The One Word that Explains Globalization's Failure, and Trump's Response

No, not "tariffs." Reciprocity. Well, OK, also "tariffs."

Donald Trump is at his best when he seizes on a common-sense position that happens also to be correct, confounding elite technocrats attempting to impose on the nation a view that both seems absurd and is in fact wrong. His insistence on framing his administration’s forthcoming actions on trade in terms of “reciprocity” is a perfect example. The United States will embrace free trade, in Trump’s framework, only to the extent its trading partners do too, and to the extent we get real, actual, honest to goodness trade as a result.

“Isn’t that how it already works?” No, no it is not. Reciprocity is supposed to form the basis of the international trading system, but other countries have flouted that expectation and the U.S. has repeatedly turned a blind eye. To keep the party going, economists constructed a narrative in which reciprocity was unnecessary. Let other countries behave however they want, the story went, the U.S. would benefit from opening its market to all comers.

As Nobel Prize–winning economist Paul Krugman asserted in 1997, in the Journal of Economic Literature, “the economist’s case for free trade is essentially a unilateral case: a country serves its own interests by pursuing free trade regardless of what other countries may do.”

On this basis, Michael Strain, the director of economic policy studies at the American Enterprise Institute, and Ramesh Ponnuru, editor of National Review, argued in 2014 against confronting China’s rampant abuses because, “That model does not ignore the possibility of a prisoner’s dilemma but rather denies that it exists. After all, the classical case for free trade was developed in a mercantilist world, and it argued that free trade almost always benefits the country adopting it, regardless of the trade policies of other nations. … For an economy as large and diverse as that of the United States, dropping a tariff is not like dropping a shield in a swordfight; rather, it is refraining from inflicting a wound on oneself.”

Krugman proudly recommended “ridicule” for anyone questioning the orthodoxy, while Larry Summers said of embracing China, “It has sometimes been remarked that asking five economists a question will generate ten different answers. On this issue there has been only one answer.” Nobel laureate Robert Solow scoffed from a White House podium, “You could not generate a hard exam question out of the material here.”

The premise underlying this confidence was that manufacturing does not matter and indeed a nation benefits most from producing as little as possible domestically and importing as much as possible from abroad. As Milton Friedman had put it back in the 1970s, “The gain from foreign trade is what we import. What we export is the cost of getting those imports. The proper objective for a nation, as Adam Smith put it, is to arrange things so we get as large a volume of imports as possible for as small a volume of exports as possible.”

By this logic, anything that slows the flow of imports, or raises their cost, would indeed be a self-inflicted wound. If the Chinese Communist Party wants to block the sale of U.S. electric vehicles in China, let it. We should still want as many cheap Chinese EVs as possible flooding into our market. In a Wall Street Journal column denouncing Trump’s strategy two weeks ago, economic historian Douglas Irwin deployed the metaphor of blocking up a harbor. “The British economist Joan Robinson once said that a country shouldn’t throw rocks into its own harbors just because other countries have rocky coasts,” he wrote. “The same principle applies here: The U.S. shouldn’t have stupid tariff policies just because other countries have stupid tariff policies.”

But the American experience of recent years has proved this mindset to be extraordinarily naïve. That’s not my word, it’s Krugman’s, from our conversation last week on the “On with Kara Swisher” podcast:

OC: The initial argument was that trade deficits are self-correcting.

PK: I don't think I ever said that. I think I said the trade deficits are not a problem.

OC: No. You wrote a piece for the American Economic Review in 1993, in fact titled, “What Do Undergrads Need to Know About Trade?” in which you said we need to teach them “that trade deficits are self-correcting.”

PK: Okay, if I did say that, that was naïve…

Former Secretary of the Treasury Janet Yellen likewise recanted last year, telling the Wall Street Journal, “People like me grew up with the view: If people send you cheap goods, you should send a thank-you note. That’s what standard economics basically says. I would never ever again say, ‘Send a thank-you note.’”

What’s remarkable about the collapsing orthodoxy is that we are not learning something new so much as rediscovering what wiser economists knew all along. Even Friedman’s claim that “the proper objective for a nation, as Adam Smith put it, is to arrange things so we get as large a volume of imports as possible for as small a volume of exports as possible,” runs directly counter to what Smith actually wrote, which was: “If a foreign country can supply us with a commodity cheaper than we ourselves can make it, better buy it of them with some part of the produce of our own industry.”

With some part of the produce of our own country. A vital assumption of the classical model was that trade would be balanced—something made here for something made there. David Ricardo, explaining the principle of comparative advantage with the example of Portuguese wine and British cloth, described what England was doing as “purchase[ing wine] by the exportation of cloth.” John Stuart Mill stated especially bluntly that “since all trade is in reality barter, money being a mere instrument for exchanging things against one another, we will, for simplicity, begin by supposing the international trade to be in form, what it always is in reality, an actual trucking of one commodity against another.” The purpose of trade was not to decimate your own industrial base (obviously), it was to trade.

