EC Tariffs And Trade Intervention

Given all the discussions about the beginning of a tariff war between the United States and China, I thought it might be helpful to wade through some of the relevant issues. To summarize, I want to make the following major points:

  • Trade deficits and surpluses typically force monetary and other economic changes in the affected countries that tend to eliminate the imbalances. The fact that many large economies have run substantial trade surpluses or deficits year after year, sometimes for decades, violates trade and economic logic; this pattern is evidence that mercantilist policy distortions, either in the surplus countries or in the deficit countries, are preventing trade from adjusting.
  • The idea that all countries lose in a trade war is unintelligible. This cannot possibly be true, not just because there is overwhelming historical evidence that countries have benefitted from trade intervention but also because the claim is logically impossible. Whether countries benefit or lose from trade intervention depends on the underlying institutions that mediate trade and capital flows, the extent of existing trade and capital flow imbalances, and the types of intervention employed.
  • While tariffs and other forms of trade intervention may indeed raise prices for consumers, this is only one way, and often a minor way, in which these policy tools affect households. Depending on underlying conditions, they may also reduce unemployment, cause wages to rise, and reduce the growth of debt.
  • Tariffs and currency devaluation are not the only forms of trade intervention and are not the only ways distortions are introduced into global trade and capital flows. Any policy that alters the relationship between a country’s savings and its investment affects that country’s trade balance. Tariffs and currency devaluation affect trade balances not by changing the relative prices of tradable goods but rather by shifting income from households to businesses, thus forcing up the savings rate. Because of this, any policy aimed at making an economy more competitive internationally by suppressing wages is effectively a beggar-thy-neighbor policy. Any such policy works in exactly the same way as tariffs and currency devaluation.
  • Because the relationship between US investment and US savings is determined externally, by the country’s role in absorbing excess global savings, tariffs and other beggar-thy-neighbor policies will not reduce US trade deficits.
  • In a globalized economy, it may be extremely difficult for any country to implement policies that protect the bargaining power of workers, that reverse income inequality, that raise minimum wages, that improve the social safety net, or that otherwise make households better off relative to businesses and governments. Implementing any of these policies causes a country’s international competitiveness to deteriorate. Consequently, rather than achieving the desired result, these policies cause the trade balance to go into deficit, and either unemployment will rise or debt must rise.
  • To put it a little more starkly, a globalized economy must choose to protect its strength in the manufacturing and tradable sectors by lowering relative wages (directly or else indirectly in the form of tariffs, subsidies, or currency devaluation), or it must choose to boost the services and nontradable goods sectors through rapid debt growth.

How do tariffs affect prices?

There seems to be a basic assumption that there is a direct relationship between tariffs and the cost of goods to consumers. A 10 percent tariff on imported Chinese widgets, for instance, would be expected to raise the cost of widgets to consumers by 10 percent.

It almost never happens this way. Theoretically, the tariff is supposed to cause an upward shift in the supply curve because a smaller number of widgets can be produced for any given price. The new supply curve crosses the demand curve at a higher price, but almost never at a price higher by 10 percent. Figure 1 below shows how this happens.

Notice that tariffs have two adverse effects. First, the price of widgets is higher. Second, widget consumers buy and use fewer widgets than they otherwise would have. Widget consumers, in other words, are worse off in two ways: they use fewer widgets, and they must pay more for each one.

But it’s clear that the ways consumers are worse off must depend on the slopes of the supply and demand curves. A lot of this reasoning is fairly obvious and is much discussed in beginning economics textbooks, so I won’t write much more about this subject, except to make one important point: every single good against which tariffs are implemented will have its own supply and demand curves, making it impossible to make any general statement about how tariffs affect prices for consumers. In some cases, they might cause prices to rise by close to 10 percent. In other instances, they will have almost no impact on prices or on quantities purchased.

All of the reasoning above assumes that producer prices are fixed, but this is unlikely to be the case. In many instances, producers will respond to a tariff by lowering prices and reducing their profit margin. In such cases, the tariff is effectively paid for by producers in the form of lower profits, and consumers are able to buy as many widgets as ever at the same price as before. This tends to happen mainly with respect to high-value-added imports, in which case there is enough profit that the producer can cut prices; or in industries with large economies of scale or low marginal costs, in which producers want to protect sales volume; or in products that are considered strategically important and receive substantial direct or hidden government subsidies.

How are households affected overall by tariffs and other forms of trade intervention?

Most economists limit their discussions about the impact of tariffs and trade intervention to the impact on consumers. This is dishonest, or at best confused because the primary impact of tariffs (and of trade intervention, generally) is not necessarily on consumption. Countries have successfully intervened in trade for centuries; yet mainstream economists often argue, against the evidence, that trade intervention is always harmful to the intervening country because it raises consumption prices.

But raising consumption prices is only one of the many ways that trade intervention can affect households. Trade intervention can also reduce unemployment, as it clearly did in the case of Germany after the Hartz labor reforms, which I discuss below. (Repressing wages, as I will show, has the same beggar-thy-neighbor impact on trade as devaluing the currency or imposing tariffs.) For similar reasons, trade intervention can affect households by allowing for domestic wage increases, as I explain in my most recent blog entry.

Trade intervention can also be used to allow for high-wage growth strategies. In a February 2017 blog entry, I discuss how the so-called American System of the nineteenth century, which included substantial trade protection, was designed in part to accommodate the fact that the United States had the highest wages in the world, and that these high wages themselves were the engine of productivity growth.

Trade intervention can also affect households directly or indirectly by slowing the growth in debt, whether consumer, government or corporate debt. In reverse, this was shown by peripheral Europe before the 2008–2009 financial crisis, and has been shown by the United States over the past several decades; in both cases, these countries’ need to absorb trade intervention among their trading partners required rapid growth in debt. I have explained how this works many times before (here and here, for example).The basic argument in the case of the United States is that, because of its role as the absorber of excess global savings, the country has run a permanent capital account surplus since the 1970s, which is also why it has run a permanent current account deficit since then.

By definition, a capital account surplus—or its obverse, a current account deficit—means that a country’s investment must exceed savings so that net foreign capital inflows must either increase investment or reduce savings. One hundred and fifty years ago, when US investment was constrained by insufficient domestic savings, it would have increased investment, whereas today investment in advanced economies is not at all constrained by insufficient savings, so it must force down US savings. There are many ways it does so, but these can be summarized as consisting basically of either a rise in unemployment or a rise in debt. For obvious reasons, the United States has almost always chosen the latter.

Limiting the discussion of the impact of US tariffs on US consumers is usually the result of either a very poor understanding of trade or a tendency to treat trade ideologically. I have often argued that US President Donald Trump’s proposed tariffs on Chinese and other foreign goods will not reduce US trade imbalances and are unlikely to be positive for the US economy. But to oppose these tariffs on the grounds that they will raise the cost of consumption is silly. That is not why they will prove ineffective.

In fact, it is precisely because tariffs will have so small a net impact on the cost of consumption that they will not benefit the US economy. If tariffs could successfully reduce the US trade deficit, only then would they raise consumer costs. But in that case, even with higher consumer prices, American households would overall still be better off because they would more than make up for higher consumer prices with lower unemployment, higher wages, less income inequality, and/or less debt.

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Gary Anderson 4 months ago Contributor's comment

Great article! I don't buy the author's argument that tariffs will bring lower unemployment and higher wages, except in cases where there is massive unemployement to start with as the author points out. But concepts in this article are very valuable in understanding our economy and global interaction.