Don’t be surprised

Mr Trump has said a lot about his plans to protect the US economy from imports. He has said that he plans to “tear up NAFTA”, impose tariffs on Chinese imports, or maybe make changes to the US tax system that are equivalent to a tariff policy. Lately, however, he has played down the rhetoric, telling Canadian Prime Minister Justin Trudeau that he just wants to tweak NAFTA.  Reassuring words, perhaps.  But if Mr Trump does have a protectionist agenda, he also has a strategic reason for playing down the idea for now and acting quickly when the time is right.

The reason is simple, while it is possible that higher tariffs could be in the US interest (if it doesn’t trigger retaliation from other countries), the announcement effect does the complete opposite. Indeed, for Mexican exporters, the dramatic depreciation of the peso, was a silver lining from Trump’s election, that temporarily made them more competitive than their US rivals.  With the downplaying of protectionism, the deviation of the peso from its trend has almost disappeared and US firms are starting to find themselves better placed again.

This post walks through the economics of a tariff and its announcement.  The long and the short of it.  If a country wants to introduce a tariff, it should be done swiftly, with as little warning as possible.

Consider what happens when the government introduces a tariff without any warning (starting from a simple situation in which the trade balance is initially zero (exports = imports) and spending only depends on income and the interest rate.

Upon announcement and introduction of the tariff, the price of imports increases immediately, encouraging domestic firms and consumers to switch their spending away from imported goods towards domestically produced ones.  As such, the tariff creates an immediate tendency for the trade balance to go into surplus and for domestic incomes to rise.

However, this story doesn’t end here. The policy induced tendency towards a boost in spending on domestic goods also puts upward pressure on domestic interest rates (making them higher than in the world economy), attracting foreign capital into the country and appreciating the exchange rate.  In turn, the appreciation puts the expenditure switching effect into reverse by making imports cheaper (and exports more expensive for foreigners). Indeed, as long as the initial (tariff) effect dominates the latter (exchange rate) effect, the exchange rate will continue to appreciate and it will do so until the exchange rate has risen enough that the trade balance is zero once again.  So long as the overall level of domestic consumption and investment does not depend on the exchange rate, and the interest rate has remained equal to the world rate, the trade balance must come back into balance and income will return to its original level.  The only changes are the tariff and the offsetting impact of the exchange rate.

This analysis is over-simplistic, but it gets us a long way in terms of the basic principles and it can be tweaked to capture tariffs impacts that have been left out of the story above. For example, tariffs tend to reduce the aggregate amount of trade, which is generally negative for income and growth (imagine a small Pacific island where trade restrictions leave it less able to sell tourism services to buy fuel and food).  On the other hand, tariffs can be beneficial when a country has some monopoly power with its trading partners (by restricting its import demand to get a cheaper import price, or restricting its exports to get a higher export price). If the second effect dominates the first, then the longer-run level of income will be higher than before the tariff, but if the former dominates, then income will be lower.

There is no hard and fast rule on which effect dominates, though many of the most sophisticated models tend to assume that most major advanced economies such as the UK or Japan are large enough so that if they were to introduce a small tariff, it will gain so long as the rest of the world does not retaliate, in which case it will most likely lose.  Still, if the country is large enough (such as the US), it is possible that it might withstand the retaliation and still come out ahead.

Now imagine what happens if the trade policy is “announced” ahead of time; say a year before it is implemented.

The analysis is similar to that above, but the two offsetting effects (the tariff and the exchange rate effect) can now happen at different times. We start at point A in the diagram below. Financial markets are forward looking, so the exchange rate appreciates immediately. This is because financial markets anticipate that the exchange rate would have to rise and, seeing a profitable transaction, international capital flows into the economy and drives the exchange rate straight away, with no immediate offsetting tariff effect (that will come in a year’s time). In the first instance, the exchange rate may not appreciate the full amount described above. Indeed, some additional appreciation is likely to come later. Still, the stronger currency hurts exports and makes imports cheaper causing the trade balance to move into deficit.  Economic activity deteriorates, prices experience downward pressure.  To prevent the economy from slipping into recession, the central bank will push interest rates fall below the world interest rate, which is possible to the extent that markets still anticipate that some further appreciation of the currency is still to come (as we have assumed)  (At point B in the diagram below).  In the short-run, the trade balance goes into deficit.  To the extent that the central bank cannot prevent a recession, there might be some reduction in the level of imports that partially offsets the appreciation as income falls. However, because the fall in income comes reduces spending on other goods and not only imports, the trade balance stays in deficit.

It is plausible that the expectation of higher future income could stimulate spending immediately, and that this might offset the negative impacts. This would put more immediate pressure on the exchange rate to appreciate, and put the trade balance into a deeper deficit. It seems unlikely that the expectation of long-run higher income would dominate.

When implementation day comes, people and firms immediately switch their expenditure away from imported goods to domestic goods.  This caused the deficit to be eliminated, boosts expenditure on domestic goods and drives up the overnight interest rate to avoid inflation. There is no additional adjustment in the exchange rate because foresighted markets had already priced it in. The interest rate returns to the world rate i*.

The deficit and slowing of economic activity could have all been avoided if the government had just not announced its policy.   So don’t be surprised if it does just that and surprises us all.


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