Observing his fellow economists allowing their enthusiasm for abstract models of efficient markets to get the best of them, John Maynard Keynes warned in his General Theory of Employment, Interest and Money, against believing that “preoccupation with the balance of trade is a waste of time. For we, the faculty of economists, prove to have been guilty of presumptuous error in treating as a puerile obsession what for centuries has been a prime object of practical statecraft.”

And Joan Robinson, she with the rocks in the harbor in Irwin’s recent op-ed, in fact made the opposite point of the one that Irwin attributes to her. (Thank you to Michael Pettis for the pointer.) While the clean-harbors argument “is unexceptionable on its own ground,” she wrote:

when the game of beggar-they-neighbour has been played for one or two rounds, and foreign nations have stimulated their exports and cut down their imports by every device in their power, the burden of unemployment upon any country which refuses to join in the game will become intolerable and the demand for some form of retaliation irresistible. The popular view that tariffs must be answered by tariffs has therefore much practical force, though the question still remains open from which suit in any given circumstance it is wisest to play a card.

Which brings us back to the present debate. Trump has repeatedly made clear that his frustration is with the imbalance in trade—the U.S. has an annual $1 trillion trade deficit, reflecting $1 trillion worth of goods made abroad for our consumption, which we acquire not with “some part of the produce of our own industry” but rather by sending back assets—ownership of our real estate and corporations, treasury debt that represents simply an I.O.U. to pay some day, and so on. Thus we simultaneously erode our domestic industrial capacity in the near-term and send abroad the claims on our long-term prosperity. As Warren Buffett observed, “Our country has been behaving like an extraordinarily rich family that possesses an immense farm…We have, day by day, been both selling pieces of the farm and increasing the mortgage on what we still own.”

The very first paragraph of Trump’s memorandum for an “America First Trade Policy,” issued on Inauguration Day, emphasized “a path toward eliminating destructive trade deficits.” The first directive to his administration was titled “Addressing Unfair and Unbalanced Trade” and instructed it to “investigate the causes of our country’s large and persistent annual trade deficits in goods.” The White House fact sheet announcing the “Fair and Reciprocal Plan” on trade emphasized twice that “lack of reciprocity is unfair and contributes to our large and persistent annual trade deficit.”

From which suit, then, is it wisest to play a card? Some analysts have taken the threat of “reciprocal tariffs” to mean literally holding a mirror up to the tariff regimes of other countries, imposing precisely the same tariff rate on each product from each country that the country imposes on the product coming from the U.S. “You’re talking more than 3.1 million different tariffs,” suggests the Cato Institute’s Scott Lincicome. But while Lincicome is talking about 3.1 million tariffs, there’s no reason to believe that’s what the administration is pursuing. Rather, Trump’s orders indicate a desire to assess the extent of imbalance in market access between the U.S. and each of its trading partners, and then use a tariff to counteract it.

This approach has two important implications. First, the focus is not only or even mainly on tariffs as the source of imbalance. Yes, other countries often have higher tariffs on U.S. products than we have on their products, but our exporters will typically emphasize that this is far from the main obstacle to doing business in those countries. Regulations that favor domestic producers, preferential treatment in public procurement, subsidies and tax breaks, and so on all contribute to the circumstance where selling in a foreign country requires setting up shop there. And sure enough, the U.S. Trade Representative’s request for “Comment from the Public on Unfair and Non-Reciprocal Foreign Trade Practices,” issued last week, seeks “information relating to any unfair trade practice by a foreign country or economy or with respect to a non-reciprocal trade arrangement. Unfair trade practices may encompass an expansive range of practices, such as policies, measures, or barriers that undermine or harm U.S. production, or exports, or a failure by a country to take action to address a non-market policy or practice in a way which harms the United States.”

Of course, all that is enormously difficult to quantify, which leads to the second implication: The trade deficit with a country may serve as a proxy for the level of imbalance in trade policies and the level of reciprocal tariff. Where trade between the U.S. and another country is wildly imbalanced, that likely indicates a situation where the relevant policies are imbalanced and thus where higher tariffs are appropriate, both as a matter of reciprocity and with a goal of reducing trade deficits. Indeed, the USTR request for comment emphasizes particular interest in “those economies that have the largest trade deficits in goods with the United States.”

This is going to drive economists bonkers, because there are also perfectly legitimate reasons unrelated to trade policy that two countries might have an imbalanced trading relationship. And indeed, imbalanced bilateral relationships might be entirely benign if they balance out in aggregate. One could imagine a situation where the U.S. runs an enormous trade deficit with Canada because it imports a lot of oil, and then an enormous surplus with Mexico because it refines the Canadian oil and sells the gasoline further south.

