What are the Effects of Tariffs on a Nation’s Wealth?

This old question has been given new life by the inauguration of Donald Trump as President of the United States of America. Using tariffs to “fix” a trade deficit is seductively appealing but, like other zombie ideas, it relies on a misunderstanding. In this case, it ignores two basic principles of economics: opportunity cost and gains from trade.

People, much smarter than I, have spent much time and effort debating the wisdom of tariffs and the net benefits of trade.

• Experts argue that “Free trade is always under attack” and debunk many of the ideas that reappear. 
• When debating with someone who is famously careless with facts, talking about data has limited value. Everybody else should remember to distinguish an imbalance (deficit or surplus) in a selected good with one country vs. in all goods and services with all countries. Also, should the measure focus on number of units or a dollar value? Understanding why these distinctions matter clarifies the net benefits of trade.
• Using an inappropriate measure reveals misunderstandings about costs and benefits, since there is an obvious alternative motive for an “excessive” trade deficit: a country (and an individual) wants a lower price for what it buys and the same country wants a higher price for what it sells.
• Careless logic produces paradoxes. Consider a country which increases its income. Its people want to buy more stuff, including more imports, and doing so increases a trade deficit, regardless of what other countries do. So, a trade deficit can be “solved” easily by reducing national income. Resolving this paradox requires recognizing that consumption has benefits not recognized by financial measures.

People who have been successful in business often suggest that they could run the government better. Superficially, this suggestion makes sense: governments and businesses should be run efficiently (yes, but which objective?); governments and businesses should provide value to their “clients” (yes, but which clients?). “A Country Is Not a Company” clarified my thinking by emphasizing specific differences in the styles of thinking between the business and economics perspectives. For example, the opportunity cost for a business differs from the opportunity cost for a government: e.g., a worker who has been fired can be ignored by their former company but a person remains in the country regardless of whether they are employed or unemployed.

Thus, a company which sells more output hires more workers but a country which increases exports (or decreases imports) does not “create” more jobs over a longer term. Especially if the effect on jobs appears large initially, market forces can be expected to lead to other changes later.

A related reason for thinking that tariffs are a generally bad idea comes from a book that many have claimed to read: Adam Smith’s “An Inquiry into the Nature and Causes of the Wealth of Nations”. When it was written (1776), tariffs were popular tools of government policy and the mercantilist view of international trade was popular. It alleged that a nation’s wealth could be summarized financially: a country which imports more than it exports feels poorer. This story is more dramatic when paying for the imports meant shipping gold to another country.

Smith argued that a more relevant measure of national wealth is the well-being of the people in that country. To use a personal example, more income is preferred but more important than the number on a paycheck is the enjoyment associated with the goods and services bought with that income. As evidence, see the complaints about “shrinkflation”. The concept of consumer surplus reveals gains from trade. This logic (and producer surplus) explains why productivity growth affects wealth.

Rather than focusing on a symptom (i.e., a trade imbalance measured financially), a wise policy responds to a real problem by understanding gains from trade and opportunity cost.

Now, it is your turn to write

• Consider this critique of free trade published in the Harvard Business Review.
  • Is it logically valid?
  • This critique was written nearly 40 years ago. If it were being written now, which of its arguments have become more important and which have become important? In your opinion, what caused that change (e.g., the facts of the economy; political priorities; social priorities)? 
  • Warning: Please see this reading as an exercise in critical thinking. I have assigned this reading to students who thought that, because it was published by a normally-reputable source, it must be correct. They learned the wrong lesson.
• This post emphasizes “gains from trade” since it is one of the five basic principles. If you are interested in the political aspects of a policy then, within a country which imposes import tariffs, you may focus on winners and losers. Who are they? Is there an obvious way to consider net benefits: i.e., under what conditions can the winners win more than the losers lose?