Can U.S. Trade Stand Apart?

We hear a lot about America’s soaring trade deficit. That deficit has zoomed past $150 billion, and the United States Commerce Department estimates that every billion dollars costs the country 25,000 thousand jobs.

It seems that we’re getting clobbered, and there’s plenty of talk about fighting back. It makes sense, doesn’t it, to pass legislation to protect American producers from foreign competition?

Let’s take a look at one of the best-known pieces of trade legislation in American history, the Smoot-Hawley Tariff Act of 1930.

World War I had made the United States a creditor nation: the world owed us more than we owed the world. In the twenties we raised tariffs in response to pressures from domestic agricultural and manufacturing interests, and thus we made it more difficult for debtor nations to service their debts to us through exportation. At the same time, we made foreign loans to keep our own level of exportation high.

Francis Bowes Sayre, assistant secretary of state under FDR, offered a lucid analysis of the consequences of this policy in The Way Forward , a study of international trade published in 1939. “In effect,” Sayre explains, “we were … shipping exports in return for promises to pay and at the same time by our tariff policy we were making it progressively more difficult for our debtors to honor their promises. Our loan and tariff policies thus had the effect of adding to the economic dislocations and tensions of our debtors.”

This house of cards collapsed in 1929. Anxiety about the quality of our loans abroad led to a contraction of credit. “Debtor nations … had neither time nor opportunity to reorganize their economies,” Sayre writes. “Credit structures were smashed; price deflation and fluctuation of currency values shook the financial foundations of even the strongest nations.”

In the United States, protectionists argued that if we raised tariffs even higher, we would check the Depression, stimulate business, and create jobs for American workers. High tariffs would ensure a “high degree of self-sufficiency,” said Senator Reed Smoot of Utah, while the congressman Willis C. Hawley of Oregon said that high tariffs would make the nation “self-contained and self-sustaining.”

Not so, said more than a thousand members of the American Economic Association, who signed a petition denouncing the Smoot-Hawley legislation. The economists predicted that the bill would lead to higher prices here and thus to a lower standard of living, and that it would cause other nations to retaliate with higher tariffs of their own, thus closing markets for our exports and producing increased rather than decreased unemployment. President Hoover ignored their warning.

In response to Smoot-Hawley, international trade collapsed. New tariffs were enacted almost immediately by Canada, Cuba, Mexico, France, Italy, Spain, Australia, New Zealand, Great Britain, and the British dominions. Not wishing to be left out, India, Peru, Argentina, Brazil, China, and Lithuania joined the hightariff club in 1931.

The value of American exports fell from $5.2 billion in 1929 to $1.6 billion in 1933—a decline of 69 percent. World exports fell from $33 billion in 1929 to $11.7 billion in 1933.

In short, Smoot-Hawley turned out to be exactly what the economists had predicted—a complete disaster. That doesn’t mean that similar policies would lead inevitably to disaster today, but it does suggest that a bit of caution might be in order. As the Wall Street Journal wrote in an editorial about an importsurcharge bill that Congress considered in the summer of 1985, the “grim ghosts of Mr. Smoot and Mr. Hawley must be watching with glee.”

Whenever I hear one of our captains of industry explaining why his company needs protection from “unfair” foreign competition, I think of the 19th-century French economist Frédéric Bastiat.

On behalf of the manufacturers of “candles, wax-lights, lamps, candlesticks, street lamps, snuffers, extinguishers,” and so on, Bastiat composed what he obviously hoped would be the protectionist speech to end all protectionist speeches:

“We are suffering from the intolerable competition of a foreign rival,” Bastiat’s beleaguered manufacturers moan, “placed, it would seem, in a condition so far superior to ours for the production of light that he absolutely inundates our national market with it at a price fabulously reduced. The moment he shows himself our trade leaves us. … This rival … the sun, wages war to the knife against us.”

From this merciless competition, the manufacturers demand relief: “What we pray for is, that it may please you to pass a law ordering the shutting up of all windows, skylights, dormer-windows, outside and inside shutters … by or through which the light of the sun has been [accustomed] to enter houses, to the prejudice of the meritorious manufactures with which we flatter ourselves we have accommodated our country.”