But that’s a theoretically valid critique with little practical purchase. The major sources of imbalance between the U.S. and its trading partners do not cancel each other out, they are all in one direction (trade deficits), and they are largely the result of trade policy. If one sees all that as a problem, as even economists are grudgingly admitting they must, then responding with tariffs—and calibrating those tariffs to the size of the imbalance—is a quite coherent approach. (For more on the debate about whether tariffs can even affect trade deficits, see “Does Trade Policy Affect Trade?”)

I have generally advocated for a single global tariff, moving up or down based on the U.S. trade deficit with the world as a whole while ignoring bilateral balances. This has a couple of advantages over the reciprocal approach. One is that it is simpler to implement, and harder to game. Setting tariffs country-by-country, and re-evaluating each with some regularity, will create a lobbying bonanza and inevitable misfires and distortions. The other is that it better handles the “deficits with some countries, surpluses with others” scenario, which would be a very plausible end state if the U.S. succeeds in eliminating its overall deficit. Bringing trade into balance, while accepting variation from country to country, seems a better goal than bringing trade into balance on a bilateral basis with every country.

The reciprocal model has real benefits of its own. In the global-tariff model, no individual country has much incentive to change its own policies toward the U.S. because no reduction in a particular bilateral deficit would significantly alter the overall trade balance. The global tariff operates only at the macro level, attempting to reshape the relative attractiveness of domestic versus foreign production and acquiring U.S. goods versus assets. Reciprocal tariffs would have the macro effect, but they would also pit countries against each other in attracting U.S. business. For instance, let’s say the U.S. continues to push supply chains out of China, where will they go? Most likely to countries facing lower reciprocal tariffs. How does a country get a lower reciprocal tariff? By reducing its trade deficit with the U.S., which will require opening access to U.S. producers and encouraging the purchase of U.S. products. That would be nice.

Finally, while both global and reciprocal tariffs could help to move toward a trading-bloc system in which the U.S. and its allies maintain high levels of free and balanced trade while collectively excluding non-market and heavily distorted economies, reciprocal tariffs might get there more smoothly. Countries that do adopt fair policies and achieve balanced trade with the U.S. would naturally transition into such a bloc as tariffs among them drop toward zero, while those that do not would find themselves outside it. Ambassador Robert Lighthizer outlined this scenario in a recent New York Times essay. The final step would be for the U.S. to insist that its partners likewise impose high tariffs outside the bloc. And lo and behold, over the weekend, “Trump Team Pushes Mexico Toward Tariffs on Chinese Imports.” (On a podcast last week, C.J. Mahoney, Deputy U.S. Trade Representative in the first Trump administration, described how an updated USMCA could provide for “common external tariffs that are consistent across North America.”)

Is this what President Trump has in mind, and can his administration implement it effectively? We shall see. What is clear, regardless, is that the consensus for unilateral free trade, regardless of what other countries do, and regardless of what deficits result, has shattered. Policy should and will change accordingly.

The day after my podcast conversation with Krugman last week, I was in London for a keynote debate at the Alliance for Responsible Citizenship’s annual forum (ARC). Former Australian prime minister Tony Abbott and Daniel Hannan of the UK’s House of Lords defended the motion that “protectionism makes us poorer.” Opposing the motion were yours truly and Michael Gove, a longtime leader in Britain’s Conservative Party who has held countless cabinet posts over the past two decades.

The several thousand people in the audience were mostly the sort who have themselves benefited quite nicely from globalization and in general are inclined to embrace free trade. Indeed, in a poll taken at the debate’s start, 56% supported the motion while 29% opposed it. But as The Critic’s Sebastian Milbank recounts, “Hannan and Abbott appeared dogmatic and out of touch, speaking in abstractions, compared to Gove and Cass, who pointed to the threat of China, and the devastation wrought on post-industrial communities, and made a pragmatic, measured case for strategic protectionism.” In the re-poll at the debate’s conclusion, support for the motion had fallen to 45% while opposition had risen to 46%. This was, according to the conference organizers, a “shocking result” meriting an exploding-head emoji.

The collapse of the intellectual case for free trade, unfolding before us all in real time, reflects one of the most dramatic failures of elite consensus in decades. Mass hysterias are nothing new, of course. But it is still exciting to know that people will someday read and wonder about the collective insanity that gripped the economics profession and cowed nearly everyone into meek embrace of unfettered globalization with the same fascination that students today study the Salem Witch Trials and the Dancing Plague of 1518.

(Seriously, though, check out the Dancing Plague of 1518. Wild stuff.)

- Oren