We'll all be poorer from Trump’s tariff wars

The Trump administration has imposed tariffs on imports to the United States, a controversial decision that will rock numerous economies directly affected. They will also likely backfire on the US.

Economists don’t like tariffs because countries are much better off producing and exporting goods in which they have a comparative advantage, rather than trying to produce all goods on their own. It makes economic sense for New Zealand to export meat and dairy, for instance, and for Saudi Arabia to export petroleum.

Yet, for 300 years, between the 15th and 18th centuries, the world remained in the thrall of mercantilism, a form of economic nationalism that argued countries should try to export as much as possible and import little, thereby maximising the country’s “profits”. Mercantilists viewed trade as a zero-sum game where the gains to one country must come at the expense of another.

Two economists, Adam Smith and David Ricardo, developed theories of international trade that demonstrated how free trade makes everyone better off, seeing it more as a positive-sum game.However, one problem with their theory is that though free trade does make countries better off as a whole, it does not benefit everyone within the country. Some are better off, some not; but typically the gains to the winners outweigh the losses to the loser. This requires some redistribution of the gains, which is often politically fraught.

The theory ran into further trouble when comparative advantage arose from differences in the quality and quantity of labour. For instance, China and Bangladesh have loads of workers without college degrees, willing to work for low wages. It makes sense for these countries to produce and export, for instance, readymade garments.

The United States has a much larger pool of college-educated workers, so it makes sense for the country to export knowledge-intensive services such as investment banking, Google Drive, and Dropbox. (Economists often refer to the former as unskilled workers and the latter as skilled, which has always struck me as misnomers; I am not aware of any investment banker or college professor who have the skills needed to sew their own shirts.)

Over time, the wages of non-college-educated workers in China or Bangladesh have risen and so have the wages of the college-educated in the US. But the wages of the non-college-educated workers in the US have fallen as the demand for their labour fell as countries such as China now produce what these workers produced in the US.

Economists have known about this impact of trade on wages since the 1940s. But the consequences of these trade patterns did not become apparent till the last couple of decades of the 20th century.

Two things happened. First, we saw the rise of the Washington Consensus, a strongly pro-free-market philosophy, including free trade across countries. The people pushing this were primarily interested in opening up the markets in low-income countries for their banking services. But an unavoidable corollary of this was to open up western markets to cheaper manufactured goods from the developing world.

Then there was the “China Shock”, a term that describes the increase in Chinese imports into the US in the 2000s. Once China opened up and started taking over the market for all sorts of manufactured goods, from garments to washing machines, one could hear the giant sucking sound of jobs moving from the US and the west to China and others.

This led to increasing calls for tariff protection even if much evidence suggests that typically the gains from such tariffs fall short of the losses. But such protectionist measures are often politically popular because the losses to consumers in higher prices are more diffuse while the job losses are concentrated in particular areas.

But for a giant economy such as the United States, the gains from a tariff may outweigh the losses. This is because the US can force Chinese exporters to bear a part of the tariffs. Hence the price increases may (and this is a big “may”) be limited for US consumers.

But the big problem is the return to the mercantilist and nationalist zero-sum game thinking. As more countries impose tariffs, this introduces significant uncertainty about the future of trade and our global economy. The volume of trade will shrink, potentially resulting in global recession. Economic historians argue that the period after the first world war saw an increase in similar thinking and protectionist policies. This ultimately led to the Great Depression. Trump’s policies may be pushing us towards that same end. By ‘us’, I mean everyone. US consumers and businesses will also pay a heavy price if that happens.