Trade Wars Aren’t Good, But Markets Can Adjust

(Bloomberg Opinion) -- Virtually all economists favor free trade. But we differ as to what the costs of trade restrictions might be. The decision of Harley-Davidson Inc. to shift more production overseas to Europe to avoid the impact of new tariffs presents a good opportunity to assess those costs – and the good news is that, so far, the economic costs of a trade war appear to be limited.

It is a standard proposition in economics that trade, foreign direct investment and immigration are all potential substitutes for each other. If goods cannot cross borders, perhaps capital or people can. Both are alternative ways of reaping potential gains from trade.

So when President Ronald Reagan imposed “voluntary” import quotas on Japanese autos in the 1980s, Toyota built more factories in the U.S. The end result was that U.S. consumers still got the cars, and without paying tariffs. You might think America enjoyed additional gains from the new jobs created, but much of that was given back through capital inflows, as a stronger dollar led to weaker exports. It was a form of market adjustment.

By putting its European production in Europe, Harley is creating a similar tariff-neutralizing effect, reflecting the market's ability to adjust to an ill-conceived policy. In turn, we can expect that some European producers will place new plants in the U.S. or expand the old ones.

Note that Harley already had plans to shrink its U.S. production, and it already was expanding into Brazil, Australia and India. So perhaps the result here isn’t so different from what might have happened anyway.

Of course it isn’t always that simple. Let’s say that tariffs went up significantly between the U.S. and Malaysia. It might not be worth it for Harley or other producers to build new plants in Malaysia, since it is a relatively small market. The good news, if you could call it that, is that the U.S. is starting a trade war with the economically large European Union. That is precisely the place where, because the potential market is so large, companies will make more investment to offset the impact of trade restrictions.

The movement of people is another partial substitute for standard foreign imports and exports. So if the U.S. further restricts French cheese, or the EU places additional limits on American beef imports, tourists adjust to limit the burden. (I don’t foresee a big increase in cross-Atlantic migration, although theoretically that is another possible response.) Even before Trump, the U.S. did not let in many French non-pasteurized cheeses. So when I go to France, the first thing I do is to buy a lot of those cheeses. Just as, I imagine, many French tourists in Texas sample the barbecue.

Another striking feature of trade today is that it is increasingly based on cross-national supply chains. U.S. car production is heavily dependent on inputs from Mexico; European factories often buy their inputs from America; iPhone manufacturing in China is based on contributions from many nations, including the U.S., South Korea, Japan, the Philippines and Taiwan. There is a certain fragility to these arrangements, but they also mean the costs of small tariffs are likely to be absorbed by suppliers, rather than shutting down trade.

That's because if you’ve spent years painstakingly constructing one of these international supply chains, you’re not going to let a few tariffs on one part of the chain shut you down. Instead, you are likely to just eat the loss and move on, because there is so much total value at stake.

At the same time, very large tariffs and trade barriers now will have much higher costs, if they are capable of shutting down the entire supply chain and disrupting so many moving parts.

Thus does a strange dynamic come into play in the global economy: Politicians start to feel they can impose small tariffs without disrupting production very much, or even necessarily inducing higher prices. They’re right – and that is exactly what makes this logic dangerous, because they may be tempted to push further and further on those tariffs, drawing ever close to the danger zone where the tariff really starts to bite.

The biggest costs of the current trade war talk may come with China, because in that case there is talk of both higher tariffs and tougher restrictions on Chinese investment in the U.S. (and possibly vice versa). The market adjustments to higher tariffs just aren’t as potent in this context, in part because China still is not a proper and open market economy.

Still, when you read about tariffs and trade wars, do not dismiss the power of institutions to adjust. One of the great virtues of markets is that it is harder to wreck them than you might think.

©2018 Bloomberg L.P.

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