Could America have avoided a trade war?
Economics in News #4
In “Why Would a Country Want to Impose Import Tariffs?” we answered the question by presenting the arguments for protectionism, while encouraging you to use the case of the recent tariffs imposed by the Trump administration on certain U.S. imports to understand and apply the theory better. We kept the field open for you, leaving you with a question asking whether you think the U.S. was right in taxing imports.
We did conclude, however, that countries may adopt protectionist measures for a diverse set of reasons, though not all of those arguments for protectionism may be logically sound.
The only times when imposing trade barriers would be considered a valid move from an economics perspective are when the country is developing or the goods being imported are harmful to consumers or the environment. National security, including military and economic security, if proved to be substantially threatened by imports, may be another debatable reason for a country to follow protectionism.
However, considering that trade policies affect various aspects including international relations, a country may face retaliation (e.g. in the form of retaliatory tariffs) if it misjudges what it deems to be necessary trade barriers (in our example, tariffs).
When one such retaliatory move is followed by another and threatened by yet another, it can end up in what newspapers are currently calling a “trade war.”
In such instances, we want to use economics to help us figure out what alternative measures countries can take in place of import tariffs.
How can countries avoid retaliation, while achieving their goals to ultimately reach a win-win solution?
Considering that we now know the motivations that guide countries towards protectionist policies, we will be able to better understand which measures can serve those same purposes but by doing lesser harm.
Lesser harm, how? By avoiding the inherent adverse effects of tariffs and their possible repercussions in the form of trade wars.
Let’s begin by familiarizing ourselves with other protectionist measures available to countries.
You may have heard them being mentioned in the news — quotas, voluntary export restraints (VERs), subsidies, etc.
These, being different from tariffs, are collectively known as non-tariff barriers (NTBs).
First up are quotas.
Import quotas are quantitative restrictions on imports, i.e. when a country does not allow imports of a commodity beyond a specific amount.
For example, if the European Union were to restrict its imports of Harley Davidsons from 40,000 motorcycles to 30,000, then it would be said to have imposed quota regulations on the imports of Harley-Davidsons.
How do quotas work?
Continuing with the above example, we can assume that the EU usually imports 40,000 Harley-Davidsons. But after the quota, it can only import 30,000 Harley-Davidsons. This means that there are 40,000 customers fighting for only 30,000 bikes.
Because of this, the price of these bikes go up. Now, only those customers who still want a Harley-Davidson and can afford to buy them at the higher price will get them. What about the remaining 10,000 people who can’t get their bike?
This is where the EU’s domestic industry for production of luxury bikes comes into the picture. The left-out consumers who want a bike will have to satisfy themselves with a relatively more affordable domestically produced one.
The result? Domestic producers are given a boost, imports remain curbed, but prices of imports increase.
How do quotas differ from tariffs? Are they better measures for protectionism than tariffs?
Let us compare the effects of both to arrive at a conclusion.
When a country imposes import tariffs, it causes the price of imports to increase by the tariff amount.
Domestic consumers may now choose to either buy those more expensive imports or opt for relatively cheaper domestic goods. It is assumed that because imports have become expensive, consumers will choose the latter, causing the quantity of imports to decrease.
On the other hand, when a country imposes an import quota, it restricts the amount of imports of that good.
This causes an increase in the price for that good. Once that good has been imported to the extent of its quota, the excess demand for it will be satisfied domestically.
In both cases, we see that prices increase, imports decrease, and domestic producers get more customers. But, in case of tariffs, it is not always likely that consumers will immediately decrease their consumption of imports. We have previously looked at a few reasons why consumers may be forced to continue importing at the higher price.
Meanwhile, if the country had opted for import quotas, it would have been assured that its imports would decrease because of the explicit quantity restriction. Quotas may, thus, be better at achieving the desired result, i.e. reduced imports.
But what about trade wars and retaliation? How does a country avoid them?
Cue voluntary export restraints (VERs).
As their name suggests, this is when two countries choose to sit together and one country willingly agrees to reduce its exports to the other nation as a means of helping that nation protect its domestic industry.
For example, in the above case, let’s say that luxury bike companies in the EU are lobbying for reduced imports of Harley-Davidsons because of the adverse impact on their domestic sales.
The EU sits with the U.S., manufacturer of Harley-Davidsons, to discuss the possible routes it can take. One possibility is that the EU can impose explicit trade barriers like tariffs or quotas.
