In this example, if the country implementing the levy is not the second lowest cost producer, the levy on Chinese textile imports may only result in a shuffling of the deck or a change in the patterns of trade. If Vietnam is a lower cost producer than the United States, then Vietnam will now fill the void and people who used to buy from China will now buy from Vietnam and nothing changes in the world economy. Only a minor inconvenience of reshuffling the trade flows. Therefore if the self-sufficiency/protectionist policy is to be effective, it has to restrict all textile imports, not the textile imports from a single country. Otherwise what the policy will accomplish is a change in the patterns of trade among the nations of the world.

A consumption tax increases the price paid by the local consumers. The domestic demand declines and so will imports. In theory, if the consumption tax is high enough, the consumption tax could wipeout the imports thereby making the economy self-sufficient.

Critics of this policy argue that although the self-sufficiency objective may be achieved through a consumption tax, the government actions distort the private sector’s choices and increase the price of the import competing or import substitute. This will clearly make the domestic consumers worse off by this action, the exception being the presence of external effects, such as pollution damage to the environment. Hence, unless one is willing to argue that there is an externality that the consumption restriction is reducing, the principle of revealed preferences suggests that the current outcome is a second best solution, not the consumers’ first choice. The obvious conclusion is that as the dependency on imports is reduced, the economy is worse off without any positive effect on the domestic employment in that sector.

A production subsidy leads to a higher level of domestic production and quite likely a higher level of employment in the protected, favored, or subsidized sector. But this does not necessarily mean that the economy’s employment level unambiguously increases. It matters a great deal where the increased labor comes from. If the higher employment in the sector reduces the economy’s overall employment, then one can conclude that the economy’s overall employment level increased. But if the increased employment is at the expense of employment in other sectors of the economy, the economy’s employment level remains unchanged.

Under a competitive outcome, the marginal cost of producing the commodity inclusive of the subsidy will be equal to the marginal costs of the imported good. While domestic consumers pay the same price for the domestically produced good as the foreign produced good, the fact that the domestic produced good includes a subsidy means that the costs, inclusive of the subsidy, exceed the price of the imported product. In the absence of an externality, the domestic economy is wasting resources producing a good that could be acquired cheaper through imports.

An import tax increases the price of the imported product. The higher imported price increases the price paid by the domestic consumer. The higher domestic prevailing price inclusive of the import tax is equivalent to a domestic production subsidy. The effects of the import tax can be replicated by the following two domestic components: a consumption tax and a production subsidy.

These tools are readily available to the government and while they tend to have a qualitatevely similar effect on self-sufficiency, they have different impacts on consumption, production, and the level of distortion in the economy. For example, a consumption tax reduces imports without significantly impacting domestic production or employment level. In contrast, a production subsidy increases domestic production and the subsidized sector employment level without significantly impacting domestic consumption. The magnitude of the consumption tax or the production subsidy depends on the domestic demand and supply elasticities, respectively. Now, since the import tax is a combination of the two taxes, its effects will be felt on both the domestic consumption and production of the taxed commodity. Since the sum of the magnitude of the demand and supply elasticities is larger than the individual demand or supply elasticity, one can safely conclude that the import tax rate that produces self-sufficiency is much lower than the stand-alone consumption tax or the production subsidy that achieves the same objective. This also means that the impact on the employment level in the sector in question will be larger than a self-sufficiency producing stand-alone domestic consumption tax but smaller than a stand-alone domestic production subsidy.

In addition to the global equilibrium conditions, each of the countries is also subject to a budget constraint. On a global basis, there is no net borrowing or lending, a condition that applies to the world economy. Each country’s income will equal each country’s expenditures. This means that any excess production of one commodity in one of the countries, that is, exports, has to be matched by an excess demand for the other commodity, that is, imports. In short, if there is no net borrowing or lending, each of the country’s trade balances has to add to zero. Therefore the value of one country’s imports equals the value of that country’s exports. The value of the US imports equal the value of the US exports and the value of the ROW imports equal the value of the ROW exports.

The conclusion derived from the budget constraint and global equilibrium is simple and straightforward: once one of the following variables—US imports, US exports, the ROW exports, and the ROW imports—is known, so are the other three variables.

A US import tax is analogous to a transportation cost tax. Whenever price differences fall within the import tax or “transportation costs,” arbitrage of the price differences is not worthwhile. It is only differences above the “transportation costs” that are worth arbitraging. Hence, the domestic producer is free to increase the price above the world price as long as the price differential is below the broadly defined import tax or trade barrier. The import tax introduces a protective price band within which the foreigners will not find it worthwhile to arbitrage these differences in prices. The higher the import tax, the greater the degree of protection for the import industry.

