Tariffs and Uncertainty

Tariffs are in the headlines. Most economists agree that tariffs are inherently inflationary. But the inflation can take many forms and depends upon business reaction in addition to governmental responses. There are many ways for business to cope with tariffs. It's this wide variety of possible responses that have raised uncertainty levels in the markets as much as uncertainty of the actual imposition of tariffs.

According to the Fractal Market Hypothesis (FMH), an increase in long-term uncertainty would result in short term behavior and actions. I originally formulated FMH for security market participants, but I believe it's just as valid for the broader economic marketplace as well, including businesses and consumers.

But how markets and consumers react will largely be dictated by the path that businesses take. It might be useful to list some of the strategies that businesses could take to cope with tariffs.

Business Strategies to Cope with Tariffs

First, lets reiterate what we're talking about. Tariffs are an import tax by the federal government on domestic businesses. This import tax increases the cost of production if it's on materials or components as well as increasing the cost of finished products to retailers. The tax is paid by importers, not exporters. So in the case of the United States, an increase in tariff rates on Mexican goods means that American businesses will pay a tax whenever they import something from Mexico. Raising tariffs are raising taxes. Tariffs are not considered a free market strategy, but a protectionist activity imposed by the government. That is, they are implemented so the government can protect domestic producers from foreign competitors, or to encourage domestic production using domestic materials and labor. Both goals conflict with a free market philosophy where the market decides how resources are allocated, not the government.

But tariffs have long been a part of economic history. So how do businesses cope with them?

Strategy #1: The exporter eats the tariff

If the tariff is small enough the exporter may reduce the price so that the importer pays the same after-tax price. In this case the exporter basically pays the tax to the importing government. So the exporter loses and the government gains. This is the only outcome where US businesses and consumers would not be affected by the tariffs. Unfortunately it only works when tariffs are around 2% (the level of most US tariffs). Also this circumvents a tariff's protectionist goal.

Strategy #2: Currency Devaluation

Exporting countries can also devalue their currency. This would lower the cost of their goods and compensate importers for increased taxes. If the US dollar continues to strengthen, however, then devaluation will happen with no action by other governments. Currency devaluation is usually a last resort by the exporting country. It also circumvents the tariff's protectionist goal.

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Strategy #3: The importer pays the tariff

This is where possibilities multiply. If the business pays the tax and keeps their prices the same, their profits will drop. Since Milton Friedman said that the mission of business management is to maximize shareholder value, its unlikely businesses would take such an action. Instead the cost of the tax will be passed along the supply chain. There are several ways this can happen:

• Inflation: The simplest outcome. Businesses raise prices so that profits remain steady. Consumers end up paying the tariffs. If wages don't raise accordingly then spending will likely decline resulting in a recession.
• Shrinkflation: This is really a subset of inflation. Business don't raise prices, but instead cut back on the quality or quantity of their products. This is a way of manipulating consumers so that they don't realize they're paying more. There may be fewer potato chips in a bag of similar size. It's only if you look at the weight that you'd notice. Processed foods like candy bars or Pringles may become smaller for the same price. For cars, items like blind spot sensors would become options where before they were standard. But the price for the car stays the same. This doesn't work for raw goods. So if the price of an avocado goes up there's no hiding that.
• Stagflation: The hypertext book discusses the three different causes of inflation that lead to Inflation Regimes. Tariffs don't fit into any of those categories directly. In fact tariffs might lead to stagflation where prices rise, but demand slows or even falls if wages don't keep up. The previous list included: (1) an increase in demand, (2) a decrease in supply, or (3) an increase in money supply.

Higher Uncertainty

Only strategies #1 and #2 are really helpful to the economy because they're neutral. Targeted tariffs can sometimes be helpful, but even then there can be unexpected consequences. For instance, a 35% tariff on Chinese tires by the Obama administration in 2009 saved some jobs in the US tire industry, but also raised the price of low-cost tires for US consumers. The result was a high cost per job saved.

In any case, potential benefits from tariffs are always in the future since they require domestic producers to create new facilities of production. With the impact and time frame of those improvements so far away, near term uncertainty is likely to rise. For the markets this will likely result in higher volatility while the story unfolds. So far, markets have been very sanguine about these events, mostly being happy that tariffs were not imposed on Day 1 of the new administration. But with the start of trade wars over the weekend, that could change.

The Outlook

The Market Uncertainty State Indicator (MUSI) remains at Neutral. But the effects of tariffs have not been incorporated into the market prices at the time of this writing. There's always a chance that the tariff's won't actually be imposed, or they may be more limited than those announced on February 1.

Please comment on this post if you're so inclined. And feel free to forward this post to anyone you think would find it interesting. Thanks for reading!

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