In this lesson you will learn:
Mercantilism is an economic philosophy or doctrine which holds that a country grows rich by encouraging exports (goods and services sold to foreigners) and discouraging imports (goods and services bought from foreigners). According to mercantilism, a trade surplus (exporting more than importing) is good for a country’s economy while a trade deficit (importing more than exporting) is bad. If mercantilism were correct, countries could succeed only by implementing beggar-thy-neighbor policies, because one or more countries can run a trade surplus only if other countries run trade deficits. In other words, it’s not possible for every country to sell more goods to foreigners than it buys from them.1 When government officials are motivated by mercantilist ideas, they view other countries as potential threats to their own nation’s interests. In such a mindset, international trade is a zero-sum game, meaning that the gains of one country must come from losses imposed on other countries.
Mercantilism was the dominant philosophy among the major world powers from the 16th through the 18th centuries. During that period, when countries used gold and silver as the basis of their trading, it seemed intuitive that running trade surpluses made a country richer. After all, by consistently having more exports than imports, a country’s stockpile of gold and silver would increase, because “more” or “fewer” exports and imports were measured in terms of gold or silver values.2 On the surface, it makes perfect sense that the path to national riches is to accumulate increasing amounts of money, especially when the money consists of physical gold and silver.
The British classical economists, notably David Hume and Adam Smith, destroyed the intellectual justification for mercantilist policies with their writings. (We will review some of the problems with mercantilism in the following sections.) You may be surprised to learn that the major powers actually acted on this newfound wisdom. During the 19th century, the world enjoyed a period of relatively free trade, in which governments substantially rolled back their policies that had previously hindered imports and encouraged exports.
As you may realize, today governments do not support genuinely free trade. Despite signing trade agreements to ostensibly capture the benefits of trade, large barriers still exist to the movement of goods around the globe. Political leaders do not openly advocate mercantilism by name, but they nonetheless support similar protectionist policies that favor (certain) domestic industries over their foreign competitors. Because countries no longer use gold and silver as the common money, the rhetorical justification for trade restrictions today rests on “saving jobs” in the protected domestic industries (rather than the accumulation of physical wealth).
The British classical economists—most famously Adam Smith in his 1776 Wealth of Nations—demolished the ideas of mercantilism, and began building a strong case for free trade. Over the years, economic thinkers have generalized these arguments and have also devised simpler, more intuitive ways of explaining the advantages of free trade among nations. In this section we’ll review the basic rationale behind free trade, and in the remaining sections of this lesson we’ll explore the specific problems with two types of trade restrictions, namely tariffs and import quotas.
Economically speaking, there is nothing significant about the political boundary separating “foreign” goods from “domestic” goods. Just as an individual American trades with other Americans to obtain his food, clothes, car repair, and medical services, there is nothing “uneconomical” about the United States in the aggregate trading with Japan.
In fact, the primary confusion underlying protectionist fallacies (i.e., faulty arguments) is to view “the United States” importing goods from “Japan.” In reality, it is individuals in the United States who buy goods from individual sellers in Japan; talk of “U.S. imports” is just the adding up of all these individual purchases. When we say “the U.S. runs a trade deficit with Japan,” all it means is that individuals in the U.S. collectively spent more money buying goods from sellers who were located in Japan, compared to the amount of money that Japanese individuals spent buying goods from sellers who lived in the U.S. There is nothing intrinsically dangerous or unsustainable about this situation, any more than it would be a “problem” if Texans bought more from Floridians than vice versa. Yet we don’t ever hear of Texans wringing their hands over a “trade deficit” with Florida.
It is true, there are arguments for protectionist trade barriers that have varying degrees of sophistication. For example, someone might worry about trade deficits with China—whereas not lose a moment’s sleep over interstate trade deficits within the borders of the U.S.—because of the specific monetary policies or relatively weak labor laws in China. In this book, we will not address such particular justifications for trade restrictions. We are here only trying to get you to see the general logic behind the case for free trade, and to understand why trade deficits (which is itself a loaded term!) per se are not a problem.
Recall from Lesson 8 the benefits of specialization and the concept of comparative advantage, as they apply among individuals in a pure market economy The case for free trade among nations is simply an application of these general principles. To restrict the imports of cars from Japan in order to “create jobs” for American workers in Detroit, would be as nonsensical as a man refusing to go to a dentist in order to “create work” for his wife so that she has to be the one to clean his teeth and look for cavities.
In Lesson 8 we explored the commonsense insight that individuals can enjoy a much higher standard of living if they specialize in one or a few activities, and trade their surplus production with others who have specialized in something else. By focusing on his or her (relative) strengths, each person in the community can enjoy more goods and services through the benefits of voluntary trade.
