Chapter Five

The Wealth of Nations

International Trade

Trade between nations – just like trade between individuals – can be mutually beneficial. We can assess the impacts of opening a country up to trade using supply and demand.

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International Trade, or trade between nations, can be mutually beneficial, just like trade between individuals. In fact, that’s all international trade is. It is trade between individuals. It is someone in America buying the products made by someone in Mexico, or vice versa. Many people in Adam Smith’s day - and still today - were skeptical of this sort of trade. “Why benefit a foreigner by buying their product instead of buying from someone close to home and helping the people around you?”, they thought. They saw trade as a zero-sum game, and this attitude persists to this day despite Adam Smith’s best efforts. --To understand why international trade can be so beneficial, we can use supply and demand. Let’s say that this is the market for sugar in the United States. We are able to grow a lot of sugar on our own in states like Florida. That would be our domestic supply. Where our domestic supply crosses with our domestic demand – representing the U.S. consumers of sugar – will be the equilibrium. Competition between different sugar producers will drive us to this equilibrium and set the market price we would see if we didn’t allow any trade with other nations. But if we open up the U.S. to trade, and allow foreign producers to sell to U.S. consumers, that will increase the supply of sugar in the U.S., as it adds the world supply to our domestic supply. This added supply will drive the market price of sugar down as foreign producers compete with our domestic ones. The lower market price with trade will be a benefit to consumers, who will choose to buy more sugar at the lower price. But our domestic producers will find it difficult to compete. At this low price, the amount of sugar we produce domestically will fall to this point. The domestic supply curve tells us how much sugar domestic producers will make at this price, and it is at this lower quantity. So, our consumers are buying this higher quantity of sugar, and our producers are only making this lower quantity. The difference has to come from the foreign producers, and so this gap will be the quantity that we import. I really think this is one of the most informative applications of supply and demand. People go totally funny in the head when it comes to foreigners, and we tend to only want to count the benefits and ignore the costs, or only count the costs and ignore the benefits. But supply and demand makes the impact of trade clear. When we import goods and services, it means consumers are able to buy more of it at the lower price, and that’s a clear win for consumer welfare. But our domestic producers end up selling less at a lower price, a clear loss for them. But we can’t stop there.--We should also think about what happens when we open up to trade and export goods and services to other countries. Let’s say that this is the market for corn. We have a large domestic supply of corn, which comes from all the corn growers across the United States. And we also have a voracious demand for corn. Competition in the market will set the price at this equilibrium. But if we open up to trade with other nations, they will probably want to buy some of our corn. The foreign consumers will add to our domestic demand, shift it to the right, with this new demand curve representing both our demand and the demand from the rest of the world. Higher demand will bid up the price of corn in order to incentivize more corn production, pushing us to this new equilibrium at a higher price and a higher quantity. With this higher market price, some domestic consumers may choose to take a pass on corn. The domestic quantity demanded will be lower than it was without trade due to the high price. So, our producers are making this high quantity of corn, but our consumers only buy this low quantity. The remainder are the exports, the corn we sell to foreigners. Here too supply and demand gives a clear picture of the effects of opening up to trade. Producers sell more corn at a higher price, practically the definition of good for business. But consumers are getting less corn and paying more for it, working out to a loss for them. --Let’s summarize the effects of opening up to trade. For imported goods, domestic consumers gain. They get more stuff at a lower price, improving consumer welfare and raising their standard of living. Domestic producers lose, however. The foreign competition drives many of them out of business, and the industry as a whole