China's export drive to the United States is in full swing before tariffs kick in. Illustration: iStock
China's export drive to the United States is in full swing before tariffs kick in. Illustration: iStock

US President Donald Trump successfully arranged a draft change (Congress must fill in details and then give final approval) in the US/Canada/Mexico trade deal: he also renamed it (USMCA = United States-Mexico- Agreement: at one point Trump proposed calling it USMC, suggestive of the US Marine Corps!). He made it clear that the US is senior partner.

He reinforced the point by making arrangements separately, talking with Mexico first, while Canada was kept waiting in the wings, its pleading prime minister rebuffed until the American president made the point that he was in control.

All the world was thereby informed that he would operate bilaterally, taking trading (junior) partners into his figurative boxing ring one at a time, maximizing American relative bargaining power.

Britain’s planned exit from the European Union (Brexit) has pushed both the remaining members of the EU and the Brits themselves toward the US as a trading alternative, further giving Trump a trading advantage, once again creating a situation where the Americans can undertake negotiations with antagonists who are divided and so less able to gang up on the otherwise more powerful “big guy in the room.”

What does the new American trade strategy imply for traditional concepts of free trade? How will President Trump’s “divide and conquer” work when the player on the other side of the table is also a big guy, like China?

President Trump is not mistaken about the theory of tariffs: In particular, he is more than clever enough to resolve the apparent conflict between his strategies and the classical idea that free trade is best. He has a broad and subtle understanding of the uses of tariffs in the service of American national interest.

Trump is not mistaken about the theory of tariffs: In particular, he is more than clever enough to resolve the apparent conflict between his strategies and the classical idea that free trade is best. He has a broad and subtle understanding of the uses of tariffs in the service of American national interest

Now and again he may fail to make it clear enough that he can easily advance his long-run goals when he advocates short-run proposals for new American tariffs. He may not clarify his understanding of the full range of consequences that will follow from these new policies.

Because he has not yet revealed (and his overall negotiating strategy will not allow him to reveal) the complete story of his planned tariff moves, and because his tariff plan is dynamic, evolving and ongoing, no one can say if either his judgments are faulty, or he has miscalculated his predictions. All we know now is that (in most cases) he has merely threatened to apply new tariffs against some but not all foreign players, and only after some of the governments in those targeted places refuse to adjust in tariffs they apply to incoming American goods.

What Trump knows better than many of his critics is that the completely free, two-nations, two-commodities, two-currencies, two-periods, before-and-after textbook diagram of international trade traditionally played out on the blackboard of every first-year economics class is a special case. That special case is a creature of limited assumptions, simplified motivations and a-historic application.

The classroom example has little relevance when nation-states as well as trading partners have global interests to advance and protect: interests that go well beyond, are independent of and even contrary to the calculus of private gains and losses experienced by direct trading players.

State traders are limited by their own histories, are sometimes desirous of helping or hurting competing political entities, are motivated by an interest in re-election or at least popular support from a vast array of foreign and domestic counter-parties having direct and indirect connections with the outcome of trading arrangements and have differing degrees of market power, or monopoly power.

The nations of the Organization of the Petroleum Exporting Countries (OPEC) do not practice free trade: If they did so, they would fail to gain the profits they obtain by way of their market power over the price and availability of oil.

The prizes in the trade game being played include national prestige, possible redistribution of initial trade profits, political alienation of private benefits by way of taxation, economic support for “public goods and bads” like national defense, nation-building, cartelization, and even corruption. Any one of those “prizes” may be “paid for” with moves away from “let us not be greedy, let us avoid taking advantage, let the other guy have profits we could easily take away from him via “free trade.”

The reason real-world trade is never completely (or even nearly) free is that more than private economic profit/interest is at stake.

The authors of this article are economists. We know and respect the classroom model.  We are also students of history, politics, national rivalries, cross-border intrigues, war and peace. That list of factors is part of rational foreign policy. The list has always been entangled with deeply complicated foreign-trade and investment policies: Donald Trump is cooking those “ingredients” together in his real-world hot kitchen.

He is informed by far more that a first-year understanding of how to get the rest of the world (ROW) to pay more attention to America’s claim on them in repayment for (according to Trump’s accounting) past and future political, social, up-till-now unpaid economic debts owed by ROW to America.

Real-world considerations for political actors who design tariff policy included, in times past, gathering a national fund (trade surplus) of foreign exchange (gold in the old days) adequate to pay mercenary armies. Today, a trade deficit is possibly dangerous to the national interest because the deficit means the indebted nation owes the creditor nation a “mortgage” that is paid off (assuming the creditor won’t “continue to hold the mortgage”) only by giving the creditor national assets.

