Trade tariffs as economic policy: the debate

Michael Pettis is an American professor of finance at Guanghua School of Management at Peking University in Beijing and a nonresident senior fellow at the Carnegie Endowment for International Peace. He has become a popular media source on China’s economy but also on global trade and investment trends.

In the wake of Donald Trump’s announcement of tariff hikes on US imports from a range of countries, Pettis has been expounding the view against the consensus in mainstream economics that tariffs can sometimes be beneficial to a country and even the world economy.

His argument centres on the view that: “[unlike in the 1930s], Americans consume far too large a share of what they produce, and so they must import the difference from abroad. In this case, tariffs (properly implemented) would have the opposite effect of [the] Smoot- Hawley [tariffs of the 1930s]. By taxing consumption to subsidize production, modern-day tariffs would redirect a portion of US demand toward increasing the total amount of goods and services produced at home. That would lead US GDP to rise, resulting in higher employment, higher wages, and less debt. American households would be able to consume more, even as consumption as a share of GDP declined.”

He goes on: “Thanks to its relatively open trade account and even more open capital account, the American economy more or less automatically absorbs excess production from trade partners who have implemented beggar-my-neighbor policies. It is the global consumer of last resort. The purpose of tariffs for the United States should be to cancel this role, so that American producers would no longer have to adjust their production according to the needs of foreign producers. For that reason, such tariffs should be simple, transparent, and widely applied (perhaps excluding trade partners that commit to balancing trade domestically). The aim would not be to protect specific manufacturing sectors or national champions, but to counter the United States’ pro-consumption and anti-production orientation.”

Pettis claimed that US tariffs, even though it is a tax on consumption, would not necessarily make American consumers worse off. “American households are not just consumers, as many economists would have you believe, but also producers. A subsidy to production should cause Americans to produce more, and the more they produce, the more they are able to consume.” For example, if the US were to put tariffs on electric vehicles, US manufacturers would be incentivised to increase domestic production of EVs by enough to raise the total American production of goods and services. If they did, then American workers would benefit in the form of rising productivity. In turn, this would lead to wages rising by more than the initial price impact the tariffs had and American consumers would be better off.

Pettis argued that “It was direct and indirect tariffs that in 10 years transformed China’s EV production from being well behind that of the US and the EU to becoming the largest and most efficient in the world”. So tariffs may not be an especially efficient way for industrial policy to force this rebalancing from consumption to production, but it has a long history of doing so, and “it is either very ignorant or very dishonest of economists not to recognize the ways in which they work…To oppose all tariffs on principle shows just how ideologically hysterical the discussion of trade is among mainstream economists.”

Pettis’ favourable view of Trump’s tariffs policy produced a broadside of attacks by mainstream neo-classical and Keynesian economists. Paul Krugman, the Keynesian guru who got a ‘Nobel’ prize for his contribution to international trade analysis, reckoned Pettis was just “mostly wrong”.

Keynesian economics blogger Noel Smith noted that Pettis reckoned that cheap Chinese imports actually made Americans poorer, by reducing their domestic production so much that Americans actually end up consuming less. Really, proclaimed Smith? “I’m highly skeptical of this argument, since a basic principle of economics is that people don’t voluntarily do things that make them poorer.” (Smith). Smith retorted that Trump’s tariffs in his first term did not boost domestic production as Pettis claimed tariffs could. Industrial production actually declined after Trump put up his tariffs:

Moreover, the trade deficit did not decline at all.

Pettis was failing to consider other factors, in particular, the dollar exchange rate with other trading currencies. The dollar appreciated in response to the tariffs, cancelling out at least part of the tariff effect on import prices. And it was not just households that had to pay more for imported goods in the shops, US manufacturers also suffered when they had to pay a lot more for parts and components.

Neoclassical economist Tyler Cowan also launched in, outlining “the mistakes of Michael Pettis”. “Michael Pettis does not understand basic international economics”. “He talks about tariffs (FT) as if they are anti-consumption, but pro-production. But tariffs are anti-production on the whole…. he basically presents an argument that we would expect economics undergraduate majors to reject.”

Certainly, the empirical evidence suggests that tariffs do not lead to a rise in economic growth. “Using an annual panel of macroeconomic data for 151 countries over 1963–2014, we find that tariff increases are associated with an economically and statistically sizeable and persistent decline in output growth. Thus, fears that the ongoing trade war may be costly for the world economy in terms of foregone output growth are justified.”

Pettis’ argument has two features. First, he reckons that import tariffs would lead to import substitution ie domestic American manufacturers would increase production and replace foreign imports and so employment and incomes would rise for all. Second, what is wrong with the world economy are the imbalances in trade and international payments. The US runs a huge trade deficit because exporting nations like China and Germany have flooded the home market with their goods. Tariffs can stop that by allowing US manufacturers to compete.

The first argument is really the old ‘infant industry’ argument, namely that countries just beginning to build their industrial base need to protect those ‘infant’ industries with tariffs from cheaper foreign imports. This was the economic basis for the tariff measures introduced by successive US administrations after the end of the civil war in the 1860s. This culminated in the Tariff Act of 1890, better known as the McKinley Tariff, which was a pivotal episode in US trade policy, dramatically raising import duties to near-record levels (by 38-50%).

