An Analogy for the US-China Trade Relations
Drawing our attention to the famous Candlestick makers' petition satire on protectionist tariffs by Frederic Bastiat, I summarize the satire and apply it with modifications to the current context of US-China trade relations. You may read the satire here or go to http://bastiat.org/en/petition.html
Concern: The sun was bad for the candlemakers' business
Petition: That the government would enable a law to prevent the sun from accessing their country so that they could produce candles, lanterns, etc. for light instead.
Arguments: This was good for their jobs and for the economy as a whole. They would produce more, hire workers in the process and would also contribute to economic growth through the spending from their higher profits, and spillover growth to other sectors etc.
Reasons to debunk these arguments:
1. Consumers of light want to enjoy the sun’s light instead of the candle light. Without having to pay for the sunlight consumers are able to spend on other things. Things which will not get produced if they spent on candles and other forms of artificial light.
2. The sun provides us with a free resource. We are better off by not needing to reproduce what we can already get freely. Should we reject free resources in a world of scarcity?
3. In the event that we as a society do care strongly about the welfare of the candlestick makers and similar producers of artificial forms of light, when we do utilize the sun, instead of candles, we can still have the consumers transfer, through a tax scheme, to the producers what they would have got in the absence of the sun. Such transfers can then be used instead to produce other things that we would not have if we had instead discarded the sun’s light and produced candles etc. instead.
4. The sun’s light represents a superior technology in place compared with candle light and other artificial forms of light. To reject that would reflect technological regression and a reversal of economic growth.
In international trade we obtain things we need or use at a cheaper price from somewhere else. Think about steel or solar panels, instead of having to produce them at a higher cost (thereby giving up other productive choices). High cost production means high prices to be paid for these goods.
Analogous to keeping the sun out, tariffs keep us from accessing the cheaper products by making them as or more expensive than what it would cost us to produce and pay for them on our own. So we end up buying them locally instead. In effect we are inefficiently reproducing part of what would otherwise have been “free”.
From Bad to Worse
Interestingly, the cheaper the foreign import is, relative to what the cost to produce is domestically, the more we believe the foreign firms are unfairly dumping their products in our markets and we seek to impose bigger tariffs, thus effectively raising their prices by a whole lot.
Now think about this... the closer the foreign product is to being free, the more we take action against the product, so in the extreme, we have a free product and we apparently do not like that. Much like we should not like the sun because its light is free... Wait, we do like the sun, well all of us that are not candlestick makers, and we do not think about sticking with candles (no pun intended) or other artificial light rather than having the sun's light.
Further, we do not even think about how the sun is obtaining its comparative advantage in providing us with free light. We are excited instead about it and give no thought of the need to reproduce light, while the sun’s light exists.
So here is some really inconsistent thinking. We seem to be more excited about obtaining light from the sun for free and think it ridiculous to indulge the candlestick makers requests, but we are not thrilled about getting cheaper steel, aluminum, products of all sorts, from abroad and are even all the more outraged the cheaper these products are and feel that we should do something to restrict access to them and instead encourage domestic production of these same goods.
The argument for tariffs or any other protectionist policy is therefore illogical and strictly based on myopia. Let's not forget, the losers from free trade can be fully compensated for their losses and we will still be better off, than if we restricted trade to prevent those losses.
But perhaps the foregoing satire is too extreme and there might be further questions or objections that this simple analogy might have overlooked, so I will try to address these...
Does it matter that the the source of the free or relatively cheaper product is China and not Providence or nature? Does it matter if the reason for the free or relatively cheaper product is that in the one case it is natural whereas in the other it is instead the result of manipulative policies? Does it matter that we are paying foreigners for the output which we should be paying to home producers?
China versus Providence
Unless we believe that dependence on a foreign country for a product that is deemed vital for national security is politically unsafe given the prospects of future hostilities, there should not be a problem with carrying over the allegory to the real world trade relation.
Similarly we should not necessarily see trade as the foreign country providing us with a Trojan horse of subtly harmful products. It is perhaps akin to suggesting that the sun might have sinister plans to expose us continually to its light so that it eventually gives us sunstroke, cancer, etc.
Let me not trivialize, given the realities of such possible hostilities, well, just as every government does have agencies that look into these things, and just as domestic production is also vetted to avoid misinformation and safety, similar could also be put in place for foreign products and if there is no reason to suspect mischief, then there should be no reason to see China or any other country we trade with in that light.
Even if we have reason to believe that the sun could have its moments (like during total eclipses etc.), in other words that the foreign country may turn hostile tomorrow, after we have ceded production of these vital industries to them, tariffs are a very inefficient way to ensure we have a backup plan. Domestic production subsidies are an alternative and much less inefficient way to achieve the objective of protecting domestic production of such arguably vital industries.
Natural versus Induced Comparative Advantage
The sun in our illustration has a natural comparative advantage in providing us with light. We can think of this along so many similar dimensions. Countries with viable climates and fertile land, have a comparative advantage in say agricultural production. But what about countries that have a comparative advantage in say technological knowledge?
Differences in labor productivity drives comparative advantage in the traditional economics Ricardian model. But how does that come about? People in some countries acquire skills or have access to better learning/ training opportunities. Those were induced and not natural. Societies and governments deliberately changed policies or developed particular institutions, either or all of which led to particular policies that incentivized the accumulation of specialized skills and training that allowed their workers to be more productive compared to others.
How is this any different when China chooses an exchange rate policy that devalues the yuan? Or why is it considered cheating when their government puts in place policies that provide heavy subsidies to certain industries it believes to be key in its development?