Profit maximization leads to the conclusion that the domestic producers will charge a domestic price equal to the world price plus the import tariff. As the degree of protection increases, so will the price of the import substitute relative to all other commodities including the country’s exported product. Therefore the import tax produces a terms of trade effect that reduces the relative price of the exported product. That, in turn, leads to the following conclusion: the US import tax is equivalent to a US export tax. The US import tax reduces the take of the foreign exporter, and the US import tax is equivalent to the ROW export tax.

Finally, the US import tax increases the relative price of US exports in the ROW. Hence, the US import tax is equivalent to a tax increase on the ROW’s imported goods.

These equivalences are important and insightful, and they allow us to ascertain the consistency of the domestic policies as far as protecting domestic industries and promoting exports. An import substitution policy is nothing more than another variant of the self-sufficiency or protectionist argument. As such, it leads to an increase in the relative price of the protected good and if successful, it will reduce the imports. But if our equivalences are correct, then the import substitution policies will reduce the relative price of the exported goods, and that results in a reduction in the net exports. Our equivalences suggest that import substitution policies, in effect, are equivalent to a policy that reduces export promotion.

In contrast, an export promotion policy will result in higher exports if successful. But it will also alter the terms of trade. As the relative prices change, imports will increase. In effect, the export promotion policy also results in an increase in imports.

One obvious insight produced by the equivalences is that, policies aimed at self-sufficiency are inconsistent with policies aimed at promoting exports. They will tend to cancel each other and the end result will be a highly distorted economy. The poster child for this was Latin America, in particular Brazil, Argentina, and Chile during the 1950s and 1960s with its famous import substitution and export promotion policies. It was not until the southern countries embraced free trade and free market economics that their economic fortunes turned for the better. Chile is the best example. It abandoned the import substitution and export promotion policies and adopted market-oriented policies. In the process, it has transformed itself into a major exporting power house. The equivalences identified in previous paragraphs help us to understand why import substitution policies combined with export promotion policies failed the Southern Cone.

A point of clarification is that, the equivalences are based on the impact of these measures on the terms of trade. However, it does matter who imposes the tax, as they get to collect the revenues. Hence, when it comes to revenues collected, the equivalences breaks down. But that is not our focus here. The focus in on the impact on output, employment, and economic well-being, which we now turn to.

As the domestic import tax rate increases, domestic prices rise, and at the margin it will be equal to the foreign price plus the import tax. The higher domestic price increases the profitability of the import-competing domestic sector. Profit maximization induces the domestic producer to increase production and employment in the import-competing sector of the domestic economy. The producers and employees of the import-competing goods are clearly better off. Any short-term rigidity that prevents the domestic import-competing sector from adjusting means that the short-run supply elasticity is smaller than that of the longer run. Hence, in the short run, the profitability exceeds that of the long run and the long run profitability will in turn be higher than the profitability prior to the import tax increase. On the consumer side, the price increase induces a downward movement along the demand curve thereby reducing the overall consumption of the import competing goods. As the domestic consumer reduces the consumption level and pays a higher price for the import-competing good, it becomes apparent that the domestic consumers of the import-competing goods are not as well off as they were before the import tax increase.

The global equilibrium condition resulting from an import tax increase leads to a number of other results. If the tax increase extinguishes the local imports, the budget constraint leads to the conclusion that the country will have no exports either. As we have two countries—the United States and the ROW—the absence of imports and exports in one country means that the ROW exports and imports will also fall to zero. In this case, both the United States and the ROW will return to its autarkic condition. The ROW exports are nothing more than our imports. As our imports decline, so will the ROW exports. The explanation for this result is straightforward.

The difference between the prices in the two countries is nothing more than the import tax. The domestic import tax increases the price of the imports in the domestic economy. However, as the tax is deducted, the price received by the exporting country declines, which leads to an increase in the demand for the exportable goods in the ROW. As a result, the ROW’s consumers of their exported goods are better-off. The relative price decline also induces a movement along the supply curve. Production, employment, and the profitability in the export sector in the ROW unambiguously declines. Again, if there are adjustment costs, this industry’s unemployment rate will increase in the ROW in the short run. Notice also that the discussion also illustrates how the domestic import tax is equivalent to, that is, has similar effects, as a ROW export tax.

The story with US exports is quite similar to that of the ROW exports. The import tax increase alters the terms of trade, that is, the price of the imports relative to the country’s exports, and this results in a decline in the relative price of our exports. The relative price decline increases the domestic demand for the US exportable goods. The higher consumption and lower price make the domestic consumer of the export good better-off. The relative price decline also induces a movement along the supply curve. Our production, employment, and the profitability in the export sector unambiguously decline. If there are adjustment costs in the short run, then the adjustment in this industry’s unemployment rate will also increase. Again, notice that a domestic import tax has similar effects as the domestic export tax.