is selling less stuff at a lower price. For exported goods, domestic consumers lose. They have to pay a higher price which has been driven up by foreign demand, and so they will be able to consume less. But domestic producers gain, selling more at a higher price. You may be thinking that these all just cancel each other out. Consumers gain from imports, producers gain from exports, and those gains cover their loses. But then you would be thinking like a mercantilist, and you would be wrong. The supply and demand analysis is showing us something that is difficult to see with just this summary. --Let’s take another look at this. Here is our market for sugar again, starting with no trade. The market sets the price, and anyone willing to pay that price is able to buy some sugar, because producers are willing to produce the quantity that people want at that price. But everyone who buys sugar is paying less than what they are willing to pay for it. Remember, demand represents what people are willing to pay. The market price is what they actually have to pay. And so, this area above the market price but below the demand curve represents what we call Consumers’ Surplus. If you walk into the store ready to spend $5 for a pound of sugar, but you only have to spend $2, you just got $3 worth of consumer surplus. Consumers’ surplus is essentially all the money we don’t have to spend in this market that we would be willing to spend if we had to. When we say that trade is mutually beneficial, this is the benefit we are talking about. A similar application works for producers. Supply represents the marginal cost of production, or how much it cost to produce that unit. Suppliers will produce any units that cost less than the price they earn when they sell it. The difference is the profit they make on that unit. So, this area below the price earned but above the cost paid to produce it is what we call Producers’ Surplus. Producers’ surplus isn’t exactly the same as profit, because firms might have start-up costs that have to come out of this, but it certainly defines what the maximum profit could be in the market. When the nation opens up for trade, and the world is able to supply this good at a lower price, it increases the supply and drives us to this new equilibrium. At the lower price, consumers buy more, and their consumers’ surplus extends down to that low price. Our domestic producers lose this area of surplus, they lose that money, because they produce less at the lower price. But every penny of what producers lose is now accrued to consumers’ surplus. In essence, the producers’ loss is the consumers’ gain. But then there is this region here. An added amount of consumer surplus that is being enjoyed by the people who can now afford this product and are willing to pay for it at the lowered price. There are new transactions, new benefits to consumers who weren’t getting anything before. This added consumer surplus is the key to the whole thing. And supply and demand analysis shows that the benefit to consumers will always outweigh the loss to producers. --Let’s look at the case of exports. Here again is our consumer and producer surplus without trade. Notice that at the market equilibrium, this is the biggest our combined surplus can be. No other price yields a higher surplus than this, which is why Adam Smith thought that this was the best allocation of our resources. But when we open up to trade, a new distribution becomes possible. World demand adds to our own and pushes the price up to this new equilibrium. At the higher price, producers take a bigger chunk of surplus, and consumers lose some of their surplus. But notice, here too, every penny consumers lose from their surplus is a penny gained by producers. But producers gain even more than that. They gain this area in surplus too, which no one was getting before. These are added profits for the producers, which means added income for our country. Just as it was with imports, when trade is voluntary and unrestricted, the gains are bigger than the loses. --It is important not to lose the details in the conclusion. Opening up to trade redistributes the benefits produced by our economy. Imports shift benefits from domestic producers to domestic consumers. Exports shift benefits from domestic consumers to domestic producers. But in both situations, there is a little extra something added to the benefits due to the increased number of transactions, transactions that otherwise don’t occur without international trade. For that reason, the net benefits are always positive, and they are positive for imports and exports independently. We don’t need one to cancel out the other. Both are net positive all on their own.

