A Cruel Irony: U.S.-China Tariffs Could Cripple U.S. Manufacturing And U.S. Economy

by: James A. Kostohryz

Economists as a group - including those on President Trump's economic team - have badly underestimated the impact that a US-China "trade war" could have on the US economy.

Ironically, the US manufacturing sector will be severely harmed by a sharp increase in US-China bilateral tariffs.

Most economists severely underestimate the importance that a shock to the US manufacturing supply chain would have on the overall US economy.

Tariffs on virtually all Chinese imports (totaling about $540 billion annually) are scheduled to rise to 25% within the next few months unless an agreement is reached between the US and China and/or both sides postpone the implementation of the threatened tariffs.

President Trump, his economic team and virtually all economists are largely unaware of the damage that the threatened tariffs - and threatened non-tariff measures - will potentially wreak on the US manufacturing sector and the broader US economy at large.

In this article, I will briefly provide readers with certain critical pieces of the analytical framework and data that they need to see why the consensus opinion of economists and financial markets commentators are currently "flying blind" on the threat that this issue poses. I also will point out how readers can explore this issue in more depth.

Why Many Economists are Underestimating the Risk Posed By Tariffs

Many economists are fundamentally confused about the impact of the proposed tariffs on Chinese imports on the US economy. Generally, economists are treating tariffs as if it were a broad tax on consumption rather than a highly destructive shock to firms in a strategically vital segment of the US economy.

Many economists are essentially reasoning as if all Chinese imports were imposed on consumer items (and/or that the cost of tariffs will more or less seamlessly be passed through to consumers) and that tariffs will act more or less as a tax on the consumption of those items. Assuming that consumers could not substitute their consumption of these goods and that they would not reduce their consumption of these items, this would imply a tax on us consumers that would be equivalent to a tax of about 0.9% on all US personal consumption and less than 0.65% of US GDP. Since economists are generally figuring that consumers and producers can and will substitute their consumption of Chinese goods for consumption of other imported and/or domestically-produced goods, they estimate that the impact of the proposed tariffs on US GDP will be even less than the 0.9% tax on consumption (about 0.65% of GDP) would imply.

Many economists are essentially operating with formal and mental models that compute the impact of tariffs in much the same way that a "bean-counting" accountant's clerk computes a company's costs for purposes of preparing an income statement. They are computing the total "cost" of the proposed tariff on Chinese imports (adjusting for substitution and other minor effects) and apply it to the entire "economy," as if the cost of tariffs were being more or less evenly distributed among millions of US consumers. Based on this sort of formal and mental modeling, these economists assume that a "consumption tax" of 0.9% that was evenly spread out among consumers could fairly easily be absorbed by the US economy without threatening the business cycle.

The problem with this conventional analysis is not with the deduction; it's with the assumptions.

Tariffs on Chinese imports are not primarily taxes that will be paid by consumers. They are a tax which will directly impact the supply chain of many US businesses by raising input costs. More importantly, the impact of these taxes on the US supply chain will not be evenly spread out. The impact will overwhelmingly be felt by a limited number of businesses in the US manufacturing sector that can scarcely afford to take such a hit. This concentrated impact, in turn, causes large indirect effects and multiplier effects.

The Impact on US Firms

Tariffs imposed by the US on foreign imports are taxes that primarily affect the input costs of US businesses. As can be seen in Figure 1, approximately 64% of US imports from China are intermediate goods or capital goods purchased by US businesses, overwhelmingly in the US manufacturing sector.

Figure 1: Tariffs On Chinese Imports Directly Hurt US Manufacturers

Therefore, rather than hitting consumers directly, the taxes on critical supply-chain inputs from China will directly hit the profitability and/or competitiveness of US firms, primarily US manufacturers - at least in the short and intermediate term.

As important as it is to understand the fact that tariffs will have a negative impact on many US businesses, it is perhaps even more important to understand that the cost of these tariffs will not be spread out evenly among US firms. The fact that some US firms will be hit disproportionately hard by the tariffs will generate negative multiplier effects for the US economy.

A select sub-sector of US firms in the manufacturing sector will be the hardest hit. By contrast, US service industries import relatively little by way of intermediate goods or capital goods.

How Will US Manufacturers Be Impacted?

To get an idea of how badly tariffs can hit US manufacturers consider this:

  • Total value added by US manufacturing was $2.335 trillion in 2018.
  • In 2018, the total value of intermediate goods and capital goods imports from China was about $346 billion.

In other words, the value of imported goods from China represents about 15% of the value added to US manufacturing.

This does not mean that imported Chinese goods represent 15% of a manufacturer's annual costs - among other reasons because the cost of capital goods is spread out over a number of years. However, this figure provides an idea of how important Chinese imports are in the US manufacturing production supply chain.

On aggregate, based on input/output data, I estimate that imports of Chinese goods probably represent a bit more than 7% of total annual input costs for the US manufacturing sector.

However, this is an aggregate figure. For close to half of all manufacturing industries - such as food, beverage and tobacco processing, chemicals and wood processing -- the impact of the increase in Chinese tariffs will be relatively minor. However, for the most complex and highest-value added industrial firms in the US economy, such as autos and computers/electronics, the impact can be quite significant. I estimate that imported goods from China represent roughly 10% of the annual costs of high-value-added producers, with the figure for many such firms surpassing 25%.

What will this hit to high-value-added US manufacturing firms mean for the US economy? The impacts are manifold, but I will only mention two direct effects here.

