Why tariffs won’t boost the economy like Trump thinks

Trump tweeted

We are not in a trade war with China, that war was lost many years ago by the foolish, or incompetent, people who represented the U.S. Now we have a Trade Deficit of $500 Billion a year, with Intellectual Property Theft of another $300 Billion. We cannot let this continue!

and he followed up by tweeting,

“When you’re already $500 Billion DOWN, you can’t lose!”

Mattew Yglesias comments that.

This reflects a view that Trump has consistently maintained in his personal rhetoric and that has been reflected in the official documents put out by some of the members of his trade team — trade deficits are per se bad, reducing them induces prosperity mechanically, and so there is no downside to a trade war with a country with whom the United States runs a large trade deficit.

One big question hanging over Trump even since the campaign has been whether this is something he really believes and is prepared to act on as president, since it happens to be totally wrong. And while so far nothing Trump has actually done on trade is all that significant in the grand scheme of things [so far], perpetually making policy on the basis of a total misunderstanding of the issue is potentially quite dangerous.

…[Trump’s] Commerce Secretary Wilbur Ross and trade adviser Peter Navarro were the co-authors of an important policy paper the Trump campaign put out during the election season that… was incredibly shoddy. George Mason University’s Scott Sumner describes it as “a complete mess,” which, if anything, is too kind. When Adam Davidson profiled Navarro for the New Yorker, he wrote that …Navarro …couldn’t find a single other economist who fully agreed with him on trade and China. Which is about what you would expect, since the Ross-Navarro trade policy analysis is based on a mistake that would get you flunked out of an AP economics class.

“When net exports are negative,” Ross and Navarro write, “that is, when a country runs a trade deficit by importing more than it exports, this subtracts from growth.”

Ross and Navarro believe that tariffs will automatically increase GDP by eliminating the trade deficit:

“To score the benefits of eliminating trade deficit drag, we don’t need any complex computer model… Trump proposes eliminating America’s $500 billion trade deficit…. Again assuming labor is 44 percent of GDP, eliminating the [trade] deficit would result in $220 billion of additional wages. This additional wage income would be taxed at an effective rate of 28 percent (including trust taxes), yielding additional tax revenues of $61.6 billion.”

This idea is ^%@#$^!. The trade deficit means that imports are larger than exports. Ross and Navarro advocate using tariffs to eliminate the trade deficit by reducing imports, but that would only boost GDP if the tariffs had no effect on anything else. That is ridiculous. Nearly half of the trade deficit is the deficit in petroleum. We could eliminate that deficit by imposing a tariff of 200% because domestic prices would rise so much that American consumers would buy less petroleum products and American oil producers would extract more domestic oil by fracking more aggressively. However, we know from experience that GDP would not rise because we have been through this kind of experience before.

For example, in 1973, OPEC imposed an oil embargo on the US as punishment for US support of Israel in the Yom Kippur war and US oil imports plummeted, but oil higher prices hurt household consumption and caused a nasty recession. Plus, as the following graph shows, net exports didn’t change much because there are other forces (such as national savings rates) which cause imports and exports to tend to move in parallel. If Trump imposes tariffs, that will reduce imports, but it will also tend to reduce exports which will hurt jobs in export-oriented industries.

Then it happened again in 1979 due to the Iranian revolution shutting down its massive oil exports. Again, US oil imports dropped, prices rose and the US suffered a nasty recession.

Ross and Navarro are essentially arguing that if the US would ban oil imports, that would eliminate half the trade deficit. Suppose the US had a $100 billion trade deficit (is it much bigger, but let’s use round numbers to simplify the arithmetic). And Trump used the same numbers when he tweeted, “…when we are down $100 billion with a certain country and they get cute, don’t trade anymore-we win big. It’s easy!”

Trump argues that banning this import would automatically boost GDP by $100 billion! His economic team (Ross & Navarro) calculated that because “labor is 44 percent of GDP” their logic figures that $44 billion of that income would go to household wages. They calculate, “that additional wage income would be taxed at an effective rate of 28 percent” which would yield additional tax revenues of ($44b * 28%) = $12.3 billion. Super simple, right?

