How Tariffs Can Help America

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Donald Trump has promised to implement a suite of aggressive tariffs on American trade partners, including a blanket 20 percent levy on goods from abroad. Although his supporters claim that these tariffs will strengthen U.S. manufacturing and create jobs, critics contend that they will fuel inflation, suppress employment, and perhaps tip the economy into a recession. As a demonstration of what will go wrong, many cite the Smoot-Hawley Tariff Act of 1930, which raised U.S. tariffs across a variety of imports. “Judging by his proposed import tariff policy,” wrote the American Enterprise Institute economist Desmond Lachman, “it is evident that Donald Trump does not remember our country’s disastrous economic experience with the 1930 Smoot-Hawley Trade Act.”

But these claims only show how confused many experts are when it comes to trade—on both sides of the tariff debate. Tariffs are neither a panacea nor necessarily injurious. Their effectiveness, like that of any economic policy intervention, depends on the circumstances under which they are implemented. Smoot-Hawley was a failure at its time, but its failure tells analysts very little about the effect that tariffs would have on the United States today. That is because now, unlike then, the United States is not producing far more than it can consume. Ironically, the history of Smoot-Hawley says a lot more about how tariffs today would affect a country like China, whose excess production resembles more closely the United States of the 1920s than does the United States of now.

Economists weren’t always so mixed up. In his classic 1944 book, International Currency Experience, Ragnar Nurkse wrote that “the devaluation of a currency is expansionary in effect if it corrects a previous overvaluation, but deflationary if it makes the currency undervalued.” Tariffs, which are close cousins of currency devaluation, act in the same way. They reduce domestic consumption and force up domestic saving rates. A country with low consumption and excess savings (like the United States in the 1920s or China today) tends to be one with an undervalued currency, in which case tariffs, like currency depreciation, are likely to be deflationary. But in a country with excessively high levels of consumption, like the modern United States, the same policy can be expansionary. Done under current circumstances, in other words, tariffs could increase employment and wages in the United States, raising living standards and growing the economy.

WRONG PLACE, WRONG TIME For those who don’t remember (or who never had a chance to see Ferris Bueller’s Day Off), the Smoot-Hawley Tariff Act was a controversial law that raised tariffs on over 20,000 goods. Named after its two Republican sponsors, Senator Reed Smoot of Utah and Representative Willis C. Hawley of Oregon, and signed into law by a reluctant President Herbert Hoover on June 17, 1930, it represented the second-highest tariff increase in U.S. history.

Smoot-Hawley was implemented at the beginning of the Great Depression, when countries around the world were already engaged in the currency depreciation, import restrictions, and tariffs that English economist Joan Robinson would later characterize as “beggar-my-neighbor” policies. As Robinson explained, these policies expand domestic growth by subsidizing production at the expense of domestic consumption. They do so through many ways, but they all use the resulting trade surpluses to shift the cost of weak demand onto trade partners. Put simply, beggar-my-neighbor policies are designed to prop up one country’s economy at the expense of another, usually by boosting domestic manufacturing at the expense of foreign manufacturing.

There is widespread consensus among economic historians that the Smoot-Hawley tariffs were a bust. They contributed to a contraction in global trade that was especially painful for the United States, which had the largest trade surplus in the world and was home to the planet’s biggest exporters. The reason behind this imbalance was understood by Marriner Eccles, chairman of the U.S. Federal Reserve from 1934 to 1948, who argued that high levels of income inequality in the United States were in effect “a giant suction pump” that had “drawn into a few hands an increasing portion of currently produced wealth.” Because the rich consume a far lower share of their income than do the nonrich, Eccles explained, Americans were unable to consume a large enough part of what they produced to balance domestic production. The huge U.S. trade surplus of the 1920s, in other words, reflected the inability of Americans to absorb what American businesses produced.

The United States again faces high levels of income inequality. But this fact doesn’t make Smoot-Hawley a reasonable model for assessing the effect of similar tariffs today. Overall, the modern American economy is very different from the one of 1930. In fact, when it comes to trade, the two are almost opposites. The United States now has by far the largest trade deficit in history. That means Americans invest and (mainly) consume far more than they produce. U.S. consumption in the 1920s, in other words, was too low relative to American production. Today, it is too high.

