The Effect of a Trade War

John R. Brock, Ph.D.

Abraham Lincoln was once advised that the U.S. should buy cheap iron rails from Britain to finish the transcontinental railroad.  He replied, “It seems to me that if we buy rails from England, then we’ve got the rails and they’ve got the money.  But if we build the rails here, we’ve got our rails and we’ve got our money.”  A different example might underscore an important weakness in Lincoln’s reasoning:  If I buy tomatoes at the farmer’s market, then I get the tomatoes and the farmer gets my money.  But if I grow tomatoes in my own yard, then I get the tomatoes and I keep my money.  If this analysis makes sense, then perhaps I should produce all my own food!

While Lincoln’s comment occurred over 150 years ago, such economic misperceptions are still with us today.  The reason I don’t produce all my food is because my time is more valuable in producing other goods or services where I am more productive.  Adam Smith and David Ricardo first articulated the Theory of Comparative Advantage, which merely advises that people should specialize in what they do relatively best and then trade for the rest.  In so doing, all parties are made better off.

Notwithstanding this theory, our country seems mired in a trade war with China.  Tariffs on goods traded between China and the U.S. have increased in multiple stages since the summer of 2018.  If trade benefits both parties, then tariffs—taxes on imported goods—reduce imports (and exports, assuming retaliation) and thereby lower the gains from trade for both parties.

The real question then becomes, “Who shoulders the burden of this reduced trade?”  This is an empirical question, and economists have been researching the 2018 tariffs to determine how the burden is distributed between 1) the Chinese and American firms that trade the products and 2) consumers.  Utilizing different methodologies, two separate March 2019 National Bureau of Economic Research reports found that imports dropped significantly, and that the tariffs were largely passed through as increased prices paid by U.S. importers rather than reduced prices and profits for Chinese firms.  One study found that tariffs on appliances were fully passed through by importing firms to higher consumer prices.  Further, since trade in intermediate goods (used as inputs in producing other goods) account for over two-thirds of world trade, input price increases, which are not faced by competing firms in other countries, may put U.S. firms producing tradeable goods at a significant disadvantage.

Freedom of trade, the issue closest to having unanimous support among economists, was summarized nicely by Adam Smith when he wrote in The Wealth of Nations, “It is the maxim of every prudent master of a family, never to attempt to make at home what it will cost him more to make than to buy … What is prudence in the conduct of every private family, can scarce be folly in that of a great kingdom.”