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There is this myth swirling around that the U.S. is winning our nascent trade war with China. The truth is, as is always the case with trade wars, both sides are losing. If the ultimate goal is to incent China and other nations to change their behavior, then a trade war is a very expensive option. And there is no guarantee that after incurring the expense, the other side will change. In fact, if history is a lesson, it is very likely they won’t.

Gains to Trade

Let’s review the harm inflicted on both sides by a trade war. Imagine that it is proclaimed everyone had to become self-sufficient in food production and that farmers and food processors would cease to exist as a result. Clearly each person’s standard of living would fall as virtually everyone would have to figure out how to produce food, since few have this skill set. This means everyone would spend more time in search of food at the expense of spending time doing their job.

Additionally, farmers and processors would be out of a job so their standard of living would also plummet.

Think of consumers as food importers and farmers as food exporters. By halting trade in food, both sides are hurt economically. That is, the gains to trade have evaporated as each side is no longer doing what they do best and, in turn, can no longer meet their consumption needs by trading with others.

Imagine taking this to the extreme of having to become self-sufficient in everything we consume. It is not a stretch to say that our standard of living would plummet to near zero. The U.S. standard of living is heavily dependent on trading with our fellow citizens and millions of others around the world. The key is to specialize on what you do best and then trade to meet consumption needs. In other words, the “magical” gains to trade.

Chipping Away

A trade war is not as dramatic as imposing the self-sufficiency declaration, but it leads to similar results. By imposing tariffs and non-tariff barriers (such as import quality standards), the cost of imports increases and so fewer imports are purchased. Domestically produced goods, which generally cost more, are substituted for reduced imports. This means resources are pulled into less productive companies that produce the item that is imported and away from more productive exporters. So, both consumers and producers collectively are worse off.

There’s little doubt the other side will retaliate with their own tariffs and non-tariff barriers, as China and other countries have recently done, and, as a result, both sides take a further hit. The risk is that ego and emotions take over, and the initial actions turn into a full-blown trade war.

The 1920s, ’30s, and ’40s provide a chilling reminder of what can happen if things get out of hand. Coming out of Word War I, only the U.S. returned to the gold standard for its currency. With European rivalries still at a boiling  point from the war, countries engaged in a series of currency wars in the 1920s, devaluing their currencies to make their exports more attractive.

These were followed in the late ’20s and ’30s by an intense trade war and the U.S. Smoot-Hawley Tariff Act, which, in turn, was a major contributor to the Great Depression.

With international trade virtually shut down, the world descended into World War II. A currency war followed by a trade war followed by a shooting war. Yikes!

Focused Pain, Widespread Gain

While international trade benefits both countries, not everyone within a country benefits. As imports displace domestic production, the impacted companies and their workers suffer. The focused pain of the wounded companies and their workers generates greater press coverage and often strong political responses.

On the other hand, consumers benefit by purchasing lower priced and perhaps higher quality imports. The widespread consumer gains are rarely mentioned by the press, and so go largely unnoticed even though collective consumer benefits exceed domestic production losses.

Another Reason to Thank China

Not only does China sell us inexpensive items, but they invest the dollars they receive via the trade deficit (the U.S. imports more from China than it exports to China) back into the U.S. at ridiculously low interest rates on T-bills and T-bonds. Low-cost goods along with low-cost borrowing!

This last statement runs contrary to most people’s emotional reaction. But the fact is that we benefit significantly by purchasing low-cost goods from China and, in turn, paying virtually no interest on borrowed funds.

An Expensive Foreign Policy Tool

This isn’t to say China’s bad behavior should be overlooked, only that the U.S. appears to be using the wrong tool for the job. Given the many benefits of international trade and the large costs to both sides of a trade war, imposing round after round of new tariffs is an ill-advised, self-defeating and ultimately ineffective tool for trying to modify competing country behavior.

Furthermore, tying the trade war to Federal Reserve actions makes matters worse. The Fed is charged with pursuing an independent monetary policy in order to maintain strong, low-inflation economic growth. Asking them to fight a rearguard action to blunt the negative consequences of a destructive trade war seriously impairs the chances of succeeding at this critical task.

For these reasons, the current trade saber-rattling is constrained by the economic downside realities of a full-blown trade war. Much better to employ other approaches to achieving our foreign policy goals.

— More by C. Thomas Howard:


Thomas Howard, Ph.D., is the CEO and chief investment officer at AthenaInvest and a professor emeritus at the Reiman School of Finance, Daniels College of Business, University of Denver. He can be reached at tom.howard@athenainvest.com.

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