One of the first things I learned in undergrad economics was the idea that free trade is one of the only things that most economists agree about. The idea is simple and was probably said best by Joan Robinson:
“If your trading partner dumps rocks into their harbor, you do not make yourself better off by dumping rocks into your own harbor.”
Donald Trump’s “America first” thinking on this idea is an attractive, but basic fallacy of composition – if you impose restrictions on your trading neighbors then they will impose trading restrictions on you. In the end you will both be worse off since you now both have a harbor that is filled with rocks that no one can navigate into or out of. So why are trading restrictions like tariffs so intuitively attractive to people like Trump and his supporters? Let’s dive in a little deeper.
Change is Hard
The global economy is changing faster than it ever has. Globalization via international trade is one of the biggest changes as companies are able to build cheaper products abroad and sell them back home. This is not a bad thing. After all, when Apple builds a cheaper iPhone in China we all get to consume less expensive phones which leaves us with that much more money to spend elsewhere.
This sort of change is highly disruptive to the domestic economy. As companies stop building the same stuff in the USA all that saved income from cheaper products flows to different industries. In the case of the USA that transition has been mostly from manufacturing to services industries. In the aggregate we are not necessarily worse off, but we are very different. This is producing new industries, but it is also destroying older industries. For those in the losing industries the pain is very real.
Trade Deficits aren’t Necessarily Good (or Bad)
The idea of being in a deficit does not have a good connotation. When we think of a deficit we think of a loss. From an income perspective that’s exactly right. A trade deficit represents more money flowing out than in. But it also means more goods coming in than going out. Again, it’s just a “trade”. China gets green pieces of paper and we get pieces of plastic that will end up in a landfill. Who’s really winning that trade? Well, we don’t really know. More on this below….
In a general sense trade deficits and current account deficits are not inherently bad. They just reflect the aggregate ex-post position of all those flows. But they can sometimes be reflective of bigger problems in an economy. For instance, before the financial crisis many countries like Spain, Greece and the USA were running very large current account deficits. This, in retrospect, was indicative of a private sector debt problem in which consumers were going ever deeper in debt to finance a lifestyle that was unsustainable. The large current account deficits were not necessarily the cause of this issue, but a coincident indicator. As we are still pulling ourselves off the mat from the financial crisis it’s not unreasonable to look back at that situation and view it as something we would like to avoid in the future.
Of course, in a world with global trade there will always be trade surplus countries with corresponding trade deficit countries. This isn’t a problem in and of itself, but it does not mean that trade deficits are always good either. For instance, when we trade with China we are getting cheaper pieces of plastic that end up in landfills and we end up with more saved income that can be spent elsewhere. I said earlier that we are just sending them pieces of paper, but we’re not really. We are also sending them corporate investment and jobs. Then again, cheaper goods and services in the USA has a multiplier effect that leads to income being spent elsewhere in the domestic economy. If this does not lead to domestic investment then the USA could be on the losing end of this trade. This, arguably, is what’s been happening in the USA over the last 30 years. While the USA has cheaper goods and services we have not seen a corresponding boom in corporate investment. Therefore, on a relative basis, it could be argued that the USA is doing worse than we should be.
Free Trade Ain’t Free
The real winners in free trade agreements are wealthy developed economies. By enacting free trade agreements they are able to impose implicit trading restrictions on their neighbors. For instance, I alluded to the potential that China is winning the international trade bet with the USA because they are getting more foreign investment than the USA gets in domestic investment. In other words, the multiplier effect of US investment in China is humongous while the USA is not experiencing the same corresponding degree of a multiplier in US domestic due to cost savings from imported goods. China wants this investment badly. They do not want to lose those jobs, training, skills and investment to Vietnam because then Vietnam will win in a relative sense.
As a result of this China is incentivized to do things that will make them more attractive in a relative sense. So it is, to some degree, in China’s best interest to do things that attract this foreign investment so that it does not flow elsewhere (in recent decades their primary strategy has been currency manipulation which is not really a US Dollar attack as much as it’s fending off the likes of Vietnam). Likewise, Vietnam will do things that make their economy more attractive to these large developed economies. Forcing these countries into free trade agreements is an implicit restriction that reduces their ability to attract foreign capital. So free trade isn’t really that free for all involved and there are inevitable winners and losers in any trade.
Tariffs are not the Solution
I’ve touched on a number of problems that Americans are presently feeling:
- High levels of household debt.
- Loss of jobs in industries such as manufacturing.
- Lack of domestic corporate investment.
- Rapid changes in our culture and environment due to globalization.
These problems are all somewhat related to international trade, but will not be solved by eliminating or reducing international trade. Tariffs dump rocks in our own harbors. That will make the goods we want more expensive because now we have to swim out to those ships to get those same goods. In other words, tariffs act as a domestic tax since it is consumers who will ultimately bear the cost of those more expensive goods. After all, we import those goods because it is not cost effective to make the same quantity of those goods in the USA. If we built the same goods here in the USA they would cost more (and corporations could theoretically pay their workers that much more, which they probably won’t), but we would be forgoing the counterfactual relative improvement where those goods cost less AND we have more income resulting from the trade flows and cost savings.
While there are reasonable concerns about global trade and the impact of globalization we should reject policies that make us all worse off. The 4 problems listed above have solutions that can be improved with domestic policies that don’t involve an implicit tax on all US consumers.
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.