Trade analysis (often) assumes one-step trade; companies live in a world of global value chains.
Trade impact analysis tends to model trade as a good produced in country A being sold for consumption in country B. A tariff creates a price wedge between what consumers pay and what producers earn, reducing trade and shifting economic activity to where the market is.
However, an increasing share of global trade follows a different dynamic. The many different steps through which goods are produced are often fragmented across different locations, creating so-called global value chains or nets. The development of these global value chains has been a key driver for world trade to grow much faster than world GDP—the same goods are moved across borders (and counted as trade) many times before they reach the final consumer.
In a global value chain, tariffs play out somewhat differently from the traditional model. A tariff makes a location less attractive because it raises import costs. Both imports and exports will fall. This can shift production away from the country that is “protecting” its producers, in particular when other countries retaliate and impose tariffs of their own on the final product. Global value chains also provide opportunities for firms to avoid tariffs by relocating individual activities. Tariffs then fail to “protect” the entire value chain and benefit only the small set of activities that need to be in a located in the market concerned for the tariff to apply.
The global automotive industry is a poster child for global value chains and shows how these dynamics play out. Many European producers have US factories from which they serve Asian markets, drawing on European parts and components. A US tariff could easily undermine this model, even more so when China reacts by imposing further tariffs of its own. This would make the US less attractive as a production site, not more. The global automotive industry has a long tradition in managing tariffs: producers sometimes export ready-to-assemble kits to markets with high tariff protection for finished cars, creating minimal value-added in these markets themselves.
Firms should assess their exposure along the value chain and review their options to respond as trade policies change. They will be affected by tariffs in many supplier industries, not just their end-product market. Global value chains create more exposure but also more flexibility. Firms with a larger global footprint will be advantaged through their broader ability to respond to changes in trade policy conditions.
It is not the tariff rate that matters most, but the market elasticities.
It is the tariff rates and the value of the trade affected that make the headlines on trade policy. But how they affect firms in the markets in which they are applied depends significantly on the demand and supply elasticities. How much of the tariff can be pushed over to customers? How easily can domestic producers step in and take market share? Are there third-country producers that are not covered by the tariffs and might be able to step in?
This affects the overall welfare gains but, more important, has dramatic implications for how economic value is redistributed among consumers, domestic and foreign producers, and the government. A high tariff in a market with low elasticities matters little to firms; it just taxes local consumers. A low tariff in a market with high elasticities, however, can dramatically change market shares.
This bias also affects the metric often used to measure protectionism: trade-weighted average tariffs. Here the level of protection is assessed by the level of trade that still occurs, not by the level of trade that has not taken place because of the tariff.
Firms should deploy their deep understanding of the market dynamics that they are exposed to and not get distracted by the nominal tariff rates. Firms with attractive (that is, differentiated) positions in attractive markets (with high entry barriers, high switching costs, products critical for consumers, and the like) will suffer the least.
Tariffs are a visible sign of protection, but non-tariff barriers have an increasingly more powerful impact on competition.
Tariff rates are transparently laid down in official rules and regulations, setting rates for very narrow product categories. The reduction in tariff rates over the past couple of decades has been very visible and has symbolized the reduction of trade barriers that has been achieved.
While tariffs have become less of a burden, the role of so-called non-tariff barriers that arise because of different rules and regulations across countries has grown. These non-tariff barriers include a wide range of policies, from local content requirements to health and safety standards. In a world of global value chains, investment regulations, including dispute settlement mechanisms that give foreign investors recourse against home country policy decisions, are part of this set of rules that matter. They are called barriers, but unlike tariffs they cannot be simply eliminated; they reflect issues that governments have a fundamental responsibility to organize in some way irrespective of trade.
Firms need to be aware of the impact that these rules and regulations have on their costs as well as on their competitive position relative to rivals. Contrary to tariffs, there is no profit shifting to governments, but there are costs from meeting specific national requirements. The complexity of these rules is in itself a cost, and often one that larger firms are better positioned to manage.
Adjustment can be costly but is usually not included in assessments.
