The Bear’s Lair: The happy new world of tariffs

As President Trump imposes tariffs on China and elsewhere, much dark muttering is heard from the media and conventional economists about Smoot-Hawley and the 1930s. They are too gloomy. Two factors have changed since the 1930s: bloated government and the invention of computers, and their combination means that the Victorian dream of universal free trade is no longer optimal, even if it ever was. By upending conventional economic thought, Trump may well have improved the human condition.

The original Adam Smith enthusiasm for free trade was born in a world of very small government. Already, when David Ricardo propounded his Doctrine of Comparative Advantage in 1817, that world was temporarily past, with British government spending, mostly debt interest, running at about 20% of GDP in that year, even after the Waterloo Army and Navy had been run down to peacetime levels. Britain’s prime minister Lord Liverpool recognized this; in his great free trade speech of May 20, 1820 he pointed out that the need for revenue and the lack of an income tax (abolished four years earlier) meant that tariffs could be lowered only gradually.

With the growth in government, especially since two World Wars, the New Deal and the Great Society, a pure free trade policy is now highly imbalanced. If government absorbs 40% of the economy, and international trade accounts for 20%, then domestic taxes must average 50% of domestic output for free trade to be followed. Given the diminishing revenue potential from very high rates of income tax, that can only be accomplished as it is in the European Union, by a Value Added Tax of 20% or more, which — as Liverpool would have and did put it — bears most harshly upon the lower orders of society. From this cause, as well as from the artificially sluggish economy produced by the Obama/Bernanke policies, stems the current yawning U.S. fiscal deficit.

That is not to say that high tariffs are cost-free. The U.S. government of the 1890s was small, but it financed itself entirely with tariffs, imposing tariffs well above 50% on numerous products. This was beneficial to the U.S. economy at that period, while Britain and its Empire were pursuing a quixotic policy of unilateral free trade – it allowed the U.S. build up world leadership in industries such as steel, where British companies had made the crucial technological breakthroughs. However, after 1929, when the British and Imperial economy was relatively much weaker and was moving to a policy of modest protection, the countervailing move by the United States through the 1930 Smoot-Hawley tariff to increase protection yet further proved disastrous. It caused world trade to collapse and the global economy to plunge into a decade of depression. Ever since, until Donald Trump came along, protectionism has been anathema.

Three developments in the last few decades have made it sensible to look again at this question. First, the inexorable growth of welfare states in every Western country, together with the increase in life expectancy, has destabilized budgets, making them impossible to balance. As a result, public debt which in the United States had fallen steadily since the end of World War II until 2000, has turned up again sharply and is inexorably increasing. The Obama administration and its overseas contemporaries, with their sluggish economic growth and phony Keynesian rationales for wasting money, have everywhere except Germany turned a difficult problem into an impossible one. Public debt levels everywhere except Germany are heading relentlessly upwards and will within the next decade reach historically unprecedented levels in the United States and several other countries.

As mentioned above, the EU’s solution to this problem is an ever-escalating level of VAT. This effectively acts as a tariff, since exports are free from the tax while imports are subject to it. Thus, EU and British sanctimony about free trade is sheer hypocrisy. However, it also subjects domestic consumers to the VAT levy on items produced domestically as well as overseas, producing a highly regressive tax system that bears especially heavily on poorer consumers.

A second change since Smoot-Hawley is the spread of manufacturing capabilities to far more countries. Back in the 1930s, most products could only be produced in advanced economies that had undergone full industrialization. Other economies, often part of a colonial system, were mostly producers of agricultural and mine output, while importing industrial products. Only in a few sectors, such as textiles, was the industrialization process sufficiently cheap and simple to allow textile industries to develop even in poor countries.

Today there are over 100 different countries from which many products can be sourced, and the major centers of manufacturing capability have moved to emerging markets with lower labor costs. Consequently, trade has infinitely many routes it can take to achieve its objectives, and a tariff that blocks sourcing in one country still leaves a vast array of other sourcing possibilities open to the importer.

The third and most important change since the 1930s is the invention of computers, and more particularly the possibility of intelligent software that can track the trade barriers existing at any instant, calculate the optimal source for the components of a particular consignment of goods, then place sourcing and shipping orders to ensure that those goods are produced and delivered to where they are needed.

With the changes that have happened since the 1930s, the outcome of a tariff escalation today would be very different to that of Smoot-Hawley. At that time, if there was a high tariff against a particular import, there were few alternative sources of the item, and little ability to find out what the possibilities were. With intelligent software (which may still need to be designed for this specific purpose but is undoubtedly feasible with today’s technology) it will today be possible to find all the alternative sources of an item as well as the possibilities for substitutions of other items from other sources. Thus, an interlocking network of tariffs today need not be anything like as trade-destroying as was Smoot-Hawley. It will simply result in new routes being found for the global sourcing process that has grown up in the last few decades.

Tariffs today would thus kill much less trade than equivalent tariffs did in the 1930s and would have a correspondingly smaller adverse effect on the efficiency of the global economic system. Since more trade would remain after the tariffs, they would produce more revenue for the Federal budget, thus helping to balance it. Even a modest 10% tariff averaged over the current $3 trillion of U.S. imports would produce $300 billion of additional annual revenue for the federal budget, not enough to balance it but enough to make a sizeable hole in the deficit.

In addition, a world of tariffs would divert a considerable amount of trade towards domestic production, thus moving the U.S. closer to a balanced payments position and producing additional revenue from the people employed in the domestic production. Overall, with a substantial tariff, the U.S. tax system would be balanced between domestic production and international trade.

To the extent that tariffs deterred international trade which would otherwise take place, the lower domestic taxation and higher domestic production would encourage economic activity elsewhere. By ensuring that a higher percentage of world output was manufactured closer to where it was consumed, a tariff system would increase (not decrease as is conventionally asserted) the efficiency of the world economy. Global sourcing may have got easier, but it is still expensive, inefficient, time-consuming and prone to fraud.

Contrary to free-tradist thinking, the overall effect of a balanced and moderate set of international tariffs should not depress global GDP, indeed it should increase it because of the greater balance in the world’s fiscal system. There will no longer be corporate tax havens, because the tariff arrangements with such havens will generally be onerous, but there will be tariff havens, which have tariff arrangements that allow goods to move exceptionally cheaply between the different trading blocs.

When the “North American Free Trade Agreement” includes Canadian quotas on milk imports and a 218% average duty on dairy imports beyond those quotas, it is not truly a free trade agreement at all, as Richard Cobden would have understood it. Likewise, the proposed Trans Pacific Partnership’s imposition of $70 billion in U.S. intellectual property protection, far exceeding the free trade effect of the agreement, indicated that TPP was little more than a handout to the Hollywood and Silicon Valley lobbies. Quotas are essentially infinite tariffs; they block trade far more than ordinary tariffs, while intellectual property protections are impediments to trade, not enablers of it. All such quotas, bounties and trade regulations are sources of inefficiency that produce no revenue (or, in the case of bounties, consume revenue) and block economic activity. They should be swept away.

The regime under which we have been working is not one of free trade and has been grossly mis-sold as such. For fiscal and other reasons, we will be far better off with a world trading system that includes revenue-generating tariffs, which can be optimized and dealt with by high-quality software. The world will be a happier place with less regulation, no bounties or quotas, and with openly disclosed tariffs, set at a moderate level.

(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)