To understand the fundamental precepts of free trade, we must understand where the gains to trade are found.
Some politicians maintain that the success of trade should be solely gauged according to the balance of trade. Doing so provides the justification to apply barriers to foreign exchange. Nothing has been politicized more and understood less than trade, as it remains the whipping boy of special interest.
Fortunately, advocates of free trade look through a much wider lens, which makes it evident that the gains to trade do not lie in the balance of trade, but rather in the ability to (1) improve standards of living, (2) increase aggregate wealth, and (3) consume beyond our production possibilities.
Those are where the true gains to trade exist. Therefore, not only is it paradoxical to attribute the gains to trade with the balance of trade and to associate the balance of trade with economic prosperity, but it is somewhat flawed to assume trade deals affect, to a large degree, the balance of trade.
Understanding these concepts make it apparent why tariffs and other trade barriers are the antithesis of economic well-being.
Seen vs unseen
Nevertheless, it’s more effective for government to create an illusion of misdirection, by necessitating a solution to the “problem” they perceive as the trade deficit. Government’s solution: override price and consumer preference in an attempt to artificially reverse the balance of trade.
This is a classic example of what Bastiat elegantly demonstrated more than 150 years ago between the seen and the unseen.
In the first place, it is much more visible for politicians to quantify change through the heavy hand of government, more so than allowing forces of the market to operate freely. Secondly, the balance of trade is very visible, whereas the connotation and meaning behind it isn’t. Thirdly, it is much more visible to identify those who have been adversely affected by foreign competition, more so than recognizing the excess amount of disposable income gained as beneficiaries of foreign competition. It is more visible to see factories shutting off lights and locking doors, than it is to realize the excess ‘wealth’ accumulated by consumers from the global trade windfall, which can then be spread to broader sectors of the economy, increasing jobs, prosperity, and economic growth.
Attempting to artificially alter the balance of trade would be like randomly spotting points to a losing team and expecting that same team to play better as a result. The points on a scoreboard are not the cause of a team’s skill level; it is the effect. A team playing well is not the effect of having more points on the scoreboard. Having more points on a scoreboard is the effect of a team playing well. It is the same concept with the arbitrary scoreboard called the balance of trade.
The paradox of tariffs
It is precisely the phenomenon between the seen and the unseen that hoodwinks innocent voters into believing that a tariff is going to effectively offset all the visible effects of trade, while the invisible benefits go undetected.
The fundamental question we should be asking ourselves is not whether imposing tariffs will help offset the effects from the negative balance of trade, but rather, would Americans be better off in so doing?
Sure, the effects of tariffs may boost producers in one industry, but it will always be at the expense of producers in another industry so that at best it will only yield a lateral effect. In more instances than not, however, the societal cost will heavily outweigh the benefit. The number of limited resources that are needed in the less productive sectors of the economy will far override those needed in the more productive sectors, meaning those industries who do not hold a comparative advantage in the production of goods and services will need more input but will generate less output. This is not a very constructive and innovative way of allocating capital.
However, those who are still unconvinced that tariffs are a paradox of smoke and mirrors may still pose the question: why, if the tariff is such a fundamental gaffe in policy, is it maintained as an effective tool by those in office?
Again, it reverts to the disproportion of incentives between the concentrated-fewer beneficiaries of protection and the wide-spread-diffuse interests of consumers. The individual benefit to those in the smaller concentrated group of special interest is greater than the individual cost to those in the larger dispersed group of general interest so that the benefits are divided over fewer individuals, whereas the costs are spread over more. However, individual gains are sustained at the expense of aggregate loss, while the economy, on the whole, experiences depletion.
The arbitrary trade balance
In light of the above, it would be unproductive to devote any more resources to combat what is perceived as an unfavorable balance of trade, either through protection or any other heavy-handed government intercession.
For one, it can be argued that the balance of trade is a very arbitrary measure. The US has run persistent trade deficits since the late 1970s. During that time, one would be hard-pressed to postulate an association between the trade deficit and economic stagnation. In fact, there have been many instances of when the trade deficit contracted as a share of GDP, real GDP averaged less than 2%.
Additionally, there have been equally as many instances of when the trade deficit expanded as a share of GDP, real GDP grew by an average of over 3%. Furthermore, countries that have some of the highest standards of living, (the US, UK Australia, and Canada) run some of the largest overall trade deficits. Secondly, the balance of trade is much less the effect of tariffs and trade deals and much more the result of internal macroeconomic effects from the relationship between domestic savings and investment, productivity, as well as exchange rates.
Americans have artificially low savings rates and alternatively high rates of consumption and investment. Interest rates, despite recent rises, have been artificially low, which has stimulated demand and economic growth.
Domestically, investment is met by savings; however, since the US savings rate is lower than the rate of investment, excess savings from abroad “subsidizes” the excess demand internally. Consequently, because of the allurement the US economy has on foreign investors, the excess amount of investment abroad distorts the equilibrium effect between savings and investment domestically in that there aren’t enough national savings to borrow from.
Let’s go a step further. Ask yourself: would Americans become better off if government would attempt to reduce the trade deficit? First, this would require altering the dynamics of consumer behavior. The economy would have to undergo a dangerously low contractionary effect: the tightening of the money supply, the upward pressure of interest rates, the reducing of liquidity, and the minimization of borrowing and lending. This would, of course, incentivize more savings and less spending. Secondly, the value of the dollar would have to be maintained at unfavorably low levels. This would force the domestic price of foreign goods to rise, while forcing the foreign price of domestic goods to fall.
This would, in fact, contract the trade deficit, but I would submit this to be hardly for the betterment of American citizens.
Dollar boomerang effect
Finally, it has been the consensus of those within the ever-narrowing circle of mercantilism that trade deficits are systematically bad and trade surpluses are inherently good.
Other than the familiar rudimentary connotations that are attached to its terminology, there are no direct assertions that would support the mercantile mindset.
By its very nature, the trade deficit is nothing more than a capital surplus. Essentially, the current account should decrease by precisely the same amount to which the capital account will increase. Consequently, the largest element within the current account is the balance of trade. This is not something postulated. It is based on principles rooted in the double-entry bookkeeping method of international finance, which determines the balance of payments.
Moreover, when Americans purchase goods and services from foreigners, the dollars collected abroad will eventually make its way back home. There is only a handful of choices the owner of dollars can choose to do with their prosperity. If those who earned dollars abroad would simply hoard them or perhaps burn them, never putting them back in circulation, that would be even more advantageous to Americans. After all, we can finance the cost of printing green pieces of paper rather cheaply. Thus, trading merchandise, which has intrinsic value, in exchange for green paper is a deal I would certainly not forfeit.
Of course, this is wishful thinking, and nobody holding dollars would permanently deprive themselves of its purchasing power. Rather, those who hold US dollars will either purchase US goods, services, or capital assets, or trade their dollars with those who do desire to purchase US goods, services, or capital assets.
The bottom line is that trade is a mutually-beneficial voluntary exchange between willing participants who both value what they want more than what they’re giving up, whether they’re exchanging money for something, or something for money. Both participants wanted more of what the other possessed. One received dollars for the exchange of goods, and the other received in goods what they paid for in dollars. There is no net loss, as both got what they wanted, and are both equally better off as a result.
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