Category: Essential Economics for Business: Ch 12

The President of the United States, Donald Trump, announced recently that he will be pushing ahead with plans to impose a 25% tariff on imports of steel and a 10% tariff on aluminium. This announcement has raised concerns among the USA’s largest trading partners – including the EU, Canada and Mexico, which, according to recent calculations, expect to lose more than $5 billion in steel exports and over $1 billion in aluminium exports.

Source: Bown (2018), Figure 1

A number of economists and policymakers are worried that such policies restrict trade and are likely to provoke retaliation by the affected trade partners. In recent statements, the EU has pledged to take counter-measures if the bloc is affected by these policies. In a recent press conference, the Commissioner for Trade, Cecilia Malmstrom, stated that:

We have made it clear that a move that hurts the EU and puts thousands of European jobs in jeopardy will be met with a firm and proportionate response.

She added that, ‘I truly hope that this will not happen. A trade war has no winners.’

Why is everyone so worried about trade wars then? Trade wars, by definition, result in trade diversion which can hurt employment, wealth creation and overall economic performance in the affected countries. As affected states are almost certain to retaliate, these losses are likely to be felt by all parties that are involved in a trade war – including the one that instigated it. This results in a net welfare loss, the size of which depends on a number of factors, including the relative size of the countries that take part in the trade war, the importance of the affected industries to the local economy and others.

A number of studies have attempted to estimate the effect of trade restrictions and tariff wars on welfare: see for instance Anderson and Wincoop (2001), Syropoulos (2002), Fellbermayr et al. (2013). The results vary widely, depending on the case. However, there seems to be consensus that the more similar (in terms of size and industry composition) the adversaries are, the more mutually damaging a trade war is likely to be (and, therefore, less likely to happen).

As Miyagiwa et al (2016, p43) explain:

A country initiates contingent protection policy against a trading partner only if the latter has a considerably smaller domestic market than its own, while avoiding confrontation with a country having a substantially larger domestic market than its own.

As both Canada and the EU are very large advanced market economies, it remains to be seen how much risk (and potential damage to the local and global economy) US trade policymakers are willing to take.

Articles and Academic Papers


  1. Explain how trade diversion works and why it relates to economic prosperity.
  2. What are the key advantages of international trade?
  3. What are the key disadvantages of international trade?

TATA steelworks, Ijmuiden, Netherlands: photo JS

Since running for election, Donald Trump has vowed to ‘put America first’. One of the economic policies he has advocated for achieving this objective is the imposition of tariffs on imports which, according to him, unfairly threaten American jobs. On March 8 2018, he signed orders to impose new tariffs on metal imports. These would be 25% on steel and 10% on aluminium.

His hope is that, by cutting back on imports of steel and aluminium, the tariffs could protect the domestic industries which are facing stiff competition from the EU, South Korea, Brazil, Japan and China. They are also facing competition from Canada and Mexico, but these would probably be exempt provided negotiations on the revision of NAFTA rules goes favourably for the USA.

TATA steel works IJmuiden Netherlands (photo JS)Assuming there were no retaliation from other countries, jobs would be gained in the steel and aluminium industries. According to a report by The Trade Partnership (see link below), the tariffs would increase employment in these industries by around 33 000. However, the higher price of these metals would cause job losses in the industries using them. In fact, according to the report, more than five jobs would be lost for every one gained. The CNN Money article linked below gives example of the US industries that will be hit.

But the costs are likely to be much greater than this. Accorinding to the law of comparative advantage, trade is a positive-sum game, with a net gain to all parties engaged in trade. Unless trade restrictions are used to address a specific market distortion in the trade process itself, restricting trade will lead to a net loss in overall benefit to the parties involved.

Clearly there will be loss to steel and aluminium exporters outside the USA. There will also be a net loss to their countries unless these metals had a higher cost of production than in the USA, but were subsidised by governments so that they could be exported profitably.

Valancia port: photo JSBut perhaps the biggest cost will arise from possible retaliation by other countries. A trade war would compound the net losses as the world moves further from trade based on comparative advantage.

Already, many countries are talking about retaliation. For example, the EU is considering a ‘reciprocal’ tariff of 25% on cranberries, bourbon and Harley-Davidsons, all produced in politically sensitive US states (see the first The Economist article below). ‘As Jean-Claude Juncker, president of the European Commission, puts it, “We can also do stupid”.’ In fact, this is quite a politically astute move to put pressure on Mr Trump.