The same logic applies to nations. Rather than having to produce everything domestically (i.e., within the geographical borders of the country), the people in each country (on average) are all enriched by the option of trading with people from other nations. Because of their different endowments of natural resources—which can include deposits of oil or diamonds, but also things like average rainfall and sunshine—different regions of the world have the comparative advantage in producing different goods, such as barrels of crude oil or bushels of wheat. There are regional differences that arise from less obvious sources as well, besides natural resources. For example, for various historical reasons, New York City and London are major financial hubs, attracting some of the largest financial institutions. Given those realities, it is only natural (and efficient) that a large portion of the world’s financial transactions flow through these centers—just as it is only natural (and efficient) for Saudi Arabia to sell oil to the rest of the world.
Because of the tremendous differences among regions along natural, historical, and cultural dimensions, total world output (and hence average output per person) is greatest when different regions specialize in their comparative advantages (oil, oranges, wheat, cars, computer chips, etc.) and produce far more of these goods than their own residents want to purchase. The excess is then exported to other regions, which in turn export their own excess goods. Although an individual country can run a trade deficit with another individual country, the world as a whole is always in a trade balance; individual deficits and surpluses necessarily add up to zero. All the countries in the world (collectively) always buy exactly as many goods and services as all the countries in the world (collectively) sell.3
If we imagine an initial situation of worldwide free trade, and then further imagine that an individual country decided to “protect” its domestic industries and “save jobs” by preventing foreign goods from crossing its borders, its residents would become much poorer (on average).4 This would happen for the same reason that the people living in a particular house would be reduced to extreme poverty if the eccentric father suddenly announced that they were no longer allowed to spend money buying things from anyone living outside of the household.
Sometimes people do not see the connection between (a) trade among countries and (b) trade among individuals living within the same country. It’s true, restrictions on goods coming into the country would not be nearly as devastating as a father’s restrictions on goods coming into a household. But the difference is merely one of degree, not of kind. In a sense, the people living in a country are in a gigantic household, and so it’s not as crippling when their “father” (i.e., the government) says they can no longer trade with people outside of the house.
Looked at the other way, our hypothetical father has prevented his children from trading with almost the entire population of the earth. In contrast, if the U.S. president sealed off the border and outlawed imports, he would only be preventing Americans from trading with people who lived outside of the U.S. The gains from mutual exchange, and specialization and comparative advantage, could still develop among the hundreds of millions of people living inside the U.S. borders. This is why extreme trade restrictions imposed on the country would not be nearly as destructive as those imposed on a single household within the United States. Still, if you can see how it would be incredibly beneficial if the eccentric father allowed his children to trade with other Americans, then you can understand why it would be incredibly beneficial if the U.S. government allowed its citizens to engage in unfettered trade with foreigners.5
Before moving on to deal with the specific protectionist measures (namely tariffs and quotas), we should emphasize an important point: The economic case6 for free trade is unilateral. In other words, the case for free trade does not say, “A country benefits from reducing its trade barriers, but only if other countries follow suit and allow the first country’s exports into their own markets.” No, as the discussion above should have made clear, when a government erects trade barriers it takes away options of exchange from its own people. Therefore, removing those obstacles—giving its citizens more opportunities for beneficial trading—makes them richer (per capita). It would of course be better still if foreign governments scrapped their own restrictions so that the foreign consumers had more options to import goods from the original country. But regardless of what foreign governments do with their own trade policies, a particular government can make its own people richer immediately by removing all trade barriers and enacting a unilateral free trade policy.
It is true that if China maintains its trade barriers against U.S. exports, then this makes Americans poorer. But that is completely irrelevant to the case for the U.S. reducing its trade barriers against Chinese (and other) imports. If the U.S. enacted its own free trade policies, Americans would become much richer (per capita), and so would other people around the world (per capita), because they would now have more trading opportunities.7 This statement is true whether or not other governments followed suit and lifted their own trade restrictions. Unilateral U.S. removal of its own trade barriers would probably provide strong diplomatic pressure for other countries to follow suit, but if this occurred it would simply be gravy for Americans. Having other countries “return the favor” is not needed in the argument for free trade, because lowering American trade barriers is not really a “favor” at all. Yes, it makes foreigners better off, but it makes Americans better off too.
Now that we’ve outlined the general case for free trade, let’s examine the typical ways that governments restrict the flow of goods across borders.