The Balance of Payments

In The Wealth of Nations, Adam Smith set out to dismantle what he called "Mercantilism", which was the prevailing attitude towards trade European governments had at the time. Through the Balance of Payments, we can see the folly in their efforts, and why Smith was right to criticize these policies.

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When Adam Smith wrote The Wealth of Nations, his aim was to tear down what he called the Mercantilist system. Government officials were thinking of the country like it was one big business, and like any business, they wanted to maximize profits. The goal of policymakers in England was to try and sell stuff to other nations like France, but to limit how much stuff the English were buying from France. But of course, France had the same goal. Sell to England, but don’t buy. We still hear this kind of thinking today, when Americans lament about how much we buy from China or Mexico, without selling them much back in return. We have a negative trade balance, and that was something that 18th century Europe wanted to avoid. Their idea was that you could sell your exports to another country in exchange for gold, which served as the reserve currency of the day. Today, it is actually the U.S. dollar which enjoys this position. But once a country managed to secure that gold, they blocked anyone’s ability to ship the gold outside of the country. The idea was that if a country maintained a positive trade balance like this, they would build their gold reserves and boost the wealth of their nation. Sounds good doesn’t it? --But Adam Smith’s best friend, David Hume outlined why this was wrong. It is called the Price-Specie Flow Mechanism, but we can better understand it with our modern language of supply and demand. Simply put, if you restrict spending gold on foreign goods, you restrict imports, and reduce the supply of goods across the economy. The result, in each of those markets, is a higher equilibrium price. Higher prices make your products harder to sell to foreigners and reduce your exports, which stops the nation’s quest for wealth dead in its tracks. --What the classical economists like Smith and Hume worked out is what we call the Balance of Payments. The Balance of Payments is a simple accounting of international transactions. It breaks transactions into two categories: The Current Account and the Capital Account, and it will always be the case that the sum of these two accounts equal to zero. The current account consists of all trade in goods and services, as well as any factor payments – or income – earned or paid abroad. If we take the dollar value of all exports and subtract the value of all imports, we get the trade balance. This trade balance has ever been the focus of misled policymakers. But it is only one part of the current account – albeit the largest part. We add to the trade balance the net income on investments. That would be any income people in the U.S. made on investments they own in foreign countries minus any income paid to foreigners on investments they own in the U.S. For example, if you own stock in Spotify, a Swedish company, and they pay you a dividend, that is income on a foreign investment. And if someone in Sweden owns Apple stock, and they earn a dividend, that is income paid to a foreigner. This item in the Current Account notes the net income coming into the country. And lastly, we have the net transfers. Transfers are just money sent between countries. For example, if someone sends some money to family living in another country, that would be a transfer. This item in the Current Account notes the net transfers coming into the country. It should be noted that any one of these items, the trade balance, net income on investments, or net transfers could wind up being a positive or negative number. As could the total when they are all added together, which would be our balance on the Current Account. The Capital Account records any movement of financial capital from one country to another. When someone in Sweden initially buys Apple stock, or if