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Understanding Tariffs and Trade

October 3, 2018

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Language and preconceptions of international trade

Few topics in economics command near-universal acceptance as the proposition that “trade can make everyone better off,” but consider this statement from the perspective of a student who is taking her first economics course. In most cases, she will have heard little beyond high school social science class about trade.  If she is “informed” she likely “knows” one of two things: 1) trade can lead to someone or something being exploited, or 2) that other persons employ unfair trade practices against us.

These preconceptions, one from the left and one from the right, create distance from the statement “trade can make everyone better off.”  Her “knowledge” makes the statement less believable and her more susceptible to the idea that exports are good and imports are bad.

The language surrounding trade reinforces this idea because economists apply the terms ‘surplus’ and ‘deficit’ to the accounting measure of the ‘balance of trade.’ Formally, a trade surplus reflects the economic state in which exports exceed imports, and a trade deficit reflects the opposite. The word ‘deficit’ evokes concern by its very nature. It signals that we do not have enough of something, whatever that something happens to be. By contrast, a surplus evokes feelings of abundance. It gives us comfort.

Measuring the importance of trade: National Income Accounting

Look again at that statement: trade can make everyone better off. Economists do not distinguish between exports and imports in this statement. For economists who specialize in trade, both imports and exports are welfare enhancing, even if the net result is a ‘deficit’.  ‘Welfare’, in an economics, is the difference between how highly we value something and how much it costs to obtain it.

However, even among economists, there might lurk some hidden bias, a subconscious preference for balanced trade or even a trade surplus. The possible reasons for such a hidden bias may be many, but one seems to offer the most plausible explanation: national income accounting.

National income accounting is how we measure our nation’s output. Most of us are familiar with the term gross domestic production (GDP). Adam Smith hard-wired the concept into the intellectual DNA of economist by observing that a nation’s income depends on its ability to produce goods and services.

Approaches to measuring trade: Income vs. Expenditures

In that introductory macroeconomics class, our student will learn two approaches to measuring national income: the income approach and the expenditure approach. The reason for the two approaches is that every transaction has a buyer and a seller. The income approach sums all wages, rents, interest payments, and profits to measure GDP.  The expenditure approach sums all expenditures on consumption, business investment, government expenditures, and net exports (= C + I + G + NX). It is this last term that might create a bias towards trade.

Net exports, as a number, has a quirky characteristic: in accounting terms, an increase in exports raises national income (and lowers it if exports decrease) but imports have no effect on national income. The reason imports are neutral on national income is that the transaction is entirely on the expenditures side of GDP.  Since imports do not change national output, the expenditure approach to measuring output must not change.

Here’s how they do it: imports are also measured as consumption. As result, GDP does not change because the increase in consumption is offset by a decrease in net exports owing to the consumed imports. Hence, a bias is born to favor an increase in net exports because, if driven by exports GDP and jobs offered increase, but if net exports increase owing to a decrease in imports we see that it is neutral in its effect on GDP.  Hence, all increases in net exports are good or neutral in the mind of the misguided observer.

The bias, however, is misguided.  The decrease in imports is a decrease in consumption, and that, in economic terms, is a decrease in welfare (the difference between how much we value something and how much it costs to make or buy).

Economists assume that imports improve living standards because economists believe most consumers are the best judges of their own welfare. A purchase indicates that a consumer benefits from goods and services more than other options including no sale. For some, economic freedom is a sufficient argument to allow free trade.

Others believe trade should further other economic goals, such as the current renegotiation requirement for NAFTA that 40 to 45 percent of auto parts imported into the U.S. from Mexico must come from labor earning $16 per hour (see https://www.cnn.com/2018/08/27/politics/mexico-us-trade-deal/index.html retrieved on 8/28/2018).

The idea is that this requirement will reduce the incentive for auto parts manufacturers to locate their operations in Mexico where wages are lower. The goal is to help workers in the U.S., but it comes at the expense of consumers and auto manufacturers. Economic theory holds that such a requirement would ultimately reduce the sale of cars and could reduce the number of jobs in the domestic auto industry.

The Inflation Bias

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This brings us back to our bias. National income accounting is measured in market prices. Economists call this nominal GDP and contrast it with real GDP. Consider an island with only one orange tree that produces 100 oranges per month. If we value the oranges at $1 each, monthly GDP is $100. If we raise the value of an orange to $2, nominal GDP doubles but the real economy has not improved as the economy still produces 100 oranges per month.

We apply the term inflation to generally rising prices. Inflation diminishes the efficiency of an economy because it reduces the value of the signals that prices send. In the absence of inflation, a rise in price signals an increase in consumer preference for a product or to a reduction in supply. Either way, rising prices encourage firms to expand. With inflation, that signal loses meaning as firms can only imperfectly distinguish between nominal (inflation) and real shocks, such a change in consumer preference.

Inflation is, as Nobel laureate Milton Friedman put it, “always and everywhere a monetary phenomenon.” In general, introductory economics textbooks tell an incomplete story about the source of monetary growth. These textbooks typically assert that the Federal Reserve (the “Fed”) controls the money supply. However, the main source of new money in the U.S. economy is the federal deficit. The deficit (government expenditures exceeding tax revenue) is funded by new government debt which is deposited by the Treasury with the Fed.  The Fed, in turn, creates money for the government by clearing the checks written against the new debt. If the Fed believes inflation is rising too much, it sells some of the Treasury bonds to the public (reducing the money supply, at least for a little while). That’s the payment side. What about the expenditure side?

As the Treasury writes checks, those are cashed by the public and treated as income and later as expenditures.  The key point is this: as incomes rise, the public buys more of all goods, including imports. Were the public not able to buy imports, the new money created by the deficit would remain in the U.S. and cause inflation, perhaps even hyperinflation.

The increase in monetary growth originates with the government expenditures (the express that GDP = C + I + G + NX) in excess of tax revenue. The increase in government expenditures increases nominal GDP at the same time it increases the trade deficit.  It all originates with monetary growth through fiscal deficits. 

Why Imports Enhance Welfare

Imports improve real GDP, and therefore welfare, in multiple ways. First, imports increase real wages of all workers through lower prices spurred on by competition. Second, imports reduce input prices such as the components of a final good for sale. Third, imports allow us to escape (or at least postpone) the consequences of large-scale printing of money by providing an avenue to expel excess dollars.

In this, the United States is unique, as the dollar remains the currency of international trade and therefore readily accepted everywhere.  Venezuela, on the other hand, cannot print money and escape inflation through trade as the U.S. does. No one wants to hold or trade in worthless Bolivars. We should be careful to ensure that no day may come when no one wants the dollar.

 


Dr. Robert Mason grew up in California where he attended the University of California at Berkeley to earn a B.A. in rhetoric. He next attended California State University, Hayward (now called California State University, East Bay) where he earned an M.B.A. in finance and a master’s degree in economics.

He moved to Georgia to earn a Ph.D. in economics from the University of Georgia. While he was doing his graduate studies, he was hired by the University of Georgia as an instructor to teach economics on the Athens campus. He later became an instructor for the University of Georgia when UGA opened its satellite campus at the Gwinnett University Center (GUC). While UGA had an undergraduate presence at the GUC, he taught all the undergraduate economic courses. Later, as GUC became Georgia Gwinnett College, he joined the inaugural faculty.