The results reported in the previous paragraphs show that the relative price of the US exported product for the ROW declined unambiguously. As the relative price of the imported product is the inverse of the exported product, the relative price of the imported product in the ROW unambiguously increases as a result of our, that is, the domestic import tax. The higher relative price increases the profitability, production, and employment in the import-competing domestic sector. The producers and employees of the import-competing goods in the ROW are clearly better-off. On the consumer side, the terms of trade or price increase induces a downward movement along the demand curve thereby reducing the overall consumption of the import-competing goods. The ROW domestic consumer reduces the consumption level and pay a higher price for the import-competing goods. The conclusion being that in the ROW, the consumers of the import-competing goods are not as well-off as they were before the import tax increase. The discussion here shows that the effects of the domestic import tax has the same effect as the ROW import tax.

Self-sufficiency advocates and protectionists view a trade imbalance, that is, a trade deficit, as a leakage or export of domestic jobs. The logic is very seductive. All else the same, if these goods were produced at home, these goods would generate additional jobs in the local economy. Unfortunately, under most general conditions, not everything else stays the same. A reduction in net imports will not necessarily increase the level of employment, as suggested by the nativist’s analysis that holds everything else the same. In fact, it is quite possible that the overall level of employment will decline.

NIPA Accounting and Global Equilibrium: To show how this may be the case, we need to go back to the National Income and Product Accounts (NIPA). Before we get into the individual countries account, it is worthwhile to review some global equilibrium relationships.

Under double-entry bookkeeping, global equilibrium requires that the global demand, the sum of the two countries’ demand, for one good equals the global supply at all times. The NIPA and global equilibrium also require that the sum of all expenditures equal the sum of all income. The equilibrium relationship means that for the world as a whole, the sum of all the countries trade balances are zero and that in equilibrium global savings will equal global investment at all times. The equilibrium relationship is means that one country’ surplus will mirror the other country’s shortage. Hence, each country’s international account will be the mirror image of the ROW’s international account.

Next, as we consider the individual countries’ budget constraints, we find additional equilibrium relationships. If one country’s expenditures exceed its income, the country will experience a trade deficit. Double-entry bookkeeping requires that the trade deficit must be financed somehow. Here is where the intertemporal considerations come into play. The country has to borrow from the ROW to finance the trade deficit, which yields the following result: a trade deficit is financed by a capital inflow that reflects the country’s net borrowing, that is, the excess of domestic savings over investments. The global equilibrium requires that the ROW’s corresponding accounts are the mirror image of our country’s international accounts.

Policy Consistency: Armed with the equilibrium relationships derived in the previous section, we can now evaluate the consistency of the different trade policies advanced by the nativist, self-sufficiency, and protectionist advocates. Many politicians view a trade deficit as a leakage of jobs and as a source of indebtedness. The question is whether that is always the case? If not, when can we tell that is not the case? What are the necessary conditions to determine whether a trade deficit makes the economy better-off or worse-off?

Let’s begin by focusing on the trade balance as a source of national indebtedness. There are several arguments made by nativists that foreigners are buying our country and as they own so much of our debt and resources, at some point in time they are going to use their clout. Another argument is that a trade deficit is a sign that we are mortgaging our future, and that we are consuming too much. If the self-sufficiency advocates and protectionists have their way, they will increase the pressure on the government to act to counter these presumed adverse relationships. The tools available to the government and suggested by the protectionists are many and may lead to in different policy responses. One may be restricting foreign ownership of certain business, or restricting capital flows and trade in goods.

The question one must ask is whether these policies will make the economy better- or worse-off? We assume that the politicians have the best intentions for the country, but that alone is not enough to insure that they adopt the best policies. In the case at hand, the policies adopted are the direct result of an assumption made regarding the trade deficit and or increased indebtedness. There is an implicit assumption that the borrowing is for nonproductive uses and that will hurt the economy in the long run. The analogy is that a person borrows money throws a big party and then wakes up with a hangover and in debt, not a good thing. In that case, an argument can be made for intervention. But that is not the only reason to borrow. What if the person borrows to invest and over time it is able to increase is earning capacity, service the debt, pay it off, and increase its income and standard of living? Clearly, the latter case produces a good outcome and should be encouraged. Given the two alternatives, then we can conclude that there will be desirable and undesirable deficits, the question is how can the government tell, to be able to take appropriate action and insure that it is not making a policy mistake?