Dead-weight losses. Of course, some firms may be able to substitute the goods provided by Chinese suppliers with goods supplied with domestic firms and/or other foreign firms. However, these will necessarily be second-best alternatives. Goods sourced from other suppliers will necessarily be either higher priced, of lower quality, or both. Building manufactured products with second-best alternatives have significant dead-weight costs for the economy. For example, the higher cost of a product produced with more expensive inputs will lower consumption of other products. Furthermore, lower quality products produced with lower quality inputs will create costs for both producers and consumers. While the deadweight losses for US economy will be significant in the short term and intermediate term, any net benefits of shifting the supply chain away from China will accrue only in the long-term, if at all.

Microeconomic multiplier effects. In a report published in Successful Portfolio Strategy, I describe these effects in greater detail. Here, I will only point out that many firms will be faced with extremely difficult microeconomic problems. Examples:

  1. Firm raises price and suffers decline in sales. Many firms that attempt to raise prices will experience a major slowdown in sales. It will take significant time before many firms are able to fully pass on additional direct and/or indirect costs of tariffs.
  2. Firm raises prices and loses market share. Many firms that raise prices will become less competitive and lose sales to foreign competitors - for example, German or Canadian firms -- that are not affected by higher tariffs.
  3. Major decline in profits. For those that are not able to pass through the higher cost of production, but which desire to maintain market share, they will be forced to suffer a major blow to profitability. The sharp decline in profitability greatly impacts hiring and capital investment.

The firms that will be hardest hit by tariffs will be in the middle of the value chain - firms that will be hit directly by higher costs, but which do not have sales/distribution to final consumers. Such firms have very limited pricing power vs. oligopolistic buyers. Thus, their ability to pass through these costs will be limited.

Many firms faced with the situations described above will slash costs by reducing employment and slashing capital expenditure plans. Some firms undergo more drastic restructuring.

It needs to be remembered that most US manufacturing firms are mature businesses with slim profit margins and high operating leverage. A relatively small increase in costs can, therefore, have a drastic impact on profitability.

And for many firms with high levels of financial leverage, sustaining a large hit to EBITDA can cause a liquidity crunch and financial distress.

How Badly Can A Manufacturing Supply Chain Shock Impact the US Economy?

A major shock to the US manufacturing supply chain, such as a sudden 25% increase in the cost of certain key components, can cause an abrupt slowdown of purchases and/or production in various manufacturing industries. This is particularly for those industries in which it's difficult to seamlessly pass on the increase in costs all the way through the supply chain. Production and sales in these industries can suffer a severe slowdown until the price shock is full absorbed, supply and demand schedules are reset, and supply chains are shifted.

Prior to full implementation of tariffs against China, US industrial production already is in the midst of a major slowdown. With full implementation of the tariffs on both sides, plus potential additional non-tariff measures, US manufacturing can be expected to enter into a sharp contraction.

In Successful Portfolio Strategy I analyze in significant detail the full impact that a full-fledged "trade war" would likely have on the US economy. Here, I will only briefly point out that a significant and prolonged shock to the US manufacturing supply chain would be sufficient to trigger a US recession. There are two main reasons:

1) When properly accounted for, US manufacturing drives over 40% of all private economic activity.

2) US manufacturing drives the US business cycle. US manufacturing activity accounts for significantly more than 50% of the cyclicality in the US economy.

Thus, a sustained contraction in US manufacturing production - which drives more than 40% of all private economic activity in the US economy and well over half of the cyclicality - would certainly throw the US economy into recession. In Successful Portfolio Strategy I have published a report in which I show that a full-fledged US-China Trade war could induce a contraction of well over 5.00% of GDP in the US economy. This includes microeconomic multiplier effects, impacts on capital investment and other factors.


There's a very real sense in which President Trump has correctly identified the importance of US manufacturing to the overall US economy. Indeed, President Trump's trade policies have been designed to help US manufacturing. However, there's a cruel irony that Trump and his team do not fully understand. A large increase in tariffs on Chinese imports (such as the proposed 25% tariff President Trump has threatened to "shortly" impose on all Chinese goods) will constitute a supply-side shock that will hit many US manufacturing firms very hard.

While reasonable people can differ on whether or not President Trump's policies will bring long-term benefits to US manufacturing, it's a fact that in the short term and intermediate term, US manufacturing will, on balance, be significantly harmed by tariffs on Chinese goods. US manufacturing will be similarly harmed by tariffs on imports from Mexico if those threatened tariffs actually materialize.

It's my view that the potential harm that can be wrought by a large bilateral increase US-China tariffs would suffice to trigger a US recession. To say that President Trump and his advisors are insufficiently knowledgeable about this is not a special critique of President Trump and his economic team. The overwhelming majority of mainstream economists clearly don't understand this issue.

On this particular issue, economists as a group are today proving to be as non-insightful regarding the dynamic risks that tariffs pose as they were in 2006-2008 when the US economy was facing grave risks due to developments in the mortgage security and housing markets. At that time, most economists failed to realize that defaults on a relatively minor percentage of mortgage loans could have enormous ripple effects throughout the financial system and the broader economy. Currently, most economists are grossly underestimating how a tax hit that, from an accounting point of view, can probably be measured as amounting less than 0.5% of US GDP (once substitution effects and other are taken into account) could throw the entire US economy into a severe recession.

In this article, I have provided readers with key conceptual tools and data that they need to properly understand the dangers potentially posed by a "trade war" with China. If you wish to explore this issue further and how it impacts the US business cycle, I invite you to consider Successful Portfolio Strategy.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.