But cannot countries appeal to the WTO? Possibly, but this route might take some time. What is more, the USA has attempted to get around WTO rules by justifying the tariffs on ‘national security’ grounds – something allowed under Article XXI of WTO rules, provided it can be justified. This could possibly deter countries from retaliating, but it is probably unlikely. In the current climate, there seems to be a growing mood for flouting, or at least loosely interpreting, WTO rules.




  1. Explain how, by countries specialising in goods in which they have a comparative advantage, all countries can gain.
  2. Can tariffs or other trade restrictions ever be justified? Explain.
  3. Is there any economic justification for the US tariffs of 25% on steel and 10% on aluminium?
  4. Can putting tariffs on US imports be justified by countries whose steel and/or aluminium industires are faced with US tariffs?
  5. Can trade wars be won? Explain.

On 8 February, the Bank of England issued a statement that was seen by many as a warning for earlier and speedier than previously anticipated increases in the UK base rate. Mark Carney, the governor of the Bank of England, referred in his statement to ‘recent forecasts’ which make it more likely that ‘monetary policy would need to be tightened somewhat earlier and by a somewhat greater extent over the forecast period than anticipated at the time of the November report’.

A similar picture emerges on the other side of the Atlantic. With labour markets continuing to deliver spectacularly high rates of employment (the highest in the last 17 years), there are also now signs that wages are on an upward trajectory. According to a recent report from the US Bureau of Labor Statistics, US wage growth has been stronger than expected, with average hourly earnings rising by 2.9 percent – the strongest growth since 2009.

These statements have coincided with a week of sharp corrections and turbulence in the world’s largest capital markets, as investors become increasingly conscious of the threat of rising inflation – and the possibility of tighter monetary policy.

The Dow Jones plunged from an all-time high of 26,186 points on 1 February to 23,860 a week later – losing more than 10 per cent of its value in just five trading sessions (suffering a 4.62 percentag fall on 5 February alone – the worst one-day point fall since 2011). European and Asian markets followed suit, with the FTSE-100, DAX and NIKKEI all suffering heavy losses in excess of 5 per cent over the same period.

But why should higher inflationary expectations fuel a sell-off in global capital markets? After all, what firm wouldn’t like to sell its commodities at a higher price? Well, that’s not entirely true. Investors know that further increases in inflation are likely to be met by central banks hiking interest rates. This is because central banks are unlikely to be willing or able to allow inflation rates to rise much above their target levels.

The Bank of England, for instance, sets itself an inflation target of 2%. The actual ongoing rate of inflation reported in the latest quarterly Inflation Report is 3% (50 per cent higher than the target rate).

Any increase in interest rates is likely to have a direct impact on both the demand and the supply side of the economy.

Consumers (the demand side) would see their cost of borrowing increase. This could put pressure on households that have accumulated large amounts of debt since the beginning of the recession and could result in lower consumer spending.

Firms (the supply side) are just as likely to suffer higher borrowing costs, but also higher operational costs due to rising wages – both of which could put pressure on profit margins.

It now seems more likely that we are coming towards the end of the post-2008 era – a period that saw the cost of money being driven down to unprecedentedly low rates as the world’s largest economies dealt with the aftermath of the Great Recession.

For some, this is not all bad news – as it takes us a step closer towards a more historically ‘normal’ equilibrium. It remains to be seen how smooth such a transition will be and to what extent the high-leveraged world economy will manage to keep its current pace, despite the increasingly hawkish stance in monetary policy by the world’s biggest central banks.


Global Markets Shed $5.2 Trillion During the Dow’s Stock Market Correction Fortune, Lucinda Shen (9/2/18)
Bank of England warns of larger rises in interest rates Financial Times, Chris Giles and Gemma Tetlow (8/2/18)
Stocks are now in a correction — here’s what that means Business Insider, Andy Kiersz (8/2/18)
US economy adds 200,000 jobs in January and wages rise at fastest pace since recession Business Insider, Akin Oyedele (2/2/18)


Dow plunges 1,175 – worst point decline in history CNN Money, Matt Egan (5/2/18)


  1. Using supply and demand diagrams, explain the likely effect of an increase in interest rates to equilibrium prices and output. Is it good news for investors and how do you expect them to react to such hikes? What other factors are likely to influence the direction of the effect?
  2. Do you believe that the current ultra-low interest rates could stay with us for much longer? Explain your reasoning.
  3. What is likely to happen to the exchange rate of the pound against the US dollar, if the Bank of England increases interest rates first?
  4. Why do stock markets often ‘overshoot’ in responding to expected changes in interest rates or other economic variables

In various blogs, we’ve looked at the UK’s low productivity growth, both relative to other countries and relative to the pre-1998 financial crisis (see, for example, The UK productivity puzzle and Productivity should we be optimistic?). Productivity is what drives long-term economic growth as it determines potential GDP. If long-term growth is seen as desirable, then a fall in productivity represents a serious economic problem.

