Economic nationalism: Trump courts conflict with his trade wars

Trump's tariff will hurt America - again (Source: here)

US President Donald Trump is a dyed-in-the-wool isolationist and protectionist, so all his threats on trade should be taken seriously. Like he did in his first term, US president-elect Donald Trump has wasted no time in his second term applying a barrage of tariffs to American imports, that is, taxing American consumers and businesses for using stuff sourced from overseas. His brand of economic nationalism is right up there among the most primitive and stupid ever implemented by a US government.

Protectionism on the scale implemented by Trump in his second term was last seen in the run-up to WW2. Such policies have a long, dark, and well-documented history in the world economy, so we know the two most common outcomes: poor economic performance and rising global tensions. Both are already in evidence.

History is replete with examples of the kind of damage caused by economic nationalism and protectionism in modern economies with deep global linkages. It is not rocket science. Economists have literally warned against protectionism for hundreds of years. Yet, here we are again. This is a reminder why economic nationalism is a really, really bad idea.

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One of Trump's first policy interventions in his first term was to withdraw from the North American Free Trade Agreement (NAFTA), sparking a renegotiation that eventually led to the United States-Mexico-Canada Agreement (USMCA).

USMCA is regarded as inferior to NAFTA, but the damage was not too great. USMCA retained most of the original features of NAFTA, while updating a few environmental clauses, working regulations, and digital trade provisions. The new agreement produced minor benefits for US dairy and automobile industries, while Canadians got more access to duty-free US goods online.

Trump's trade war against China in his first term was a far most costly failure – for the United States. Trump applied tariffs to US imports from China with the aim of reducing the US trade deficit, but he failed then, as he is failing now to grasp the core macroeconomic reality of trade imbalances, namely that they are the result of broader macroeconomic conditions, not the prices of individual goods (which are what you impact with tariffs). Trump kept US aggregate demand unchanged, so his tariffs merely shifted the US trade deficit with China to third countries. The US bilateral trade deficit with China declined in the wake of the tariffs, but US ended up import far more goods from third countries (at higher prices), so the overall US trade balance actually worsened.

US and Chinese broad trade balances were unaffected by Trump's tariffs, but trade ended up being diverted via other Asian economies - and American's paid the price (Source: here)

Predictably, the opposite happened in China. Direct Chinese exports to the US declined, but Chinese exports were just diverted to the US via re-exports from other Asian countries. Result: China’s trade surplus continued to rise. In fact, the only material difference between the pre- and post-tariff situation was that US trade became much less efficient, negatively impacting American welfare and jobs. The Carnegie Endowment estimates the US lost a quarter of a million jobs due to Trump’s tariffs (see here).

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So, having unleashed sound and fury signifying nothing in Mexico and Canada and scored a big fat own goal with his China trade war in his first term, Trump is now doing the same thing all over again, except with even greater vigour! Good luck, America! I have no doubt Trump’s second stab at economic nationalism will fail as badly, if not worse, than his first. Neither Mexico nor Canada nor China nor the Europe have rolled over in response to Trump’s trade taxes. Americans are already paying a high price, judging by the latest economic data. Again, no surprise, because a major deficit country the United States relies so very heavily on goods from abroad that when these goods are suddenly not available it hurts. Badly.

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Unfortunately, the general public repeatedly falls for the protectionist snake-oil. As an economist, I find voters' recurring failures to understand why protectionism is so bad deeply exasperating. Obviously, the bulks of the blame must be placed at the door of the policy-makers and interest groups, who promote tariffs, because these people actually know fully well that protectionism is bad. Yet, the continue to peddle tariffs. They are rancid opportunists, but it is still sad that after so many disasters the wider public is still not even close to appreciating the full damage economic nationalism causes. This is why I am writing this piece. I want to explain - as many have done before me - why economic nationalism is so bad for the economy and for international relations.

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Economies function best when economic activity can take place without distortions or barriers to trade. Ideally, the only time you would consider intervening in the prices of traded goods is when there are significant market failures, such as monopolies, or externalities like pollution. In these cases, governments may be able to improve the efficiency of the market by adjusting prices using various taxes. In all other cases, the notion that the government can make the economy work better by imposing taxes on, or entirely banning trade is simply wrong; protectionism always hurts society in the aggregate and the benefits, if there are any at all, tend to accrue to special interest groups.

