10/1/20: U.S. Tariffs on European Wines: Inflicting Self-Harm

Next week, the  Office of the US Trade Representative is expected to make a determination on the potential imposition of an up to 100% tariff on imports of wine from Europe. Which is a bad thing for the overall state of the global trade, bad news for the European producers of wine, bad news for the American consumers and their European counterparts, and bad news for the U.S. wine industry. But 'bad things' do not stop there. There will be costs imposed on restaurants and bars. There will be negative spillover effects - in the long run - to the competitiveness of the U.S. wine making industry competitiveness. In other words, the new tariffs are a perfect exemplification of how poor policies in one sector can hammer the entire complex chain of value added across a much broader economy, both in the long run and the short run.

Let's start from the top.

Causes

The reason for the introduction of the tariffs on wines made in Europe - the first wave of which came in in October - has absolutely nothing to do with the wine makers or wine importers or wine consumers. Back in September this year, the WTO Arbitration Panel has ruled that Boeing (the U.S. civilian aircraft manufacturer - in addition to being also a major military-industrial complex player) and Airbus (Boeing's European counterpart) received tens of billions in illegal state supports and subsidies over the period of 15 years. These supports included tax subsidies and credits and subsidised loans. All of which was well known to anyone even remotely familiar with economics of both the EU and the U.S. well before the WTO rulings.

Given the state of the U.S. trade policy (War First, Trade Later) and the fact that Boeing is in a pile of financial problems stemming from its disgraceful handling of the 737 Max scandal, the U.S. rushed out of the stables to mount its trade offensive against the EU. imposing 25% tariff levy against European wine producers. The measure, of course, was 'designed' (if one call it thus) to hurt European economies. Wine industry is iconic for countries like France (Airbus major domicile), Italy (which hasn't much to do with Airbus and was partially spared from the hit) and Spain (another Airbus HQ domicile). Germany also got hit, especially given its well known white wine production. Now, Airbus has also major presence in Mobile, Alabama, USA (where is works on A319, A320 and A321 models) and Mirabel, Canada (A220 model), although Chateau Mobile and the fabled reds of Mirabel were spared by the U.S. trade authorities.

The new round of tariffs - the 100% ones being currently considered - also come on foot of the finding that France’s new digital services tax discriminates against US tech companies, according to USTR, even though the French tax is a de facto precursor to the OECD's Digital Services Tax initiative (covered here: https://trueeconomics.blogspot.com/2019/08/12819-oecd-tax-plans-some-bad-news.html and, in more detail, here: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3406260).

European response to the same triggers was to call for a negotiated resolution of the disputes over Boeing and Airbus. Which, of course, is not how the U.S. does business these days.

First round impact

The first round of sanctions had little impact on the wine makers, hammering instead U.S. supply chain - distributors, warehousing, wholesalers and retail - and U.S. consumers (just in time for the Holidays season). The reason for this is that European producers have a massive latent excess demand for their wines in Asia-Pacific and Eastern and Central Europe, where consumers prefer European wines - by taste, brands and cost points - to the U.S. wines. U.S. distributors and wholesalers took a direct hit: most of the 25% tariff has been absorbed into lower profit margins by the importers.

One of the reasons this worked is that the U.S. demand for wine is growing, which means that for relatively benign tax hikes, suppliers can lower unit margins in hope of compensating with continued growth in demand.

Demand has grown from the recent plateau of 2 gallons pa per person in 1999-2002, to just under 3 gallons in 2018. This margins logic breaks down when tariffs rise above 35-40% mark, making cost pass-through to the consumers virtually unavoidable.

A message from the small wine importing firm, specialising on ESG impact-driven natural wines, makes another case: http://www.jennyandfrancois.com/2019/12/17/wine-tariffs-threaten-our-very-existence/. "These [proposed 100%] tariffs are really without precedent, but to glimpse a window on the possible disastrous consequences, we could examine the 1930 Smoot Hawley Act. History teaches us that this act hastened the arrival of the Great Depression, extended its length, led to a 65% downturn in global trade, and made imported goods a luxury item only affordable to the top 1% of the American population. What’s more, those tariffs were only between 40-48%, not the 100% tariffs currently in discussion. Smoot Hawley is the reason most of the world’s leaders today favor unregulated free trade." And "I spent 20 years of my life building a successful business, and in one signature the Trump administration could make it all crumble."