The U.S., however, does not want it to do that, as doing so will harm the American company’s exports. It chooses to take a friendlier approach and agrees to “voluntarily” restrain its exports of Harley-Davidsons to the EU.
Sound like a win-win situation?
Wellll. Everything does look quite rosy. But, that’s not always how it is.
For one, VERs aren’t truly “voluntary.”
Even from an economics perspectice, here’s a case when two countries negotiated a voluntary export restraint that did not necessarily leave the importing country better off.
In 1981, the U.S. persuaded Japan to apply VERs on its automobile exports because of intense competition from Japanese car manufacturers.
American consumers who chose not to buy the resultant pricey Japanese cars began to instead demand American produced cars. This allowed Japanese car companies to shift their focus to higher quality, luxury car manufacturing, letting them increase their profit margins. Further, to circumvent these VERs, Japanese auto manufacturers also began building their production plants in the U.S.
Meanwhile, there still were American consumers who chose to continue buying Japanese cars. The result? American car buyers were the losers and though American car companies gained market share, there was a net welfare loss of $3 billion — kind of like what happens with tariffs.
We have only barely touched upon the concept of VERs.
But if you read further (or if we decide to write more about them in a later article), then you will realize that VERs also hurt exporting countries who were coerced into “voluntarily” restraining their exports or proved to be ineffective, with consumers adjusting to the higher prices.
Ultimately, during the Uruguay Round in 1994, World Trade Organization (WTO) members decided to update the terms of the General Agreement on Tariffs and Trade (GATT) and discontinue VERs.
Are we doomed then?
Well, we are left with one last measure, which we will look at with high hopes: subsidies.
Subsidies can take the form of direct payments, tax-reliefs, or subsidized loans.
Here, we are not talking about export subsidies, which are considered protectionist measures and given to companies for the goods that they export.
We are focusing on production subsidies or subsidies in general, given to certain industries, chosen by the government, irrespective of whether or not they export their products.
The aim is to encourage local production and allow companies to offer their goods to domestic consumers at lower rates, allowing for higher sales.
The downside? Subsidies require government funds.
And if a government does not have the funds to provide subsidies, then tariffs can appear highly lucrative. Why? Because of the increased government revenue that they provide, as we have already seen.
So where does all of this leave us?
Confused. Confused, and in awe of the economists and policy makers who invariably have to think through all of the possible effects before taking a decision.
What about the ongoing US-China trade war?
Maybe it is time to rethink the Trump Administration’s motivations behind imposing tariffs. Why didn’t it choose quotas? Or subsidies? Why tariffs?!
Well, we know that choosing quotas wouldn’t have been a great way to avoid retaliation. Even if it had opted for quota restrictions, it would have likely ended up the same way: in a trade war.
And subsidies? Well, when the government is focused on reducing its trade deficit, it would probably want to take that approach which will help bridge the gap. Production subsidies are a purely domestic solution to a domestic problem. They would certainly help boost the steel and aluminum industries and reduce the supposed threat to national security. But when the administration seems to blame a foreign country for its problems, why would it want to rack up its own money to provide the solution?
So, could America have avoided a trade war?
Probably, yes, by avoiding protectionist measures of any kind. Should it have done so? Well, that depends on why it wanted to impose tariffs in the first place.
If all it wanted was to protect its industries, it could have opted for subsidies, but it didn’t, bringing us to the revelation that the entire premise for choosing protectionism may have been wrong.
It’s a different thing that protectionism by itself is largely a big no-no in the world of economics. But going the protectionist way because of reasons that protectionism can’t even solve?
When there are multiple factors in play, such as national security, the trade deficit, and the stand against China and its trade practices, the objectives appear unclear and the entire matter complicated.
It’s like asking whether tariffs are the answer when we don’t really know the question or when we know that there are a bunch of questions but we expect only one reply to be sufficient to answer them all.
Real life is complicated. But we hope we managed to simplify the economics part of it.
Special thanks to “International Economics: Trade and Finance” by Dominick Salvatore for supplementing my learning and equipping me with the knowledge to write this article.
Up next…
We promised giving you better insight into trade deficits and why they cause so much hullabaloo. Here’s our attempt at giving you a wider understanding of trade deficits, their implications, and more.
In the meantime…
If you feel that you are better off for having read this article, then the next time your eyes scan the headlines and you spot the word “trade war,” take a few seconds to mentally send us some love and blessings.
You can also make our day by expressing your feedback and suggestions in the Comments section below. After all, learning is a two-way process, and we would appreciate all the help we can get!
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