Free Trade Doesn't Work

by Ian Fletcher

  This all raises an important question: is there a fundamental us vs. them dynamic in America’s trade with the developing world? Is a sound trade policy for ourselves ultimately about nothing better than grabbing an economic advantage at the expense of other nations, especially poorer ones? No. America’s serious economic rivals are “big boys” whom nobody needs to cry over. We need not have ethical qualms about taking industries away from Japan. This is true even of the advanced sectors of nations that are still poor overall, such as India and China, as it is not the Third World peasant sectors of these nations that meaningfully compete with us; it is the developed sectors of these nations, which are like islands of First World industry in the Third World. The yuppies of Bangalore are legitimate objects of our rivalry.

  What Third World nations really need is things like, in the words of the International Forum on Globalization:

  The right to control financial flows across their borders, set the terms of foreign investment, give preference to domestic finance and ownership, place limits on resource extraction, and favor local value-added processing of export commodities.782

  None of this is a particularly meaningful threat to American prosperity, so there is no reason for us to object. These policies would bring significant benefits to poorer nations, but impose trivial or zero costs on us. Individual corporate interests in the U.S. will certainly complain—and doubtless dress up their complaints as the interests of the U.S. economy as a whole—but there is no reason to expect these policies to impose meaningful harm on America at large. In fact, any U.S. strategy based on exploiting poor nations will be a waste of time for us. Like colonialism as analyzed in Chapters Nine and Ten,783 it is a low-quality economic strategy that will be outperformed by better strategies. We should be battling it out with Japan, Europe and the emerging technological powers in high technology, not fighting to keep cocoa processing from migrating to Ghana.

  A POLITICS-PROOF SOLUTION

  The natural strategic tariff is imperfect, but infinitely better than free trade and relatively politics-proof. Above all, it is a policy people are unlikely to support for the wrong reasons (like producer special interests) because it does not single out any specific industries for protection. It thus maximizes the incentive for voters and Congress to evaluate protectionism in terms of whether it would benefit the country as a whole—which is precisely the question they should be asking. It would also create the right balance of special-interest pressures: some interests would favor a higher tariff, others a lower one. This is a prerequisite for fruitful debate, as it means both views will find institutional homes and political patrons.

  The exact level at which to set the tariff remains an open question. Thirty percent was given as an example because it is in the historic range of U.S. tariffs784 and is close to the net disadvantage American goods currently face due to America’s lack of a VAT.785 The right level will not be something trivial, like two percent, or prohibitive, like 150 percent. But there is absolutely no reason it shouldn’t be 25 or 35 percent, and this flexibility will provide wiggle room for the compromises needed to get the tariff through Congress.

  A natural strategic tariff has other benefits. For one thing, it avoids the danger of getting stuck with a tariff policy that made sense when it was adopted but gradually became an outdated captive of special interests over time, always a risk with tariffs. Although it is a fixed policy, it would not be fixed in its effects, but would automatically adapt to the evolution of industries over time. In 1900, for example, it would have protected the American garment industry from foreign (then mostly European) competition. It wouldn’t do that today. As which industries are good industries changes over time, which industries it protects will change accordingly.

  The tariff’s uniformity across industries also avoids the problems that occur when upstream but not downstream industries get tariff protection. For example, if steel-consuming industries do not get a tariff when steel gets one, they will become disadvantaged relative to their foreign competitors by the higher cost of American-made steel. And why should steelworkers be protected from foreign competition at the price of forcing everyone else to pay more for goods containing steel? The only reasonable solution is that steelworkers should pay a tariff-protected price for the goods they buy, too. This logic ultimately means that all goods should be subject to the same tariff.

  The political bickering that a tariff varying by industry would cause also militates in favor of a flat tariff: as we saw in Chapter Six, the inability of different industries to coalesce around a common tariff proposal sabotaged efforts to achieve a tariff in 1972-74.786 But this is a policy around which the greatest possible number of industries can unite.

  The natural strategic tariff is also more ideologically palatable than most other tariff solutions. Above all, it respects the free market by leaving all specific decisions about which industries a tariff will favor up to the marketplace. It will thus be considerably easier for ideological devotees of free markets to swallow than some scheme in which tariffs are set by a federal agency, leading to that nightmare of free-marketeers: government picking winners. In the real world, zero government intervention in the economy is impossible, so the issue for believers in economic freedom and small government is to design policies that work through the smallest possible, carefully chosen interventions. This is precisely what the natural strategic tariff offers because it operates at the periphery of our economy, leaving most of its internal mechanisms untouched. In fact, the more wisely we control our economic border, the less we will probably need to control the inside of our economy.787

  REASONABLE OBJECTIONS TO A TARIFF PART I: DOMESTIC

  One obvious objection is simply that a tariff is a tax increase. So it is. But it does not have to be a net tax increase if the revenue it generates is used to fund cuts in other taxes. In order to obtain a “clean” policy debate, in which the tariff is debated purely on its merits as a trade policy, unmuddied by differing opinions about the total level of taxation, any tariff proposal should be packaged with precisely compensating cuts in other taxes.