This analogy was inspired by an example from Mattew Yglesias who goes on to ask:

So why doesn’t Congress take this simple, easy step to boost growth and create jobs [by banning oil imports]?

Well, because it’s ridiculous.

What would actually happen is that gasoline would become much more expensive, consumers would need to cut back spending on non-gasoline items, businesses would face a higher cost structure, and the overall economy would slow down with inflation-adjusted incomes falling. Modeling the precise impact of a total shutdown of oil imports is hard (hence the computer models). But we know from experience that the directional impact of sharp disruptions in the supply of imported oil, and it’s not at all what Ross and Navarro say it would be.

Ross and Navarro made a subtle but basic error

…Gross domestic product (GDP) is meant to measure the dollar value of everything produced in the United States. To calculate GDP, you take everything the government purchases (G for government purchases), then add everything households purchase (C for consumption), then add everything businesses buy but don’t sell to customers (I for investment). That gives you a picture of everything that was bought in America. But then you need to adjust for the fact that Americans buy some foreign-made stuff (imports) and sell some stuff to foreigners (exports) — so you add that together and get net exports (NX), which need to be added or subtracted from the total.

That’s written down as an equation: GDP = G + C + I + NX.

But this is an accounting procedure, not a causal theory. The accounting procedure says that government purchases are an element of GDP — higher G means higher GDP, and absolutely everyone agrees on that. But whether increasing government spending will boost or harm the economy is obviously a hot topic of political debate. A sensible high-level take would be “it depends.” It matters what you spend the money on; it matters how you raise the revenue and what the larger economic situation is.

The net exports situation is just the same. If America’s net exports grow because America becomes a fashionable tourist destination and sales of Boeing airplanes surge, then that will boost the economy. But if America’s net exports grow because new Trump-imposed taxes cause the price of imported goods to surge, then the economy is going to shrink.

It is reasonably common for [uneducated] people to make the kind of mistake that Ross and Navarro are making here, which is why [economists] generally make it a point of emphasis when introducing the GDP concept to students. Why a credentialed economist would do it in a policy paper for a presidential candidate is [^%@#$^!].

In theory, a tariff could boost GDP, but in practice it is nearly impossible and I’m not aware of any real-world example where it actually worked. It certainly hasn’t ever worked for the US. For a tariff to boost GDP would require several preconditions that we do not have. A tariff could only work to boost GDP IF

  1. There is no trade war. If other nations retaliate by raising tariffs of their own, then net exports will not rise and all nations will suffer because production will simply fall everywhere. Trump was wrong when he tweeted, “trade wars are good, and easy to win.” That was the day after Trump imposed new tariffs on steel and aluminum, so he is serious about it, but he is wrong.
  2. There is slack in the economy (i.e. a recession) so that there is flexibility to increase production without merely reshuffling production from somewhere else. If there were zero unemployment, it would be impossible to increase GDP by increasing tariffs because everyone is already working as much as they can. We are pretty close to full employment right now, so tariffs would be particularly useless as a boost to GDP at this time.
  3. The eliminated imports can be efficiently substituted with domestic production. This was a big problem during the oil shocks of the 1970s, and because oil is still about half of our trade deficit, it is still a substantial problem today. US producers simply cannot produce everything as efficiently as foreigners. Chinese-made clothing, computers, and TVs will simply rise in price which will hurt consumers and reduce their demand for American-made goods due to higher prices.

There are more conditions too such as needing domestic savings rates to rise, but listing everything would be like beating a dead horse. The fact is that I know of no PhD economist who doesn’t work for Trump, zero, who agrees with Trump and his economist flunkies, Ross and Navarro, about tariffs and trade wars.  Navarro couldn’t come up with anyone either.  No Keynesians on the left like Paul Krugman, nor Keynesians on the right like Greg Mankiw, nor conservative libertarians like Scott Sumner, nor probably any Real Business Cycle theorists although it is hard to know what they would say because they don’t usually come out of their ivory towers to sully themselves with commenting on policy much.

Posted in Globalization & International, Macro

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