Killing wine wasn't a great policy back in the 1930s. For everyone involved. Hammering European wine today won't be either.

A wider impact can be seen in the restaurant and catering sector. Here is how disastrous tariffs on wine can be for restaurants business: https://www.postandcourier.com/blog/raskin_around/proposed-wine-tariffs-could-spur-widespread-charleston-restaurant-closures-opponents/article_3a07ee26-2e44-11ea-a9e1-b3eafe8429c4.html. "One downtown Charleston restaurant owner estimates the loss of Prosecco alone would amount to a $57,167 annual revenue loss... Just those drinks hypothetically work out to more than $1,000 a month in server tips, on average. Assuming that loss is equally shared by a 12-person front-of-house crew, each employee would be out approximately $94, or about two-thirds of the average monthly household utility bill in Charleston."

The impact is not lagged: "when the 25 percent tariff was implemented, Root says, “it became part of our working capital immediately. We had to come up with $40,000 unexpectedly” in order to free up wine which had already shipped. But he characterizes a 100 percent tariff as “impossible.”"

Even in the time-sensitive, so less tariff-elastic cases, it is the U.S. businesses that have been absorbing the lion's share of the cost increases, as illustrated by the 2019 vintage of Beaujolais Nouveau release last year that came after the 25% tariff hike of October 2. This is covered well here: https://www.winemag.com/2019/10/29/tariffs-on-european-union-goods-impact-u-s-wine-industry/. In theory, producers should be absorbing more of the tax increase cost in lower elasticity supply cases. But due to supply chain complexity and the fact that producers face global demand, with lots of substitution options, while the U.S. wholesalers, retailer and consumers have inelastic demand (due to timing-sensitive nature of the market for Nouveau releases) this is not the case.

Bad news for the U.S. producers

So higher tariffs on European wines should be a good thing to the American producers of wine, right? After all, as prices of their competitors rise, their products should experience increased demand due to consumer substitution in favor of cheaper alternatives.

This is a fallacious argument, given complexity of the wine business.

Firstly, price-sensitive consumers who have a greater incentive to switch away from European wines toward other alternatives are likely to go for cheaper Chilean and Australian wines instead of the already higher-priced Californian, Oregonian and other U.S. offerings.

Secondly, demand for all wine is likely to decline due to higher prices, but also due to the reduced range of wines that consumers might consider affordable to them. Consumers do not simply buy the wine by the price. Instead, consumers buy, say, California wine because they want something different from the Italian wine, and they buy Italian wine to diversify their consumption (broaden the range of taste options) from French offerings, and they buy French offerings because they have been consuming Spanish ones, and so on, until they reach back to California wines. It is exactly the same with food: making Thai cuisine more expensive does not necessarily mean Italian restaurants will gain more customers. Instead, it might mean that consumers will reduce demand for eating out in all restaurants and switch to fast food instead.

Thirdly, wine business is also complex. U.S. producers innovate and collaborate with European producers. Adversarial trade is not good for technology and intellectual property transfers between them. And U.S. producers are also worried about inevitable EU counter-measures. Worse, if tariffs were to trigger significant drop off in the number of wholesale, retail and restaurant businesses and trading volumes, smaller U.S. producers (who tend to be more innovative and have greater intellectual property investments in the industry) will have fewer channels to sell and market their own offerings. Here is one California wine producer views on the effect of potential decrease in the number of wholesale / distribution partners under the 100% tariffs proposal: https://tablascreek.typepad.com/tablas/2019/12/no-100-tariffs-on-european-wines-wont-be-good-for-california-wineries.html. To quote them on restaurants part of the chain impact alone: "Restaurants are famously low-margin businesses anyway. Increasing the costs of their wine programs will push some out of business, further reducing outlets for our wines."

Lastly, no U.S. producer of wine would want to face a prospect of their brand capital worldwide being associated with state-imposed tariff 'protection'. Majority of the American winemakers compete on their own creativity, experience, and marketing. In a highly product-differentiated world, hammer-all tax measures do little to help indigenous producers to succeed. They dilute quality of signalling that successful brands develop with their sweat and capital.

