To the American policy elite, there are few heresies greater than tariffs. In the world of think-tank white papers and academic panel discussions, tariffs keep Marxism company in the ashbin of history, supposedly discredited by the mathematical models of orthodox economists and disdained by every presidential administration since Herbert Hoover.
Entrenched skepticism was no match for the Trump administration, which shattered decades of consensus by increasing average tariffs on Chinese goods from 3 percent to almost 20 percent. This new trade war has been condemned by virtually every quarter of mainstream policy opinion, yet rather than restore the pre-Trump status quo, the new Biden administration appears ready to continue the supposedly backwards policy. Biden — a career free-trader who supported NAFTA and China’s ascension to the World Trade Organization — has no plans to rescind Trump’s China tariffs.
The most polarizing president in modern memory has apparently forged a new consensus in support of one of the most disfavored tools in economics. Tariffs have unexpectedly crawled out of the ashbin of history, and post-Trump Republicans will have to decide if they’ll try to push them back in. But that requires a fair understanding of what tariffs can and can’t do — and few policy tools are more misunderstood than tariffs.
Republicans and neoliberal Democrats have long told a story about America’s use of tariffs that goes like this: During the laissez-faire heyday of the 19th century, America enjoyed unprecedented growth and industrialization. But as the 20th century crept on, domestic industries began insisting on protection from foreign competition and successfully lobbied for tariffs, culminating in the disastrous Smoot-Hawley Tariff of 1930, which helped turn the stock-market crash into the Great Depression. Tariffs became increasingly obsolete in the post-war world after economists proved that they lead to deadweight loss and retaliation and are useful only for dying industries that can’t handle competition, and for corrupt governments that use them to pick winners and losers.
Virtually every part of this story is wrong. The United States spent much of the 19th century as the most protected economy in the developed world, becoming a manufacturing juggernaut despite average tariff rates hovering between 20 percent and 50 percent (today’s average is 2 percent). The supposedly catastrophic Smoot-Hawley tariff wasn’t even the decade’s largest hike on a percentage basis. That would be the now-forgotten Fordney-McCumber tariff of 1922, which was followed not by depression but by the Roaring Twenties. Smoot-Hawley itself did not cause the Great Depression, the Fed did. Barry Eichengreen has even argued that Smoot-Hawley’s effect on the United States was likely expansionary, with prices declining less sharply in the U.S. relative to its foreign competitors.
Tariffs can have this effect in part because of optimal tariff theory, a concept developed by Nicholas Kaldor in 1940. This theory states that for a large economy with substantial buying power in the world market, taxing imports can increase national wealth by lowering demand (and therefore prices) for imported goods and increasing demand for domestic goods exported to the world. That depends, however, on trading partners’ not retaliating.
Unfortunately, for much of recent history, we have been the trading partner that doesn’t retaliate. Ideological commitment to free trade turned the U.S. into the “mark” in international trade negotiations, allowing our partners to gain entry to our market without granting equal access to American exports in return. Tariffs aren’t principally about protection; they’re about leverage. Absent the threat of tariffs, competitors feel free to break rules and create asymmetric advantages.
For instance, under Obama, inbound tariffs for Chinese exports carried an average tariff of 3 percent while Chinese duties on our exports averaged 8 percent, to say nothing of non-tariff trade barriers. Such unequal arrangements contributed to America’s record-high trade deficits, with consumption outstripping production by around 2 to 4 percent of GDP for most of the past 20 years, for a combined goods-and-services deficit of $605 billion through November 2020.
Conservatives have long insisted that trade deficits don’t matter. Armchair policy wonks are fond of pointing out that you run a trade deficit with Shake Shack, yet both are better off from this exchange. But as U.S. Trade Representative Robert Lighthizer points out, if you run a trade deficit with everyone, with no net-positive income stream from selling goods or services of your own, you’re just in debt, and your consumption of Shackburgers depends on your credit-card company’s patience.
Some believe that creditor patience is virtually limitless for the United States, because the dollar’s reserve-currency status means that our trading partners will always accept dollar-denominated IOUs in the form of U.S. Treasuries to fund our consumption. But trade deficits necessarily get plugged by sales of assets as well as by debt — meaning we are auctioning off our future productive capacity to consume more in the present.
Nor is debt without drawbacks: When exporters such as China and Germany recycle their profits into Treasuries, it lowers interest rates and stimulates borrowing — and financial bubbles — at the same time their production glut deepens American deindustrialization. As Warren Buffett said, “our country has been behaving like an extraordinarily rich family that possesses an immense farm. In order to consume 4 percent more than we produce — that’s the trade deficit — we have been both selling pieces of the farm and increasing the mortgage on what we still own.” If this can’t go on forever, eventually it will stop.
