For anyone who believes in the open international trading system the last week has been pretty depressing, with president Trump threatening to slap further tariffs on imports from China and the EU, both of which are promising to retaliate. But does Trump have a point? And whether he does or not, what will be the consequences for the world economy if things continue in a protectionist direction?
Even off-the-wall ideas often have at least a grain of truth behind them. Trump’s ideas on trade do. It is well known that China does not play by the normal rules, including subsidizing its exports, and hindering many foreign firms from competing there.
In addition, there are widespread allegations regarding theft of intellectual property. Moreover, it runs a trade surplus – that is to say, an excess of exports over imports from abroad. Meanwhile, America runs a deficit.
Apart from the damaging implications for jobs in particular sectors exposed to overseas competition, the most important consequence of these trade imbalances is that they help to build up the financial wealth of countries with surpluses and they diminish it for countries with deficits.
This isn’t exactly the justification that president Trump gives for his actions, nor indeed does it reflect what he seems to understand about international trade.
He seems to believe that the trade balance is like a company’s profit statement. Exports are good and imports are bad. Accordingly, if your exports exceed your imports then you are “winning” and if your imports exceed your exports then you are “losing.” Moreover, he seems to believe that this is true even on a bilateral basis. This is the economics of the madhouse. Since deficits and surpluses must necessarily sum to zero, the implication of Trump’s economic philosophy is that international trade brings no net benefit for the world as a whole.
It is all about the battle as to who is going to “win”. This is nonsense. Moreover, if the overall trade balance is satisfactory, bilateral deficits are of no significance whatsoever.
Actually, America’s overall trade deficit has fallen. It runs at about 4 per cent of GDP, down from 6 per cent 11 years ago. China’s surplus is now 4 per cent of GDP, down from a peak of 9 per cent.
But suppose that president Trump carries on down the protectionist route. What are the likely effects?
It is vital to make a distinction between the impact on demand and the impact on supply.
The impact of a tariff on your imports should be to expand demand for your country’s output.
Consumers pay more for these imports, so their incomes and spending are squeezed. But the government receives the tariff revenue and we should assume that they will spend it. So the net effect of this is demand neutral.
The expansionary effect on demand comes from the switching of expenditure from foreign imports towards domestic suppliers in response to the higher prices now charged for imports.
But, of course, once trade disputes get going, it is normal for the other side to retaliate. If they retaliate commensurately, they will enjoy the same boost to their aggregate demand and you will suffer an equivalent reduction in yours. In other words, these two effects will net to zero. No one will be any worse, or better, off than before.
Admittedly, if a country is running a large surplus, as far as aggregate demand is concerned, it has more to lose from a trade war than a country that is running a deficit.
But even if the demand effects are neutral overall, in the short term people who lose incomes and/or jobs in the exporting industries hit by tariffs will not easily and quickly find new employment elsewhere.
Accordingly, for both countries involved in a trade dispute, the short-term effect is likely to be to destroy jobs and diminish national income.
Yet all this is small beer compared to the supply side. International trade accentuates competition, which helps to drive efficiency, and it promotes specialization, which optimizes the allocation of resources. If a trade war reduces the extent of international trade, then we will all end up producing things less efficiently. The losses will be particularly significant where there are major economies of scale, as there are with most manufacturing.
Let’s take aircraft as an example. There are only two major manufacturers of civilian aircraft in the world, Boeing and Airbus. These two companies represent the very highest level of specialization.
If trade in aircraft were closed down and each country in the world had to manufacture its own, then the cost of doing so would be astronomical and Boeing and Airbus would have to enormously reduce the scale of their operations, thereby dramatically driving up their unit costs.
When people ask what the effects of a trade war would be, it may be best to consider this as simply a reversal of the process of globalization.
Most economists would acknowledge that some individuals and groups have lost out from globalization.
But they would argue that overall it has enriched not only those countries like China that have risen up the relative income scale, but also countries like America that have been able to benefit from cheap supplies and the concentration of economic effort on those areas where they have a comparative advantage.
So if the world ends up going down the protectionist route we are all going to be poorer.
Prices in the shops would be higher and our real incomes would be lower. Reflecting this, stock markets would undoubtedly be lower and perhaps property prices would be lower too.
So, all in all, we have to hope that president Trump either gets what he wants or that he backs off. The action he has taken so far is disproportionate to its flimsy justification.
He is playing a very dangerous game. If he is not careful, he could be the cause of the next global economic downturn.
Roger Bootle is chairman of Capital Economics