  A related concern is that a tariff is a tax on consumption. This is generally better than a tax on income because it rewards saving and avoids penalizing work. Unfortunately, consumption taxes also reduce the progressivity of the tax system because the poor consume, rather than save, a higher percentage of their incomes. So any tax rebate financed by the tariff should also be designed to leave the overall progressivity of the tax system unchanged.788

  Another objection to a tariff is that if American industry is granted tariff protection, it will just slumber behind it. Many industries indeed long to shut out foreign competition, reach a lazy detente with domestic rivals, then coast along with high profitability and low innovation. But the natural strategic tariff resists this danger because it does not hand out a blank check of protection: it gives a certain percentage and no more. Any industry that cannot get its costs within striking distance of its foreign competitors will not be saved by it. This discipline, although unpleasant for the losers, is the price we must pay for having a tariff that actually works, rather than one which eliminates the discipline of foreign competition entirely and protects all industries, whether or not their protection is useful to the economy as a whole.

  It is sometimes objected that protectionism stifles competition. This, too, is a real threat. As a result, antitrust policy will become even more important than it already is. Luckily, there is a compensating benefit: rivalry between domestic firms actually appears to be a more potent competitive force than rivalry with foreign ones. As Michael Porter observes:

  Domestic rivals fight not only for market share but for people, technical breakthroughs, and, more generally, ‘bragging rights.’ Foreign rivals, in contrast, tend to be viewed more analytically. Their role in signaling or prodding domestic firms is less effective, because their success is more distant and is often attributed to ‘unfair’ advantages. With domestic rivals, there are
no excuses.

  Domestic rivalry not only creates pressures to innovate but to innovate in ways that upgrade the competitive advantages of a nation’s firms. The presence of domestic rivals nullifies the types of advantage that come simply from being in the nation, such as factor costs, access to or preference in the home market, a local supplier base, and costs of importing that must be borne by foreign firms...This forces a nation’s firms to seek higher-order and ultimately more sustainable sources of competitive advantage.789 (Emphasis in the original.)

  So replacing foreign rivalry with strong domestic rivalry is probably a net plus. Japan’s ferociously competitive (and protected) automobile and consumer electronics industries illustrate this well.790

  If a tariff gives companies back market share and lets them raise prices, they may just harvest profits, rather than reinvesting them in long-term growth. As noted previously, this was a problem with one of America’s largest recent protectionist undertakings: the Voluntary Restraint Agreement with Japan on automobiles.791 As also noted, one major difference between effective and ineffective industrial policy is that effective industrial policy involves not only the “carrot” of tariffs and subsidies, but also the “stick” of measures to prevent companies from merely taking out added revenues as profit, rather than investing them in long-term upgrading of their capabilities.792 Does this mean that a tariff should be accompanied by agreements on investment levels? No; the needed investment may be in another industry anyway. The solution probably lies in creating generalized incentives for investment. Since increased investment is a good thing even if we leave trade out of the picture, and already the object of tax incentives supported across the ideological spectrum, this should not be too hard to swallow politically.

  REASONABLE OBJECTIONS TO A TARIFF PART II: FOREIGN

  Another common objection to a tariff is that our trading partners would just shrug it off by increasing subsidies to their exporters.793 This would force us into an endless game of matching these moves on a country-by-country, industry-by-industry, and even product-by-product basis. However, such subsidies by our trading partners would be restrained by the fact that they would be very expensive in the face of an American tariff. Right now, these subsidies are relatively affordable only because they don’t have to climb an American tariff wall. But if they did, their cost would increase dramatically. Currency manipulation is probably the only subsidy that is affordable over prolonged periods of time (and even then problematic in the end), as it involves buying foreign assets and debt, thus accumulating wealth rather than just expenditures. But other subsidies amount to a giveaway from the exporting to the importing nation. While this doesn’t prevent them absolutely, it does tend to set a limit. This is all we need, especially as we have no hope of eliminating or countervailing all foreign subsidies no matter what we do, tariff or no tariff.

  The same goes for the objection that our trading partners would just devalue their currencies. As previously noted, we can end foreign currency manipulation at any time simply by restricting or taxing foreigners’ ability to lend us debt and buy our assets.794 We would need to raise our own savings rate if we did this (or face rising interest rates), but we need to do this anyway.

  Another objection is that any tariff large enough to mean anything would impose a sudden shock on the U.S. and world economies, which would tip them into recession as other shocks, notably the 1973-4 oil shock, have done. This is a legitimate concern, as economies do not adapt well when the rules governing them change faster than the economy itself can keep up with. If a 25 percent tariff suddenly makes it economically rational to manufacture disk drives in Colorado rather than Kyushu, this doesn’t make plants sprout in Colorado overnight. So until the U.S. and Japanese economies adapt to the newly implied distribution of industries between them, they will be out of balance and thus underperform. Phasing in a tariff over five years or so would mitigate this.

