.S. to avoid all tariffs. Oops, there are raw materials required, and they may be subject to tariffs. Assuming that can be dealt with, now the question is does it make financial sense to build a new factory? How many years to build and be at full production? Oops, the machines (mostly robotic) needed in the factory are subject to tariffs. Assuming that can be dealt with, now we need workers. Oh, they're in short supply at the location where the factory is to be built. So, this turns out to be a 2, 3, or 4-year effort to get the first product out the door. Oh, wait. What to do with our existing factory in Thailand? Don't need it anymore, so how much does it cost to close it down? Ok, we can now add up all the costs to move production to the U.S., and guess what? The only way this works is if the price of the product is 15% higher to get a return on investment in 10 years. What if a competitor does not move production to the U.S. and engineers their product and supply chain to only be 10% higher? Now, by moving the factory, we're not competitive in the U.S. anymore. So, how many businesses will take the gamble to invest in U.S.?  BTW - while the dollar is dropping in value, a good thing for those wanting to export from this new (or any) U.S. factory, the lower dollar means it costs foreigners more to build factories here.

In a global trading system where not just products can be made and shipped anywhere, but also components, design, logistics, and final assembly, some businesses were only possible because of this global system. Take, for example, outdoor backpacks and duffels. This business could start in the U.S. and design and sell these items for consumer tastes in the U.S. However, to make them affordable, they'll do final assembly in Vietnam with fabric, straps, wheels, and zippers from China and India. Ship to the U.S. for packaging and distribution logistics. Under high tariffs, they would either have to raise prices by 10% or more or move production somewhere else. Do they make the investment and take the time to redo their business model in an environment where trade "deals" are in constant flux?

Next, we have inflation. Since inflation measures the rate of change and not the price level, the tariff might only add to inflation at the beginning. Slap a 25% tariff on aluminum, the price of beer goes up next month (rate of change, beer is 7% more, but then stays elevated as the tariff remains in effect. After a period of time, the tariffs are not directly causing inflation; they have just made everything more expensive. If your budget only allows for $10,000 of spending this year, you'll be buying 10% or 20% less stuff for the $10,000. So, in that sense, it's like a sales tax. With the same amount of money, you cut back on the quantity of what you buy. Since many Americans live paycheck to paycheck, they have to consume less for the same spending. If they consume less, and it doesn't matter where the stuff they buy is made or tariffed, that results in lower revenue and profit all along the supply chain: trucks, warehouses, stores.

But inflation from tariffs doesn't just impact consumers; it also impacts the businesses that make things that are sold to consumers. Take a company that makes material handling equipment for warehouses. Their product is made from metal, plastic, and electronics. A good percentage originates outside the U.S. and is subject to tariffs. They might "eat" or reduce profit a bit to ease the sticker shock of the price increase on their product, but by having to raise their price, they might sell fewer of them. Then, they might slow hiring because not only are they selling less, but their profit is now less. While the inflation on factory equipment is not "seen" in the monthly consumer price statistics, it will be seen in hiring, and if they are a public company, in their quarterly stock earnings.

Finally, there is the impact on competition. In a global economy, items from countries with the lowest cost will gain market share. And that global market share, here in the U.S., may drive a U.S. company out of business. And certainly, 100's of thousands of U.S. manufacturing jobs were lost in the last several decades due to the cost disadvantage against foreign imports. Now, what happens, though, if you have a U.S.-based business and your competition raises its prices? You can now make more sales and grow your business, up to your capacity, or you can increase your price because you have less price competition now. If the price of imported steel is now 20% higher, then the U.S. producer can raise prices 15% and is now more price competitive with the imports.

Tariffs have mainly been used in history to protect domestic production, for jobs, or national security (steel, for example). Very specific tariffs can be used to offset cheating by another country that subsidizes its exports. But when applied in a broad sense, the unintended consequences could cost the U.S. far more in overall economic activity than the revenue generated by the tariffs. In the example of the outdoor backpack company earlier, what if dozens and dozens of companies like that, each employing 100 or 200 U.S. workers, go out of business because they either don't have the money to re-engineer their buisiness model or are not competitive with a competitor that happend to have a different supply chain already in place that gave them the price advantage. Loss of small businesses results in more unemployment, less tax revenue for states and counties, and the ripple effect; thus, the tariff could lead to a net loss for the U.S. economy. As I said, unintended consequences.

I'll end with this thought. Global trade, in a world with low tariffs, allowed all the countries participating in the system to have a better future. They could grow their economies by producing what they are good at for everyone around the world at the lowest price. And, their citizens could afford imported products for a better life that wouldn't be possible if they insisted they be made at home. When trade barriers dropped, everyone was better off. Erecting trade barriers, which is what tariffs effectively do, is like saying, "you can't have it anymore because it will be taxed so that you can't afford it". The result doesn't happen immediately, but no doubt will be seen in the economic statistics over time.