Persistent trade deficits also carry distributional consequences. Every American worker is both a consumer and a producer. When we import more than we export, domestic producers face more competition without a commensurate increase in demand for their labor. This hurts American producers to help (for now) American consumers — an arrangement that most Americans don’t regard that as an equal trade-off. The outcomes of this choice are visible in the research of David Autor, David Dorn, and Gordon Hanson, who find that exposure to Chinese import pressure predicted male wage declines, which in turn predicted increased mortality and out-of-wedlock births. The economic models said that these workers would move into more-efficient sectors, but that didn’t happen. If we want to minimize these harms we should seek balanced trade, so that, as Oren Cass points out, “workers not only face greater competition but also enjoy greater opportunity.”
Tariffs are often not the best way to balance trade. Picking which goods to tax invites rent-seeking and lobbying, and the policy can have unintended effects due to the complexity of supply chains with inputs that jump from country to country before final assembly. Aiming for balanced trade merely means considering the contexts in which tariffs can be part of the solution alongside other approaches. For too long, an ideological attachment to free trade has foreclosed inquiry.
The requirements of national security have trumped free trade since the publication of Wealth of Nations, when Adam Smith noted that “if any particular manufacture was necessary, indeed, for the defence of the society, it might not always be prudent to depend upon our neighbours for the supply.” The Trump administration invoked that logic when it used Section 232 to place a 25 percent tariff on imported steel and a 10 percent tariff on imported aluminum, claiming that national security required the U.S. to safeguard its domestic capacity to produce defense inputs. The context for the tariffs was a longstanding policy by Chinese manufacturers to overproduce these metals, depressing world prices and giving China a majority share of world production.
The tariffs immediately attracted critics. Most of our imported steel and aluminum comes from allies like Canada and the European Union, not adversaries such as Russia and China, supposedly ensuring that our supply of needed goods would remain secure in a crisis. And the economic models said that even if prices spiked owing to shortage, the price signal would pull new producers into the market and quickly boost supply.
The COVID-19 pandemic put those theories to the test, and the results were bleak. Having offshored its capacity to produce personal protective equipment (PPE), medical devices, and pharmaceuticals, the U.S. found itself dependent on global supply chains that were falling apart. Adversaries and allies alike restricted the export of needed goods to ensure that their home markets were adequately supplied, and the process to bring new production online took a while as the body count climbed.
The lesson of the crisis is that productive capacity is not liquid, growing or shrinking to instantly match demand. It exists within a fragile ecosystem — the “industrial commons” — made up of human know-how within many interconnected, geographically rooted supply chains. When a supply chain gets offshored and the know-how migrates elsewhere, it has cascading effects, and can’t be recreated just because there’s an emergency. Harvard Business School professors Gary Pisano and Willy Shih explain this cascade:
Once manufacturing is outsourced, process-engineering expertise can’t be maintained, since it depends on daily interactions with manufacturing. Without process-engineering capabilities, companies find it increasingly difficult to conduct advanced research on next-generation process technologies. Without the ability to develop such new processes, they find they can no longer develop new products.
If the manufacturing gets offshored, the engineering, research, and design will follow, because these activities reap efficiency gains by locating close to the assembly line. Then you lose the future. This dynamic is well underway in the U.S., where R&D that American firms used to conduct in America is increasingly moving to East Asia. Tariffs alone are unlikely to reverse this trend, but in conjunction with industrial policy to support firms in bearing reshoring costs, it can work. For example, Taiwan has successfully reshored over $33 billion of investment from China through a “non-red supply chain” policy of tax credits, subsidies, and other state support to reshoring firms. It wouldn’t have succeeded without U.S. tariffs on China changing the cost structure of exporting from China.
This means tariffs that disincentivize the offshoring of manufacturing can be part of a strategy to gain new high-value industries rather than merely protect existing ones, by helping America’s industrial commons stay healthy enough to attract innovation. Doubters need only look to the advanced technology industries that sprung out of the Asian Tiger economies behind high tariffs and export promotion. Indeed, there is evidence that lowering tariffs on intermediate inputs actually decreases firm-level innovation because firms can purchase someone else’s technology instead of developing it internally. In some sectors, that’s efficient, but in others, dependence on someone else’s technology is a grave threat.
The industrial commons supporting our defense-industry supply chains are in dire straits. A 2018 Pentagon report identified dozens of militarily significant inputs with at most two, and in some cases zero, domestic suppliers, each of which functions as a choke point for our defense capacity. These include key inputs for satellites and missiles, casting for submarines, fasteners, high-voltage cables, flares, valves, fittings for ships, circuit boards, batteries, night-vision systems, sensors, and specialty chemicals. China is the sole supplier for many of these goods. Offshoring our ability to manufacture ships, satellites, and armaments not only renders us dependent on international supply chains that might not be there in an emergency, but it also hamstrings our ability to innovate and maintain our competitive edge.
