What People Don’t Understand About Trade

[This article has been updated. Please see notations at the end of the page.]

I’m constantly amazed by events in this country. Almost on a daily basis, I see or read about people that have an enormous amount of passion about a particular issue, yet at the same time, are woefully uninformed. Today’s amazement comes at the perception of foreign trade, how it impacts American jobs and the solutions being proposed to address the issue.

As we speak, Senate Bill S.1619 is working its way through Congress. Although it has almost no chance of passing the House, the goal of this particular legislation is to designate China as a currency manipulator and opens the door to imposing more tariffs and import regulations. To many people, this sounds perfectly reasonable. It sounds like a logical response to protect American interests while giving us a way to punish currency manipulators for their misdeeds. The problem is that it in fact, only reinforces that the bill’s supporters don’t understand the subject that they are so passionate about.

Here’s why:

Currency Manipulation

First, let’s address the currency manipulation charge. Does China hold it’s currency artificially low? Yes. I don’t think there’s any dispute on this issue. They intentionally hold their currency value down, which makes their goods less expensive and helps drive the manufacturing base that they are so dependent on. With that said, let’s not forget that the United States does the same thing.

Remember Quantitative Easing? This was the action taken by the Federal Reserve, on two separate occasions over the last few years, to inject money into the economy with the hope of assisting job creation. The premise was that this would help make sure there was sufficient capital in our monetary base to provide for investment. The problem is simply this: The Federal Reserve accomplished this by printing money out of thin air.

The result of this is that the amount of money in circulation increased, making each US Dollar worth less, while also driving up the prices of commodities like corn, wheat, dairy products and oil. All of the major commodity prices have increased by roughly double over the last two years. No, it’s not because of evil speculators, it’s because these commodities are priced in US Dollars. When you make the dollar worth less, it takes more dollars to buy the same amount of goods. This chart shows the direct correlation between commodity prices and the implementation points of QE1 and QE2.

The value of the US Dollar has been artificially lowered as a direct result of Quantitative Easing, so how can we, with any sense of credibility, stand up with righteous indignation and accuse China of manipulating their currency when we have done the exact same thing?

Proposed Solutions

Now let’s take a look at the proposed solutions. It wasn’t that long ago that a certain candidate for the GOP Presidential nomination claimed that China has been “stealing our jobs” and “screwing us” for years. His solution? Give China a “talking to” (effectively nothing more than a schoolyard beat-down) and imposing massive tariffs on imported goods. This position has a surprising level of support among Americans. The tough stance resonates with many of us but unfortunately, most people seem to base their positions on sound bites from the evening news instead of by actually understanding the subject matter.

The Effects of Massive Tariffs

Imposing large tariffs on imported goods would be a disaster that defies common sense and established economics. If anyone wants us to revert to a third world economy, this would be one of the fastest ways to accomplish that goal. Let’s not forget that we’ve taken that action before and the unintended consequences far outweighed any benefits. The Embargo Act of 1807 was implemented to protect American interests and avoid war over trade. The result was the opposite. It proved to be an economic catastrophe and was a leading cause of The War of 1812. A similar result was achieved as a result of the McKinley Act and of course, let’s not forget the Smoot-Hawley Tariff Act, which brought new meaning to the phrase “economic disaster”.

Increasing tariffs has two significant effects. The first is that almost overnight, we create a massive increase in the cost of Consumer Goods that Americans purchase every day. This hurts every one of us, but it especially impacts the poor, since spending for consumer goods is generally a much larger percentage of their incomes than it is for people in higher income ranges.

A common claim by supporters is that the higher prices will be offset by more jobs created in the US, which will make those goods more affordable. Once again, on the surface this claim seems to be a reasonable theory. If imported goods are more expensive, there will be less demand for them and more demand to manufacture these goods here. Manufacturing more goods in the US will mean more workers will be needed, employing more people that will then have the financial means to purchase the higher priced goods. It sounds great, except for the fact that this argument substitutes sunshine and lollipops for reality.

U.S. Imports and Exports

Photo by GrrLashIn 2010, we imported $1.899 trillion worth of goods into the US, while we exported $1.278 trillion (Source: Adopting a protectionist philosophy by imposing large tariffs will dramatically reduce the flow of imports, but will also dramatically reduce exports. Nations don’t trade with Nations that don’t want to reciprocate. More than two thirds of the theorized increase in manufacturing demand will be offset by the loss of demand for exports.

