The impact of Donald Trump’s tariffs on EU and UK exports is likely to be far less than is commonly thought, writes Tsjalle van der Burg. But the uncertainty caused by Trump’s policies could still cause severe economic damage.
One of the apparent aims of Donald Trump’s “Liberation Day” tariffs on 2 April was to repatriate jobs to the United States. Yet when the tariffs were unveiled, unemployment in the US was already at 4.2%. For economists, this means there is “full employment” as some unemployment is unavoidable, not least because it can take time to find a new job.
This is not to say that with full employment the number of jobs cannot increase at all, but it can grow only to a small extent. This raises the question of whether US production and employment can actually rise and, if so, whether this will induce wage and price increases that harm the competitiveness of US firms.
Two scenarios
To analyse the effects of tariffs on the US economy, I use two different base scenarios (scenarios that describe the situation without the tariffs). In the first scenario, unemployment in the US is so low that total production cannot rise at all. In the second scenario, there is no full employment, so it is possible in principle that production rises due to import tariffs.
I focus on unilateral trade tariffs and put to one side the fact that other countries may respond by raising their own tariffs. I also have not accounted for the impact of uncertainty. According to Paul Krugman, the uncertainty associated with Trump’s tariffs is the most significant disadvantage of the policy as it risks preventing investors from investing in, among other things, the sectors that are supposed to grow due to tariffs.
Full employment
In the first scenario, the prices of imported consumer goods and inputs for firms increase due to the tariffs. This disadvantage, however, can be compensated in principle by using the tariff revenues for targeted tax cuts. As a result, I ignore the specific price increases discussed above for both of the base scenarios.
The tariffs also cause some of the previous imports to be replaced by more expensive domestic production. This increases the prices of consumer goods and inputs for firms, and here, there are no tariff revenues that can be used for compensation.
In the first scenario, I assume, for simplicity, that the higher consumer prices do not lead to higher wages and that workers accept lower real wages insofar as they are caused by the inefficient import substitution. Such a restrained reaction of workers helps to avoid a reduction in the competitiveness of US firms. However, the story does not end there.
Because of the tariffs, companies in the US increase production of goods that used to be imported. To do this, they need labour, which has to be withdrawn from other US companies. After all, total employment cannot rise. Consequently, other US companies produce less, while total domestic demand remains static. This means that exports decrease, while imports rise somewhat again as US firms decrease their production of goods that can also be imported.
For all countries outside the US taken together, this means the following: the original decrease in their exports to the US is fully compensated for by the combination of fewer imports from the US and new exports to the US. Thus, total net exports from all countries outside the US do not change on balance (after a transition period).
This does not mean that other countries are not harmed. First, there will be a transition period, in which the effects can differ from those discussed above. Many countries will experience serious decreases in certain exports during this period. They will also incur transition costs.
Second, in the longer term, there will be significant shifts in world trade. The net exports of some countries outside the US can decrease, but this implies that other countries will see their net exports increase. China may be among the losers given Trump’s high tariffs on the country, which makes it likely that the EU and the UK will be among the winners.
No full employment
In the second scenario, the US lacks full employment. This means that production and employment can rise in principle. To begin with, in this case too, tariffs lead to import substitution.
Because the domestic products produced this way are more expensive than the products that used to be imported before the tariffs, prices for consumer goods and inputs for firms rise. Since higher consumer prices lead to higher wage demands, a wage-price spiral may reinforce the price rises. In this way, the competitiveness of US firms in the world market is reduced. This hurts US net exports.
It follows that the net exports of countries outside the US will increase. Thus, the original reduction in their net exports is compensated for by the higher prices of US firms, at least to a certain extent. The magnitude of this compensation partly depends on the increase in US wages.
There are two reasons for the wage increases. As stated, one is that workers wish to be compensated for higher consumer prices. However, the rise in production caused by the import substitution also reduces unemployment and, according to the Phillips curve, a reduction in unemployment causes higher wage demands and therefore higher wages.
If unemployment in the base scenario is still relatively low, say 5-6%, a reduction in unemployment caused by tariffs leads to a larger wage increase than in a scenario where unemployment is higher (according to the Phillips curve). This means that the adverse effect of tariffs on US firms’ competitiveness is larger the lower the unemployment in the base scenario.
Finally, the import tariffs also have another effect: tax revenues increase because of the rise in production caused by import substitution. In principle, this revenue increase can be used to finance tax cuts that improve competitiveness. Of course, it is unclear whether the government will take this road.
The fact this possibility exists means we cannot draw any final conclusions about the total effect of tariffs on the competitiveness of US firms. However, the point remains that the import tariffs have a more negative impact on US competitiveness, and therefore a more positive effect on the net exports of other countries, the lower the unemployment rate in the base scenario.
A macro perspective
The import tariffs can also be analysed from a macro perspective. This analysis starts with a simple point: a country with a deficit on its current account spends more than it earns (by definition). The US typically has a high national income, or in other words, high earnings.
Nevertheless, it has had a current account deficit in all years since 1992 (and in most of the fifteen years before 1992). Indeed, its earnings have grown strongly over the years, but its spending has grown more. This means that the US, in contrast to China for instance, has a structural tendency to spend more than it earns.
There is no reason to assume this tendency will disappear in the near future. Thus, if Trump’s import tariffs increase US production and earnings in the first instance (which is far from certain in view of the above), then the new earnings will probably be used for additional spending – which implies that the tariffs will not improve the US current account on balance.
Consequently, the current accounts of all other countries taken together will not deteriorate. There will be shifts in production, which will harm some countries while benefiting others, but for all countries outside the US taken together, the picture will not be negative.
Whatever other countries do, they cannot eliminate the deficit on the US current account. A single country could potentially eliminate its trade surplus with the US, for instance if Israel bought more weapons from the US. However, in the end, this will improve the current accounts of countries other than the US, unless the US reduces its propensity to spend, which does not seem likely.
Reasons to show restraint
Although the points raised above are self-evident, they have been overlooked in most assessments of the impact of Trump’s tariffs on the net exports of the EU, the UK and other countries. These accounts are far too pessimistic because they have not considered the situation in the labour market in the US or the price increases of US products.
The fact that the impact on the EU and the UK is likely to be less than we think is a good reason to avoid retaliating with tariffs on US exports. Another reason is that unemployment in the EU is at 5.7%, with some member states having serious labour shortages. In the UK, unemployment is at 4.4%. This means that, although EU and UK import tariffs will help some of their domestic companies initially, they will also lead to serious price increases overall, which will have negative consequences for the competitiveness of their firms.
The real problem Trump’s tariff policy creates for the EU and UK is high uncertainty. This alone could cause a serious recession. While there are potential strategic considerations, such as the possibility EU pressure could encourage Trump to reduce his tariffs, the threat of uncertainty means a transparent and predictable policy of restraint from the EU and UK would be the best course.
Note: This article gives the views of the author, not the position of EUROPP – European Politics and Policy or the London School of Economics. Featured image credit: noamgalai / Shutterstock.com