Recent data suggest that the problem, if anything, is worse than previously thought and does not seem to be getting better. Productivity is now some 21% below what it would have been had productivity growth continued at the rate experienced in the years before the financial crisis (see second chart below).

In its latest productivity statistics, the ONS reports that labour productivity (in terms of output per hour worked) fell by 0.1% in the second quarter of 2017. This follows a fall of 0.5% in quarter 1. Over the whole year to 2017 Q2, productivity fell by 0.3%.

Most other major developed countries have much higher productivity than the UK. In 2016, Italy’s productivity was 9.9% higher than the UK’s; the USA’s was 27.9%, France’s was 28.7% and Germany’s was 34.5% higher. What is more, their productivity has grown faster (see chart).

But what of the future? The Office for Budget responsibility publishes forecasts for productivity growth, but has consistently overestimated it. After predicting several times in the past that UK productivity growth would rise towards its pre-financial crisis trend of around 2% per year, in its October 2017 Forecast evaluation Report it recognises that this was too optimisitic and revises downwards its forecasts for productivity growth for 2017 and beyond.

As the period of historically weak productivity growth lengthens, it seems less plausible to assume that potential and actual productivity growth will recover over the medium term to the extent assumed in our most recent forecasts. Over the past five years, growth in output per hour has averaged 0.2 per cent. This looks set to be a better guide to productivity growth in 2017 than our March forecast of 1.6 per cent.

Looking further ahead, it no longer seems central to assume that productivity growth will recover to the 1.8 per cent we assumed in March 2017 within five years.

But why has productivity growth not returned to pre-crisis levels? There are five possible explanations.

The first is that there has been labour hoarding. But with companies hiring more workers, this is unlikely still to be true for most employers.

The second is that very low interest rates have allowed some low-productivity companies to survive, which might otherwise have been driven out of business.

The third is a reluctance of banks to lend for investment. After the financial crisis this was driven by the need for them to repair their balance sheets. Today, it may simply be greater risk aversion than before the financial crisis, especially with the uncertainties surrounding Brexit.

The fourth is a fall in firms’ desire to invest. Although investment has recovered somewhat from the years directly following the financial crisis, it is still lower than might be expected in an economy that is no longer is recession. Indeed, there has been a much slower investment recovery than occurred after previous recessions.

The fifth is greater flexibility in the labour market, which has subdued wages and has allowed firms to respond to higher demand by taking on more relatively low-productivity workers rather than having to invest in human capital or technology.

Whatever the explanation, the solution is for more investment in both technology and in physical and human capital, whether by the private or the public sector. The question is how to stimulate such investment.


UK productivity lagging well behind G7 peers – ONS Financial Times, Katie Martin (6/10/17)
UK productivity sees further fall BBC News (6/10/17)
UK resigned to endless productivity gloom The Telegraph, Tim Wallace (10/10/17)
UK productivity estimates must be ‘significantly’ lowered, admits OBR The Guardian, Richard Partington and Phillip Inman (10/10/17)
UK productivity growth to remain sluggish, says OBR BBC News (10/10/17)
Official Treasury forecaster slashes UK productivity growth forecast, signalling hole in public finances for November Budget Independent, Ben Chu (10/10/17)
The Guardian view on Britain’s productive forces: they are not working The Guardian, Editorial (10/10/17)
Mind the productivity gap: the story behind sluggish earnings The Telegraph, Anna Isaac (26/10/17)

Data and statistical analysis

Labour productivity: April to June 2017 ONS Statistical Bulletin (6/10/17)
International comparisons of productivity ONS Dataset (6/10/17)
Forecast evaluation report OBR (October 2017)


  1. Explain the relationship between labour productivity and potential GDP.
  2. What is the relationship between actual growth in GDP and labour productivity?
  3. Why does the UK lag France and Germany more in output per hour than in output per worker, but the USA more in output per worker than in output per hour?
  4. Is there anything about the UK system of financing investment that results in lower investment than in other developed countries?
  5. Why are firms reluctant to invest?
  6. In what ways could public investment increase productivity?
  7. What measures would you recommend to encourage greater investment and why?
  8. How do expectations affect the growth in labour productivity?

