Tariff threats are damaging, even if not executed
Donald Trump’s (temporary) retraction of his 25% tariff threats on Mexico and Canada caused major relief in financial markets. Though the retraction is clearly welcome news for the global economy, the continued threat of tariffs is problematic on its own (even if tariffs are never implemented). Indeed, as historic examples such as the 2018 trade war and Brexit show, trade uncertainty can cause significant declines in business investment, thus affecting GDP growth. Unfortunately, as Trump’s tariff threats hang as a sword of Damocles over the global economy’s head, we can expect lower rates of US and global business investment growth over the next four years.
Introduction
Donald Trump is bombarding countries around the world with tariff threats. From Colombia, to Taiwan, to Denmark, countries all over the world have been threatened with exorbitant tariffs. Most recently, Trump threatened to impose blanket tariffs on Canadian, Mexican and Chinese products from 4 February onwards.
The 10% tariffs on Chinese imports have come into effect, prompting retaliation from China. However, the 25% tariffs on Mexican and Canadian imports have been suspended by a month, as both countries’ leaders vowed to help stop the flow of migrants and fentanyl into the US. The suspension of tariffs is clearly good news. The implementation of such elevated tariffs on two important trade partners would have been very damaging to the US and the global economy (see also our opinion of 24 January). That said, the continued threat of tariffs (even not implemented) will create problems on its own.
Tariff threats undermine investor confidence
Tariff threats create an uncertain business climate. Indeed, as companies don’t know how high tariffs will end up being, they might alter their behaviour in economically damaging ways. They might delay or even cancel some investments. They might increase inventories, relocate factories or build up excess capacity, raising their costs and lowering productivity.
Surveys show US businesses are taking current tariff threats very seriously and indicate they might implement significant operational changes in response. A CBIZ-Hofstra Survey interviewed 256 US middle-market CEO’s on their response to the tariff threats. The responses were concerning: 80.9% of participants considered relocating production, 75.4% said they may reduce their workforce, 72.3% planned to delay investments, 66.4% were exploring new supplier options and half of respondents were contemplating price increases1. Needless to say, such actions would severely hinder GDP growth in aggregate.
Impact on the wider economy
So how would this trade-related investment uncertainty impact the wider economy today? The 2018 trade war during Trump’s first term can give us an indication of its economic implications. An FOMC memo back then estimated that the trade policy uncertainty reduced the level of aggregate investment by 1 to 2%, thus dragging down GDP by 0.25%2.
However, the trade uncertainty now is far larger today than during Trump’s first term. Trump’s tariff proposals have far higher percentages now and target a wider range of countries and products than in 2018. Consequently, the US Trade Policy Uncertainty Index, an index compiled using text-based analysis of newspaper articles, reached all-time highs and is now far above the peaks observed during the first trade wars (see figure 1). Furthermore, the trade war is likely to last much longer this time. Back in his first term, Trump only launched the trade war two years into his term. Now tariff threats are likely to persist during the next four years.
Another interesting comparison might be the uncertainty the UK endured during Brexit. The Brexit vote happened in June 2016, but only came into force 4.5 years later. US trade (imports + exports) with the wider world accounts for 24.9% of GDP. UK trade with the EU was only slightly lower in 2016 (20% of GDP). Similarly to the US today, the UK Trade Policy Uncertainty Index spiked to historic highs in the post-referendum years. Unsurprisingly, UK business investment took a big hit post-referendum. Business investment was growing at about 6% per year between 2011 and 2016, but was almost flat in the post-referendum years (between 2016 and 2019). Two UK economists made a counterfactual analysis, estimating what UK business investment would have been from 2016 to 2022 had Brexit not happened (using long-term averages and adjusting for the pandemic). They estimate that business investment would have been 10% in 2022 had the Brexit vote not happened3 They also estimate that GDP would have been 1.3% higher in that case. A doppelgänger analysis, using input data from 22 other advanced economies, yielded similar results (i.e., 11% shortfall in UK business investment by Q2 2022)4.
That said, a hard Brexit scenario would have been highly disruptive, not only pushing tariffs up but also creating non-tariff barriers to trade. The hit on US investment today is thus likely to fall between what the US experienced in 2018 and what the UK experienced post-Brexit referendum. In its October World Economic Outlook, the IMF envisioned a scenario where the US, the euro area and China impose a 10% tariff on each other’s imports and the US imposes a 10% blanket tariff on all imports worldwide by mid-2025. The investment uncertainty in this scenario would cause a 4% decline in US business investment. Though the direct effect of tariffs would push US GDP levels down by 0.5% by 2026, this decline doubles when the investment uncertainty effect is added.
Conclusion
The investment uncertainty created by tariff threats can create serious economic cost on its own even if tariffs are never implemented. Historical examples and current analyses show they can cause serious hits to business investment and cause material hits to GDP growth. As the trade-related investment uncertainty is likely to last during the full second Trump term, a material hit to GDP can be expected.
2 “Trade Policy Uncertainty and the U.S. Economy”, 2018, Steven B. Kamin and David W. Wilcox
3 How has Brexit affected business investment in the UK? - Economics Observatory
4 The cost of Brexit to June 2022 | Centre for European Reform