someone in China purchases a U.S. Treasury bond, or if someone in India buys a hotel located in California, that would be capital inflow, or an increase in foreign holdings of U.S. assets. Essentially, the foreigner is financing investment in the U.S. economy. Likewise, if you buy stock in Spotify, or buy Japanese government bonds, or purchase a home in Italy, that would be capital outflow, or an increase in U.S. holdings of foreign assets. The difference between these is the balance on the capital account. Together, these two have to add up to zero. If we have a negative trade balance and a negative current account, it means we are sending more dollars overseas than are coming back to us to purchase our goods and services. Foreigners holding those dollars have two options, they can either buy our stuff, boosting our exports, or they can save the money. Those savings don’t sit idle – as we will come to understand more in future videos – they are used to finance investment. And since the savings are in dollars, the investment is going to happen here. The money will always find its way back, on one side of ledger or the other. --Let’s dig a little deeper on what this all means. Suppose that England manages to sell some grain to France in exchange for gold. This influx of currency won’t just sit idle. Financial institutions will benefit, and so will the overall economy, if this gold is used to finance investment and growth. With a greater supply of gold, interest rates will be pushed down in England. But over in France, where there is now less gold than before, interest rates will rise. This mechanism is what attracts money back to the importing country if the exporter isn’t going to use it to buy goods and services. But in Mercantilist England, they made it illegal for that gold to leave the country. Since the accounts can’t balance, the result will be price increases in England and price decreases in France. This will encourage the people of France to buy locally, rather than import from England, and the balance of payments will be restored through future reductions in trade. England doesn’t end up getting any richer from that policy. --Modern economies are far more complex than they were in the 18th century. The U.S. economy is a major part of the fabric of a global economy which trades extensively. Some of this trade is driven by comparative advantage, like U.S. exports of food. Other trade is driven by economies of scale, where access to a worldwide market allows companies to economize on production of massive quantities. Such is the case for automobiles, where we sell a lot to the world, but we also buy a lot from foreign producers. And even more trade is driven by transportation. It is just a better deal for parts of the country to sell oil to other nations while other parts of the country import oil from other nations. Trade is a complicated web, but one thing is for sure, there is no free lunch in trying to limit that trade. --Here is the U.S. Balance of Payments from 2019 using data from the Bureau of Economic Affairs. You can see we ran a much-chided trade deficit of $620.2 billion. This was somewhat mitigated by a positive net income on investments, though transfers were net negative. This gives a balance on the current account of -$505.2 billion. On the capital account, we have a big increase in foreign holdings of U.S. assets – much of this is foreigner buying government bonds – which outweighs the increase in U.S holdings of foreign assets. The balance on the capital account according to these numbers is positive $498.4 billion. So, why aren’t they exactly equal? Well, these figures represent estimates made from data collection on the part of the BEA, and the best they could do is extrapolate from survey and transaction data. It would be quite a feat to have a clear record of absolute every international transaction, and even if you did sometimes the exact value would be hard to calculate. And so, all of these numbers are estimated with statistical error. If we did have perfect data, we would expect them to match up exactly.