With the Conservatives having lost their majority in Parliament in the recent UK election, there is renewed discussion of the form that Brexit might take. EU states are members of the single market and the customs union. A ‘hard Brexit’ involves leaving both and this was the government’s stance prior to the election. But there is now talk of a softer Brexit, which might mean retaining membership of the single market and/or customs union.

The single market
Belonging to the single market means accepting the free movement of goods, services, capital and labour. It also involves tariff-free trade within the single market and adopting a common set of rules and regulations over trade, product standards, safety, packaging, etc., with disputes settled by the European Court of Justice. Membership of the single market involves paying budgetary contributions. Norway and Iceland are members of the single market.

The single market brings huge benefits from free trade with no administrative barriers from customs checks and paperwork. But it would probably prove impossible to negotiate remaining in the single market with an opt out on free movement of labour. Controlling immigration from EU countries was a key part of the Leave campaign.

The customs union
This involves all EU countries adopting the same tariffs (customs duties) on imports from outside the EU. These tariffs are negotiated by the European Commission with non-EU countries on a country-by-country basis. Goods imported from outside the EU are charged tariffs in the country of import and can then be sold freely around the EU with no further tariffs.

Remaining a member of the customs union would allow the UK to continue trading freely in the EU, subject to meeting various non-tariff regulations. It would also allow free ‘borderless’ trade between Northern Ireland and the Republic of Ireland. However, being a member of the customs union would prevent the UK from negotiating separate trade deals with non-EU countries. The ability to negotiate such deals has been argued to be one of the main benefits of leaving the EU.

Free(r) trade area
The UK could negotiate a trade deal with the EU. But it is highly unlikely that such a deal could be in place by March 2019, the date when the UK is scheduled to leave the EU. At that point, trade barriers would be imposed, including between the two parts of the island of Ireland. Such deals are very complex, especially in the area of services, which are the largest category of UK exports. Negotiating tariff-free or reduced-tariff trade is only a small part of the problem; the biggest part involves negotiating product standards, regulations and other non-tariff barriers.

All the above options thus involve serious problems and the government will be pushed from various sides, not least within the Conservative Party, for different degrees of ‘softness’ or ‘hardness’ of Brexit. What is more, the pressure from business for free trade with the EU is likely to grow. Brexit may mean Brexit, but just what form it will take is very unclear.


Free trade area, single market, customs union – what’s the difference? BBC News, Jonty Bloom (12/6/17)
Brexit: What are the options? BBC News (12/6/17)
After the election, the real test: Brexi The Economist (8/6/17)
May’s Ministers Plot Softer Brexit to Keep UK in Single Market Bloomberg, Tim Ross, Alex Morales and Svenja O’Donnell (11/6/17)
UK’s Hung Parliament Raises Business Hopes for a Softer Brexit Bloomberg, Stephanie Baker and James Paton (12/6/17)
Do not exaggerate the effect the election will have on Brexit Financial Times, Wolfgang Münchau (11/6/17)
What is soft Brexit? How could it work as UK negotiates leaving the EU? Independent, May Bulman (12/6/17)
Brexit-lite back on the table as Britain rethinks its options after election The Guardian, Dan Roberts (11/6/17)
Review plan to quit EU Customs Union, urges FTA, James Ridler (12/6/17)
Freight leaders urge government to review decision to leave EU customs union RTM (12/6/17)

Making Brexit work for British Business: Key Execution Priorities M-RCBG Associate Working Paper No. 77, Harvard Kennedy School, Peter Sands, Ed Balls, Sebastian Leape and Nyasha Weinberg (June 2017)


  1. Explain the trading agreement between Norway and the EU.
  2. How does the Norwegian arrangement with the EU differ from the Turkish one?
  3. What are meant by the terms ‘hard Brexit’ and ‘soft Brexit’?
  4. How does a customs union differ from a free trade area?
  5. Is it possible to have (a) a customs union without a single market; (b) a single market without a customs union?
  6. To what extent is it in the EU’s interests to negotiate a deal with the UK which lets it maintain access to the customs union without having free movement of labour?
  7. The EU insists that talks about future trading arrangements between the UK and the EU can take place only after sufficient progress has been made on the terms of the ‘divorce’. What elements are included in the divorce terms?
  8. If agreement is not reached by 29 March 2019, what happens and what would be the consequences?
  9. Will a hung parliament, or at least a government supported by the DUP on a confidence and supply basis, make it more or less likely that there will be a hard Brexit?
  10. For what reasons may the EU favour (a) a hard Brexit; (b) a soft Brexit?