Trump Administration's Tariff Increase on Steel Imports and Economic Theory

Shock Waves Around the World

The decision by the Trump administration to increase tariffs on steel imports has sent sizable shock waves around the world. The administration claimed the measure was decided owing to declining steel prices caused by China's surplus steel production. However, only 2% of the steel imported in the U.S. is coming from China. Canada and EU, the major steel exporters to the U.S., rebuked the proposed tariffs. This action will have little impact on eliminating the trade deficits against China.

Mr. Seko, the Minister of Economy, Trade and Industry of Japan, called on the U.S. to exempt the whole or some of Japanese steel products from the proposed tariff, taking into account the alliance of Japan with the U.S. and high demand for Japanese high-quality steel products by U.S. manufacturers, notwithstanding the U.S. claim that the steel industry is indispensable for the national security of the country. However, he was not successful. The true objective of the U.S. in introducing this measure is to protect the U.S. steel industry, not for national security reasons. Thus, a wide range of countries are targeted without any exclusion.

The U.S. suggests that there will be some possibilities of exemption for particular cases. Canada and Mexico are exempt, but this is not because of the reason officially stated that both countries are exceptional due to national security interests. Rather, it is due to the intention of the U.S. to gain concessions on other issues from both countries in the process of renegotiating NAFTA. The administration implied the exemption would be cancelled, and high tariffs would be imposed unless both countries made concessions. If Japan requests an exemption, the U.S. will surely ask Japan to reduce its tariffs on U.S. agricultural produce.

It is likely that the Japanese government will tell the Japanese public that they are requesting an exemption. However, trade officials should be well aware that this will not be easy to achieve.

Even if Japan is exempted, the reduction in steel imports in the U.S., caused by high tariffs imposed on steel imports from other countries, will increase the steel supply in the world market and negatively affect global prices, resulting in a huge loss to the Japanese steel industry. Unless the basic problem of the U.S. tariff increase is rectified, the issue will not be solved. The Japanese government should not adopt a temporizing measure for individual tariff exemption, but should demand directly that the U.S. revisit the measure as a whole.

The Trump administration's move reminded me of two economic theories.

Optimal Tariff Theory

The first is the optimal tariff theory in international economics.

International economics differentiates the effects of tariffs imposed by a big country and a small country separately; a big country, where changes in trade volume or policies have impacts on global prices, and a small country, where, with a small trade volume, such changes do not affect global prices. An increase in tariffs by a small country would have a minimal effect on global prices. On the other hand, if a big country increases tariffs on imports, the domestic demand on imports will reduce owing to increases in the price of goods for consumers, and subsequently imports will fall. In other words, the reduction in demand in the big country will proportionately reduce world demand, which will lead to a decline in global prices.

Let us use specific figures for ease of understanding.

The U.S. previously imported steel at 100 USD per unit. Since they imposed the 40 USD tariff on imports, the global price has fallen to 80 USD (American consumers pay 120 USD; 80 USD plus the tariff).

The price of corn, which the U.S. exports, is 100 USD per unit, which is the same asbefore. Before the tariff was imposed on steel imports, both steel and corn were traded at 100 USD per unit. Because of the reduction in the steel price, the U.S. is now able to purchase one unit of steel for the export of 0.8 units of corn. (This is known as an improvement of the terms of trade.)

Given that exporting is to produce (to work) and importing is to consume, the U.S. (the big country) could consume as much as before while working less. In brief, to impose tariffs on imports makes the U.S. more affluent. (Producers benefit from the increase in price and the tax revenue goes into the national treasury.)

Of course, if a tariff is too high, the loss to domestic consumers caused by the increase in price will become huge. There is a threshold for the acceptable level of a tariff increase. With a certain tariff rate, U.S. profits will be optimized. This is called the optimal tariff.

Victims of Tariff Increase

The EU is concerned that this U.S. introduction of a tariff could cause cheap steel that had been destined for the U.S. to flood into the EU region. Certainly, there is no assurance that the 25% tariff proposed by Mr. Trump would be the optimal tariff. However, the reduction in global steel prices will work favorably for the U.S. terms of trade, which will bring some profits to the U.S.

On the other hand, exporters will suffer from the reduction in global steel prices. If the EU, being as big as the U.S., increases tariffs on U.S.-made products as a retaliatory measure, the U.S. will be hit. (If many exporting countries, other than EU, collectively increase tariffs, the same effects will be expected.) The world trade volume will shrink, which will damage all countries, including the U.S., compared with the time before the U.S. tariff increase. Further, if the U.S. decides to retaliate, and measures taken by both sides escalate, a rapid decrease in world trade and an eventual standstill will occur. This would be the outcome of trade wars.

Prisoner's Dilemma

The other theory is the prisoner's dilemma in game theory.