If argument by celestial analogy could kill, protectionism would be dead. But, of course, bad ideas die hard. Nearly all of our politicians and business leaders claim to believe in open markets and free competition. Yet, in 1985, according to The New York Times, protectionist measures that found “broad support” in Congress included bills to restrict the importation of telephones from Japan, cement from Mexico, lumber from Canada, wine from France and Italy, blouses from Indonesia, shirts from China, and shoes from Taiwan and South Korea.

Modern economists use graphs and equations to make the argument in favor of free trade, but no one has made the case more effectively than Adam Smith in The Wealth of Nations, with a ringing appeal to the common sense of his readers. “It is the maxim of every prudent master of a family,” Smith wrote, “never to attempt to make at home what it will cost him more to make than to buy.”

“What is prudence in the conduct of every private family,” he went on, “can scarce be folly in that of a great kingdom. If a foreign country can supply us with a commodity cheaper than we ourselves can make it, better buy it of them. … The general industry of the country … will not thereby be diminished … but only left to find out the way in which it can be employed with the greatest advantage.”

When he considers the common belief that a nation cannot tolerate a “disadvantageous” balance of trade, Smith loses his cool. This doctrine would find no support, he fumes, “had not the interested sophistry of merchants and manufacturers confounded the common sense of mankind.” Trade favors both parties to the exchange, and it makes no sense to fret about an “unfavourable” balance.

Nonetheless the advocates of protectionism have three arguments that deserve serious consideration:

First, it is often suggested that “infant industries” need to be guarded until they have grown to the point where they can stand on their own feet. This argument might justify the protectionist measures passed in support of the American textile industry just after the War of 1812, for instance, and the protectionist measures passed by Japan when it was rebuilding its economy from scratch after World War II. It does not justify the retention of trade barriers by Japan today, nor does it justify current demands for protection on the part of a textile industry that ought to have outgrown infancy a century ago.

Second, as even Adam Smith conceded, tariffs may be justified as retaliatory measures when it seems likely that they will “procure the repeal of the high duties or prohibitions complained of.” As the example of the Smoot-Hawley tariffs suggests, however, retaliation can be a slippery slope. We should not leap upon it too eagerly or presume that we’ll be able to stop our plunge whenever we choose.

Third, though virtually all economists agree on the theoretical advantages of free trade, some of them argue that these advantages cease to exist if trade is not perfectly free. “This argument has no validity whatsoever,” says Milton Friedman, the winner of the Nobel Prize for economics in 1976. Other countries that raise barriers to trade do hurt us. But “if we impose restrictions in turn, we simply add to the harm to ourselves and also harm them as well.”

On balance, I think that a strong presumption against protectionist legislation is justified. When we examine arguments about “unfair” foreign competition, too often we find that what is unfair is that foreign competitors are making products that Americans want to buy, usually because the products are more reliable than American products, cheaper, or both. One answer to the problem is to improve our own products; a second is to get out of markets where we can’t compete and to concentrate on markets where we can.

It is important to understand that the rise in America’s trade deficit is tied to recent macroeconomic policy—specifically, the tight monetary policy that the Federal Reserve initiated to check inflation late in 1979. Tight money drove up interest rates, and high interest rates attracted foreign capital, with the result that by late in 1984, the exchange value of the dollar had risen by almost 60 percent. The strong dollar made foreign imports comparatively cheap for Americans and made our exports comparatively expensive for foreigners.

There’s an interesting fact about the foreign capital that our high interest rates have attracted: it helps us to finance our budget deficit. Net foreign investment in the United States rose from a negligible amount several years ago to almost $100 billion in 1984. Without that foreign investment, we would have to come to grips with the fact that we’re spending hundreds of billions of dollars more on government programs than we’re raising in tax revenues.

Here, as in the case of noncompetitive domestic industries, our problems proceed from our own lack of discipline. Instead of making products that can compete in the marketplace, our manufacturers sulk and cry foul. Instead of living within our means, we cheerfully run up deficits of nearly $200 billion.

Getting tough on Japan won’t solve these problems: we need to get tough on ourselves. The current revival of protectionist sentiment may delight the ghosts of Mr. Smoot and Mr. Hawley, but the ghost of Frédéric Bastiat shakes with laughter, and the ghost of Adam Smith groans.