Trump's changes in US trade policy have put Japan in an even better position in bilateral talks

The Trump administration made two changes to its trade policy on May 17.

First, the Trump administration lifted tariffs on steel and aluminum from Canada and Mexico that it had imposed citing a threat to national security. (Tariffs on these metals from Japan and the EU remain in place). Second, the administration decided on a 180-day extension of the May 18 deadline for judging whether to raise auto tariffs in order to defend national security.

Good news for the auto industry

Higher auto tariffs, if imposed by the US, will have wide implications for the auto industry. As auto tariffs cover tariffs on auto parts as well, increased auto tariffs will affect, for example, finished products that the Japanese auto industry exports from Japan to the US‒its biggest overseas market‒as well as those it assembles at its plants in the US using parts from Japan.

Higher auto tariffs will mean lower earnings for the auto industry. If the industry cannot pass on additional duties to consumer prices, it will have to shoulder the extra costs. Even if the industry can do so, higher prices will reduce the amount consumers buy‒or seen from the auto industry‒the volume of sales, resulting in lower sales. The actual equilibrium point is found somewhere between, but the earnings for the industry will shrink at any rate.

Trump argues that any increase in tariffs should be borne by suppliers in exporting countries. However, this logic is mistaken (expect for extreme cases) in terms of economics. As Larry Kudlow, Director of the National Economic Council (NEC), admits, US consumers will shoulder part of the additional duties. Passing additional duties on to consumers may be rather easy for products that are very popular in the market, such as Japanese cars. Yet there is no way for the auto industry to avoid shouldering part of the higher costs associated with two factors: (i) lower earnings due to the inability to pass all the additional costs onto consumers and (ii) lower sales volumes due to higher prices.

In fact, higher tariffs on steel, a major material for automobiles, have already contributed both to higher costs of Japanese cars manufactured in the US and to downward pressure on earnings for their manufacturers. Thus the May 17 changes in trade policy must be good news for the auto industry.

The Rust Belt‒the key to the presidential election victory for Trump

Trump grabbed the US presidency after winning in the Rust Belt in the Mid-West‒a traditional stronghold for the Democrats‒by maintaining that free trade had stolen US jobs.

The Rust Belt is represented by the steel and auto industries. These two industries were once considered the symbol of American prosperity. What was good for GM (General Motors) was said to be good for the US.

The flood of imports, however, sent these industries into a decline. Gigantic ironworks fell into ruins. The city of Detroit, which thrived as a center of the US auto industry, went bust in 2014.

It was a matter of course that Trump, who won the presidency thanks to the victory in the Rust Belt, set out a policy of raising tariffs on steel and automobiles. In fact, higher steel tariffs have pushed up steel prices, providing a certain boost to the steel industry.

So, why did the Trump administration make these policy changes?

The downside of steel tariffs for the auto industry

Two factors were at work for Trump's changes in policy.

First, next year's presidential election is always on Trump's mind. His seemingly inconsistent behavior is in fact consistent in the context of winning the presidency. The latest policy changes likely stem from the conclusion that higher tariffs on steel and automobiles will not help him win the presidential election.

Let me focus first on the lifting of higher tariffs on steel and aluminum from Canada and Mexico. To begin with, such tariffs meant higher costs and lower earnings for US industry.The auto industry was hardest hit.

American cars exported to China were suffering from a significant increase in costs as they were subject both to the aforementioned higher tariffs and to tariffs raised by China. If additional duties on steel and aluminum push up the cost of automobiles by 10%, for example, the total cost will be 54% higher because China's retaliatory tariff of 40% amid the US-China trade war enters into the equation (1.1 x 1.4). In fact, the surge in costs dealt a major blow to BMW and Mercedes-Benz, which manufactured finished units in the US and exported them to China.