Exchange Rates

Exchange Rates are the price of one nation’s currency in terms of another nation’s currency. Since currencies are traded in open markets, speculators often hunt for arbitrage, or the opportunity to profit from buying and selling. Of course, the best kind of arbitrage is just the trade in goods and services!

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Ever since money was invented, different nations have had different currencies. Exchange rates are the price of one nation’s currency in terms of another nation’s currency. If you travel to Europe, you’ll need to exchange some of your U.S. dollars for euros. At the time of this recording, 1 U.S. dollar bought you 0.86 euros. Or, equivalently, 1.16 U.S. dollars – or $1.16 - bought you 1 euro. This is the exchange rate between U.S. dollars and euros, and it applies both ways. If you come back from your trip to Europe with some extra euros in your pocket, you would be able to exchange each one for $1.16. Different currencies have different values. $1 might only get you only 0.86 euros, but it will buy you more than 112 Japanese yen! Likewise, one Japanese yen will get you less than a U.S. penny. These exchanges happen in markets for currency, and they are an important step in international trade. If someone in the U.S. wants to import some Japanese cars, they are going to need to convert their American dollars into Japanese yen. These days, it’s very easy to find buyers in that market, as there are many people in Japan looking to trade their yen for dollars in order to buy some American goods or to invest in the American economy. --Nations have options about how they approach these exchange rates. Most modern countries have a system of floating exchange rates. They allow the value of their currency to fluctuate based on the market. A domestic currency appreciates when it buys more foreign currency. This is great for importers, because an appreciating U.S. dollar means foreign goods get relatively cheaper. A domestic currency depreciates when it buys less foreign currency. This is great for exporters, because it means our exports become relatively cheaper for foreigners to buy. Keep this in mind the next time you hear someone bemoan a falling value of the dollar. In my experience, most people who are upset about a depreciating currency think it spells doom for U.S. businesses exporting goods and services abroad, when in fact the opposite is true. Alternatively, a country can embark on a policy of fixed exchange rates, where the country maintains a consistent exchange rate with another currency. Until 2005, and again for a while until 2010, China maintained a fixed exchange rate with the United States. This meant that China had to keep a tight control on their own monetary policy and enact capital controls which prohibited capital outflows to maintain a steady exchange. The upside is that it helps facilitate international trade between the two countries, by keeping relative prices stable. From the late 1800s until around the 1970s, countries had an on-again-off-again relationship with the Gold Standard, where each country fixed the value of their currency to gold. From 1958 until 1971, for example, U.S. dollars were convertible to gold at a fixed exchange rate of $35 per ounce. That means you could take $35 to the U.S. treasury department, and by law they had to give you one ounce of gold in exchange. If many nations all fix the value of their currency to the same thing, like gold, their exchange rates become fixed. As it did with China, this helps promote trade between nations, which can be good, but it comes with the tradeoff of potential financial calamities, as we will see in later chapters. --Fixed exchange rates can be hard to maintain without political discipline, and markets will ensure that whether fixed or floating, systems of exchange rates are equivalent across the board. Here is an example with real data. I can take 1 US dollar and convert it into 0.86 euros. The exchange rate between euros and yen is 130.88 yen for every euro. So, 0.86 euros buys me 112.56 yen. And 1 yen would get you 0.0089 US dollars, which means 112.56 yen gets me 1 dollar. If you send money through a bunch of currencies, it should return as the same amount. Actually, you’d end up with a lot less because you’d be