Tariffs distort markets (for a more comprehensive exposition on tariffs read this). Let me spell it out why. A tariff is a tax, which is placed on top of the free market price. It is paid by the consumer, whose income therefore does not stretch as far as it would without the tariff. Having less real income, the consumer consumes less, which reduces the level of economic activity. Tariffs also have the effect of prompting foreign firms to direct their exports elsewhere, so domestic consumers end up with less choice.

When a tariff is placed on imports, domestic firms producing similar goods can sell their wares at the higher tariff-augmented price, giving domestic firms a de facto windfall, but at the expense of domestic consumers. In other words, tariffs are an income transfer from consumers to businesses. However, this transfer only becomes material if the domestic firm is able to produce the wares in question at a cost, which is below the market price plus the tariff, because otherwise consumer demand will shrink at the higher tariff-augmented price, reducing sales volumes and possibly eroding away entirely the hoped-for higher revenue at the tariff-augmented price.

Domestic firms benefitting directly from tariffs usually like them quite a lot, because they rig the market in their favour (at the expense of domestic consumers). Once protectionism becomes policy, however, domestic firms tend quite soon to become heavy lobbyists to ensure tariffs (a) are never removed and (b) increase in size of time. In order to ensure this happens, companies that benefit from tariffs often allocate more and more resources and effort to ‘protect’ their protection, to the point they neglect even their core business. In other words, protected firms gradually become less efficient and less competitive over time and therefore ever more dependent on state protection. Think French farmers! Think the US steel industry. These businesses would die without government support; hardly a sign of a healthy market economy.

In general, the greater the tariffs, the greater the costs to society. In the extreme case of a prohibitively high tariffs, no trade takes place at all. This means, of course, that prohibitively high tariffs also produce no tax revenue. At that point, consumers only have access to goods produced at home, which means the goods typically have far higher costs than the goods that would have been available from overseas in the absence of tariffs. Many domestic goods are typically also of inferior quality and, naturally, there is less available to consumers when tariffs have shut down international trade entirely. All the usual benefits from trade – greater variety, cheaper goods, specialisation, superior quality as well as more efficient and competitive domestic industries – are lost, leaving society demonstrably worse off.

Incidentally, it is poorly appreciated, but perfectly logical that free trade is best regardless of whether you talk about domestic trade or international trade. It is very rare to hear any politician call for intra-country tariffs. For example, when you did last hear anyone call for tariffs on trade between, say, New York and Philadelphia? Or between Brooklyn and Queens? Or between England and Wales? One of the greatest strengths of the US economy is precisely that it is one giant free trade area without any internal tariffs. The same is true for the European Single Market. Politicians get away with placing tariffs on trade with other countries, because they exploit cultural anxieties and prejudices within the domestic populations about consumers and businesses abroad. But you only need to look at the disastrous effects of Brexit in the UK to see that barriers to free international trade is harmful. Technocratic governments - unlike populists like Trump - constantly seek to lower trade barriers through free trade agreement with other countries precisely because tariffs and other types of restrictions on international trade are so damaging.

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Why, then, do nations still engage in protectionism? As alluded to in the previous paragraph, an important part of the answer is culture. Citizens and businesses in one country tend to ignorant, suspicious, and prejudiced about citizens, businesses, and business practices in other countries. On the other hand, they tend to be extremely familiar with and accepting of the behaviour of their own citizens and businesses and business practices. This asymmetry gets exploited for political purposes again and again - and the main manifestation is protectionism.

What Trump is really saying when he announces tariffs on America’s trading partners is that evil foreigners are hurting American industries. He will use words like "our" and “American” to subtly, but powerfully divide sentiment of voters between ‘them’ and ‘us’. Voters fall for this type of rhetoric over and over again due to the profound levels of cultural brainwashing in most societies (see here). You may not even work in the affected industry, let alone own its shares, you may not even a consumer of the goods produced in the industry, but you are still very likely to be sympathetic to a domestic industry the moment a politician says it is “ours” and it is under threat and needs protection from foreigners.

A slightly more sophisticated protectionist argument is that tariffs are necessary to offset industry protection abroad. China, it is alleged, protects its industries and has done so for years in multiple ways, including through government subsidies and subsidised directed bank credit. These measures, it is alleged, amount to beggar-thy-neighbour policies in response to which some people see targeted tariffs as legitimate and even efficient.

There are two problems with this argument.