To quote, again, the excellent Tablas Creek folks (link above): "Why wouldn’t the wine community just switch its sources to other, non-tariff countries? Wine is not a commodity, where a customer can simply swap in a wine, even one made from the same grape, from one part of the world for another and expect them to be comparable. Wines are products inextricably tied to the place in which they are produced. And the disruption of 100% tariffs on wines from the world’s oldest wine regions would have cascading impacts that would reach deep into a whole network of American businesses, investors, and consumers."

23/5/19: Winning the Trade War: Easily and Bigly

NY Fed just published some interesting numbers on President Trump's Trade War with China. Available here: https://libertystreeteconomics.newyorkfed.org/2019/05/new-china-tariffs-increase-costs-to-us-households.html, the Fed note states that per recent study "the 2018 tariffs imposed an annual cost of $419 for the typical household. This cost comprises two components: the first, an added tax burden faced by consumers, and the second, a deadweight or efficiency loss... the tariffs that the United States imposed in 2018 have had complete passthrough into domestic prices of imports, which means that Chinese exporters did not reduce their prices. Hence, U.S. domestic prices at the border have risen one‑for-one with the tariffs levied in that year. Our study also found that a 10 percent tariff reduced import demand by 43 percent."

Thus, in simple terms, China is not paying the tariffs, American consumers are paying the tariffs. Just as Mexico is not paying for the Wall, and just as Mr. Trump is probably not paying his taxes in full (legally or not - a different matter). Same as the Trump Organization is not employing the greatest bestest American workers, preferring to employ cheaper legal and illegal migrants. And same as the Trump Organization is not paying their employees 'tremendous' salaries. And... well, you get the drift.

The Fed note states that, of course, the net loss to the U.S. economy is mitigated by the fact that the tariffs revenue is collected by the Federal Government and "could , in principle, be rebated". Alas, this is of little help to ordinary American households, because the U.S. Federal Government is not particularly know to be efficient spender of the money it collects. One can't really argue that taking $419 from an average household and pumping the cash into, say, new missiles and bombs to be dropped in Yemen is an equivalent economic activity. Or, for that matter, spending the same $419 on fighting in Afghanistan, or subsidizing loss-making perpetually insolvent boatbuilding docks in the U.S. that are already reliant on the atavistic Jones Act to sustain any pretence at building something. And so on... you get the drift.

The Fed researchers go on: "Some firms may also reorganize their supply chains in order to purchase their products from other, cheaper sources. For example, the 10 percent tariffs on Chinese imports might cause some firms to switch their sourcing of products from a Chinese firm offering goods for $100 a unit to a less efficient Vietnamese firm offering the product for $109. In this case, the cost to the importer has risen by nine dollars, but there is no offsetting tariff revenue being paid to the government. This tariff-induced shift in supply chains is therefore called a deadweight or efficiency loss." And the deadweight loss is fully, even in theory - forget practice - carried by the households.

Worse, "economic theory tells us that deadweight losses tend to rise more than proportionally as tariffs rise because importers are induced to shift to ever more expensive sources of supply as the tariffs rise."

How does that work? Marvellously, of course.

"... Compare the estimates of the costs of the 2018 tariffs with those of the recently announced higher tariffs on $200 billion of Chinese products. ...in November 2018, purchasers of imports were paying $3 billion per month in added tax costs and experiencing another $1.4 billion in deadweight losses. Thus, the total bill for U.S. importers was $4.4 billion per month. If we annualize these numbers, they amount to a cost of $52.8 billion, or $414 per household. Of this cost, $282 per household per year was flowing into government coffers as a tax increase and could theoretically be rebated. ... However, deadweight losses accounted for an additional $132 to households per annum and represent a net loss to the U.S. economy that is in excess of any tariff revenue collected by the government."

And the Fed analysis shows the effect of the rising deadweight loss on the U.S. households under the latest bout of tariffs hikes: under 2018 tariffs, deadweight loss was $132 per household per annum, and the total loss to the household was $414 per annum. Under 2019 tariffs, the deadweight loss is estimated to rise to $620 per annum per household and the loss to household budget of $831 per annum.

Now, the Fed study does not take into the account that higher prices charged on consumers as the result of tariffs are also subject to sales taxes imposed at the State level. Which means that for a 7% sales tax state, actual out of pocket losses for 2018-2019 tariffs war for an average household will be in the region of $889 per annum.

