How Government Feeds Spurious Support for Protectionism

Tariff increases might make good political sense, but they are bad economic policy.

There are many textbook arguments in economics against using tariff policy to engage in protectionism. Donald Trump has no doubt heard them all. Yet he shows no sign of wavering from his promise to institute significant tariff increases after he takes office.

The next two months are crucial. Now is the time to consider trade policy from a broader perspective to help the incoming administration avoid inadvertently making a serious and completely avoidable policy mistake.

Politicians in both parties want to get elected, so many of them buy votes by spending money on things voters want. This works best if they do so with borrowed money. This makes future voters, whose support they don’t need for reelection, pay for it.

But if the economy is near full employment, the increase in consumption arising from such vote buying can only be achieved by importing the difference. This increases the foreign trade deficit.

This is because the closer we are to full employment, the truer it is that deficit spending will push up the prices of goods produced domestically. This reduces the relative price of imported goods and thereby induces consumers to shift from domestically produced goods to foreign produced goods. The level of imports rises which increases the foreign trade deficit. Other factors matter too, of course. But the larger federal deficits already are relative to GDP, the stronger this effect will be.

Some politicians then point to trade deficits to justify supporting special interest groups like industrial unions by adopting protectionist policies through things like tariffs. But think about what that means. Many of the same politicians who cause foreign trade deficits through fiscal irresponsibility then call for solving the problem they caused with protectionism.

This may sound like a stretch, but the visual correlation over time is rather striking. In the graph below from the year 2000 there has been a clear trend toward greater fiscal irresponsibility in the form of rising federal budget deficits (the farther below the zero line, the larger the deficit).

FRED Federal Deficit

In the graph below from the year 2000 there has also been a clear trend toward larger foreign trade deficits.

FRED Trade Deficit on Balance of Payments Basis

Note that the only strongly contrary period was during the financial crisis, which involved extraordinary interventions in financial markets and affected countries differently depending on the nature of the goods they normally export.

The Trump administration is refining its policy agenda right now. If it does not consider its policies in this broader context, it will almost certainly enact policies to address problems that are largely byproducts of the true problem, which is growing fiscal irresponsibility.

With respect to revenues, it is one thing to not allow the Trump tax cuts of 2017 lapse. It is quite another to add new tax cuts to the mix, especially when many are precisely targeted and therefore unlikely to produce a general supply-side effect that would increase revenues, like the 2017 cuts did.

With respect to spending, deficits are currently driven by runaway entitlement spending. From innumerable charts like this one below, it is clear that this spending dwarfs everything else.

Congressional Budget Office Report, 2023 (PDF)

Clearly, federal spending on Social Security, Medicare, Medicaid, and other income security programs is now well over half the federal budget. This does not include interest payments on the debt or future increases in these programs.

But the incoming administration has given no indication that it is going to seriously address the problem of runaway entitlement spending. Building a cabinet that will reduce regulation and cut unnecessary discretionary spending is very welcome news, but those savings will amount to a drop in the bucket of the overall budget.

Given the obvious effect that large and growing federal deficits have on the foreign trade deficit, tariff increases might make good political sense, but they are bad policy. One cannot cure a disease by treating one of its symptoms. One must also treat the cause. Just as inflation is ultimately a fiscal problem, the artificially high foreign trade deficit we are now experiencing is, too. There is simply no substitute for substantial entitlement program reform.  



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