Meanwhile, the additional cost of automobiles exported from Japan is lower. The production of such vehicles is free from steel tariffs by the US, of course. Those exported to China are subject to a tariff of only 15%. In other words, there is a gap of 39 percentage points in tariff between US-made cars and Japan-made cars. Thanks to a relatively lower tariff, Toyota boosted its exports to China.

The US motorcycle manufacturer Harley-Davidson, which also uses steel as a key material, was dealt a double blow of higher steel tariffs and an additional tariff of 25% that the EU imposed in retaliation for the higher steel tariffs by the US. In short, the EU's retaliatory tariffs were added on top of steel tariffs. (As in the case of automobiles, if steel tariffs push up the cost by 10%, the total cost is 37.5% higher.)

Succumbing to cost pressures, Harley-Davidson could not help but transfer the production of its products destined for the EU market from the US to other countries. Trump, who had been praising Harley-Davidson as a real symbol of America, was so furious that he expressed support for the boycott of Harley-Davidson. But Trump was paying for his own mistakes (see, "Trump is enraged by Harley, but he deserves it as a result of his own actions.").

The impact of steel tariffs on agriculture in the Mid-West

Canada and Mexico took retaliatory measures like those taken by the EU against US farm produce. As demanded by the US, these two countries entered into negotiations to revamp the North American Free Trade Agreement (NAFTA), though reluctantly. The negotiations resulted in the signing of the US-Mexico-Canada Agreement (USMCA).

Yet the Trump administration did not refrain from raising tariffs on steel and aluminum from Canada and Mexico. In response, the two countries maintained retaliatory tariffs. The US market is extremely important for them; Canada is the largest exporter for the US, accounting for 16.7% of the US total imports for 2017 and Mexico is the fifth largest exporter, representing 9.1% for the same year.

Mexico, in particular, raised tariffs on dairy products from the US in retaliation. This dealt a severe blow to the farming industry in Wisconsin in the Mid-West, a traditional dairy production area in the US. It is reported that eight dairy farmers were forced out of business in each passing day.

If this situation remains unaddressed, Trump may lose the Mid-West, which overlaps not only the Rust Belt but also the Corn Belt, a leading agricultural region in the US. As American farmers have been traditionally supportive of the Republican Party, losing the Mid-West may mean a defeat in the presidential election for Trump.

The lifting of steel tariffs is a condition for approving the US-Mexico-Canada Agreement (USMCA)

In the USMCA, the three countries agreed to raise the percentage of US-made parts in finished products as a condition for the tariff-free export of automobiles to the US. This effectively meant that the US will allow such export only for finished products that can be described as almost US-made.

The US also won a deal from Canada and Mexico that will allow it to raise auto tariffs if autos exported from these countries exceed a certain number of units. In short, the USMCA was a desirable agreement for the US auto industry.

Canada, however, insisted that it will not give parliamentary approval to the USMCA unless the US lifts the higher steel tariff. Until the USMCA comes into force, NAFTA will remain in place. Canada and Mexico will not be hurt. But Trump cannot put into practice the deals he won in the USMCA.

The USMCA was also desirable for the US agricultural industry, which was affected by the US-China trade war, as it would help it regain the lost ground in the market. Putting the USMCA into force necessitated the lifting of the higher steel tariffs.

The auto industry's objection to auto tariffs

The US auto industry is against auto tariffs, claiming that they will result in higher prices, less demand, and fewer jobs.

It is unclear to what extent Trump is aware of the situation, but, unlike the steel industry, the auto industry involves a wide range of supporting industries as it assembles products from many different parts. Accordingly, auto tariffs affect not only automakers but also such supporting industries, ranging from materials and electronics. If higher auto tariffs reduce the earnings for the US auto industry, the demand for steel, a key material of automobiles, will decrease, pulling down the earnings for the steel industry as well.

Higher tariffs on automobiles, which are final consumer goods, have wider implications than higher tariffs on steel and aluminum, which are materials for other manufacturing industries. Higher auto prices associated with higher auto tariffs will reduce sales, which in turn will not only reduce the demand for steel and aluminum but also drag down the earnings for many car dealers across the US.

