Economic Nationalism: Trump Courts Conflict with His Trade Wars

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

Like he did in his first term, US president-elect Donald Trump is once again busy applying tariffs to American imports, that is, taxing American consumers ans businesses for using stuff sourced from overseas.

Trump is a dyed-in-the-wool isolationist and protectionist, so his threats on trade should always be viewed as credible. Sadly, his particular brand of economic nationalism is right up there among the most primitive and stupid implemented by a US government. Ever. No wonder the economy is beginning to show signs of genuine distress.

History is replete with examples of the damage protectionism inflicts on modern economies with deep global linkages. It is really not rocket science. Economists have warned against protectionism for hundreds of years.

Yet, here we are again. This blog is a reminder why economic nationalism is a really, really bad idea.

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Let us first remind ourselves what Trump did on the trade front in his first term. One of his first interventions was to withdraw from the North American Free Trade Agreement (NAFTA), which sparked a renegotiation that eventually led to the United States-Mexico-Canada Agreement (USMCA).

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

Trump's first-term trade war against China was a far most costly failure – for the United States. Trump failed then, as he does now, to grasp the macroeconomic reality at the core of trade imbalances. Trade imbalances reflect broader macroeconomic conditions, not the prices of individual goods (which are what you impact with tariffs).

Trump applied tariffs to US imports from China with the aim of reducing the US trade deficit, but at the same time he kept aggregate demand unchanged, so he 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 went on to 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 merely went via other Asian countries, which then re-exported the goods to the United States. Result: China’s trade surplus continued to rise. In other words, 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 Carnagie 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 whatsoever that Trump’s second attempt at protectionism will fail as spectacularly as, if not more spectacularly, than his first. Mexico and Canada and China and Europe have already announced counter-tariffs in responce to Trump’s trade taxes. Americans will pay a high price. After all, as a major deficit country the United States relies more on goods from abroad than most other nations.

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As an economist, I find the general public’s recurring failure to understand why protectionism is bad deeply exasperating. Much of the blame lies at the door of the policy-makers and interest groups, who promote tariffs. These people know fully well that protectionism is bad, but they do it anyway. They are rancid. As for the ignorance of the wider public, it seems that no matter how many times protectionism is shown not to work, the public still falls for the old snake-oil arguments.

Sigh!

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Allow me to explain in greater detail why economic nationalism is so bad for the economy.

Economies function best without distortions or barriers to trade. Ideally, the only time you intervene in prices is when there are significant market failures, such as monopolies, or externalities like pollution. In these cases, governments can improve the efficiency of the economy 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, accrue only to special interest groups.

Tariffs are bad, because they distort markets (for a more comprehensive exposition on tariffs read this). Let me spell it out. A tariff is a tax, which is placed on top of the competitive 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.

Tariffs enable domestic firms to sell their goods at a higher tariff-augmented price, giving domestic firms a de facto windfall at the expense of domestic consumers. In other words, tariffs are an income transfer from consumers to businesses. However, this transfer is onky material to the extent the firm is able to produce at a cost below the market price plus the tariff and that consumer demand does not shrink so much at the higher tariff price that the lower sales volumes do not entirely erode away the income from the higher tariff-augmented price.

Domestic firms are obviously quite happy with tariffs, because tariffs rig the market in their favour (at the expense of domestic consumers). Once protectionism becomes policy, however, you quickly tend to see domestic firms become heavy lobbyists to (a) ensure the tariffs are never removed and (b) the tariffs are increased further.

In fact, it is quite common for companies that benefit from tariffs to gradually allocate more and more resources and effort to ‘protect’ their protection, to the point they neglect their core business. This is why protected firms gradually become less efficient and less competitive. Think French farmers! Think the US steel industry. These businesses are now chronically dependent on government support.

The greater the tariff, the greater the cost to society. In the extreme case of a prohibitively high tariff, no trade takes place at all. At this point, consumers only have access to goods produced at home, often at far higher costs than goods sourced overseas. Many domestic goods are typically also of inferior quality and there is naturally far less choice when tariffs are high enough to shut down 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. Society is demonstrably worse off.