DOUBLE-EDGED SWORD Like most industrial and trade policies, tariffs operate by transferring income from one part of the economy to another, in this case from net importers to net exporters. They do this by raising the price of imported goods, which benefits the domestic producers of those goods. Because household consumers are net importers, tariffs are effectively a tax on consumers. But by raising the price of manufacturing and other tradable goods, tariffs also act as a subsidy for domestic producers.

This consumer-to-producer shift means tariffs have repercussions for a country’s gross domestic product, or the value of the goods and services produced by its businesses and workers. Because everything an economy produces is either consumed or saved, any policy that raises production relative to consumption automatically forces up the domestic saving rate. By taxing consumption and subsidizing production, tariffs effectively raise production relative to consumption, which means they lower the consumption share of GDP and raise the savings rate.

But there are two very different ways by which tariffs can lower consumption as a share of GDP. One way is by increasing GDP as a whole. This happens when a tariff’s implicit subsidy to production results in more jobs and higher wages, which in turn leads to an overall increase in total consumption. The higher savings—or the gap between the increase in consumption and the greater increase in production—show up either in the form of higher investment or in a rise in exports relative to imports. Either way, these types of tariffs leave both businesses and households better off.

Americans consume too large a share of what they produce. The other way, however, involves decreasing consumption as a share of GDP by suppressing consumption itself—not by fostering overall economic growth. This occurs when tariffs raise the price of imported products without raising wages, making it harder for people to purchase goods. Such tariffs do not produce a rise in production because domestic producers cannot respond to the tariffs with higher overall output. If American businesses were suffering primarily from weak domestic demand, for example, tariffs would reduce such demand even further by acting as a tax on already low levels of consumption. If the rest of the world were unable or unwilling to absorb larger U.S. trade surpluses, American tariffs would then depress domestic production.

Understanding whether tariffs will prove helpful or harmful requires understanding which of these scenarios will result. In the case of Smoot-Hawley, it was clearly the second. At the time those tariffs were enacted, the United States suffered from too much saving and too little consumption. It is why the country exported so much to the rest of the world, like China does today. What Americans needed then (as Eccles understood) was to boost the share of production distributed to households in the form of wages, interest, and transfers—which would, in turn, raise living standards, boost domestic demand, and reduce U.S. dependence on foreign consumption. Instead, by raising the price of imported goods, Smoot-Hawley did the opposite. It increased the implicit tax on American consumption while further subsidizing American producers. Rather than reduce U.S. reliance on foreigners to absorb excess production, the tariffs increased it.

Today, by contrast, Americans consume far too large a share of what they produce, and so they must import the difference from abroad. In this case, tariffs (properly implemented) would have the opposite effect of Smoot-Hawley. By taxing consumption to subsidize production, modern-day tariffs would redirect a portion of U.S. demand toward increasing the total amount of goods and services produced at home. That would lead U.S. GDP to rise, resulting in higher employment, higher wages, and less debt. American households would be able to consume more, even as consumption as a share of GDP declined.

TURNING THE TABLES Thanks to its relatively open trade account and even more open capital account, the American economy more or less automatically absorbs excess production from trade partners who have implemented beggar-my-neighbor policies. It is the global consumer of last resort. The purpose of tariffs for the United States should be to cancel this role, so that American producers would no longer have to adjust their production according to the needs of foreign producers. For that reason, such tariffs should be simple, transparent, and widely applied (perhaps excluding trade partners that commit to balancing trade domestically). The aim would not be to protect specific manufacturing sectors or national champions but to counter the United States’ pro-consumption and antiproduction orientation. The goal of American tariffs, in other words, should be to eliminate the United States’ automatic accommodation of global trade imbalances.

These tariffs would still come with domestic risks. But for economists to suggest that the effect of tariffs in 1930 must be the same as today only shows how muddled most economists are about trade. The real lesson of Smoot-Hawley is not that the United States cannot benefit from tariffs, but rather that persistent surplus economies should not implement policies that exacerbate global trade conflict.

In the end, tariffs are simply one among many tools that can improve economic outcomes under some conditions and depress them under others. In an economy suffering from excess consumption, low savings, and a declining manufacturing share of GDP, the focus of economists should be on the causes of these conditions and the policies that might reverse them. Tariffs could be one such policy.

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