We have argued many times that there is a simple way to determine whether the trade deficit is enhancing the economy’s potential or not. If the country can earn a higher rate of return than in the ROW, then capital will flow in and the country will experience a net capital inflow and see an increase in foreign borrowings. As the capital flows are invested, the economy’s productive capacity increases, as will output, employment, and profits. All of this suggests a series of relationships and correlations among the different variables. The capital inflows will be positively correlated to the trade deficit, higher output, higher employment, and higher profits. This correlation allows us to distinguish between the nativist, self-sufficient protectionist views and the pro-growth, free trade views of the world. Under the pro-growth scenario, we should observe a deterioration of the trade balance as a percent of GDP to be associated with an improving real GDP growth rate, improving stock market, and declining unemployment rate relative to the ROW.

Looking back, for most of the last three decades that is the prevailing relationship. So the question is, if instead of pursuing free trade, had the United States followed a protectionist strategy aimed at improving the trade balance and reducing its indebtedness, where would the United States be? We believe that the US economy’s output, employment, and stock market would be much lower than they are today and the world would be worse-off.

One interesting case study that illustrates and validates many of the insights developed here is the case against Chinese steel, as documented John W. Miller in several articles in the Wall Street Journal where he chronicles the case against China, the trade action, and the initial impact of the trade restriction on various sectors of the economy.

The case against China is as follows: the Chinese government supports its industries through cash assistance, subsidized electricity, and other benefits. The grievance is that Chinese overproduction of steel and other products has driven down world prices and hurt its competitors resulting in the loss of jobs in the steel industry of these other countries. Not surprisingly, we have witnessed workers protest against Chinese imports in Europe, Australia, and the United States. The latter launched seven new investigations into alleged dumping during the first 3 months of 2016. During 2015, US Steel Corporation lost $1.5 billion, closed plants and laid off thousands of workers, actions which the company mostly blamed on Chinese imports. In response, the US Commerce Department imposed a 266% preliminary import duty on Chinese cold-rolled steel. In 2016, US Steel filed a complaint against China at the International Trade Commission (ITC). The injury allegations include price fixing, transshipment via third countries to avoid duties, and cyber espionage to steal technology from US Steel computers.

The new tariffs on the steel imports produced higher prices in the United States. Steel producers were quick to take advantage of the new environment. Major US producers of steel sent letters announcing nonnegotiable price increases. The steel producers were also quite pleased with the government. According to a Wall Street Journal article, Stuart Barnett, owner of Chicago-based Barsteel Corporation was been quoted as saying, “our government has done a pretty good job of boxing out the guys who were importing the most-cheap steel.”

The tariffs offered some protection to the local steel industry and it is apparent that they took advantage of the situation. Consistent with the analysis presented here, the import restriction resulted in an increase in the profitability and employment levels in the industry, while the ROW’s production declined. By this account, the measure was quite successful.

Yet the press failed to identify the losers of the protectionist measures. One group of losers from the protectionist measures are consumers, who now had to pay higher prices. Another potential sector that may be negatively affected would be the rest of the economy. As long as resources migrate away from the rest of the economy into the steel sector, the production of the other goods or their costs will increase. One reason why these costs are usually not mentioned is that they are quite diffused and spread over large segments of the economy. The protectionist policy in effect creates a special interest group that will engage in politics aimed at continuing and extending the benefits are concentrated in the sector and the costs are spread over the economy. It will be hard for the people paying the costs to get together, while that is not the case for the industry and employment in the sector. To the extent that the politics of special interest groups is successful, the likelihood of the protective measures enduring increase significantly.

Not everyone is in agreement or in favor of trade restrictions and, not surprisingly, special interest groups emerged against the tariff. Car companies lobbied against steel tariffs. On a brief filed with the ITC, lawyers for Ford Motor Co. wrote “innovation and product quality are best served by a cutting-edge, competitive US steel industry; not one walled off from competition.”

Although, initially the tariffs appeared to be effective, the question is whether they will remain so over the longer term and whether people will be able to circumvent them. Profit maximization gives the market an incentive to find a way around the restrictions. In a letter to the Department of Commerce requesting an exemption, Steelcase Inc. said a tariff on a special kind of Japanese steel could cost its subsidiary, Polyvision, $4–$5 million a year and may even result in the closing of one of its plants that employs about 50 people. The letter states that schools cannot afford to pay more for the whiteboard that Polyvision makes. They argue that if they raise their price, their customers may substitute their product for cheaper ones of lower quality and not made in the United States This argument suggests an obvious circumvention mechanism that Mr. Barnett is worried about. In his own words, he makes this point clearly: “but now the greatest fear we have is that China keeps the cheap steel for itself and makes products that undercut other industries.”

Will the protectionists argue that the tariffs should be extended to these products too? If they do and are successful, the United States may be sliding down the slippery protectionist path.