Commercial Reprisals Are a Mistake

Where goods do not cross borders soldiers will.
—attributed to Frédéric Bastiat1

The issue of free trade is being posed anew with the anti-trade measures being implemented by President Donald Trump. The President is worried about the size of the trade deficit of the United States and so are his voters. He attributes the artificially low prices of some of the imports entering America, especially from China, but also Canada, Mexico, and the European Union to unfair practices. He fears that foreign competition is sending many blue-collar workers into unemployment and stymying the progress of the middle class. As a first step he slapped a 20% tariff on foreign solar cells, thus saving inefficient producers at the cost of harming the state-of-the-art firms. And now he has variously increased the tariffs on imports of steel and aluminum, and may do so on Chinese and European cars. This is leading the governments of the countries that export to the United States to take or threaten reprisals in the form of tariffs and quotas on American goods.2 The June meeting of the G7 was thrown into disarray by President Trump refusing to sign a joint trade statement counter to his protectionist measures.

I will address three questions in this unconventional essay: one, whether such reprisals will make the United States change its restrictive commercial policy (my answer is no); second, whether such reprisals will harm the nations taking them (my answer is yes); and whether we are thus running the danger of reducing world trade (my answer is yes again). My thesis is that taking reprisals is a mistake; no reprisals is better; unilateral free trade is best.

Trade as cooperation

Let me start with some elementary points.

• People trade because they are different: they have different tastes, resources, and abilities. This is why people seek the goods and services offered by others.
• A voluntary exchange of goods and services only happens if both sides gain, but they need not gain the same amount.
• Trading within a country and trading across borders is substantially the same thing. In fact, it is not countries that trade, only people and firms do, wherever they may be placed.
• The mistaken perception that international exchanges are special is due to their taking place between individuals and firms in different monetary and tax zones.
• The monetary value of flows of goods and services across borders are summarized in an accounting document called the balance of payments.
  • A balance of payments in deficit is not a problem in itself. It is a symptom, but symptoms can feel very unpleasant.
• There can be losers from international competition as there can be from competitors inside the country. But the net effect of competition in both cases is to increase national income and wealth.3
• In sum, competition is a form of social cooperation.

Buying where it is cheapest

Adam Smith in The Wealth of Nations (1776) wrote that people have an innate tendency “to truck, barter, and exchange”. Some of his disciples, mainly David Ricardo (1817), dug a little deeper and, when discussing trade among nations, adverted the differences in tastes, resources, and abilities to explain why people specialized and exchanged goods, when they could have produced them all at home. The classical economists from David Hume to John Stuart Mill started by showing the advantage gained in trading with people of other nations, on the assumption that rational people would trade only if they (and their nation) gained by it. In the course of discussing the gains from trade, they took a second step: to try and explain what goods were exchanged and in what quantities. In sum, the classics researched two questions: (1) the benefits (or the welfare, we would say today) of trade, and (2) the amount of trade flows.

Adam Smith, as regards the advantage obtained by trade, was not as complete as Ricardo (1817). He simply said that nations, like the master of a household, would try to buy where it is cheapest. He backed his argument with a reductio ad absurdum: grapes could be grown in Scotland with hothouses and good wine could be made with them, but at a much higher cost than in Bordeaux.4

Comparative or opportunity cost

David Ricardo saw what was missing in Smith’s analysis: he showed that often it could be rational for a country to buy abroad what could be supplied more cheaply at home! This was so in the case of Portugal buying cloth in England at a greater expense than making it locally, if that allowed Portugal to concentrate all its resources in the production of much cheaper wine than the English could make. Even if Portugal was more efficient in the production of both wine and cloth than England, it would be able to get more cloth by concentrating in wine production and trading part of its wine for English cloth. The more productive country would fare better if it specialized in the good in whose production it was comparatively more efficient than in the other good, even if it was efficient in both.

Paul Samuelson illustrated this important theorem with the homely example of an exchange between him and his secretary: he was better at typing and economics, but so much better at economics, that he could specialize in economics and perhaps hire two secretaries. The opportunity cost of typing his own letters was prohibitive in terms of his production as an economist.