Have western economies including the US not been doing that through provision of high quality education so that our work force has specialized superior labor skills? Have we not been doing that through subsidizing research in agricultural production, so that we can produce larger crops per acreage? But even more pointedly, we do unashamedly subsidize explicitly many other industries and production processes. When we also conduct monetary policy we stabilize our economies but perhaps transmit to other countries adverse impacts through resulting changes in the exchange rate.
Why do we do these things? To maintain price stability, stave off unemployment and set us on the path of long term economic growth. Well, that is what these other countries are also doing? To foster the same economic growth for their economies. What we perhaps call cheating is simply a realization that other countries have caught on, are competing by making specific policy choices, as we have been doing all this while.
What about the situation where China appears to be forcefully obtaining valuable intellectual property from US businesses in exchange for market access?
Again, other than thinking from that usual position of antagonism toward other countries, we need to ask what really is going on behind the labels? Businesses are not being strong armed into making choices that are not in their interest. They want market access. This is the price they are required to pay for it. They can walk away if they think it is too steep, but by choosing not to, they reveal that access to Chinese markets is more valuable to them.
If we think this is unfair, then think again. When foreigners seek the valuable education we have here in the US to increase their own productivity, we ask them to pay a price, often it is very steep to them, coming from relatively poorer countries, but they are often willing to, because again to them the education is more valuable. This is the same thing. Foreigners do not question the price they face, they can walk away. The same with US businesses, they can walk away...
Think about it this way, everyone can really choose what "currency" they want to get paid in. When foreigners pay for a US education, we have chosen to be paid "dollars". When social media sites offer their platforms to us to use seemingly for free, we, perhaps inadvertently, are paying with our "personal data and behavioral profiles". When businesses want access to Chinese foreign markets, well, the payment they have asked for is "intellectual property rights". There is nothing unfair in being smart and asking to be paid in a forward looking and advantageous "currency". That is the new business model.
The Spending Leakage Concern
Does it matter that with the sun analogy there is no outflow of earned incomes but with the real world international trade we have this leakage problem?
Money is a medium of exchange and its use is to allow us carry out a transaction. Imports would normally be a leakage from the economy, in the sense of incomes earned being spent outside of the economy and not to produce further goods here, but the story should not end there.
In a world without money, if we traded directly goods for goods then we have to ask where are the extra goods being produced by which we are able to trade for imports? With resources being scarce, they have to come from moving resources away from the import duplicating industry to the other industries so that we can produce more and export (i.e. goods that foreigners would be happy to buy from us and not from their own countries).
Intuitively, we cannot import unless we can export.
You can immediately see that this does not particularly change if we introduce money into the picture. If we paid for imports in our currency, it would not be legal tender in their own country, so with our dollars we have to trade that to holders of the foreign currency for their currency, in order to buy the goods that are priced in their currency. Why would foreigners accept this exchange and want to hold US dollars, if not to ultimately buy goods (or assets) denominated in US dollars. Without this, they will not be able to purchase our exports. Trade is a two-way street.
We should therefore not be able to import goods from abroad unless foreigners believe that we have something that from their own perspective is valuable that they can in turn purchase - hopefully our exports.
But we have a huge trade deficit with China for instance which means that they are not buying our goods but are either just hoarding our currency or/ and are using it instead to purchase financial assets including US debt. That is because they have those other options.
We are a free country where consumption choices (including imports) are not particularly constrained. In China on the other hand is a setting where the government does restrict consumption choices through policies that transfer foreign currencies from the private sector to the government so that import choices are largely determined by the government. This therefore allows China to choose to purchase, instead of more US exports, US financial and real assets.
So we have to realize then that the huge trade deficit is simply because we have other things to offer other than our merchandise to foreigners, and this shows up in the corresponding financial account surplus we have with China. The only problem here is that because these choices are not consumption but of an investment nature, from a political perspective this perhaps gives China increasing leverage over domestic policy choices through ownership of these assets including government debt.
One solution here would be for the US government to reduce its need to borrow by reducing the yearly deficit through restrained spending choices. That’s a tall order but so long as we need to run larger deficits, then the attractiveness of our debt to the Chinese will loom larger than what merchandise we have to offer. Another solution would be to restrict the amount of assets we will permit to be sold to the Chinese. This is of course inefficient from an economic point of view, but may be necessary from a political perspective, and it may force the Chinese then to spend their dollar reserves on our merchandise instead.
The point in all of this is that tariffs are not the solution. Tariffs will reduce the amount of Chinese goods we import, but this will in turn reduce the amount of US dollars that they are able to obtain. This will not necessarily induce them to discriminate against purchasing US assets but rather further reduce whatever US exports they were previously carrying out, to the extent that given a menu of options, the government controlled spending favors that.
This means a further deterioration of the trade deficit with China will be the outcome. Worse, to the extent that the US government continues to need to borrow increasingly large amount of money, it may have to do so at higher cost, as China will necessarily have a reduced amount of US dollars from the reduced imports.
Should we then see government borrowing being sourced instead from domestic sources? Not when incomes are reduced from the reduction in trade volume. Consumers and businesses already facing higher prices from restricted trade and exporting firms recording lower production and incomes, financing of further government deficit spending from domestic sources is unlikely.
Now all of this becomes a lot amplified if the tariff does lead to a trade war, especially when they lead to terms of trade losses for the other country, which is what we are looking at currently with China. The Trump administration has doubled down and so also has the Chinese government using strong words as stating its commitment to react “at all costs”.
A political economy prediction here says, for all President Trump can do or will do, he is constrained by a democratic electorate that has already begun to react to these war of words, let alone the action of things, which are yet to play out. The Chinese on the other hand have just established the permanent presidency of Xi Jinping, so there is no constraint per se on him. We should expect to see Trump make an about face on this, but as I have stated in a previous blog, he may stay the course and still come out of this with a political win. In any case, it will be an economic loss of colossal proportions for the rest of us.