Even under those circumstances, one would think that we would still be better off due to it being a “net gain”. Again, there’s a small little detail that most supporters don’t consider. That small little detail is that American manufacturers are not running at full capacity. Today, these manufacturers are only running at about 72.6% capacity and historically from 1972-2010 have only operated at 79.0% capacity (Source: Federal Reserve). What does this mean? Simple. A relatively small increase in manufacturing demand will not create jobs because manufacturers already have the capacity they need to produce more goods without hiring any additional workers.

Let’s also not forget that there really isn’t any such thing as a trade deficit. We can measure the import and export of goods and services which likely results in a gap between the two, but that leaves out currency, which is also a critical component. If we buy goods from China, we pay in US Dollars. Those dollars can’t be spent in China so they are only valuable if they are used to purchase American goods and services, or if they’re invested in American financial instruments (how do you think we finance a large portion of our deficit spending?).

Net Results

The net results of imposing large import tariffs are higher prices to Consumers, strained relations with other countries and very few, if any, new jobs.

Americans are rightfully concerned about the jobs situation and are understandably concerned about the increase in outsourcing. What people need to understand though, is that importing manufactured goods from overseas is the natural result of an unfriendly business climate and the fact that we enjoy one of the highest standards of living in the world. There will always be cheaper places to have products made, unless we completely tank our economy and become the cheap labor country. Trade is good for our economy. It provides for less expensive products, increasing the purchasing power of Consumers, and it helps build stronger relationships with other Nations, which is also good. Countries that trade with each other don’t shoot at each other, and since the majority of wars are fought for economic reasons, trade can help stem the tide of aggressive nations.

Increasing American Jobs

We can bring a lot of manufacturing back to the US. We can make our country a destination for business, but first we need to stop regulating everything that moves and make the tax rates competitive. Recent surveys show that the most common reasons why businesses are not hiring is due to the uncertainty in regulatory and tax policies. Between the Health Care legislation, Dodd-Frank, Sarbaines-Oxley and the overwhelming desire of many to tax corporations at higher rates, is it really surprising that companies choose to do less business in the United States and more elsewhere?

The US has the highest corporate income tax rates in the world (we used to be second, but after the “lost decade” Japan finally wised up and lowered their rates). Yes, there are also far too many loopholes and subsidies that companies like General Electric use to avoid paying any taxes at all. Even so, the overwhelming majority of businesses do not have that option which means that they pay the full 35%, or very close to it. In reality, businesses don’t pay corporate income taxes. Consumers and workers pay corporate taxes through higher prices and lower wages and benefits. Let’s not be naive and recognize that raising taxes on business is nothing less than lowering the purchasing power and ultimately, the standard of living of Americans.

If we want to create jobs here, we need to think about the big picture and not just the snappy sound bites. Businesses can create jobs if the Federal Government will take its thumb off the scale and get out of the way. Eliminating all loopholes and subsidies, lowering the tax rate to around 10-15% and going easy on the regulations will create an environment where businesses can create jobs on a massive scale.

When that happens, nobody will care that we get our alarm clocks from China.


+Kevin A. Nye

The Cato Institute published a Policy Study by Robert Krol, an economist at California State University Northridge, that examines this subject in detail. The study, titled Trade, Protectionism, and the U.S. Economy: Examining the Evidence, is much more thorough than my ramblings and uses actual economic statistics to address concerns about the impact of foreign trade on economies, specifically employment, wages and consumer benefits.

UPDATE 3/16/2012:
The Heritage Foundation makes a similar point about the measurement of trade in international transactions (dollars) being what’s important. In this article, Bryan Riley discusses the fact that though the difference in imports and exports was $473.4 billion in 2011, there was no difference in the cumulative total of international transactions. It’s about dollars kids, not boxes.

UPDATE 4/7/2016:
While this article is pushing 5 years old, the underlying premise hasn’t changed. With the the recent populism trend in this election cycle, it’s good to remind people that the emotional protectionist philosophy does not represent reality. I saw the article below this morning and think it makes a very powerful, succinct case for the current reality of global trade and its overwhelmingly positive effects on the economy.

“In total, over 2 million American manufacturing workers are employed by foreign-owned companies. And while American companies have invested over $700 billion in foreign production facilities since 2000, foreign-owned companies have invested over $1.3 trillion in the U. S. manufacturing operations during the same time frame.

The result: a $614 billion manufacturing investment “surplus” for the United States from 2000 to 2015. U.S. manufacturing output has never been higher, and foreign investment in the United States is a big reason why.”

Read the full article on Washington Politicians Aren’t Telling the Truth About Trade

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