Economic models tend to compare equilibrium situations: what does the world look like now, and how will it look like with the tariff(s) in place? This is a reasonable approach, especially when looking at aggregate changes in welfare. But it can miss significant adjustment costs as value (and production) is shifted around. It can understate short-term implications, for example the temporary over- and under-shooting of investment across different locations as companies adjust their production footprint to a new trade policy environment. And if decisions about costly adjustments have to be made in an environment where the long-term trade policy context is uncertain, it might lead to a backlog of postponed investments with consumers paying higher prices in the meantime.
As an example, think about the highly integrated US-Canadian automotive industry in the Great Lakes region. Building new plants in the US and training a new workforce will take time and resources. It will also lead to economic fluctuations: Assume that the current capital stock across the US and Canada is divided 80:20. With higher trade costs, that optimal division might now shift to 85:15. This implies not only that Canadian automotive investment drops by a quarter from now on. It also means that in the intermediate period investments in Canada will drop by even more until the lower new capital stock ratio is reached. And if US producers are unsure about the level of capital stock they should have in the US longer term, their investment in the US might not fill the gap with higher prices and lower output as the result.
Firms need to analyze the relevant adjustment path of the economy and what it means for them, and not just look at the potential new end state. Long-term market elasticities tend to be higher than short-term elasticities. Short-term movements in prices and investments might overshoot their long-term levels. And any adjustment requires investments to be made. Firms need to ensure that they have the resilience to manage these fluctuations.
Benefits from tariff protection are not a windfall—they come with expectations attached.
Tariffs are generally imposed with the purpose of increasing domestic production and employment, not to generate tariff revenues or create profits for domestic firms. But in most economic models, the tariff revenues do play a significant role in making protection a potentially welfare-enhancing policy intervention. Beyond that, policy makers hope that protection will encourage domestic producers to shape up and become more competitive.
The evidence on whether this actually happens seems to depend on local market conditions as well as the performance gap between domestic and foreign producers. The critical view of traditional industrial policy was the result of many cases in which the benefits from protection or government support were not invested in creating more competitive firms. Concerns about Chinese industrial policy are conversely driven by the view that government subsidies and a protected home market have enabled Chinese firms to build a war chest that they are investing in market positions and technological leadership.
Firms benefiting from tariff protection thus need to embrace a two-step task: First, exploit the change in market context to enhance current profits through a combination of gaining volume and raising margins. Second, decide whether to invest in strengthening capacity and capabilities with a view to compete more successfully in the future, with or without protection. The expectations from policy makers will be that firms raise volumes and invest. This might not always be the profit-optimizing choice. Firms need to be aware of the political repercussions of their choices.
Protectionism alone will not trigger a global recession, but its macroeconomic repercussions could.
The overall loss in global GDP predicted by traditional models from even a substantial increase in tariff rates is meaningful but far from dramatic. Studies to model a breakdown of the WTO system with all countries moving to non-cooperative tariffs predict average tariffs to rise to between 35% and 60%. Global trade would suffer, but global GDP would drop by only 3%. Countries with higher trade exposure would be hit harder—this was also true during the global financial crisis—but these also tend to be economies with higher competitiveness that are able to recover more quickly.
So is the fear unfounded that protectionism could trigger global growth to stumble? Not entirely. It will depend on how protectionism shapes the broader view investors and financial markets take about the future, and what repercussions their actions might have. Investment reluctance due to higher uncertainty could reduce momentum. Expectations of rising inflation due to higher import prices could lead to a tightening of monetary policy that slows growth. And a higher pricing of risk could lead to substantial redirection of financial flows, for example out of emerging economies that are more reliant on trade and generally more volatile. These macroeconomic repercussions are the reasons central banks and international organizations come to more pessimistic assessments of the impact that a trade war could have. In fact, the Bank of England assessment views such secondary effects to weigh much more on the UK economy than the direct effect of higher tariffs.
Firms should be aware of these risks to the global economic climate that the trade policy disputes have created, despite the seemingly moderate direct effects on global GDP predicted. Being resilient, and having plans for how to manage a changing economic climate, has therefore become more important.