In the case of the US, annual trade deficits along with other public and private purchases have built up the world’s largest net public and private external debt. In 2003, the total was US$862 billion. It is now $18.6 trillion, about $57,000 for each and every American person. China’s comparable number is $1,100 per capita.

In other words, to pay off America’s gross debt to ROW, each and every American person would give up $57,000 of his current wealth. How? By transfer to ROW title to $57,000 worth of farms, factories, forests, and financial assets. ROW would, from that day forward, have a right to the earnings and dividends produced by those transferred producing assets.

Of course, the US does have some counterbalancing claims against ROW, amounting to about $10 trillion, leaving a net external US debt to ROW of more than $8 trillion. OK, so to settle the net external (international) public and private debt, the average American person would have to give up to ROW persons “only” $25,000 worth of wealth: that’s a relief(?!).

It’s the numbers above that caused President Trump to tell the ROW that there is a new sheriff in town; he is going to cut that debt down. Not by collecting tariffs: the revenues would be pennies, and much of that would be collected from American buyers of foreign products. He intends to “make the other guy pay” (the foreign producers of goods sent into American markets).

He is focused on all the ways the American national wallet leaks dollars mopped up by foreign players. The US pays for ROW military preparedness. For example, only five of the 23 nations in the North Atlantic Treaty Organization now spend the 2% of gross domestic product they are treaty-bound to pay on defense. (The US pays 3.6%, Canada pays 1%. China pays nothing to defend the West: Arguably, it should at least pay something to control North Korea, since China would suffer if Trump removed that troublesome stone from his shoe.)

Trump’s total foreign-policy package (of which the tariff is a small but noisy part) is aimed at stopping that imbalance, which, if others paid their way, would reduce US overseas spending, and thus chip away at the accumulated American international debt. That is, the Americans are, in a way, not so different from the olden days of “mercantilist” (gold-buildup) international trade theory, currently “paying for foreign mercenary troops,” and President Trump is saying “no more.”

What are some other angles that make “big idea” sense of Trump’s new direction for American foreign trade, investment and “America first” overseas policy? Indeed, what are all the angles pursued by the entire spectrum of nations who use tariffs (positive and negative, taxes and subsidies) and other regulations affecting international flows of goods, investments and traded services, always in pursuit of a variety of national interests and concerns?

In 19th-century American history, protective tariffs and barriers to international capital allowed the “infant industries” of the United States of America to grow large enough eventually to compete with well-established foreign firms.

For example, the Mexican War and the later Spanish-American War were both fought with protected US steel. That steel allowed for high-volume production of top-quality weapons, and made possible the statehood of California, New Mexico, Arizona, Texas and Nevada, to say nothing of territorial status for Puerto Rico, and an extension of US presence in the Pacific theater consisting of a port and eventual base in the Philippines, combined with ownership of the island of Guam in the Marianas chain.

Indeed, had it not been for congressional squeamishness, America forces, armed by industrial power, would have, at the time of Teddy Roosevelt, settled the status of Cuba and the rest of the Caribbean’s trouble spots.

Nobody lives by the rules of the free-trade model. OPEC uses what is really a tariff on exports to keep the price of oil much higher than it would be under free trade: It makes the rest of the world much worse off, but OPEC likes it

Nobody lives by the rules of the free-trade model. OPEC uses what is really a tariff on exports to keep the price of oil much higher than it would be under free trade: It makes the ROW much worse off, but OPEC likes it.

China has been charged with “dumping” steel and various other manufactured products (selling at less than the cost of production, using a negative tariff or subsidy) into world markets. Anti-Chinese players say “the plan” is to hollow out competing heavy industry in the buying nations, so as to set the stage for, perhaps, later price boosts, way above cost of production. It is likely the real Chinese intention, to the extent that such grand intentions actually work out, is to advance the internal growth rate of key domestic industries quickly, prior to the ability of Chinese consumers to buy, and move ahead the capacity of China’s “up the food chain” industries to use the raw steel etc to feed local needs. But whatever the motive, negative tariffs (subsidies) are part of the departure from free-trade classroom doctrine.

Manipulation of foreign investments is another commonplace “national interest” use for taxes, burdens, regulations and barriers. For example, President Trump recently blocked Singaporean chipmaker Broadcom’s proposed $117 billion takeover of US high-tech firm Qualcomm: Trump cited problems with national security as his reason.

Right or wrong, military needs are a universal factor not present in the classroom argument in favor of free trade. China routinely limits the presence of US social-media services. Even during the relatively “free market” Stephen Harper administration in Canada, that government blocked the proposed $37 billion purchase by BHP Billiton (an Australian mining company) of the Potash Corporation of Saskatchewan. Canadian internal politics were blamed for this departure from classroom trade/investment openness.

