We are all aware that US President Donald Trump has unilaterally imposed a widening array of tariffs on whole ranges of goods imported from China, the European Union and a range of other countries. Martin Wolf of the Financial Times calculates that these tariffs are being applied to 800 billion euros of traded goods – that is, roughly 20% of US imports. They are not in any sense negligible. Not surprisingly, both China and the EU have replied with a range of punitive counter-tariffs on goods and services designed to cause maximum pain in American industries and states that are strong supporters of Trump. This tit-for-tat sequence is called a trade war and it is not just a threat, it is now a reality.
Because the economic and eventually political impact of such a trade war will in the medium term be immense, it demands interpretation and comment from the standpoint of professionally trained political economists.
The theory of comparative cost advantage: a reminder
It may be fashionable to decry experts and to ridicule economists – certainly there have been excesses in the past by both. However, there remain in both the natural sciences and in economics certain theories that provide a rock-solid basis for our understanding of the real world and that cannot just be wished away. In physics, for example, whether one uses Newton or Einstein, if you jump from the 20th floor of a building in your natural state into a busy city street below, you will end up dead. While I am the first to recognise the often ideologically slanted nature of much of the production of the economics profession, there are some theories that have the same universal applicability as the hard-physics example just cited. One is that of comparative cost advantage in relation to international trade. It is supremely relevant to the assessment of this trade war that we are witnessing.
This is perhaps the oldest core theory in economics, going right back to the great classical economists, Adam Smith, David Ricardo and Frédéric Bastiat. At its heart lies a simple, mathematically necessary truth. To illustrate this truth, consider two countries A and B that have (for whatever reason) differences in costs of production for certain goods. (If every country had exactly the same costs of production for every good and service there would be no point in trading internationally).
Let us say that the unit cost of producing a good X in country A is €100 and that unit cost of producing another good Y in A is also €100. The ratio of costs of production in country A is then clearly 1:1. Let us say that in country B, the unit cost of producing the very same good X is €120 and of producing good Y is €60. The ratio of costs of production in country B is then clearly 2:1. In such a situation where the ratio of comparative unit costs of production of X:Y in country A is less than the corresponding ratio in country B, A is then said to have a comparative cost advantage in good X and B in good Y (by simple inversion of the comparative-cost ratios).
Let us imagine that a situation of total protection (closure) prevails in these two economies. In that situation each country produces and supplies its entire domestic demand for each good X and Y from its own domestic firms and there is no international trade between them.
If, instead of protection, these countries decide to open free trade among themselves it will be evident that country A will have a competitive advantage in the now open common market in good X (€100<€120) while country B will have a competitive advantage in good Y (€60<€100). Hence under the pressure of competitive market forces country A will specialise in good X and country B in good Y.
Now comes the mathematical crunch of the theory. Let us examine what happens to total amalgamated production of the two countries taken together. As country A specialises in X while keeping its total resource usage (of labour, capital, land) the same, for every extra unit of X produced one unit of good Y will be sacrificed (since unit resource cost of each good is the same in A). But in country B as it specialises in good Y for each extra unit of Y produced in B it only needs to give up half a unit of good X (since the cost of production of y is €60 while that of X is €120 in B). Hence over the two countries taken together and with exactly the same usage of scarce resources total amalgamated output will increase. Through free trade, we can get a greater output of goods and services from exactly the same resources. What this clearly means is that both countries can for sure be materially better off as a result of trading. This potential for both countries to be materially better off is not contingent; it is a mathematical necessity.
This same truth can be expressed in diagrammatic form in terms of production possibility frontiers for pairs of goods as illustrated in the figures below: (in each case the heavy line represents the production possibilities of the United States and China with given resources before trade and C is the position they can reach in terms of production possibilities after trading:
Admittedly, what we have shown is just the potential for each country to gain from trade; this is a notion familiar to economists as potential Pareto improvement and I intend to expand on it and on other economic purist quibbles in a future contribution. But let us be clear that while we have only demonstrated the possibility for each country taken individually to gain from trade it is at the same time necessarily true that taken together the two countries aggregate output from the same resources must rise; and hence a fortiori at least one of the countries if not both will gain from free trade.
It also follows that to retreat into protectionism from a free trading position as is now happening with the trade war(s) must involve (by the same mathematical logic in reverse) a reduction of the total output of the economies engaged in trade warring taken together (potential Pareto dis-improvement). One economy taken on its own may be able to make some gains from trade warring but in a retreat to protectionism overall there is an inevitable loss of output from exactly the same total resource set and it is therefore certain that some countries must lose out in the trade war.
Ignorance in the seat of power
The basic theory of comparative cost advantage in international trade as outlined forms an integral part of any typical first-year undergraduate economics curriculum. It is therefore no exaggeration to say that if Donald Trump or his leading economic advisors on these matters, Peter Navarro and Larry Kudlow, were to sit a typical end of first year undergraduate examination, they would fail (at least on the international trade question). They have initiated one of the most spectacular retreats from free trade and therefore of Pareto dis-improvement in the world economy witnessed since the 1930s.
In a subsequent article I intend to dissect in detail the philosophical and ideological roots of this surprising economic ignorance. Put in a nutshell, in the trade war initiated by Trump and his team they are aiming to be the country that potentially gains from protectionism (through repatriation of US jobs, etc.). But as we have seen, if the United States is to gain from the trade war(s), it necessarily follows that the rest of the world must lose. Mathematically this just cannot be the win-win so beloved of Trump’s deal-making. In this context, the “America first” slogan takes on an aggressively sinister meaning in relation to the rest of humanity.
If the United States is to gain from trade wars, the rest of the world must lose. It is of course also possible that all will lose, including the US, and given the degree to which the supply chain of so many US industries remain global, this is also a very real possibility.