Ricardo thus showed that two countries would trade with each other even if one was less productive than the other in all lines. This explains why poor, inefficient countries can still find things to sell to advanced countries.5

Sharing the gains from trade

What was implicit in Ricardo is that consumers in all trading countries would profit from the greater world availability of wine and cloth, or whatever. But even from the point of view of producers in international trade, both sides gain, though not always equally. The young John Stuart Mill (1828) explained that the country with the keenest desire for the other’s good would end with a smaller share of the gain. So that, if the English were great drinkers, they would tend to send more cloth to Portugal for each barrel…6

Whether equally shared or no, the gains of free trade were clearly and un-ambiguously positive for both nations and the world as a whole: international specialization will always result in an increased world output of both cloth and wine. Free trade will foster growth and is a boon for the poor. A protectionist policy will make the world less productive and will especially reduce the welfare of producers in less efficient developing economies.

Opening of borders to international trade forces changes in the economic structure of production in both countries. The only way to study this effect is dynamically.

Who loses?

At first, textile workers in Portugal will be unemployed and so will wine producers in England. Displaced workers will have to accept lower wages and pensions or seek employment in another industry or even move to another state, at least temporarily. Foreign competition, as does national, forces greater specialization and lower costs, and makes the economy grow.

This is what happened with the motorcar industry in Detroit: it had to be saved with public money so as to sweeten a cut in wages, a reduction of pension rights, and reduction of trade union privileges with a write down of debt. A substantial part of the population had to leave the city and seek employment in other states. All this also harmed auto producers in free labor southern states.7

Joseph Schumpeter called this kind of phenomenon “creative destruction”: progress, technological and commercial, results in forced changes on the production side of the economy and the closing down of unsustainable activities. To express it otherwise, foreign competition breaks up domestic monopolies and oligopolies, including unions protected by legislation. The ensuing greater productivity creates new jobs and makes for higher wages for those who find employment under the new dispensation. The argument against free trade can also be used against the penetration of artificial intelligence and robots. Slapping tariffs on foreign goods and services is another way to try to stop progress.

Still, some people do lose, leading many to want their society to progress by kinder or more inclusive means than competition. But will it be possible for America stay at the top in innovation, entrepreneurship, and productivity while stymying competition, foreign or national? The European Union seems to have given up running this race.

Also, as Barbara Dluhosch points out (2018), such protectionist attitudes are an invitation for special interests to band together for the purpose of seeking rents. This kind of overt rent-seeking is less harmful than the more hypocritical kind tending to hide behind false pretexts: thus President Trump has announced that he is “taking action to protect America’s national security” from the effects of global oversupply of steel and aluminum. He could not justify these measures by a need to reduce unemployment, as out-of-work people today amount to 3.8% of the US population. His advisors must also have told him that Article XIX of the World Trade Organization treaty would limit these measures to a period of four years, give rise to claims for compensation, and be open to retaliation. So he plumped for Article XXI b) which allows a state to adopt all measures deemed necessary to protect “its essential security interests, relative to: (i) fissionable material; (ii) arms, munitions, and war materials […]; and (iii) in times of war and grave international tension.” In what way can cheap steel and aluminum imports endanger the safety of the United States? Beats me.

Another hoary legend is that protection promotes growth and hence free-trade makes industrialization more difficult. This is known as the ‘infant industry argument’.8 One of the accepted ‘facts’ of economic history is that the United States, the German Empire and France were able to catch up with Britain in the 19^th century because they fostered their industrialization with protection. However, Bismarck’s ‘iron and rye’ 1879 tariff was a clear surrender to the interests of the great industrialists and the Junkers of East Prussia. The turn to protection by the French in 1881 and the U.S. tariffs of 1864 and 1890 changed the arrangement of industrial sectors but did not increase total production. And I need not say anything about the disastrous effects on the whole world of the 1930 Smoot-Hawley tariff.9 History is replete with examples of the failure of American protectionism.

Balance of payments deficits as a symptom

It is the fond belief of half-baked economists that tariffs and quotas can mend a balance of payments deficit by making imports more expensive and exports cheaper. People forget that the balance of payments is only an accounting document that will tell you that a country is buying more (or less) abroad than it is selling but not what causes the imbalance.