A tariff (or a duty) is a tax that the government places on foreign imports. Although the government might levy a tariff for the simple purpose of raising more revenue, usually the official justification for a new tariff (or a hike in an existing tariff) is that it will help domestic producers of the imported good. It is this latter claim—that a tariff on foreign imports helps workers in the protected industry at home—that we will examine in this section.
To make the analysis easier, let’s work with a concrete example involving the U.S. and Japan, using unrealistic but nice round numbers. Suppose that initially there is completely free trade between the two countries, and that the equilibrium market price is $10,000 for a no-frills sedan. At that price, American manufacturers can profitably produce some vehicles, but not enough to satisfy the demands of American consumers. The remaining cars are supplied by Japanese producers, so that American consumers can buy exactly as many cars at a price of $10,000 as they want.
U.S. car producers send their lobbyists to Washington. They explain that labor costs are lower in Japan, that the Japanese government provides unfair subsidies to their car companies, etc. etc., and that Washington needs to “level the playing field.” If only the federal government would impose a 10% duty on Japanese imports, American producers could profitably expand their operations and provide more jobs for U.S. workers!
The politicians are only too happy to oblige, and they slap a 10% tariff on any Japanese cars entering the U.S. market. This means that if a U.S. consumer wants to buy a Japanese car, he now must pay a total of $11,000 out of pocket: $10,000 goes to the Japanese car manufacturer (as before),8 and the other $1,000 goes to Washington in the form of tariff revenue. Because U.S. consumers are now being forced to pay $11,000 for Japanese sedans, it means U.S. producers can raise their own prices too. And lo and behold, the lobbyists were right! At the higher price of $11,000, U.S. producers move along their supply curve, and manufacture more cars built in American plants by American workers. Employment goes up in Detroit and other cities with U.S. car factories, just as the lobbyists predicted. So is the new tariff an economic success?
Most economists would say no. It’s true that workers and shareholders in the U.S. car industry benefit from the new tariff, but it’s also true that U.S. car consumers are hurt by it. After all, Americans who wanted to buy a car could get one for $10,000 before, but now they have to pay $11,000—they are clearly worse off because of this change. Even consumers who faithfully “buy American” are hurt, because American car prices have gone up by $1,000 as well. Under fairly general assumptions, it’s easy to show that the benefits to the car producers are more than offset by the losses to the car consumers.9 On net, therefore, the tariff makes Americans poorer.
In an introductory book such as this, we won’t dot every i and cross every t in the argument. Instead we’ll try three intuitive approaches to demonstrate that a new tariff makes the country poorer on average.
Tariffs Are Taxes on Domestic Citizens
Perhaps the most obvious way to realize that tariffs make a country poorer is to realize that tariffs are taxes on domestic citizens, not on foreign producers. In our numerical example, it’s actually misleading to say, “The U.S. government imposes a tax on Japanese car producers,” because the tax is really applied to American car consumers. Any revenue that the U.S. government collects from the new tariff has come out of the wallets of Americans.10
Everything we said about the distorting effects of sales taxes in Lesson 18 applies here, because a tariff is simply a sales tax on goods that happen to be produced abroad. The original market price of $10,000 per car was a signal guiding consumers and producers as to the most efficient way to use resources. The tariff interferes with that signal, and makes Americans act as if the rest of the world is less capable of producing cars than it really is. Those who advocate tariff barriers to “protect” American industry are really saying that raising taxes on Americans is the path to prosperity.
A Tariff Doesn’t Increase Employment, It Just Rearranges It
Perhaps the single biggest mistake in the protectionist approach is to believe that a new tariff increases total employment. But this belief is wrong, because a new tariff doesn’t suddenly create new workers out of thin air. In our example, if the new tariff allows the U.S. auto industry to expand output and hire more workers, other U.S. industries necessarily must shrink their output and produce it with fewer workers.11
People who think tariffs are a good way to boost the economy usually focus narrowly on the jobs that are “created” in the protected sector, and then further take into account all the extra jobs that are “created” when those new workers spend their paychecks at the mall, restaurants, and so forth. And it is undeniable in our example that not only U.S. employment at auto factories, but also at nearby businesses, would increase after the new tariff is erected.
However, what this shortsighted analysis overlooks is that jobs would be destroyed in other sectors spread around the country. For one thing, anyone who buys a new car is out an additional $1,000 compared to the pre-tariff situation. Such a car buyer now has that much less money to spend on restaurants, movie theaters, etc. in her neighborhood, and so the merchants in her area suffer.