First, tariffs easily provoke reciprocal tariffs, thus triggering trade wars. Trade wars are unambiguously bad, because they simply destroy trade. A world with less trade is sub-optimal in economic terms. The world avoided a broader trade war in response to Trump's China tariffs in his first term, because China showed great restraint. Whether the same will happen this time is less clear.

The other - more significant - problem with the argument that tariffs can remedy beggar-thy-neighbour policies is that China’s industrial policies, while successful in expanding China’s global influence in certain sectors, such as electric vehicles, have not actually benefitted China overall. Nor have China's industrial policies evidently damaged the United States.

Take the US economy. The US economy is unambiguously the strongest in the world. It is highly diverse and extremely resilient to shocks. The US has gone from strength to strength throughout the last three decades during which China rapidly emerged as a global economic superpower. The reason why the US economy is so strong and so resilient is that US governments generally refrained from distorting the economy through protectionism. In fact, if there is one reason Americans should worry about Trump’s tariffs it is this: they could undo the very thing that has kept the American economy so strong for so long, namely faith in markets that the US economy will be well-managed.

As for China's experience with industrial policy, China is actually a great example why tariffs and protectionism are ineffective and damaging. China’s rise from economic isolation to global superpower was achieved despite protectionism, not because of it. The four core drivers of China’s economic ‘miracle’ were not tariffs. Instead, they were: (a) the opening of the economy to international trade; (b) high savings and investment rates; (c) sound macroeconomic management; and, (d) a relentless focus on long-term policy objectives.

Chinese industrial policy has generally worked against China’s economy. China’s recent pronounced economic downturn was directly attributable to government intervention in the house market. By subsidising capital for the real estate sector for far too long, China ended up building too many houses, leading to an eventual collapse in the building sector and years of painful macroeconomic adjustment. The housing sector may have grown rapidly for a period of time under protection, but it is now clear that much of the capital allocated to the sector was mis-directed and now China’s macroeconomy is paying the price. The same happens in traded sectors of the Chinese economy when market forces are not given great prominence in the allocation of resources.

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What should a country do if its industries happen to be competing in sectors in which foreign competitors benefit directly from governmental protection? First, the country should rejoice that its consumers have more choice and access to cheaper goods at the expense of tax payers in the protectionist country. The United States has enjoyed such benefits due to trade with China for three decades. Second, home industries should focus on areas where they have a genuine competitive edge, taking world prices as given and letting resources find their most optimal allocation. Remember industries always have a competitive edge, because trade depends on comparative, not absolute advantage. Comparative advantage means home industries can be competitive even if all the goods they produce cost more than those produced overseas. Countries end up specialising in the goods in which they are better relative to the other goods they produce. Each country ends up producing a sub-set of goods rather than all of them.

What countries should avoid at all cost is to act like King Canute, who famously tried in vain to stop the tide. Take world prices as given. Take China as given. Do not guide precious resources down some blind alley that has been artificially created by tariffs and other trade distortions. Resources, when misallocated, never deliver genuinely competitive firms, only rent-seeking, corrupt and inefficient companies as well as fiscal problems and they never improve trade balances.

If a government really wants to help an industry, it can provide temporary financial assistance to enable an industry to adjust swiftly and easily to changing global conditions. Even more importantly, the government can maintain sound, sustainable macroeconomic policies, including a commitment to free and undistorted international trade. By removing itself as determinant of relative prices, the government ensures the most stable economic environment, which in turn provides the best possible conditions for investment.

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It is extremely worrying that protectionism is now once again rearing its ugly head. It is particularly concerning that the US – hitherto the world’s most stalwart proponent of free trade – embraces full-on economic nationalism. Some countries will surely follow the US example. When one country goes down the road of economic nationalism, it is often the thin edge of a wedge. Protectionism is stupid economic warfare. History shows it often leads to other types of warfare. As such, we may be entering a new dark age in which protectionism ultimately turns out to be the least of our worries. Trump’s draconian tariffs are rightly seen as provocative and aggressive attacks on other countries, in other words, a step towards conflict. They provoke anger, possible retaliation. The last time the world descended into wholesale protectionism of this kind was in the 1930s, when nationalism was on the rise in Europe and the US withdrew into isolationism. Indeed, the protectionism of the 1930s turned out to be an excellent early indicator of future global war. It may yet prove to be so again. If so, it would be consistent with my general thesis (see here) that the West is being sucked ever deeper into a downwards economic and political spiral that began with the Global Financial Crisis in 2008/2009.

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