paying small fees for each exchange, but you can see that the rates still work out. --But what if Japan decided to suddenly fix their exchange rate so that 1 yen got you 1 dollar, and vice versa. Well now I convert my dollar to euros and euros to yen, netting me 112.56 yen just like before. But now, that 112.56 yen converts to 112.56 dollars! Holy schmoly! We have ourselves a money pump. We could just keep sending money through until we are the richest people on earth. This is called arbitrage, and there are many currency speculators who buy and sell currencies where the exchange rates don’t line up. Of course, in this scenario, we would hardly be the only ones who notice and send money through, and this massive increase in the demand for euros and yen will quickly cause an adjustment in the market prices. --Of course, currency isn’t the only thing with an opportunity for arbitrage. Differences in the prices of goods and services can also be exploited. Take these big macs for example. A big mac in the U.S. cost $3.99 – at least at the time of this recording – while in Britain it cost 3 pounds and 19 pence. Based on those prices, we would expect that 1 US dollar gets you about 80 pence, or 0.8 pounds. But in the market, you only get 74 pence for your dollar. That means that big macs in the U.K. are relatively more expensive than they are in the U.S. and you could make some money if you could figure out a way to get U.S. big macs to the U.K. and sell them. Uhhhh, that might be a little difficult, but this sort of thing happens all the time with other goods and services, we just call them imports and exports. But this Big Mac Index, where we compare the prices of Big Macs across countries – which is a real thing by the way that fully-fledged real important economists actually keep track of – helps us compare something else: the cost of living. A big mac has lots of ingredients from all over the world as well as lots of ingredients that are sourced locally. If we had to pick one thing, it’s not a bad choice to represent the entire cost of living in a particular place. But we can do better. --Purchasing power parity is a theoretical exchange rate that allows you to buy the same amount of goods and services in every country. We already know about the consumer price index, which tracks the prices of a basket of goods in a country in order to monitor for inflation. Well, we can also compare identical baskets of goods between countries and see how the cost of living differs. In this chart, on the right is the nominal GDP for each country. Since it is all from the same year, 2018, they are comparable to each other, and we can see that from a global perspective, U.S. GDP was much higher than China’s. But on the left is GDP by purchasing power parity. Because prices in China are so much lower than they are for the same products in America, China’s GDP is actually higher than ours. That is, they can afford more stuff with all their income than we can, even though their income is lower than ours. Of course, this is GDP, not GDP per capita, and China has 3x the population of the U.S. to split that income among. Nevertheless, purchasing power parity is an important metric when comparing countries.

Practice Questions

1. In response to trade restrictions imposed by the U.S. on South Korean refrigerators, South Korea's government imposes trade restrictions on U.S.-made automobiles. Who benefits, and who is harmed, by these countervailing barriers?

Reveal the Answer

Trade barriers reverse the effects of opening up for trade. When we impose tariffs on imported goods:

Domestic consumers lose
Domestic producers gain

When another country imposes tariffs on our exports:

Domestic consumers gain
Domestic producers lose

Policy 1: The U.S. imposes trade restrictions on South Korean refrigerators.

U.S. refrigerator consumers lose
U.S. refrigerator producers gain
Korean refrigerator consumers gain
Korean refrigerator producers lose

Policy 2: South Korea imposes trade restrictions on U.S. automobiles.

Korean car consumers lose
Korean car producers gain
U.S. car consumers gain
U.S. car producers lose

2. A country has $300 billion in imports and $600 billion in exports. Net income on investment is $20 billion, and net transfers are -$10 billion. What is the balance on the Capital Account?

