From a small northwestern observatory…

We know, as a matter of empirical evidence, that chaotic tariff wars are horrendous for the economy. The research on that sailed a long time ago. So why do some countries still use them?

First, it’s helpful to understand an economic truism of the Law of Comparative Advantage. We teach a simplified version of this to undergraduates (at least the ones who pay attention) and Nobel Prizes have been won in its wake. Indeed, if you ever saw the movie “A Beautiful Mind” about the life of the great John Nash, you may be interested to know that while his Nobel was about game theory, it in fact was based on his observations about world trade.

It goes a bit like this. Let’s say there are two countries (in the classic example, we use Britain and Belgium). Let’s say Britain is wealthier than Belgium (which at the time, it was) and let’s also say that these two countries both make two things — Wine and Wool, in the classical example. Now Britain, being the wealthier and more advanced nation, is better and more efficient at both products than Belgium. This would suggest that Britain should make both products and simply ignore any trade with Belgium. Britain could do that by establishing huge trade barriers — tariffs — against Belgium, much like the U.S. is doing today against, well, everyone.

However, and here’s the rub — internally, Britain is better at wine than at wool. Make no mistake, it’s better at both than Belgium, but it make wine more efficiently and more cost effectively than it does wool. Belgium, on the other hand, is better at wool than at wine. Again, it’s less efficient than Britain at both, but internally, it’s better at wool than at wine.

The Law of Comparative Advantage has proven, time and time again, that Britain would be better off making nothing but wine, and Belgium at making nothing but wool, and the two countries trading freely with one another. Tariffs, in such cases, are not only bad for the poorer country (Belgium) but also for the richer one (Britain)!

Late last year, the conservative journal The Economist proclaimed that the U.S. economy was the ‘envy of the world.’ We had amazingly low unemployment, our inflation was coming down, our GDP had been growing constantly since the pandemic, and our stock market was on a tear. Yes, we had some internal inefficiencies, but these tended to be granular and needed to be addressed with a surgeon’s scalpel, not a sledgehammer. Yes, middle class incomes had not kept up with the cost of living over the past half century, but this was a matter of income inequality and not trade imbalance, and needed to be dealt with accordingly.

Over the years, America has made LOTS of things that other countries wanted. We export vast quantities of oil and natural gas. We export significant quantities of computers, vehicles, electrical machinery and equipment, aircraft, optical and medical apparatus, and pharmaceuticals. Vast swaths of America are devoted to growing exported agricultural products, such as soy beans and corn.

Further, and this may come as a shock to some, but one of the things other countries wanted was our dollar. They hoarded it. The rest of the world used it as a default currency, the one stable currency (along with, arguably, the Euro) which could be considered strong during chaotic times. It served the purpose that gold had served a hundred years ago. And yes, we produced it by the boat load (metaphorically speaking), and foreign countries had an insatiable appetite for it.

Poor nations use tariffs in order to protect and stabilize emerging businesses. In the previous example, if Belgium wanted to build up its own domestic wine industry, it would enact a tariff on imported British wine. In the short run, and in small doses, this may work. However, in the long run, it reduces British exports to Belgium, and thus the quantity of Belgian money they have to spend on Belgian wool. (The ‘what goes around comes around’ model of the economy.) Canada has an interesting tariff on imported milk products, which was agreed to during the current president’s prior administration. Indeed, he signed off on it as part of the replacement for NAFTA. Canada admits American milk products, but only up to a certain limit, and then above that taxes American milk heavily. Make no mistake, though, this Canadian tariff is a tax on Canadian consumers. Indeed, some emerging or mid-level economic countries prefer a mix of tariffs (which are like a sales tax on their own consumers) and income taxes to finance their governments. However, tariffs, being a sales tax, are highly regressive and depress the well-being of the middle class.

Rich nations, like the U.S., prefer to use income taxes (since there is so much income to tax, and it’s more efficient and less regressive) and let the middle class prosper without burdensome tariffs. Indeed, free trade benefits rich nations, like ours, more than it benefits poor nations. Nonetheless, the Law of Comparative Advantage tells us that both rich nations and poor ones are better off without burdensome and chaotic tariffs.

But, as the country song said, “not no mo’…” It takes a long time to craft a stable relationship with our trade allies. Like dropping a valuable vase on the floor, it only takes a moment to shatter it.

John A. Kilpatrick, Ph.D.

john@greenfieldadvisors.com