Trade wars are sometimes not too distinct from real war. Cheap Cuban sugar, rum, cigars and even beachfront vacation weekends were denied to American consumers for many years, in order to make that country’s communist government pay for at some of the damage it did, especially during the years it was a puppet of the Soviet Union, to the general US interest in the Caribbean and the rest of the Western Hemisphere. Once again, the free-trade model is irrelevant to the usefulness (or not) of a real-world national-interest trade policy.

Prior to World War II, and going all the way back to Victorian times, the UK had a policy of “imperial preference,” or later “Commonwealth preference,” that set up a kind of free-trade group, headquartered in Britain, consisting of Canada, Australia, New Zealand and South Africa that was transparently a system to limit the then rapid growth of the US as a world economic power. The Brits wanted to offset the American potential to threaten the importance of the British Empire.

Indeed, some historians say the UK trade and investment support for Canadian nationhood in 1867 (a moment when some Europeans feared the victorious armies of the US North might march north and create a three-ocean colossus) was another manifestation of national-interest economic policy aimed at harming a political, economic and social competitor.

None of these facts of political economy are found on the Free Trade blackboard.

So by now we have convinced you that Mr Trump’s theory of international trade and his understanding of how to use the instruments of trade, tariffs, subsidies, and investment regulation in the advance of national interest is sophisticated and quite in line with historical traditions. But what could he be getting wrong? Or better yet, what might go contrary to his hope and expectation? China, that’s what.

By the way, we say “China” because the other possibilities (for organized, successful opposition to America’s change in policy) like the European Union, the World Trade Organization, the United Nations are, at best (Woodrow) Wilsonian semi-utopian, treaty-based political institutions, without the deep roots or national purposefulness that motivate real nation-states like the US or China. To the extent that some of those international institutions have had brief success (none of them existed prior to World War II), that success has not been tested with by the potentially far-reaching change in American willingness to put international stability ahead of America’s permanent domestic interest.

The situation is not so much trade theory as it is game theory. Trump’s model is of his Superpower ability to divide and conquer and then face down, one at a time, a sequence of individual nations, comprising an opposing line of squabbling, badly organized lesser powers, some of them quite trade-dependent (albeit rich: for example Germany), others indebted and vulnerable to anyone able to provide cheap credit (PIIGS, or Portugal, Italy, Ireland, Greece and Spain) or willing to sell out badly managed but “recoverable” national assets for dimes on the dollar.

Let us get back to China. We find a situation that will challenge Trump’s small-nation strategy. In ROW (but within China’s sphere of influence), there are nations with promise, already on the road to near-full economic “adulthood.” The World Bank predicts these growth rates: the Philippines 6.9%, Laos 7%, Cambodia 6.9%, Myanmar 6.9%, Bhutan 6%.

Further afield, there are countries, interesting to China, with promise (Peru’s predicted rate is 3.7%: It has lots of gold, copper, zinc and lead). Panama will grow by 5.8% next year, says Bloomberg. Its money-machine, the Panama Canal, will be even more important as a facilitator of South American raw-materials exports to China.

All these countries now have links to the US. If they begin to worry about stability or generosity in their terms of trade with the Superpower, they may listen to a China that has a long-run view and is willing to make long run commitments.

Why would China make such promises? With the deep purpose of assuring, maintaining and even increasing its own internal growth rate, while making sure (again purely as an internal matter) that those parts of its domestic economy that need to “catch up” will have the wherewithal needed for accelerated, equalizing development.

Any such ambitions on the part of China do not have to be classically imperial. They could, and should they come to be, will correctly be seen to be aimed at creating greater internal security and stability. But if it happens, it will be partly a consequence of American use of uncertainty (only tactical to be sure, but nonetheless unsettling to others) in its willingness to sacrifice American national interest in the name of international stability.

In conclusion we repeat: Donald Trump’s actions are quite consistent with a “big idea” conception of trade, investment, tax, subsidy and tariff theories. His thinking goes way past the simplified free-trade classroom case. He understands how to use foreign trade in a way that supports foreign policy and national interest.

His conception is subtle and complex, and not yet fully laid out. For example, it is already clear that any new constellation of tariffs, for example on steel and aluminum, will not be uniform across nations or across rates.

But the very sophistication and studied complexity in his strategically vague plan may leave an opening for China to advance its own interests, possibly at the cost of at least some of America’s hoped-for gains.

This article was co-written with a banker who wishes to remain anonymous.

Tom Velk is a libertarian-leaning American economist who writes and lives in Montreal, Canada. He has served as visiting professor at the Board of Governors of the US Federal Reserve system, at the US Congress and as the chairman of the North American Studies program at McGill University and a professor in that university’s Economics Department.

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