The clever protectionist might point out that we are here focusing on the small potatoes, because the (allegedly) big bonanza to U.S. industry comes from switching so much business to domestic producers and away from Japanese producers. In other words, rather than focusing on the $1,000 increase in car prices which is a wash—U.S. car consumers are “down” $1,000 per car, whereas U.S. car producers are “up” the same amount12—we should be focusing on the fact that for every additional U.S. car produced by American workers, that’s $10,000 being kept “in the country” rather than being “sent to Japan.” So surely this effect is the relevant one, and shows how the country as a whole benefits from the new tariff, right?
Actually no. The analysis of our clever protectionist is still overlooking one enormous effect of the tariff: By penalizing U.S. imports, the tariff simultaneously penalizes U.S. exports. Specifically, for every car that U.S. consumers buy from Detroit rather than from Japan, it means Japanese citizens now have $10,000 less to spend on goods made in America. Thus the extra business of U.S. car producers is offset by the drop in sales among American producers of wheat, software, and other exports.
A crucial principle to remember is that a country ultimately pays for its imports with its exports. Just as an individual household couldn’t (in the long run) continue to buy goods and services from the outside world without producing something in return, by the same token an entire country couldn’t continue to import cars, electronic goods, sweaters, and all sorts of other goodies from foreigners, unless that country shipped them goods and services in return.13 To put it bluntly: The protectionist implicitly assumes that the Japanese car producers are idiots, who are willing to bust their buns and use up scarce resources making beautiful new cars for Americans, all in exchange for green pieces of paper featuring pictures of U.S. presidents.
Before leaving this section, we should emphasize an important point: Focusing on dollar amounts can be misleading, because ultimately it is real goods and services that constitute the standard of living citizens enjoy. In the paragraphs above we “followed the money” just to show what the standard protectionist arguments overlook, and the producers they usually forget. In reality, the significance of a tariff isn’t the effect it has on dollar bills—the number of dollar bills isn’t changed by a tariff law, and it’s ultimately not green pieces of paper that make Americans rich or poor. No, what makes Americans richer or poorer is how much they can produce with their own labor and other resources, and how much they can consume by either purchasing output from domestic producers or by trading surplus production with foreigners.
A new tariff diverts U.S. labor and other resources out of those industries in which they have the comparative advantage, and into industries in which they do not. It hinders the benefits of specialization among nations. Just as mutually beneficial trades make both parties better off, so too does free trade make all participating nations better off. When a government interferes with this pure-market outcome through the imposition of a new tariff, it hurts not only foreign countries but also the domestic population.
If Tariff Barriers Are Good, Are Naval Blockades Great?
Perhaps the simplest argument to demonstrate the absurdity of tariff barriers was devised by Henry George, who observed that in peacetime nations impose tariffs on themselves in order to keep out foreign goods, while in wartime nations impose naval blockades on other countries in order to prevent them from receiving foreign goods. If the protectionist arguments were correct, wouldn’t naval blockades make the enemy country prosper?
An import quota is another popular form of government interference with international trade. In this arrangement, the government doesn’t directly interfere with the price of the imported good, but instead sets a limit on how many units can be imported.
For example, rather than imposing a 10% tariff on Japanese cars, while leaving the ultimate determination of total imports up to the (distorted) market, the U.S. government instead could impose a 100,000 vehicle quota. Japanese producers would be allowed to sell 100,000 cars in the U.S. market, and they would receive the (distorted) market price without any of these expenditures flowing into the coffers of the U.S. government. But after the quota had been reached, it would be illegal for any more Japanese cars to cross into the United States for sale.
The primary effects of an import quota are the same as those of a tariff. If U.S. legislators knew in advance how many Japanese vehicles Americans would import after they imposed a 10% tariff, then the legislators could in principle achieve roughly the same outcome on the U.S. economy by simply setting an import quota equal to that number of vehicles. In that case, the major economic effects would be roughly the same, and our analysis in the previous section would apply.
However, in practice import quotas are probably even more dangerous than tariffs, because they seem to burden foreign producers more than domestic citizens, and because it is not as obvious how much damage they cause relative to the pure market outcome. For these reasons, politicians may be more likely to impose an incredibly onerous import quota, rather than an equivalent tariff.
To see this possibility consider: Under a tariff rate of 50%, it is quite visible how much the government is penalizing foreign producers and rewarding (particular) U.S. producers. People can see what the original import price is, and then realize they are paying 50% more straight to the U.S. government. But if the government simply imposes an import quota, it is not as easy to see how much the distorted pattern of production differs from the pure-market outcome, especially as time passes and conditions change. If the foreign producers came up with innovations that allowed them to slash prices, for example, then American consumers would still benefit if there were a tariff in place, because the post-tariff price would fall. But with a rigid import quota, American consumers would not benefit nearly as much from cost-cutting foreign innovations.