The Paradox of Tariffs for Free Trade

One of the myrid of excuses we’ve heard for Trump’s various trade wars is that the ultimate goal of the tariffs is to reduce/eliminate other countries’ tariffs on US goods (see, for example, here). Indeed, in The Wealth of Nations, Adam Smith mentions as a possible justification for tariffs the “recovery of a great foreign market,” although Smith just hedge on this justification (emphasis added):

The recovery of a great foreign market [from prohibitively high tariffs imposed on domestic goods] will generally more than compensate the transitory inconveniency of paying dearer during a short time for some sorts of goods…When there is no probability that any such repeal can be procured, it seems a bad method of compensating the injury done to certain classes of our people, to do another injury ourselves, not only to these classes, but to almost all the other classes of them. (WN Pg.468.39).

Where the paradox alluded to in my title arises is from this “recovery of a great foreign market.” How much benefit is the domestic nation likely to incur from such a recovery? I argue: not much.

When a nation has relatively free trade already, they don’t stand to benefit particularly much from increased free trade; the nation has already capitalized the gains from free trade. To take an example, when the US entered NAFTA, greatly reducing tariffs between the US, Mexico, and Canada, US real incomes rose only 0.1% (see Paul Krugman’s article “The Uncomfortable Truth About NAFTA”). The US was already a largely free-trade nation and there was already moves toward integration before NAFTA came about. Thus, a small increase in real income. Let’s assume a no-NAFTA world and let’s say the US were to launch a trade war with Mexico to reduce tariffs. The above analysis indicates that, for the US, costs of the trade war (ie, the higher prices paid by domestic citizens) would very quickly outpace the benefits of lower tariffs (ie, increased trade with Mexico). For Mexico, however, they would stand to gain from increased trade more than the US. They would be able to launch a longer trade war as their potential benefits are higher. Thus the paradox: the country least likely to benefit from a trade war to reduce tariffs is the country already free-trade oriented and the country most likely to benefit from a trade war to reduce tariffs is the country tariff-oriented. The free-trade country would stand to lose from the trade war.

One might object, reasonably, that in my example Mexico is relatively small, and thus a larger economy like China would be a bigger boon to the US. While that is true, I argue that it doesn’t change the analysis a whole lot. Real incomes in the US would be unlikely to increase a lot from increased trade with China because, as mentioned already, the US has already capitalized on much of the gains from free trade. US tariffs on Chinese goods are fairly low (even with Trump’s tariffs, but let’s discuss pre-trade war for now). Thus, reducing tariffs even more are unlikely to increase imports a whole lot and unlikely to reduce the prices of those imports a whole lot, thus leaving the consumers of those goods relatively unchanged. Exporters would stand to gain from reduced Chinese tariffs on their goods, but even then it is unlikely to cause a major increase in exports. Currently, US trade with China (total, so imports + exports) works out to be about 3.5% of US GDP. Imports would not likely change, but let’s assume for the sake of argument that US exports to China double if China eliminates tariffs. Total trade with China would rise to 4.3% of GDP, a gain of approximately $180 billion. These improvements, and improvements they are, are relatively small (it’s also worth noting that these numbers are a quick and dirty calculation).

For China, however, they stand to gain. By reducing tariffs, the real income of their consumers would increase dramatically as they suddenly have access to all kinds of goods cheaper. The purchasing power of their wages goes up and their standard of living increases. Their exports likely remain the same, but their imports increase, enriching the nation. Thus, though the US would still benefit from lower tariffs with China, the US’ ability to launch a trade war against China for the purposes of reducing tariffs is limited.

The short version of the above: paradoxically, the nation best equipped to win a trade war where the goal is the reduction of tariffs is the nation that is relatively protectionist. But, if the nation’s government is protectionist by design, a trade war is unlikely to get them to change that stance.