Assume the following: two criminals are interrogated in separate rooms. If one confesses while the other remains silent, the one who confessed will be set free, while the other will serve 10 years in prison. If neither confesses, both will serve two years in prison. If both confess, both will serve six years in prison.

No guarantee is there that the other will not confess. If the other remains silent, one will be set free by confessing. If the other confesses and one does not, one will be sentenced to 10 years in prison. If both confess, the sentence will be reduced to six years in prison. In the end, both make the same decision to confess, and as a result, both will face a worse penalty than if both had not confessed.

Let us apply it to the tariff case above. Mr. Trump planned that he would be set free (maximize profits) by confessing (increasing tariffs). However, since the other also confesses (increases tariffs in retaliation), the outcome will become more disadvantageous than in the case where both remain silent (no increase in tariff).

What causes people to be caught in the prisoner's dilemma?

It is because criminals are interrogated separately and have no means of communicating with the other. If both were in the same room and cooperating with the other, the possibility of ending up with this result would be minimized.

What History Tells Us

We have learned lessons from past experiences in international trade. After the Great Depression, each country adopted policies to impose tariffs on imports with the aim of protecting domestic markets at the expense of neighboring countries. Eventually, such policies hurt every country. It was an example of the prisoner's dilemma. To prevent it from happening again, the GATT, the predecessor of the WTO (World Trade Organization), was formed. ("GATT" is the name of the organization as well as theagreement.) The fundamental principle of GATT was collectivism in which each country would not engage in competition to increase tariffs.

　

As an agreement, GATT stipulates in the Article 2 that no country will increase tariffs by more than what has been agreed. Trump scrapped this. This is a reckless attempt that ignores lessons from history that policies pursuing only self-interests result in devastation for every country, including the country which adopted such policies. It is only natural that Mr. Cohn, the Director of the National Economic Council (NEC), who had been lobbying against this measure, resigned.

The EU is tough. They proposed that retaliatory tariffs target bourbon, which is made in Kentucky, the home state of Republican Senator McConnell (the Senate Majority Leader), and Harley-Davidson, the corporate headquarters of which are in Wisconsin, the House Speaker, Mr. Ryan's state. This move led Republican leaders to turn against the tariff increase. (President Trump, in return, warned that the U.S. would also consider raising its tariffs on cars made within the EU bloc. He seems not to mind starting a trade war.)

In 2002, when the administration of President Bush increased tariffs on steel, the EU targeted orange juice from Florida, where the President's brother was governor, for retaliatory tariffs. At that time, Japan joined the EU to take the case of the U.S. tariff increase to the WTO and won the case.

China is also considering retaliatory measures against soya beans and corn, imports from the U.S., since they could be imported from Brazil and other countries.

This will have huge adverse effects on the U.S. as well. The Americans drink beer from a keg, which is a steel container, at parties. The industry producing kegs is complaining that if they are required to use more expensive steel to produce a keg, they could not compete against imports made of cheap steel. At the end, they would be forced to lay off their employees and shut down their factories. To protect the inefficient domestic steel industry, other industries, including those of kegs and automobiles that consume large amounts of steel will be forced to bear the cost, and, contrary to what was originally intended, many jobs will be lost. Many members of the Republican Party, which is currently in power, released a letter urging the White House to reconsider the measure. Needless to say, trade wars will eventually hurt consumers.

So, what should Japan do?

If no retaliatory measure is in place, the U.S., which broke the rule of law, will unilaterally benefit. As indicated in the prisoner's dilemma, one will be sentenced to severe punishment if the other confesses while one remains silent. This is exactly why Mr. Juncker, the president of the European Commission, said that it was not reasonable but there would be no other choice but imposing retaliatory measures. What if Japan announces increased tariffs on beef and cereals, which are produce of Republican-supporting farmers?

　

What would be even better for Japan is to declare that it will not go into any free trade negotiation with the U.S., not only for the U.S.-Japan Free Trade Agreement but also for U.S. participation in the Trans-Pacific Partnership (TPP), because the U.S. defies free trade and prefers a protectionist trade policy.

Due to the Trump administration's withdrawal from the TPP, the U.S. agribusiness industry will lose the Japanese market. This means that tariffs on U.S. agricultural produce will become higher than those from Canada and Australia. It has the same effect as increasing tariffs on U.S. agricultural produce. This is completely legitimate. It could be legally justified if the U.S. retaliates against retaliatory measures adopted by the EU. However, the U.S. has no means to retaliate against this Japanese initiative.

We need to be clever as well as wise. There are apparently things which we should learn from the more Machiavellian EU.

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(This article was translated from the Japanese transcript of Dr. Yamashita's column in "Webronza" on March 12, 2018.)