Reveal the Answer

We know that:

Current Account + Capital Account = 0

The trade balance for this country is found by taking the exports and subtracting the imports:

$600 billion - $300 billion = $300 billion

Then we add net income on investments and net transfers to this to get the balance on the Current Account:

$300 billion + $20 billion - $10 billion = $310 billion

So, the balance of payments is:

$310 billion + Capital Account = 0

To make that true, the Capital Account must be -$310 billion.

3. The exchange rate between Galleons and Pen is 1 Galleon for 12 Pen. One Pen will get you 0.8 Republic Credits. What is the exchange rate between Galleons and Republic Credits?

Reveal the Answer

1 Galleon buys you 12 Pen.

If 1 Pen gets you 0.8 Republic Credits, then 12 Pen would then get you 9.6 Republic Credits (12 x 0.8).

When we convert our 9.6 Republic Credits back into Galleons, we should end up with what we started with: 1 Galleon.

So, 1 Galleon = 9.6 Republic Credits. Or, dividing both numbers by 9.6, 1 Republic Credit = 0.104 Galleons.

The Case for Free Trade

As we have seen in the previous videos, free trade between nations leads to a more efficient use of our global resources, which lowers prices and raises incomes. And the benefits of trade do not just apply to goods and services. There are potentially enormous economic gains to be had if the world allowed more mobility of people across borders.

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We have already built the case for free trade in the study of supply and demand. Trade between people, whether they live in the same country or not, offers the opportunity for gains due to the science of comparative advantage. Trade allows us to take advantage of each other’s lower opportunity costs, and gives every person, town, city, state, or country the chance to reach outcomes they could not otherwise have reached on their own. Free trade between nations allows us to optimize that process, and achieve the most efficient outcomes. --Imagine that after years of tinkering, you built an incredible machine. At the top of this machine, you throw in various chemicals, plastics, and leather. The machine buzzes and churns for a minute, and then out pops a car. You don’t have to do any other work. You just load in the chemicals, plastics, and leather and boom, you’ve got another car. Not only would you be rich, you would be heralded as a genius, praised for a clever invention which was going to cut down on the costs of making cars, a be a boon for consumers and the economy. But you would also be too late. This machine already exists. It is called a cargo ship, and we already load it up with chemicals, plastics, and leather- our largest exports to Japan - and then we send it to Japan, and they return it full of cars. Free trade allows us to use our resources more efficiently. Through trade, it takes fewer resources to achieve the same outcomes. To block those gains would be the same as blocking genius new inventions which do the same thing. --But you might be thinking, “Doesn’t buying local help the economy with jobs and stuff?” If you buy a product from a local supplier instead of a manufacturer in China, doesn’t that keep the local person employed, which in turn means they will have money to buy what you produce? If we just rely on China or other countries to make everything, there will be no jobs left for us. Aren’t we shooting ourselves in the foot with trade? No. When we buy products from China, we exchange our currency for theirs, which means that someone in China is getting American dollars. Sure, that person might just sit on those dollars forever, never bothering to spend them on anything. But that would be good news. That means we traded cheap green pieces of paper for actual useful stuff. We would virtually be getting the stuff for free. But that isn’t what happens though. Instead, the Chinese person with American dollars is going to spend them. They are like gift cards only good in American stores. We already know this from the Balance of Payments. Whether you spend the money locally, or on imports, it is going to come back and stimulate demand in our country. Going out of your way to spend money locally just helps your local governments collect taxes on local transactions, and directs local resources to inefficient uses. --[A Clip from The West Wing, Season 2, Episode 16 – No Transcript Available]-- Protectionism – or the policy of restricting international trade through tariffs, quotas, and subsidies – is a benefit to producers, but at the greater expense of consumers. For example, the U.S. government guarantees a high price for sugar produced here, and limits imports by imposing prohibitively high tariffs above a set quota. As a result, the price of sugar in the United States is about twice as high as it is around the world. This helps line the pockets of sugarcane producers in Louisiana and the politically important state of Florida, where over half of U.S. sugarcane is grown. But it also directs our resources inefficiently. In the 1980s, the U.S. price of sugar was four times that of anywhere else. Canadian entrepreneurs developed a super-high-sugar iced tea that could be sifted after it had been shipped to the United States, avoiding the tariff on sugar by instead paying the tariff on beverages. And then the people in the United States could extract the sugar from the beverage for resale. The high price of sugar also led to changes in other beverages. Coca-Cola and Pepsi both switched their formulas from using sugar to using high-fructose corn syrup, as did a slew of other products. Now, if you want a Coke made with real sugar, you have to import it from Mexico, another work-a-around for the restrictive tariffs. Estimates suggest that US consumers lose $2.42 billion every year while producers only gain $1.1 billion, and that doesn’t include the changes in product quality that comes from these inefficiencies. --Prohibiting trade preserves an inefficient state of affairs for incumbent firms who don’t want to compete. And while opening up to trade will bring about a painful transition, the outcome is one that leaves everyone better off. Economic studies which explore the costs of protectionism conclude that global incomes would be 1.7% higher if all nations eliminated barriers to trade, which works out to about $200 per person per year. But of course, this is because trade between nations is already pretty free. We’ve gotten most of the gains.Nevertheless, it should be pointed out that these arguments for economic freedom do not just apply to the movement of goods and services across borders, but also of people. Many of the same fears people have about free trade are fears they have about immigration. While trade in goods and services between nations is mostly free in the modern world, the ability of people to move from one country to another is severely restricted. Economic studies which have investigated the costs of these restrictions have all come to a startling conclusion. The consensus estimate is that eliminating all barriers to emigration would roughly double global GDP. Double! It takes more than 20 years for the global economy to double, and right now there are trillion-dollar bills sitting on the sidewalk that the nations of the world could pick up with the stroke of a few pens.Trade – it’s an incredible thing.

