Donald Trump pursues a trade and tariff policy that lacks justification in economic theory, in commercial practice and in political philosophy. Milton Friedman, the most unrestrained advocate of free markets and a Nobel prize-winning economist, makes a cogent and simple justification for free trade and for the absence of all tariffs. His argument begins with Adam Smith and David Riccardo and continues to the present with the agreement of NeoKeynesian economists such as Larry Summers, Paul Krugman and Joseph Stiglitz. Watch him at https://www.youtube.com/watch?v=urSe86zpLI4.

The support for free trade and the absence of tariffs rely on David Ricardo’s explication of comparative advantage. Consider England and Portugal separated by the English Channel, by different weather conditions, and by different skill sets. Further consider both countries producing cotton and port wine. England has a comparative advantage in producing cotton since its economy favors cotton production, and Portugal has a comparative advantage in producing port wine since its economy favors wine production. By producing only cotton, England can produce more cotton than England and Portugal together. Similarly, by producing only port wine, Portugal can produce more port than both England and Portugal together. Now introduce unrestricted trade between England and Portugal. By trading port and cotton, both countries can consume more cotton and port than they could before trading. This argument for free trade still persists for over 200 years without academic challenge.

Consider a rupture of the English-Portugal free trade environment. Each country retreats to its status quo ante position and produces both port and cotton. The countries again produce less cotton and less port. The two countries divide less wine and less port between them. Both countries are poorer because each country consumes less wine and less port. Poorer becomes the appropriate adjective since each country consumes a smaller port-cotton bundle. Only a smaller national income describes the smaller port-cotton bundles. Trump’s proposed trade and tariff polices replicate the smaller port cotton bundles. Trump’s policies harm the United States and all its trading polices with reduced levels of national income and with reduced consumption.

Donald Trump’s abhorrence of trade deficits identifies him as an outdated mercantilist from the 1600 to 1800 era. As a form of economic nationalism, mercantilism sought increased prosperity through restrictive trade practices such as tariffs and quotas. Instead, mercantilism slowed growth and limited prosperity by discouraging innovation, stifling efficiency and protecting domestic industries from competition. Limiting competition conflicts with free market capitalism that relies on progress through social Darwinism and the survival of the fittest.

The trade deficit actually occurs on the U.S. macroeconomic level when U.S. aggregate investment exceeds U.S. aggregate savings. Since U.S. aggregate savings must equal U.S. aggregate investment in macroeconomic equilibrium, the U.S. must borrow an amount equaling (aggregate investment – aggregate savings) abroad on the capital account to eliminate the imbalance between aggregate U.S. savings and aggregate U.S. investment. To finance the borrowed capital, the U.S. must import more than it exports on its current account. The difference between exports and imports is the trade deficit that equals the borrowed investment. Combining the capital and current accounts, aggregate U.S. investment equals aggregate U.S. savings. Instead of the U.S. subsidizing foreign production as Trump asserts, foreign production subsidizes U.S. investment. The subsidization becomes increased U.S. debt.

Like all debtors, the U.S. relies on the beneficence of its creditors. In attacking the neoliberal order, Trump attacks his creditors. Creditors such as Japan and China have advantages and weapons since Japan and China hold trillions of U.S. dollars in long-term U.S. treasuries. Were either China or Japan inclined to devastate the U.S., either could sell U.S. treasures, drive down U.S. treasury prices, drive up U.S. interest rates, and generate a U.S. depression not unlike the 1929 depression. As the reserve currency, the dollar facilitates financing U.S. debt. Competing or replacing reserve currencies hinders U.S. debt financing. More counties such as the BRICS challenge the dollar as the reserve currency. Hostile Trump behavior may strengthen reserve challenges, hinder U.S. debt financing and slow US growth.

Even without foreign selling of U.S. treasuries, the Trump tariff policy is sufficient to generate stagflation in the U.S. The Fed has little ability to fight stagflation since raising interest rates increases recessionary tendencies and lowering interest rates increases inflationary tendencies. Given the persistence and perniciousness of inflationary expectations (with inflationary expectations distinct from ordinary inflation by being self-generating), the Fed is more likely to err in raising interest rates. A hard money man such as Paul Volcker might be more aggressive. During the 1970s, as Fed Chairman, Paul Volcker held rates above 20% for several years to eliminate inflationary expectations and to warehouse the Phillips Curve that traded inflation for unemployment.

John Drake

Friday Harbor