Incidentally, this logic - that free trade is best - applies equally to trade within and between countries. Yet, you rarely hear of intra-country tariffs. For example, have you ever heard anyone call for tariffs on trade between, say, New York and Philadelphia? Or between Brooklyn and Queens? Or between England and Wales? The answer, I suspect, is no. One of the greatest strengths of the US economy is precisely that it is one giant free trade area. The same is true for the European Single Market. Brexit has been such a disaster for the UK, because it impedes free trade between continental Europe and Britain. Every free trade agreement in operation in the world today was signed out of a wish to reduce trade barriers, precisely because they are so damaging.

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So why do nations still engage in protectionism? An important part of the answer is, as always, culture. Citizens and businesses in one country tend to ignorant, suspicious, and prejudiced about citizens and businesses and even business practices in other countries. By contrast, they tend to be extremely familiar with citizens and businesses and business practices within their own countries. 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 all those evil foreigners are hurting “our” industries. His use of the words “American” and “our"industries is a subtle, but powerful rhetoric designed to divide sentiment between ‘them’ and ‘us’. And voters tend to fall for over and over again due to their cultural biases.

You may not work in the affected industry, you may not own its shares, you may not even a consumer of the goods in question, but you are likely to be sympathetic to a domestic industry the moment a politician says it is “our” industries and it is under threat and needs protection from foreigners.

A slightly more sophisticated protectionist argument is that tariffs are necessary to offset broader types of industry protection abroad. China, it is alleged, has protected its industries for years in multiple ways, including government subsidies and directed credit. These measures supposedly amount to beggar-thy-neighbour policies in response to which some people see targeted tariffs as legitimte 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 hugely sub-optimal in macroeconomic terms. It is bad for all countries. The world largely avoided a broader trade war in response to Trump's first-term China tariffs, because China showed great restraint.

The other and more significant problem with the argument in favour of tariffs as a remedy for 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 clearly not benefitted China overall, nor have they evidently damaged the United States.

Take the US economy. The US economy is unambiguously the strongest in the world. It is also highly diverse and therefore extremely resilient to shocks. The US has gone from strength to strength throughout the last three decades, when China rapidly emerged as a global economic superpower. The reason why the US economy is so strong and so resilient is precisely because tUS governments have generally refrained from distorting the economy through protectionism. In fact, if there is one reason Americans should worry about Trump’s tariffs it is that they could undo the very thing that has kept the American economy so strong for so long.

Now look at China, which is actually a great example how 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: (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.

By contrast, Chinese protectionism has generally worked against China’s economy. China’s current pronounced economic downturn is 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 radidly for a period of time under protection, but ultimately the misallocation of capital brought down the sector and now China’s macroeconomy is paying the price. The same may well happen in other sectors of the Chinese economy unless market forces are given greater prominence in resource allocation.

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What should a country do if its industries happen to be competing in sectors, where foreign competitors benefit from governmental protection? First, the country should rejoice that its consumers have more choice and cheaper goods than in protectionist countries. This is basically the case of the United States over the past 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 accordingly. Remember there is always 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. The country’s industries end up specialising in the goods in which they are better relative to the other goods the country produces. 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, if thus misallocated, never deliver genuinely competitive firms, only rent-seeking, corrupt and inefficient firms, and fiscal problems, without in any way improving external balances.

If a government really wants to help an industry, it can provide temporary financial assistance to enable industry to adjust swiftly and easily to changing global conditions. Even more importantly, the government should 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 – is embracing economic nationalism, because other countries will surely follow suit. It is the thin edge of a wedge; we are entering a new dark age in which protectionism ultimately turns out to be the least of our worries. Tariffs, you see, are rightly viewed as hostile actions, ways to attack other countries (even though the perpetrators often get more damaged than the intended targets).

Trump’s draconian tariffs will be seen as pure aggression, a clear step towards conflict. They will provoke anger, possible retaliation. The last time the world descended into wholesale protectionism was in the 1930s, when nationalism was on the rise in Europe and the US had withdrawn into isolationism.

With hindsight, the protectionism of the 1930s was, in fact, an excellent early indicator of future global war. It may yet prove to be so again. This would certanly be consistent with my 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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