An enduring balance of payments deficit can tell you a number of things. One is that national expenditure is greater than national saving and investment and that domestic expenditure has to be topped up with borrowing from abroad. This can be good or bad. In an underdeveloped country foreign direct capital investment may not immediately and fully be paid for with exports but helps growth. In advanced economies, a sustained balance of payments deficits is largely due to the negative savings of the federal deficit. Hence tariffs will not correct such a deficit – a balanced budget will. Only the fact that the U.S. Treasury is the banker of the world can explain the huge amount of American bonds held by the rest. This is a happy result for American consumers and capitalists since they get foreign goods, both final and intermediate, in exchange for pieces of paper called dollar bills or bonds. This, however, may make life difficult for local firms and workers, who have to face more abundant imports.

Another warning given by a sustained balance of payments deficit is that it will have an effect on the currency exchange. If the rate of exchange is fixed, as within the euro area, the country will have to use its reserves to stop the currency from devaluing, and in the process it may run out of such reserves. This is what happened to Greece after the 2010 crisis when cash disappeared. If it is a floating currency, then it will depreciate with expected budget deficits, as is happening today with the Argentinian peso. A substantive depreciation is equivalent to a large cut in the money holdings of the people.

In sum, enduring balance of payments deficits and sudden excessive devaluations should lead governments to make substantive reforms of populist budget structures and of excessive regulation, especially of the labor market. Moves such as that of President Trump are cosmetic and in the end harmful.

The effects of a commercial war

So protection will not mend the foreign deficit. The effects of protection (and retaliation) will be others. It will make imports more expensive and make the price of substitutes rise. It will also make exports more expensive, in that a tariff on imports is a tariff on imported intermediate goods used by exporters.

The consequences of President Trump’s commercial policies is already being felt, both directly and indirectly through third party retaliation. It is clear that Trump’s protectionist measures point to a fall in world wealth, starting with America itself, ceteris paribus. The cycle has been on an upward drive for some time now and the cost increases and corporate investments due to action and reaction may ultimately result in the turn to a recession. There will be large increases in costs for industrial corporations in the United States and the retaliating nations. The uncertainty caused by war-monger rhetoric will surely affect investment, especially of international companies. In sum, protectionism and the ensuing trade war will only result in small corrections in balance of payments deficits by reducing trade.10

As to the likelihood of ‘victory’, a large economic area such as the United States will feel an imposed reduction of imports much less keenly than a small one, such as Belgium or a Baltic country.11 Hence reprisals against President Trump’s new policy have a high probability of failure when the aim is to punish as large an economy as the United States.

Cutting your nose to spite your face

Most people are ignorant of the well-established analysis of international trade I have put forward in the previous paragraphs. The general attitude is, you win when you export, you lose when you import. Instead of seeing the increase in total trade in goods, services, knowledge, and freedom as best for your people and nation, they feel they win when they impose a monopoly on other nations through the exercise of power.

I believe I have given good arguments to prove that Trump’s protectionist moves will hurt the American people. But these arguments are equally applicable to reprisals. By waging a commercial war or actively replying to an offensive move, you must be ready to suffer to attain victory. In that case, the least bad (or second best) reprisal strategy would be to do nothing and simply rely on the foreseeable reduction in U.S. exports due to the increase in American prices following the higher degree of protection. If you see the world of business as the imposition of power, yours is the world of President Trump and the retaliating nations. If you see international trade as non-designed cooperation through competition, the intelligent strategy is to let the power-hungry rival nation trip itself up by the brainless use of its own force, in the ju-jitsu tradition of unarmed self-defense.

Unilateral free trade

The best measure for me would be to go further than doing nothing. What I propose is in the spirit of the slow and far from easy establishment of total and unilateral free trade in the United Kingdom from 1823 to 1860.12 Imagine the possible move by Britain as an example after having left the European Union at the end of two years of failed negotiations. ‘Hard Brexit’ would allow Britain to unilaterally and totally free its imports and repeal non-tariff barriers on services. This would of course greatly benefit British consumers. But it would also reduce UK production costs across the board. As at the same time American steel and aluminum would necessarily increase in price and so would American cars, very possibly President Trump’s protectionist measure would have no effect on British trade.

More generally speaking, the best retort against US protectionism would be to bring down the production costs of exports by the other nations. To achieve this, China, Canada, Mexico, and the European Union should unilaterally free imports from all duties, fully alleviate non-tariff barriers, and drastically reduce or repeal regulation on services, especially financial services. Such measures need no compact or international agreement: nations can implement individually. Further to this point, if most other countries harmed by President Trump choose the reprisal way, those that do not will be even more favored. This is why Frau Merkel is pleading for all EU nations to join in the reprisals and not undermine the trade powers vested on the Commission in Brussels.

