President Trump recently announced tariffs on metal and aluminum. Sticking to his major communication channel for all foreign policy, he announced it on Twitter and mentioned “Trade wars are easy to win!”. However, this policy has met been met with a lot of uncertainty, and experts from around the world are afraid of the ramifications. The term for this economic phenomenon – “trade wars” sounds ominous, implying there is a winner and a loser. So, what exactly is a trade war, what does history teach us, and what will happen in the future?
Ricardian economics advocates for trade based on comparative advantage, as opposed to trade based on absolute advantage. The principle of comparative advantage is driven by opportunity cost. Opportunity cost is the next best amount foregone by doing an activity. For example, you could be doing one of three things right now:
- Reading this article
- Watching Black Panther
- Watching Jersey Shore
Reading this article will give you 100 satisfaction points, watching Black Panther gives you 80 satisfaction points, and finally, watching Jersey Shore gives you 10 satisfaction points. So as a rational human being (hopefully) you will choose to read this article. Consequently, you forego option 2 and 3, and between them, option 2 has the highest points. Thus, your cost for choosing opportunity 1 is 80 points (because it is the next best alternative). Applying this concept to Ricardian comparative advantage is the next step to understanding international trade. In his 1871 book “Principles of Political Economy and Taxation”, David Ricardo idealizes a global economy with only two countries, England and Portugal. Without going into details, it basically shows that if a country specializes in what it is good at producing, then it is more beneficial to international trade compared to autarky. The corollary of this is that countries engaging in international trade are dependent on each other for goods, which is why increasing tariffs on imports are not a good idea.
The idea behind increasing import tariffs is to stifle international competition, and to allow domestic industries to grow. Consequently, the other countries’ industries face losses due to reduced exports, causing them to retaliate in a similar, if not aggravated manner. This loop goes on and on, which is why there are no clear winners or losers in trade wars.
History tells us that protectionist policies have more negative consequences than their intended positive effects. Although these policies have been around beginning with mercantilism, there are three examples in this article which show the politico-economic costs.
- Italy and France
After Italy’s formation in 1871, the government wanted to protect its infantile industries from international trade, especially from the influence of France, which was much stronger in terms of political and economic influence, compared to Italy. To this extent, Italy practically ended trade with France, by raising tariffs to 60%, one of the highest in history. In retaliation, France passed the Meline Tariff in 1892, which crushed Italian exports and delivered a monumental blow to the Italian economy.
- United States of America and Canada
During Republic governance after the Civil War, the government took protectionist measures in accordance with its economic nationalist platform. As a result, it suspended trade with Canada, and faced retaliatory measures. 65 major U.S. companies shifted production to Canada, instead of paying the high import tariffs. Thus, in an effort to limit outsourcing, this resulted in loss of jobs for the American economy.
- Smoot-Hawley Tariff Act
Considered to be one of the most extreme efforts undertaken by the U.S. towards protectionism, the Smoot-Hawley Tariff Act was implemented in 1930. Tariffs were imposed on hundreds of goods, however, the main purpose of this was to shield the domestic agricultural industry after the devastation of World War I. It is no coincidence that the Great Depression was also during the same time. Although this law did not cause the Depression, it certainly aggravated the situation. Canada and Europe retaliated to this, pushing trade barriers on more goods. In 1934, President Roosevelt retracted this law, and Reciprocal Trade Agreements Act. The U.S. also supported the General Agreement on Trade and Tariffs (GATT), the North American Free Trade Agreement (NAFTA) and the World Trade Organization (WTO).
Evidently, imposing tariffs on international trade indisputably leads to trade wars. Some economists conjecture that only countries with immense bargaining power over its trade partners are in a position to push for tariffs and still gain from it. However, (as big as) U.S contribution to the global economy may be, governments like Canada and organizations like the European Monetary Union are in a position to retaliate. The EU has already threatened to impose tariffs on blue jeans, Kentucky Bourbon and Harley-Davidson motorbikes. Coming back to President Trump’s proposal to increase steel and aluminum tariffs by 25% and 10% would lead to more structural unemployment in these sectors. Employment numbers in the steel industry have been declining, with around 650,000 people working almost half a century ago and 140,000 working today.
It remains to be seen how the world will react to this. With China being a credible competitor to the U.S. economy, the Trump administration must make wise moves. Or, they will be met with fire and fury, like no one has ever seen before.