Based on the most recent data from the Tax Policy Center, "the middle one-fifth of income earners [in the U.S.] got an average tax cut of $1,090 — about $20 per biweekly paycheck" as a result of 2017 2017 Tax and Jobs Act (TCJA or Trump tax cuts). Transfers from corporate tax cuts to average salaried employee amounted to additional $233 per annum pre-tax. So an average household with two working parents gained somewhere in the neighborhood of $1,330 per annum from the 'massive tax cuts'.

You get $1,330, we take $889 back, and we call it 'America winning the trade war. Easily. And bigly!'

17/1/19: U.S. Imports Demand and Final Household Consumption

A great post from the Federal Reserve Bank of San Francisco blog (https://www.frbsf.org/economic-research/publications/economic-letter/2019/january/how-much-do-we-spend-on-imports/) showing estimates for total imports content of the U.S. household consumption, with a break down of imports content across domestic value additive activities and foreign activities.

Key results: “Our estimates show that nearly half the amount spent on goods and services made abroad stays in the United States, paying for the local component of the retail price of these goods. At the same time, imports of intermediate inputs make up about 5% of the cost of production of U.S. goods and services. Overall, about 11% of U.S. consumer spending can be traced to imported goods. This ratio has remained nearly unchanged in the past 15 years”.

Note: Top bars in both panels are computed directly from PCE and headline trade data. Bottom bars in both panels reflect authors’ adjustments to account for imported content of U.S. goods and U.S. content of imported goods.

The above shows that imports play far lesser role in the U.S. households' consumption than popular media and public opinion tend to believe. This, in part, explains why Trump tariffs war with China has had a very limited adverse impact on domestic demand in the U.S.

19/4/18: Geopolitical Risk: Who Cares?..

Geo-political risks, geo-shmalitical risks... who cares... not the markets...

None of the geopolitical risks registered on S&P 500 companies reporting radar according to Factset in 1Q 2018 https://insight.factset.com/more-than-half-of-sp-500-companies-citing-positive-impact-from-fx-on-q1-earnings-calls.  This is not very surprising as majority of earnings for 1Q accumulated before any spikes in these, and as "Tariffs" category probably absorbed the 'China' effect. Notably, however, earnings were impacted adversely by trade conflict and cyber risks (total of 3/25 companies impacted).

25/3/18: Average Tariffs: 2000-2016

So how do the world's largest 50 economies (by size) score when it comes to the average trade tariffs they have in place? Who is the free trade champion? And who is not?

Here is the data on top 50 largest global economies (I have aggregated EU members of the top 50) into one group, as they share common tariffs against the rest of the world:

Source: data from the World Bank

One thing is clear: tariffs did come down quite substantially between 2000 and 2016. Average world-wide tariff in 2000 stood at just over 8.69%, which fell to just under 4.29% by 2016.

Another interesting fact is that the U.S. average tariff of 1.61% is matched by the EU's 1.6%, with both higher than Australia's 1.17%, Canada's 0.85%, Japan's 1.35%, and Norway's 1.02%. So, the free trade champions of the U.S. and EU are, sort of, poorer than average for the advanced economies, when it comes to trading free of tariffs protection.

Third point worth noting relates to the BRICS: these the largest emerging economies, jointly accounting for 32.0% of the global GDP (PPP-adjusted). Brazil's average tariff in 2016 stood at 8.01%, down from 12.69% in 2000. Russia's average tariff in 2016 stood at 3.43% and we do not have that figure for 2000, while India's was at 6.32% (down from 23.28% in 2000), China's fell from 14.67% in 2000 to 3.54% in 2016, while South Africa's average tariff declined from 4.5% in 2000 to 4.19% in 2016. So, amongst the BRICS, today, Brazil imposes the highest tariffs (86.8% higher than the global average), followed by India (47.4% above the global average), S. Africa (2.3% below the global average),  China (17.4% below the global average), and Russia (20% below the global average). In other words, based on average tariffs, Russia is the most open to trade economy in the BRICS group, followed by China.

Of course, tariffs are not the only barriers to trade, and in fact, non-tariff protectionism measures have been more important in the era of the WTO agreements. However, the data on tariffs is somewhat illustrative.

Here is the same data, covering 2010 and 2016 periods, arranged by the order of magnitude for 2016 tariffs:

Source: data from the World Bank