My conclusion is that free trade is the best reprisal. But if such a move should prove politically impossible, there always is the possibility of lying low and doing nothing. Dixi et salvavi animama meam.

Footnotes

[1] The British radicals who wanted “peace and free trade”, and decried the creation and extension of Empires were overtaken by unwilling imperialists as Gladstone and willing imperialists as Disraeli and Bismarck. The nadir of liberalism was the Congress of Berlin of 1885, which started the ‘scramble for Africa and Asia’. The wealth created by merchants, manufacturers, and inventors in the first part of the 19^th century was used by States to arm themselves for what was to be World War I.

[2] See among many others the analysis by M. Conthe (2018).

[3] Costinot and Rodriguez-Clare (2018, page 21) summarize present-day estimates by various authors of the gains from trade obtained by Americans as 2 to 8% of GDP: such gains may look small, but they are “nothing to spit at”.  Do not forget that the United States is a very large mostly self-contained economy. See note 9 below.

[4] As regards trade flows, Elmslie (2018) has shown that Smith understood, and formulated in bits and pieces, what we today call ‘the gravity theory of international trade flows”. Here we mean ‘gravity’ in the sense of Newton, not in the sense of composed behavior. Tinbergen (1962) finally modelled this very powerful explanation for trade flows on the basis of cost by saying that trade flows tended to be directly proportional to the proximity and the size of the two markets, and an inverse proportion to the institutional barriers between them put up by authorities jealous of their neighbors’ prosperity. Indeed a ‘frontier effect’ is observable: so, the net border negative effect between Canada and the US has been calculated as a 44% compared with trade within each country. Adam Smith mentioned that this effect was smaller the larger the respective markets.

[5] I will not go down the way of later theories that explain Ricardian trade patterns by predicting that countries will specialize in exporting the goods they use more intensively than the resources they are more abundantly endowed with: this is what the Heckscher-Ohlin theory (1919, 1933) theorem predicts. Dluhosch (2018) however explains that, in the present day world, merely resting on abundant resources may not be very wise, because such an endowment may lose its possibilities through innovation or new markets: suddenly, a shale-oil-and-gas innovation may undercut your traditional resource advantage.

[6] Neither will I attend to more recent theories of trade that advert to changes in terms of trade or to trade under conditions of imperfect competition.

[7] One negative effect of international trade studied by Stolper and Samuelson (1941) is that it moves low skilled production abroad. This theorem is closely related to the ‘factor equalization theorem’. Trump-minded people want to correct this effect with protective measures that stop low skilled products from being imported and displacing workers. Dluhosch (2016 and 2018) notes that new information and communication technologies (ICT) also threaten high-skilled workers but also that these ICTs so much increase productivity all round that the net effect may be positive for all kinds of workers. This reasoning is similar to Ricardo’s conclusion for the world as a whole.

[8] The infant industry argument is based on the belief that imperfect competition undermines the argument for free trade. See Bhagwati’s Harry Johnson’s Lecture of 1992.  It is curious that developing countries reject free trade because their budding industries cannot compete with the returns to scale of advanced countries industries, while advanced countries want to level the world trade playing field tilted by the unfair labor conditions of the Third World. The result is that every country now complains of dumping by their trade partners. Even oligopolies such as OPEC prove to be evanescent in the face of technological progress and climate ideology.

[9] For anybody who may doubt what I say, an easy-to-read survey of present day research on the fairy-tales of protectionism can be found in Scott Lincicome (2017) Cato Institute no. 819 Policy Analysis.

[10] F. Pacicca (2018)

[11] Costinot and Rodriguez-Clare (2018, pgs. 11-12) compare the weight of foreign trade in the US economy in 2014 with that of Belgium: the US, 8%; Belgium above 32%.

[12] The slow repeal of the old mercantilist regime started in 1823, with the permission for British Governments to sign reciprocity treaties with foreign nations. It proceeded with with the permission for mechanics settle abroad and for workers to form trade unions. It was effectively dismantled with the repeal of the Corn Laws in 1846 by Robert Peel; and finally was achieved by Gladstone in 1860, reflected in the Cobden Chevalier. Commercial Treaty with France. It ended in1932, when a 10% duty was charged on imports, excepting imports from the Empire (Imperial Preference).