When steel tariffs were announced in March 2018, the commentariat agreed almost unanimously that higher steel prices would weaken U.S. industry, including the defense sector, by raising input costs. Yet only one year later, U.S. steel prices had dropped back down to their pre-tariff level as steelmakers added capacity, and dire predictions failed to materialize. Protests that we already made enough steel to meet defense needs missed the point: By allowing the steel industry to continue to produce its full product range and remain profitable in the face of the Chinese supply glut, the tariffs may have arrested Pisano and Shih’s know-how cascade and safeguarded long-term viability.
But steel is only one part of the puzzle, because U.S.–China trade competition is increasingly about who will own the technologies that shape the future. Tariffs should be aimed at winning what is essentially a zero-sum competition for global market share in strategic sectors such as 5G telecom, advanced semiconductors, biotechnology, new materials, and aerospace. The free market is agnostic on American leadership of defense-critical industries; Americans should not be. If American capital wants to speed the rise of an adversary, at the very minimum, it should pay a tariff that internalizes the national-security costs of doing so.
Economists are trained to identify solutions that improve aggregate welfare. But as the economist Dani Rodrik points out, taking $100 away from Peter and giving $200 to Paul improves aggregate welfare and yet will leave half of this two-person society fuming. If net improvements occur through redistributions that people regard as illegitimate or rigged, it’s cold comfort to insist that society as a whole is better off.
Free trade makes society richer but involves major wealth redistributions between winners and losers. The international trading system has “level playing field” rules to ensure that the redistributions are accepted as legitimate. For example, the World Trade Organization allows states to place tariffs on imports that were subsidized by their home state, or were “dumped” on a trade partner for less than the cost of production.
But subsidies and dumping aren’t the only way to break the rules and make your goods cheaper than your competitor’s. You could be willing to fill your supply chains with slave labor. You could be willing to violate even your “free” workers’ rights by banning independent labor unions. You could ignore basic health-and-safety regulations, and you could be willing to despoil the environment. You could also be willing to evade even those international trading rules that do attempt to enforce a level playing field, by hiding subsidies as low interest loans from Party-connected banks and foiling WTO dumping calculations by exporting certain goods at artificially high prices so it all averages out.
When a competitor cheapens its goods by ignoring its legal obligations and violating its citizens’ rights, it’s called social dumping, and it’s just as illegitimate to ask workers to compete with socially dumped goods as with conventionally dumped goods. The competitor’s policy choice distorts the domestic bargain that workers struck in their own country, by forcing them either to abandon that bargain — for civilized labor standards, for breathable air, for safe products — or lose their jobs. If you think it’s illegitimate to ask an American worker to compete in a market with state-subsidized goods, it makes no difference whether that subsidy comes from a government check or the government’s suppression of collective bargaining. Tariffs are justified against such goods to preserve each society’s autonomous right to its own social contract.
This exposes the mistaken view that tariffs are merely a tool for government to unfairly pick winners and losers. When the global trading system includes rule breakers, free trade with that rule breaker means letting their artificially cheap goods into your market, where they will distort prices and put your firms out of business. Some on the right believe that if our trading partners want to use their taxpayers’ money to subsidize exports, American consumers should happily accept the philanthropy: cheaper inputs and cheaper prices. But Americans will remain competitive only in those industries that its trading partners have chosen not to subsidize, so the decision to avoid tariffs results in the Chinese Communist Party picking our winners and losers for us.
The bottom line is this: Trade imbalances harm us, and they are caused by competitors breaking the rules of the international trading system to create unreciprocal advantages. These include subsidies and dumping but also currency manipulation, forced technology transfer, inadequate or selective regulatory enforcement, IP theft, and intentional supply gluts. Ending this rule-breaking would require the U.S. to either find a governance mechanism that could force China to change its domestic system — none currently exists — or take enforcement action. That’s what Lighthizer’s USTR office did when it investigated which Chinese exports benefited from rule-breaking and imposed 25 percent tariffs to offset their unfair advantage.
Some say that this tit-for-tat escalation, fueling higher costs and greater uncertainty, is the single greatest drawback of tariffs. These fears often follow a naïve pattern of observing some unfair competitive act but cautioning against a response lest it invite “retaliation” — ignoring that the fight is already upon us. Complaints that China tariffs raise prices on American consumers are really complaints about losing a foreign subsidy, paid for by frittering away America’s long-term productive capacity. And certainty that this fundamentally unfair system will continue is not the kind of certainty our trade policy should protect. We can either grit our teeth and make our competitors feel that there are consequences for breaking the rules — or we can continue to be the mark.