- March 9, 2018 Economy
Steel Tariffs’ Chilling Effect on American Manufacturing
The White House has just formally announced its decision to impose tariffs of 25% on steel and 10% on aluminum. In defending this decision, President Donald Trump stressed how he intends to reduce the trade deficit, particularly with China. Although the tariffs are now a fait accompli, that hasn’t prevented numerous economists, and even some of the president’s own political constituency, from pointing out the dire impact such tariffs will have on downstream industries. Yet the administration quickly dismissed these arguments as “fake news.”
So will downstream industries remain unscathed by the tariffs?
Contrary to the administration’s casual dismissal of downstream effects, this 25% tariff on steel will have significant ripple effects on consumers of steel—namely US manufacturers and producers—who are even more sensitive to input prices. With roughly 140,000 employees in the steel-making industry and a steel-consuming manufacturing industry of 6.5 million, the US economy likely has more to lose than to gain. In fact, steel tariff may lead to even more outsourcing because the price of US steel will likely also rise. That will make it less economical for US manufacturers to buy steel and produce domestically, instead opting to further outsource certain production to other countries with cheaper input and labor costs, resulting in the shifting of jobs abroad.
And that is exactly what happened in 2002. When the George W. Bush administration imposed tariff of up to 30% on steel imports, also exempting Mexico and Canada at the time, the Producer Price Index for hot-rolled steel, a commonly used benchmark for steel prices, rose 30%. Rising costs forced many steel-consuming companies to move supply sourcing offshore where it was cheaper to produce steel-based products. The 2002 tariff lasted just 11 months, about two years shorter than it was originally intended. Even during that short period of time, the tariff was estimated to have caused the loss of 200,000 jobs, more than the total number of employees in the US steel-making industry (187,500) at the time.
This time around, the stakes are just as high. At the macro level, US manufacturers that rely on steel as a key input hire over 40 times the number of workers in the steelmaking industry. Many of these manufacturers already outsource simple steel parts with little value added to so-called “best value countries (BVCs)” such as China and Mexico, while they focus on doing what American manufacturers do best—making high value-added complex steel products with multiple procedures.
As the steel tariff takes effect, it may force these US manufacturers to outsource even more portions of their business to BVCs with lower steel prices and cheaper labor. In fact, now that the tariff is a done deal, it is very likely many manufacturers across the country are in the midst of making real-time decisions: is it more profitable to produce this or that part in the United States or to outsource it?
One such manufacturer is Mike Schmitt, owner of the 150-employee Metalworking Group (MWG) located in southwest Ohio and member of the National Tooling and Machining Association. Today, MWG sources about 10% of its steel-containing parts and components from China. Schmitt believes that importing “has not hindered American manufacturers but allowed them to stay globally competitive.”
MWG had begun exploring the outsourcing option in 2008, when the global financial crisis hit and market conditions deteriorated. Customers of MWG demanded the factory to source parts from BVCs to cut cost. It was not an easy task to develop a global supply chain, especially for a small and medium-size enterprise (SME) like Schmitt’s. Many American SMEs like MWG start the process by literally Googling and hoping to find Chinese factories’ websites. Then they will cold-email the factories, and if they are lucky enough to get a response, they will email blueprints of a particular part to see if the factory is capable of producing it. This approach rarely yields results—more often than not, these Chinese companies do not have the machines or technical specs to complete such tasks.
Luckily, MWG found intermediaries in China that could help select the right outsourcing partners among the thousands of manufacturers scattered across southern China. One of the factories MWG works with is located in Ningbo, a coastal city 135 miles south of Shanghai. MWG flies a group of engineers to China to stand side-by-side with their Chinese counterparts on the factory floor and show them how to make the components.
But even with all the training and close supervision, the Ningbo factory still struggles with a major challenge in manufacturing: the defect rate. Many Chinese factories have not implemented the same quality processes that have become routine in the United States and Japan, such as the six sigma process. These processes are supposed to help manufacturers enhance their quality to the point where there is only one defective part for every 300,000 parts made.
For simpler parts with fewer production steps, a defect rate of about 20% (that is, throwing away 20 defective products for every 100 made) could be justified by a 30% to 50% discount in production cost—meaning that it would still be more economical to outsource the manufacturing of that particular part.
To illustrate, MWG makes steel-cast gas pumps that are immediately familiar to anyone who has visited a US gas station. The gas pump has several parts: handle, lever, nozzle, and the shell. The handle is made of steel and outsourced to the Chinese factory. For MWG, the company is willing to outsource the steel handle production despite a relatively high defect rate, because it’s still more economical to produce that specific part in the Chinese factory and assemble the entire product later. According to Schmitt, it usually pays off to outsource parts with relatively simple components that take roughly 4-6 steps to produce. Anything more complex than that will likely result in too high of a defect rate to justify outsourcing. In other words, above a certain defect rate threshold, it would be more economical to produce domestically in the United States, assuming steel prices remain the same.
This, however, could change with the latest steel tariff. The tariff will result in higher steel prices across the board, including US steel, and will thus further widen the production cost gap between the United States and China. This means that some parts that were previously too complex to outsource may now prove more economical to outsource.
Here’s how this would work for a product that is currently made entirely in the United States: lottery machines (the kind found in bars or grocery stores). A quick back-of-the-envelope calculation can illustrate a scenario under which the tariff can potentially provide an incentive to outsource the manufacturing of lottery machines.
Assuming the labor cost in a BVC factory is 50% lower than that of the American factory and that the same BVC factory has a 60% defect rate for producing a part of the lottery machine. As shown in the top equation below, before tariff the American factory’s tolerance for defective products is only 50.5%, lower than the assumed defect rate of 60% in the BVC factory (see Figure 1). Therefore, the lottery machine makers would likely decide to keep production in the United States.
After the tariff is imposed, however, the BVC factory will use steel that costs 25% less than that in the United States, and assuming the US defect rate and labor cost remain constant, the American factory’s tolerance for defective products goes up to 63%. That rate is higher than the 60% defect rate in the BVC factory, which means the decision becomes easier for the US manufacturer to outsource lottery machine parts to countries like China or Mexico.
Figure 1: Tolerance for Defect Rates Before and After Tariff
Source: Author’s own calculations.
To be sure, outsourcing imposes economic costs and has led to fewer jobs on American factory floors. Over the past 40 years, there have been two periods that saw large reductions of manufacturing employment in the United States—first in the late 1970s when Japanese cars began to flood the US market and then in the 2000s after China joined the World Trade Organization (see Figure 2).
Figure 2: The Decline of Manufacturing Jobs in the United States
Source: US Department of Labor.
Today, there are thousands of SME manufacturers like Schmitt’s MWG in Ohio and scattered across the US rust belt. The 25% tariff on steel will change these manufacturers’ calculus in deciding whether to outsource or keep production in the United States. These aren’t mere abstractions but real-time decisions that such businesses make every single day. Tariffs may relieve certain domestic industries and retain some jobs in specific sectors. But if executed without precision, however, these tariffs risk triggering a wave of unemployment, outsourcing, and welfare loss—the opposite of what was intended.
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