Trump must have been aware of the wider‒and probably more profound‒implications of higher auto tariffs than those of higher steel tariffs. He raised steel tariffs but has not raised auto tariffs.

Trump postponed the introduction of higher auto tariffs this time around as well. Although he often raised tariffs to obtain concessions from the countries thus affected, he seems to be toning down his intimidation as far as automobiles are concerned. He is just threatening to raise auto tariffs in the future unless his demand is met.

The legislative branch (Congress) versus the executive branch (the White House)

Another factor behind Trump's change of policy is Congress's objection.

In order to deliver on his campaign pledge to build a wall on the Mexican border for keeping illegal immigrants at bay, Trump declared a national emergency and redirected part of the defense budget to fund the wall construction. This constituted an annulment of Congress's resolution on the budget. Accordingly, Congress passed a resolution against the national emergency declaration with some of the Republicans‒who control a majority in both houses‒breaking away from the party line.

My previous article "Trump's approval rating will not fall despite Cohen's testimony" contains the following passage.

It is important to note here that the framework of the legislative branch versus the executive branch is also relevant to how Congress will respond to trade issues as in the case of the national emergency declaration. Under the US Constitution, the powers to address trade issues rest on Congress, not on the President. Congress just delegates such powers to the executive branch under special law. Nevertheless, Trump has raised tariffs on steel and aluminum and will raise tariffs on autos at his will by taking advantage of Section 232 of the Trade Expansion Act of 1962. This is something many legislators are uncomfortable with. In fact, a bill has already been submitted to the effect that it should be up to the Department of Defense, rather than the Department of Commerce, to decide whether there is a threat to national security as provided for in Section 232. It is reported that this bill has bipartisan support. Attention should be paid to how Congress will act in trade issues.

There is a bipartisan agreement on the need to take a hard line against China. Even Senate Minority Leader Chuck Schumer (D-NY), who has always been at loggerheads with Trump except for the issue of infrastructure development, urged Trump to remain firmly resolved on China and not to back down.

This stance is gaining the understanding of legislators who were originally opposed to raising tariffs on Chinese goods. And it should be noted that the legal basis for such higher tariffs is not Section 232 but Section 301, a statutory means the US government has often taken advantage of.

Yet Congress is showing bipartisan opposition to raising auto tariffs due in part to pressure from the auto industry. On May 8, 159 House of Representatives members (78 Democrats and 81 Republicans) sent a letter to National Economic Council Director Larry Kudlow, urging him to advise Trump against raising auto tariffs. The letter argued that such action will have a chain of negative effects on the supply chains and shrink the American economy. It also maintained that higher auto tariffs will invite retaliatory action, which in turn will adversely affect the agriculture and manufacturing industries as well as consumers in the US.

At a deeper level, there is a bipartisan ill feeling in Congress that Trump is infringing on the intrinsic power of Congress to decide on tariffs by arbitrarily revoking Section 232. In more practical terms, if higher auto tariffs have a negative impact on the constituencies, legislators of the governing Republican Party, to which Trump belongs, will have fewer chances to be reelected. If their activity becomes sluggish, Trump's election campaign will be affected as well.

Tokyo is even better positioned in negotiations

The US threat of higher auto tariffs drew Tokyo to the negotiating table on bilateral trade. In light of opposition by the US auto industry and Congress, however, it is unlikely that Trump will raise auto tariffs in 180 days. The threat has been significantly reduced.

Even if the US does raise auto tariffs, Japan may impose retaliatory tariffs on US farm produce as the US Congress fears. Fear of the possibility of being retaliated against will make Washington have second thoughts about tariff increases.

It seems reasonable to conclude that Tokyo is even better positioned in negotiations with Washington.

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(This article was translated from the Japanese transcript of Dr. Yamashita's column in "RONZA" on May 24, 2019.)