Tariffs

what most people get wrong and why

Four widely believed propositions about trade and tariffs

1. A trade deficit, an “unfavorable” balance of trade, importing more than you export, is bad. A trade surplus, a “favorable” balance of trade, is good

2. One reason a country has a trade surplus is that it has low wages, allowing it to undersell countries with higher wages.

3. A country with a trade deficit can reduce or eliminate it with tariffs to reduce its imports, giving more jobs to its workers, better able to compete now that they are protected by the tariff from unfair competition with the lower wage country.

4. The one problem with this tactic is that the other country may retaliate, impose its own tariffs, reduce its imports and so your exports and jobs producing them, restoring the previous uneven balance.

All four of these propositions are taken for granted by most people who think they understand tariffs and trade, including the current president of the US. All four are false.

One clue to the fact that they are false is the claim that workers in China are paid much less than workers in America, that that explains why Chinese firms can produce goods at prices American firms cannot compete with. Chinese workers are paid in yuan, American workers in dollars. On the face of it, saying that a Chinese wage in yuan is less than an American wage in dollars is like saying that my height is less than my weight.

To compare them you need an exchange rate, a price of yuan in dollars or dollars in yuan. At an exchange rate of one yuan for ten dollars, current Chinese wages would be much higher than American, at one yuan for a US cent much lower. Before you can use the wage difference to explain the balance of trade you first have to explain why the exchange rate is at a level at which China exports more to the US than it imports from the US.

The Simple Case

The first step in doing so is to consider the simple case of two countries and no capital flows. The only reason Americans want to sell dollars for yuan is to buy Chinese goods, the only reason Chinese want to buy dollars with yuan is to buy American goods. If Americans want to buy more dollars worth of Chinese goods than Chinese want to buy of American goods that means that Americans are trying to sell more dollars than Chinese want to buy, so the price of the dollar on the dollar-yuan market falls. As it falls, Chinese goods become more expensive for Americans, since it takes more dollars to exchange for their price in yuan, American goods become cheaper for Chinese. The process stops when the exchange rate reaches the level at which Chinese want to buy as many dollars as Americans want to sell, which means that the Chinese are spending as much on American goods as the Americans are spending on Chinese goods. US exports match US imports. Trade balances.

The US now, for some reason, imposes a tariff, a tax on imports from China. That makes Chinese goods more expensive to Americans so they buy fewer of them, sell fewer dollars for yuan. Supply of dollars is now less than demand, so the price of the dollar rises. A more expensive dollar makes American goods cost more to the Chinese so they buy fewer. The price stops rising when supply and demand on the dollar/yuan market are again equal. US imports again match US exports, both lower than before. The US has gained jobs in import competing industries, lost jobs in export industries. No retaliatory tariffs required.

I have just shown that trade always balances, so how can it be that the US currently has a large trade deficit with China? To answer that question, we now drop one assumption

Capital Flows

One reason Chinese want dollars is to buy US goods and take them to China. Another is to buy US capital assets, shares of stock, land or government securities. The assets remain in the US, only their ownership goes to China, so the purchase is not included in the trade statistics. Every dollar sold is bought, so the total purchases by Chinese from Americans equal the total purchases by Americans from Chinese. The difference between US exports and US imports is, must be, equal to the net inflow of capital.

What if the Chinese simply accumulate dollars? They are not likely to accumulate very many, since dollars do not pay interest and dollar denominated securities do, but they could accumulate some. I am counting American currency held by Chinese as a capital asset, since it is a claim against US goods that could be executed at any time in the future.

Suppose the US imposes a tariff. Chinese goods are now more expensive for Americans so they buy fewer, sell fewer dollars. As before, the exchange rate shifts, making American goods more expensive for Chinese. When supply again equals demand, it is again the case that the deficit is equal to the net inflow of Chinese capital to the US. It might be larger, it might be smaller, depending on the effects of the tariff on the demand by Chinese investors for American capital assets.

Trump has suggested that one purpose of his tariffs is to persuade foreign entrepreneurs to build factories in the US to avoid them. Doing that would require foreign capital invested in the US, so if it happens the US trade deficit will increase, not the result he wants.

Errors Corrected

1. A trade deficit, importing more than you export, an “unfavorable” balance of trade, is bad. A trade surplus, a “favorable” balance of trade, is good

A trade deficit means the country is importing capital — that is an accounting identity, not a piece of economic theory. If the reason is that the government is running a budget deficit and funding it by with loans from foreigners, loans that will eventually have to be paid back, that is probably a bad thing but, if so, what is bad is the budget deficit not the trade deficit. If the reason is that the country is using foreign money to build canals and railroads, as the US did in the 19^th century, it is probably a good thing.

2. One reason a country has a trade surplus is that it has low wages, allowing it to undersell countries with higher wages.

The wages are in each country’s currency. The exchange rate that makes it possible to compare them is the price, for one country’s currency in the other’s, at which exports plus capital flow just balances.

3. A country with a trade deficit can reduce or eliminate it with tariffs to reduce its imports, giving more jobs to its workers, better able to compete now that they are protected by the tariff from unfair competition with the lower wage country.

The tariff shifts the exchange rate, making the country’s exports less attractive, so while it increases jobs in import competing industries it reduces jobs in export industries.

4. The one problem with this tactic is that the other country may retaliate, impose its own tariffs, reduce its imports and so your exports and jobs producing them, restoring the previous uneven balance.

The other country might do that but the effect occurs via the change tariffs produce in the exchange rate even if it doesn’t.

Why?

Popular discussions of disease epidemics do not blame them on miasmas. Discussions of the space program do not express concern that probes will crash into the crystalline sphere that, according to Ptolemaic astronomy, carries the moon, embedded in it, around in its orbit. Why is it in trade policy and only in trade policy that accepted views are centuries out of date?

There are three reasons. The first is that the wrong theory, absolute advantage, is easier to understand than the right theory, in part because it is simpler, in part because it better fits competition as it occurs within one nation’s economy, where there are no exchange rates to complicate comparisons.

A second reason is that the wrong theory better explains negotiations between countries as they actually occur. In terms of the correct theory, each country is offering to stop shooting itself in the foot, injuring itself by imposing tariffs, if the other country reciprocates. That only makes sense if you realize that negotiators on each side are pursuing their political interests not their citizens’ economic welfare, offering to give up an opportunity to trade a favor, a protective tariff for a favored industry, for votes and campaign contributions. The benefit of a tariff is obvious and concentrated, the costs, to domestic consumers and export industries, diffused and less obvious, so imposing a tariff can be politically positive even if economically negative.

The negotiations make much simpler sense if you believe that each country’s tariffs benefit it at the cost of the other country.

The third reason is that the wrong theory is the one it is in the interest of each country’s politicians to have their voters believe.

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For more explanations of the economics of tariffs see earlier posts on the topic.