  Another objection is that a tariff would trigger a downward spiral of retaliation and counter-retaliation with our trading partners, resulting in an uncontrolled collapse of global trade. But this oft-bandied doomsday scenario is unlikely. Above all, our trading partners know that they are the ones with the huge trade surpluses to lose, not us. Foreign nations would probably raise their tariffs somewhat, but there is no reason to expect the process to get out of control. After all, the world has survived their trade barriers long enough.

  Indeed, there is an opposite possibility. Suppose we tell foreign nations that our tariff increase is in retaliation for their own various trade barriers. (This is, of course, largely true.) And suppose we then threaten to raise our tariff even higher if they don’t open up, but offer to drop it back down somewhat if they do. Then our trading partners may even reduce their barriers in response to our imposing a tariff. So our imposing a tariff could, paradoxically, further the cause of global trade openness, not retard it.

  We can call this alternative managed open trade. It is not the same thing as free trade. Fully elaborated, it would be based on the internationally shared twin goals of zero tariffs and zero deficits. These goals would be shared, despite the reality of international rivalry and the absence of a sovereign to enforce them, because every nation would know that a) other nations would retaliate in response to excessive surpluses inflicted upon them, and b) the alternative is the system breaking down for everyone, including themselves.795 This substitute for free trade would spare a lot of ideological sacred cows, as it would come fairly close to free trade if it worked. (Many people who think they are defending free trade are actually defending covertly managed trade with zero tariffs, anyway.) But it would depend upon our ability to credibly threaten a tariff if our bluff were called. It would therefore depend upon our having viable contingency plans to function with a tariff. This is one reason why even free traders thinking through how to save as much of free trade as they can should take the option of a natural strategic tariff seriously.

  ALTERNATIVES TO A NATURAL STRATEGIC TARIFF

  There are a number of alternative proposals on the table for solving America’s trade problems. Perhaps the most famous is billionaire investor Warren Buffet’s proposal for import certificates. He proposes that exporters be given a $1 certificate for every dollar of their exports, and that importers would then have to buy a certificate from them for every dollar of goods they imported. This would, of course, force America’s trade into balance automatically.

  It is not a bad idea, but contains less than meets the eye. If the certificates traded on the open market (as proposed) then an equilibrium price would be set, which price would then be the de facto tariff on imports. Since the revenue from selling the certificates would go to exporters, the scheme would thus amount to an import tariff plus an export subsidy. Because the tariff would be flat, it would have the same natural strategic effects as a natural strategic tariff.

  The main differences between Buffet’s idea and the natural strategic tariff are that Buffet’s proposal would operate on both imports and exports, and it would not raise money for the government. Because it would not raise money, it could not finance progressivity-neutralizing cuts in other taxes, and would therefore make the tax code more regressive. (It would also be a giant transfer of wealth to our export industries.) The main advantage of Buffett’s scheme is automatic tariff setting at a level that would zero out the deficit. But a flat tariff (or a U.S. VAT) could be calibrated over time to do this, too.

  Another possibility is simply to institute a VAT in the U.S.796 Although this is a well tried system of taxation, used in every other developed country, it is generally regarded in this country as a strange European affectation, which probably dooms its rational consideration. Although mentioned recently as a possibility by Senate Budget Committee chairman Kent Conrad (D-ND) and others, it has attracted vehement opposition.797 As with a natural strategic tariff, it would not have to be a net tax increase, and would not have to change the overall progressivity of the tax code. The great advant
age of a VAT is that, while a natural strategic tariff and import certificates would abrogate America’s NAFTA, WTO, and other treaty obligations, a VAT would not. This is an attractive option for legalistic minds in the State Department, for those who fear the consequences of unraveling the international legal infrastructure, and for those who wish to withdraw America from free trade while obfuscating this fact for ideological reasons. (Perversely, the obvious alternative of a so-called Border Adjustable Tax or BAT, which resembles a VAT but without its domestic aspects, would be illegal.) Another big advantage of a VAT is that, like a tariff, it is a consumption tax. Its biggest disadvantage is simply that it would mean having a domestic VAT, a giant change in domestic tax policy simply to address a foreign trade issue.

  Another alternative to the natural strategic tariff is a tariff on manufactured goods that exempts raw materials and agricultural products. This is roughly what traditional mercantilism has done for 400 years, is what Alexander Hamilton proposed in 1791, and is commensurate with U.S. policy in our tariff era after 1872.798 It is based on the idea that we are not trying to capture raw material or agricultural industries. The main problems are that if unprocessed goods are admitted duty-free and processed goods are subject to a tariff, then a) we lose the apolitical simplicity of a flat tariff, b) we have to deal with borderline cases and successive stages of processing, and c) we avoid dealing with America’s dependence on foreign raw materials. Furthermore, our only really big raw material import is oil, and there are energy-conservation and national-security reasons to tax imported oil anyway. And members of Congress from agricultural and raw materials-producing states will object if the industries of other states are protected and theirs are left to fend for themselves.