The Problem With Protectionism

| April 2, 2018 | 0 Comments

On balance, global trade makes everyone better off. Trade lowers prices for domestic consumers and increases the choice and variety of goods available. Sixty-inch flat screen TVs would not be selling for $600 today without the increased availability and lower costs of global trade. So how do tariffs affect trade, and why is the stock market starting to freak out about it? I’ll get to that in a minute.

Global trade isn’t free, no matter the branding. If foreign workers can produce goods cheaper than domestic workers, then production will move overseas. Domestic workers will suffer unless they are able to find other jobs. The owners of capital benefit from lower labor costs, higher profits and cheaper goods. Domestic workers only benefit from the lower costs if they are able to find another job. This has been a concern of workers for some time, even as business owners and investors have profited.

How does trade lower prices? For any given price of a good, domestic manufacturers will produce a given amount. But we live in a global marketplace, so if a good can be produced cheaper overseas, it will be imported at the lower cost and undercut domestic production. Imported goods are cheaper for domestic consumers, but at the cost of fewer domestic production jobs. This essentially has been Walmart’s business model: import the cheapest goods they can from wherever they can get them to sell to U.S. consumers at the lowest price possible.

How do tariffs impact trade? A tariff is basically a tax that makes imported goods more expensive. This artificially raises the cost of imported goods, thus discouraging imports and encouraging more domestic production at the higher price. While this can lead to more domestic production (jobs), it also raises the price of the affected goods for consumers. In other words, inflation.

If tariffs can encourage domestic jobs, then why are they problematic? For one thing, our trading partners will not sit idly by while we tax their exports. The effect on their workers is that the goods they produce cost more, so demand falls and those foreign workers lose their jobs. Thus, the countries on which we impose tariffs will probably retaliate by imposing tariffs on our exports. So while some U.S. industries may benefit from tariffs, others will be hurt as our exports become more expensive. In the long run, everyone loses as prices rise and the global market for goods and services shrinks. Balancing higher inflation against the interests of harmed or protected industries is challenging and hard to get right.

But don’t tariffs protect domestic jobs and allow industries to flourish? Maybe, but an industry without real competition stagnates because there is no incentive to improve. Think Detroit in the 60s and 70s before competition from Germany and Japan forced innovation, cost cutting and product improvements. Tariffs and trade barriers do protect domestic producers in the short run, but higher costs and inefficiencies outweigh those benefits in the long run. And that’s before considering retaliation.

The argument for tariffs on Chinese imports basically relies on punishing China for its aggressive and anti-competitive trade behavior of the past 30 plus years. But tariffs and protectionism can cause more pain than they fix, and should only be done with the support and agreement of our other allied trading partners. Never mind that picking a fight with China while we ask them for help solving the Korea puzzle seems to be a very poor negotiating strategy.

So why are investors freaking out about tariffs and potential trade wars? In short, uncertainty. The discussion above suggests higher costs and lower profits for some companies and industries. But investors don’t know who will benefit and who will be hurt, or how this will end. In addition, the “Goldilocks” economic scenario we currently enjoy, where economic growth is global and moderate (without overheating) relies heavily on global trade, so anything threatening that equilibrium adds uncertainty to investors’ outlook. Finally, expanding global trade has contributed to the relative global peace since World War II. Trade wars create additional stress, increasing geopolitical risks. All this added uncertainty causes volatility as investors try to guess at the impacts, winners and losers.

This column is prepared by Rick Brooks, CFA®, CFP®. Brooks is director/chief investment officer with Blankinship & Foster, LLC, a wealth advisory firm specializing in comprehensive financial planning and investment management. Brooks can be reached at (858) 755-5166, or by email at brooks@bfadvisors.com. Brooks and his family live in Mission Hills.

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