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To see why Trump is wrong on tariffs and trade, just look at his iPhone

CNBC logo CNBC 6/20/2018 John W. Schoen

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President Donald Trump's threat to impose steep tariffs on Chinese exports to the U.S. would inflict a lot more harm on American consumers than it would on China.

To see why, you have to understand how Trump's policy fundamentally misreads the reason the U.S. runs a trade deficit in the first place. The iPhone is a good example, with parts coming from many trading partners, not just China.

Last month, Trump promised to impose steep tariffs on $50 billion worth of Chinese goods entering the U.S. unless Beijing engineered a $200 billion reduction in its trade surplus with the U.S. by 2020. On Tuesday, Trump raised his tariff threat by another $200 billion on Chinese goods yet to be determined.

"Last year, we lost $500 billion on trade with China," Trump said, erroneously, at a March 23 news conference. "We can't let that happen."

To begin with, Trump's math is off - by more than $100 billion.

A country's trade balance is nothing more or less than the difference between the value of everything it imports from a trade partner and everything it exports back to that country. A trade deficit occurs when the value of imports is greater than the value of exports, in terms of both goods and services.

Last year, the U.S. imported roughly $505 billion in Chinese goods and shipped about $130 billion back, a difference of about $375 billion.

But even that number masks the true story of who gets the better deal from U.S. China trade.

For one thing, unlike Trump's portrayal, a trade deficit is not the same as a one-way transfer of funds from one country to another. Some $70 billion of the U.S. trade deficit with China comes from shipments of cellphones, for example. But in return for that $70 billion, American companies and consumers came away with $70 billion worth of cellphones.

Those cellphones, in turn, helped raise the productivity of American workers, including those in jobs that earn much higher wages than the Chinese workers who assembled their phones.

And that $70 billion is not an accurate measure of the value China added to the cellphones it shipped to the U.S. That's because the accounting used in the "official" trade statistics hasn't kept up with the growth of global supply chains, which source parts and raw materials from multiple countries to make a single product.

"About two-thirds of world trade now is involved in value chains that cross borders during the production process," said David Dollar, a senior fellow at John L. Thornton China Center, in a blog post.

Each country that adds a link in the chain also adds a little value to the final product. But those intermediate contributions are rolled up into the final export value that tallied when the product reaches its final destination. As a result, much of that $70 billion U.S.-China cellphone trade deficit really comes from other U.S. trade partners like South Korea, Japan and Singapore.

To better understand the why that happens, all Trump has to do is take a closer look at his iPhone the next time he tweets.

Of the $1,000 retail price, about $370 presents the cost of making each phone, including parts and assembly costs, according to an analysis by IHS Markit. The most expense part, the display, comes from Samsung Electronics in South Korea, and represents about $110 of the final price of the phone.

Another $44.45, for memory chips, goes to Japan's Toshiba Corp and South Korea's SK Hynix. Other suppliers, from Singapore to Switzerland, provide parts and components that are assembled by a contract manufacturer in China. But the value Chinese workers add by putting those parts together represents only between 3 to 6 percent of the of the retail price of the phone, according to an analysis by IHS Markit.

When the assembled phone is shipped to Apple and its distributors in the U.S, though, the entire $370 cost of making it - including parts – is rolled into the "export value" and becomes part of China's total trade deficit with the U.S., even though much of the value was added by suppliers in other countries.

That also means any tariff on Chinese shipments of iPhones to the U.S. would also hurt the countries caught in the middle of that supply chain, as well as the American consumers who would pay more for the phone.

"A policy that sounds straight-forward—such as a 45 percent tariff on imports of 'Chinese' products, as then-candidate Donald Trump proposed during his campaign—would hurt many firms and workers in the United States, as well as in allies such as Japan, Korea, and Taiwan," wrote Dollar.

The same analysis applies to any product that is manufactured with parts and materials supplied by multiple countries, based on the resources those countries can offer at the lowest cost.

Countries with lower labor costs can compete more effective on labor-intensive phases of manufacturing. Those with highly-skilled workers, like designers and engineers, can better apply those skills to create the patents and designs that often create the bulk of a product's value.

That specialization is at the heart of a three-decade expansion of globalization, a trend made possible by cheaper air shipping (to move parts, materials and finished goods around the world) and the information revolution (which allows companies to manage these increasingly complex global production and distribution networks.)

U.S. consumers would pay

Companies that produce products globally aren't the only ones who benefit from these multi-national value chains. So do the consumers of the much cheaper products that result.

Slapping large tariffs on the movement of goods and materials across borders would quickly drive up the prices of goods whose producers rely most heavily on global supply chains.

American consumers have enjoyed substantial discounts on these goods over the last two decades as the pace of globalization has picked up. With steep tariffs, those discounts would evaporate.

Trump's obsession with the trade deficit in goods made in China also conveniently ignores a widening U.S.-China trade surplus in services.

When a Chinese family travels to Disneyland on an American airline or a Chinese student pays tuition to an American university, that adds to the trade surplus for the U.S. Last year, the U.S. services trade balance with China widened to $36.8 billion.

The growth in that trade surplus reflects a broader shift in the U.S economy away from manufacturing toward in service industries.

And because fewer of those service providers rely on supply chains that cross borders, a greater share of the value they created stays within U.S. borders and benefit American workers.

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