Economists generally agree on few economic theories, but the negative impact of tariffs is one of them. The theory advocating for free trade without tariffs or barriers between countries was first articulated by Adam Smith in 1776 in “The Wealth of Nations,” showing that even if a country has an absolute advantage in producing goods, trade is still beneficial.
David Ricardo expanded this theory in 1816 with the concept of comparative advantage, demonstrating that free trade can be beneficial for all countries involved, even when one has an absolute advantage in all areas of production. Give or take some some critique on specific points and assumptions, these principles remain unchanged to this day.
This is the context to judge the economic impact of Trump’s announcement of a 25% tariff on goods from Canada and Mexico a 10% tariff on China followed by a 25% tariff on European and other countries’ steel and aluminium products and threats of more tariffs if there’s any retaliation. The last time he did this there was retaliation as there is this time from Canada and Mexico. Chinese retaliation in 2018 drove 20% of US farmers into bankruptcy and led to hundreds of billions of state support.
Understanding the negative impact of tariffs
For clarity, tariffs are a tax on imports. They are paid by the importer, and the taxes are collected by the government, which may boost their coffers until slower growth reduces it. The importer transfers the costs to consumers, whether they are other producers using the imported products (e.g., steel) in an intermediate process to produce other goods (e.g., cars, dishwashers, washing machines) or final customers using the products as imported (e.g., toys sold in Walmart but made in China because it’s cheaper for the final consumer in the US).
Taxes, such as tariffs, increase the price of goods and disincentivise economic activity. They also increase firms’ costs, which can reduce the likelihood of hiring additional employees or increasing their wages. Companies may be forced to pay workers less, reduce staff, or accept lower profits. For struggling companies, low profits could lead to company failure, a serious consequence of tariffs that could further exacerbate job losses.
That rise in price as a result of tariffs, lowers economic activity, raises the prices of goods and can lead to higher price inflation, a key concern for the central bank tasked with keeping inflation low and stable. This can lead to the central bank raising interest rates or not cutting them in a timely way, thereby weakening economic activity even further.
Not everyone is worse off from tariffs
Not everyone is negatively affected by import competition, however and it would be naive to believe otherwise. Domestic firms that produce goods at higher prices than imported alternatives benefit if those lower-cost imports are restricted. Consequently, these firms often advocate for import controls, citing reasons such as ‘subsidised imports’, ‘low-cost imports’, ‘substandard imports’, or simply that foreign competition should not be allowed to displace them because it means the loss of local jobs.
The latter argument is particularly seductive because it may well be true that the local producer of that product goes bust in the face of cheaper overseas competition. However, it’s also true that because locals are better off by buying the alternative at lower prices, they have more funds to spend elsewhere, and that can then boost employment in other local industries.
The key issue is whether policymakers recognise this situation but support it anyway for political reasons. Therefore, rules on protecting local industries are generally established and enforced by the World Trade Organization (WTO) if subsidies exceed a certain limit. Such practices lead to unfair competition and, if widespread, would ultimately be detrimental.
These firms argue for special treatment on the basis that they are domestic producers, asserting a right to charge higher prices to local consumers to ensure their survival. However, this situation may result in local consumers being disadvantaged due to higher costs compared to purchasing similar goods from abroad and spending savings on other local products.
The role of trade in the Great depression
The lesson from the Great Depression was so clear and indelibly marked that no one repeated it until Trump was elected in 2018. Indeed, just the opposite, post-war international trade arrangements lowered tariff barriers, leading to the greatest increase in global wealth in history, see chart 1. Following the Bretton Woods Agreement, global institutions such as the World Bank, International Monetary Fund (IMF), WTO, International Courts of Justice, and United Nations were established to promote trade, resolve disputes, and uphold a rules-based international system. This system, crucially led by the US and Europe, is now under threat as Trump reverses course.
Tariffs on imports have a long and inglorious history
Unfortunately, we have a test case of exactly some of these possible outcomes based not on what happened in the 1930s but what has happened more recently: in Trump’s first term. In 2018 he led the US into its first tit for tat tariff increases since the Great Depression of the 1930s. Then of course these tariff trade increases became known as ‘beggar thy neighbor policies’ because all that happened was that the countries involved in it made each other poorer, therefore prolonging the global economic downturn.
US prices for intermediates and final goods rose significantly due to the tariffs, affecting supply chains and reducing imported varieties. Tariffs were passed through entirely to domestic prices, leading to a $1.4 billion monthly loss in US real income by year-end across the economy. Similar trends were observed in countries retaliating against the US, thereby causing a global decline in real income.
Economists have long contended that import protection results in substantial income losses. The 2018 trade war provides compelling evidence, revealing a staggering cumulative welfare cost of $6.9 billion in real or inflation-adjusted income reduction. This figure, coupled with an additional $12.3 billion cost to consumers and importers due to tariff revenue transferred to the government in the first 11 months of 2018, underscores the significant economic toll of import protection.
By November 2018, the deadweight – or income losses – had escalated to $1.4 billion monthly. The trade war precipitated significant upheaval in international supply chains, resulting in the loss or redirection of $165bn of trade (including $13bn of imports and $29bn of exports) to circumvent tariffs. US tariffs were reflected in domestic prices, affecting consumers and importers, while foreign exporters remained unaffected. But there were similar patterns for foreign countries who retaliated against the US, which indicates that trade wars have no winners as the retaliation also reduced their real incomes. Better not to respond to a rise in tariffs by raising your own even though it looks like surrender. Your consumers would be better off if you do not raise the price of their imports.
Trade protectionism leads to higher prices
US producers, in response to reduced import competition, took the opportunity (another lesson about the effects of competition) to raise prices. While estimates in the study did not factor in other significant costs like policy uncertainty, it is highly likely that these costs contributed to substantial declines in US and Chinese equity markets during the period of the major trade announcements being made at the time.
So, it’s clear that one outcome of reduced import competition is higher prices as is the effect of the increase in tariffs. This tendency is reflected in OECD figures recently released on their analysis of the tariffs which have been announced so far, see chart.
The uncertainty being generated now by announcements of on-off tariffs and threats of further tariffs if there is retaliation to the US’s tariffs, is being reflected in the volatility that we are currently seeing in share prices, particularly US share prices, and would almost certainly lead to less investment than otherwise and therefore weaker economic activity.
What does this mean for the UK?
The UK will be affected by US tariffs despite their close relationship. The US is the UK’s largest trading partner, with 17.2% of trade in goods and services in the four quarters to Q3 2024. UK exports to the US were £182 billion, and imports were £112 billion, resulting in a UK surplus of £71 billion. Tariffs may reduce this surplus and weaken UK economic growth, as shown in chart 2. However, if the UK does not impose retaliatory tariffs, economic effects might be mitigated as consumer costs for US goods and services won’t rise.
The OECD estimates that tariffs will reduce the UK’s growth by 0.3% in three years. Higher inflation expectations could lead the Bank of England to maintain its higher interest rates (currently 4.5%) than the EU’s current average of 2.5%, further impacting growth.
This period of renewed trade uncertainty highlights, just as the 2018 US experience and the one just shy of 100 years ago did, that reciprocal trade protectionism rarely leads to good outcomes.