Tariffs

Today's entry is an excerpt from my new book, FQ: Financial Intelligence - 

Tariffs

I should have included this in Module 7 but since it’s a late addition, I’m giving myself a pass.

But I felt compelled to include it since it is all over today’s news and universally misunderstood.

First, let’s look at the supply chain. Left is a simplified visual.

At any point in this chain, products may traverse borders, whether they be component parts or completed goods, and thus may be subject to levies from the importing country. A tariff is the fee (duty) paid by the exporter to the country receiving their goods. Albeit some will quibble, technically, it’s a tax. What purpose does it serve other than to raise money for the taxing country? It is meant to ‘level the playing field.’

Here’s a simple example: BMW exports automobiles to the US from Germany. The cost to the US auto distributor purchasing said vehicles is $5,000 less than a comparable US-made auto thus making the BMW more financially attractive to the American consumer. The US government levies an equivalent tariff, thereby eliminating the German company’s competitive advantage.

Tariffs are designed to protect a nation’s domestic businesses from lower-cost foreign alternatives. Sometimes, off-shore entities simply make a cheaper, better product. Staying with automobiles, in those pesky 1970s, Japanese imports took away huge market share from US manufacturers who were slow to adapt to rising oil prices (and who were producing inferior vehicles). Other times, however, foreign governments subsidize their home-grown companies thus artificially lowering their export cost. Tariffs are designed to discourage this behavior.

So, who ultimately pays the tariff? Government pundits will swear the foreign entities absorb the cost, but the math says otherwise. In virtually all cases, the foreign company will pass along the cost by raising prices. The domestic entity then has to decide how much of this increase they will push down the supply chain. Usually, it’s much.

Over 90% of the tariff will ultimately be paid by the consumer. Harkening back to our supply and demand curves of an earlier module, the impact may be a decrease in demand or an increase in supply. Regardless, someone takes a financial hit. That someone will most likely reside in the country levying the tariff! An additional unintended consequence may be inflation, a reduction in corporate profits, or a dreaded trade war where there are no winners, only survivors.

Now, it’s not all gloom and doom. In the case of BMW, they decided that one way to defeat the tariffs was to move production onshore. Building US plants and hiring US workers is great for the US economy and a wonderful public relations coup for BMW. Many foreign companies don’t have that luxury, so tariffs may adversely affect their exports and their domestic economy in turn.

In addition, levying pejorative tariffs may dissuade a foreign nation from manipulating the supply chain. But that may also come at the risk of throwing cold water on the economy of the tarifee while the effects shake out. So, it becomes a case of trading a short-term pain for long term gain which is NOT the standard operating strategy of any freely elected politician. To a large degree, it’s a game of economic chicken where the one who swerves will invariably be the one who has the most to lose.