The Case for Protectionism

Unfair labor practices, child labor, slave labor, national security, key industries, and protecting jobs are all common reasons given to restrict international trade. They are not without merit. There is more to our policies than just economic life, but we should never lose sight of the fact the trade restrictions are inefficient.

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Worldwide in 2020, around 1 in 10 children aged 5 to 17 years old worked for a significant number of hours per week. And while this is down from 18% in 2009, child labor remains a global problem. In 1992, when it was found that Walmart was selling clothes made by teenagers in Bangladesh working 80-hour weeks at $0.14 per hour, public outcry led Congress to consider legislation imposing trade barriers on these products. Even though it didn’t pass, Walmart stopped buying clothes from that manufacturer. Economists who continued to follow the situation long after the headlines faded away found that more than 30,000 children were dismissed from these sweatshops, which would be a great victory for the world except that the children didn’t go to school or remain home with their families. Instead they were forced to find work in lower paying jobs with worse conditions. This inhumane treatment – a form of slavery – is not uncommon around the world, and it is estimated that around 40 million people are trapped in some form of slavery today. Frankly, this sort of immoral and reprehensible economic activity is something we don’t want to compete with. It is something we want to do away with. And so, trade restrictions are often proposed as a tool for bringing about that change. And while economic sanctions like this have occasionally worked as a means of getting hostile governments to the negotiating table, it is important to remember that the people paying the largest price for these policies are the very people they are meant to help. So, it is best not to keep them in place very long unless we intend to do something that will genuinely and substantially improve their lives. Trade restrictions alone won’t do it.--National Security is another good reason to restrict trade. We have to be realistic about the world, and while free trade is one of the most effective deterrents of international conflict, it is wrong to suggest that nations that trade with each other will avoid conflict altogether. Industries which are critical to our national defense are worth protecting, because if we rely on other nations to produce what we need for defense, we risk losing our defense if we wind up in some sort of conflict with those nations. This doesn’t just have to be the production of military equipment. It is wise policy to have a strong vaccine industry in the event of a global health crisis, where scarcity may leave everyone unwilling to share what they have. Thankfully we saw only mild bickering between nations over the vaccine for Covid-19, but certainly if you have to choose, you would want to be in the position of the United States, which produced more vaccines than we needed. Of course, as with all things political, people go funny in the head when it comes to national defense. And since the U.S. gives the President a great deal of unilateral authority on the matter, it is often invoked as the reason for trade restrictions which – in truth – have little to do with the national defense. Goods like mohair and beeswax end up on the list of protected products vaguely described as important for the national defense, with no real reason for it. The real reason is political.--As some have said, “It is better to make computer chips than potato chips.” I’m not sure that is actually true, but the point still comes across. There are industries which have a learning curve, and it takes time for firms to figure out how to compete with other global producers. Consider electronics manufactured in Japan. Many decades ago, they were considered to be cheap, low quality products, and they were. But Japan used trade restrictions to protect their electronics companies from global competition so they had time to refine their production processes and learn what they needed to so they could compete. Now, Japanese electronics are considered some of the highest quality and value for money on the market. Some industries may also provide spillover benefits. Amazon’s investments in shipping direct to consumers’ homes benefited them greatly, but they also benefited other companies like UPS and FedEx, and in turn those improvements benefited other smaller online retailers who can offer affordable shipping as well due to those investments. Some argue that trade restrictions could be used to protect industries which have these kinds of spillover benefits. While this is true in principle, in practice it is very hard to identify which industries these are, and they often change. It is also important to note that at some point, you want to remove those trade barriers, like Japan did in the 1990s. --Of course, the most common reason people give for trade restrictions is that they protect jobs. Over the past couple decades, many public figures have lamented the decline in manufacturing in the United States, as many of those firms have moved production overseas or been competed out of business by firms in countries like China and Mexico. Whole cities like Detroit in Michigan have decayed due to the loss of auto industry jobs. There is no doubt that trade restrictions on automobiles would help the U.S. auto industry, and would boost employment at U.S. car companies. But that comes at the expense of employment elsewhere. Trade restrictions raise prices, and if consumers have to pay more for the protected good, they will have less money to spend on everything else, and while the impact on any one industry will be tiny, collectively the impact of this reduced demand will result in more jobs lost than gained. Nevertheless, it is easy for the stuffed shirt economist to sit here and say, “Well, actually, trade restrictions mean fewer jobs not more.” But that is no consolation for the factory worker who gets laid off when corporate decides to move the plant to southeast Asia where they can hire workers at a fraction of their wage. Their experience and skills can be rendered useless because the whole industry makes this change, and there just aren’t any “help wanted” ads for the kind of work they are most qualified to do. People end up having to retool, learn new skills, move to a new location, and inevitably take jobs with lower pay than their old one. That is bad. Unequivocally bad. This sort of disruption in the economy can leave many people worse off, in defiance of the mathematics of mutually beneficial trade. Trade restrictions can be a temporary part of policies aimed at easing the transition and ensuring that trade does, in fact, leave everyone better off. But as with every other concern, it must be paired with programs that actually do something about it, so that down the road we can lift the restriction and enjoy the fruits of an efficient free trade economy.

Quick Quiz

Now is the time to test yourself on these concepts! This quick quiz is a great way to see what has clicked and what needs more attention. It is also a good time to reach out to your instructor with questions.

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Deeper Thoughts and Extra Practice

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Example Question
The tables below show the Balance of Payments for Aparri.

Current Account

Exports $665

Imports $551

Trade Balance ???

Net Income on Investments $182

Net Transfers $-43

Capital Account

Capital Inflow $374
Capital Outflow ???

Assuming no statistical discrepancy, what is the value for the Capital Outflow?

Your answer should be a positive number.

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Example Question
You observe the following exchange rates:

1 USD = 0.86 Euro

1 USD = 127.03 Yen

1 Euro = 188.07 Yen

You start with 100 USD and you can make 3 exchanges. What is the maximum amount of USD you can end up with?

Do not round until your final answer, at which point you can round to two decimal places.

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