Tariffs and Trade

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by Joseph Joyce

Capital Ebbs and Flows

The Republican nomination of Donald Trump as its nominee for President ensures that international trade will be a major issue in the campaign. Trump views trade as a zero-sum game and the existence of U.S. trade deficits as proof that other nations have taken advantage of U.S. openness (= weakness). Tariffs are the primary policy tool to respond to the unfair treatment of U.S.-made goods and even the playing field.

Trump, of course, had (and has) many advisors in his first term as President who share his views, such as Robert Lighthizer and Peter Navarro. But there are other Republicans not affiliated with Trump who have similar views. Oren Cass is chief economist at American Compass, a conservative think tank. He graduated from Williams College with a degree in political economy and has a law degree from Harvard. He recently (July 17) was a guest on Ezra Klein’s podcast to discuss the foundations of the economic “populism” advocated by a number of the younger representatives of the Republican Party. These include Senator J. D. Vance, the Republican Party’s Vice-Presidential candidate.

Oren Cass is a very bright fellow, and I always read his newspaper columns. He articulates his line of reasoning very well. I chose his particular line of reasoning because he raises many legitimate points. Part of the discussion (see transcript here) dealt with Trump’s proposals to impose 10% tariffs on all goods and 60% tariffs on Chinese goods. Cass’ justification of the proposals deserves scrutiny. He makes the statement that the U.S. $1 trillion deficit includes foreign-made goods that could have been made here:

“ …what you’re doing is you’re taking what would otherwise have been demand for things that are produced in America and you’re just eliminating it. You’re just saying there is now less demand for stuff made in this country.”

He goes on to say that this is “a terrible model”, particularly for American workers in communities where manufacturing can be productive.

There is a lot to unpack from Cass’ claims. His statement about buying foreign goods rather than American made goods implies that if we cut imports to zero, GDP would rise as we switch to the production and sale of the domestic versions of the goods. But there are legitimate reasons to purchase foreign goods. Coffee is grown in Hawaii, but do we expect that at higher prices Hawaiian or other U.S. made coffee could replace coffee from Asia, Africa and Latin America?

Other goods could be produced here but at higher prices. At one point Cass points out that iPhones were designed in California but assembled in China. One of the reasons for Apple’s original decision to locate production in China was cheaper costs. As a result of the rise in Chinese wages and political factors, Apple is looking at establishing a production facility in India, while other companies have moved to Vietnam.

All this could be interpreted as examples of countries using their comparative advantage to produce exports and attract foreign investment. But Cass states that comparative advantage “…does not describe a modern industrial economy. Comparative advantage is really created, not discovered and based on who invests in what.” He cites semiconductor manufacturing as an example of an industry where foreign firms became the dominant suppliers because of subsidies from their home governments. There may indeed be a case for using subsidies and other industrial policy measures to maintain domestic production of some strategic goods, and a subsidy is preferable over a tariff. Economies do evolve, and China now produces goods that it did not in the 1990s. But the definition of a “strategic good” is subjective and was certainly overused in the Trump administration.

There are products that do not fit under the umbrella of “strategic good,” such as textiles. And yet Cass seems to believe that we could successfully compete in these fields as well. Klein states at one point that it is difficult “…to imagine a world where most garments that Americans wear are made in America.”  At the end of the interview, Cass replies: “…garments are an extraordinary potential area of innovation. And I would love to see our policy be – it’s going to be more expensive if you have to use foreign stuff than if you can use domestic stuff. Now, companies of the free world, investors of the United States, go forth and figure out what to do.”

Cass has a strong belief in the powers of U.S. ingenuity. But there are several responses. First, does he believe that it is possible to devise a way of manufacturing garments in this country that is cheaper than using Bangladeshi laborers? Multinational firms would have adopted the new machinery by now if were feasible.  Second, are there any goods or services that we import that he believes we should accept? His arguments are consistent with a mercantilist view that exports are needed to project national power that imports diminish. Third, what happens when other countries retaliate with their own tariffs? Do we enter a downward spiral of trade, as occurred in of the 1930s?

Moreover, all these trade measures involve costs that will show up at some point in the price of the protected goods. But Cass is not concerned about this aspect of protectionism. In response to a question from Klein about the public response to higher prices because of tariffs, Cass responds that if higher prices were linked to policies favored by the public, then the public will accept them: “…when you tell people honestly, here are the ups and downsides of a tariff—one of the downsides of a tariff is it raises prices—that doesn’t reduce support for tariffs.” The public may indeed tell a pollster that they are willing to accept hypothetical higher prices i(just as they claim to be willing to accept cuts in government expenditures), but the reality of higher prices (or spending cuts) may produce a very different response.

Perhaps most surprising, Cass does not tie the trade deficit to its macroeconomic determinants, savings and investment. Students in the Principles of Macroeconomics course learn that the trade deficit (X- M) equals the gap between Investment spending (I) and private and public, i.e. government, savings (S, (T – G)):

X – M = (S + (T – G)) – I

If investment is greater than domestic savings, then it must be financed by foreign savings in the form of capital inflows through the financial account. The trade and financial accounts are mirror images of each other, so a surplus in the financial account must be offset by a trade deficit.

This is not a theorem—it is an identity. It holds true because of how Gross Domestic Product and the balance of payments are defined. But the relationship between investment and savings implies that closing the trade deficit requires a change in savings, beginning with fiscal deficits. Trump showed in his first term that he was quite willing to sacrifice fiscal solvency for a tax cut, and nothing has shaken his enthusiasm for tax cuts.

 The battle over trade, therefore, will be fought over tariffs. Again, I am not denigrating Cass. Biden was willing to use tariffs as part of his industrial strategy and it is difficult to imagine any other candidate forsaking their use. That leaves a continuation of financing the deficit with capital inflows. These could include attracting FDI by foreign firms or issuing more Treasury debt to be held by foreign investors as “safe assets.”  Until the root cause of the trade deficit is addressed, these other measures only distort trade patterns and push up prices.