Donald Trump referred to McKinley when announcing his executive orders to raise tariffs. “Under his leadership, the United States enjoyed rapid economic growth and prosperity, including an expansion of territorial gains for the Nation. President McKinley championed tariffs to protect U.S. manufacturing, boost domestic production, and drive U.S. industrialization and global reach to new heights.” Indeed, McKinley campaigned on raising tariffs so that internal taxes could be lowered, just as Trump campaigned in the 2024 election. “You go back and look at the 1890s, 1880s, McKinley, and you take a look at tariffs, that was when we were proportionately the richest,” Trump said.

In 1890 McKinley as a congressional rep proposed a range of tariffs to protest American industry. This was adopted by Congress. But the tariff measures did not work out well. They did not avoid a severe depression that began in 1893 and lasted until 1897. In 1896, McKinley became US President and presided over a new set of tariffs, the Dingley Tariff Act of 1897. As this was a boom period, McKinley claimed that the tariffs helped to boost the economy. Called the ‘Napoleon of Protection’, he linked his tariffs policy to the military takeover of Puerto Rico, Cuba and the Philippines to extend America’s ‘sphere of influence’ – shades of Trump But early in this second term as president from 1901, he was assassinated by an anarchist who had been enraged by the suffering of farm workers during the recession of 1893-7, which he blamed on McKinley.

Now we have another ‘Napoleon of Protection’ in Trump, who claims his tariffs will help American manufacturers in the same way that McKinley argued. But this time. the price will be paid by American households. Trump’s last set of tariffs in his first term raised domestic prices and hurt consumers much as the McKinley Tariff did in its time.

The debate here between Pettis and his critics boils down to two things. First, did the ‘infant industry’ argument hold at least for 19th century America, and if it did, can we apply it now for the US economy in the 21st century? The mainstream critics like Cowan are outright neoclassical supply and demand equilibrium theorists. Cowan reckons that over the long term, any change in supply and demand for American exports and imports caused by tariffs will lead to a price adjustment and a new balance. So there will be no gain for American industry.

Pettis correctly replied to Cowen’s fantasy world of equilibrium: “While I understand Cowen’s reliance on the “Econ 101” model, which assumes that prices always adjust to balance supply and demand, this framework isn’t relevant in the context of current global economic conditions. Prices have not adjusted in the US or many other countries over several decades.”

But Pettis fails to accept the obvious: that the US in the 21st century is not an emerging industrial power that needs to protect burgeoning new industries from powerful competitors. Instead, it is a mature economy with a declining industrial sector that will not be restored in any significant way by tariffs on Chinese or European imports.

As long ago as the 1880s, Friedrich Engels pointed out that when a capitalist economy is dominant worldwide, it is in favour of free trade and no tariffs, as Britain was in the mid-19th century and the US was in the 1950s to the 1980s. But the long depression of the 1880s and 1890s saw Britain’s manufacturing dominance decline and British policy switched to protectionist tariffs for its vast colonial empire.

Engels commented then: “if any country is now adapted to acquiring and holding a monopoly of manufacturing, it is America.” Engels reckoned that America’s tariffs from the 1860s had helped ‘nurture’ the development of large scale industry, but eventually as the US gained dominance, protective tariffs would “simply be a hindrance.” In the 21st century, America is Britain in the late 19th century; and China is the America of the 20th century – at least in industrial terms. Thus now Trump and Pettis want tariffs; while China wants free trade.

Pettis, in defending his argument for tariffs against his mainstream critics raised, what he called the “wider picture”, namely that China (and until recently Germany) exported for growth rather than consumed. As a result, workers wages were held down in China and Germany while the US became the final consumer for their exports and thus over consumed. This was the reason for trade imbalances that must be corrected by tariffs.

It is the thesis that Pettis and co-author Matthew Klein developed in their book Trade wars are class wars, a title that so enthused not only the mainstream media but attracted support from the left (indeed, I remember Klein being invited to participate in a left-wing online discussion on international trade and suddenly realising where he was, blurted out that he was ‘not a Marxist’. Of course, this was not his fault as the hosts should have known better!).

Klein-Pettis reckoned that the industrial policy of ‘investment for export’ by countries like China and Germany create ‘global imbalances’ that encouraged dangerous reactions like those from Trump. So Trump’s actions were the fault of China and Europe. You see, some economies (China) are ‘saving’ too much ie not investing at home enough to use up savings and instead export abroad, running up big trade surpluses. Others are forced to absorb these surpluses with excessive consumption (US) and so run large current account deficits. So we have trade wars as governments like Trump’s try to reverse this trend.

This is a bit like Trump’s argument that Mexico and Canada were causing a drugs overdose epidemic in the US by exporting fentanyl and it had nothing to do with Americans demanding cheap imported drugs to help their depressions.

Klein and Pettis were saying that these trade imbalances are caused by the decisions of governments like China and Germany that seek to suppress wages and consumption (the class war), in order to boost investment and export surplus savings. Klein and Pettis reckoned that “The problem emerged when the Chinese economy could no longer absorb new investment productively. … Once China reached that point, consumption was too low to drive growth, and it entered into a state of excess production.”

But as I showed in my review of that book and in several other posts, this thesis is nonsense. It was just not true that household consumption in China is being repressed. Actually, personal consumption in China has been increasing much faster than fixed investment in recent years (even if it is starting at a lower base) and faster than in the US or any other G7 economy. Pettis and Klein’s own empirical analysis reveals that there has been a rise in consumption as a share of GDP in China in the last ten years, even without recognising that this is a probable underestimate of the size of household consumption in the stats (which exclude many public services or the ‘social wage’).

Any proper analysis of the trade imbalances would recognise that they are not the result of ‘excess savings’ or ‘weak domestic demand’ in China and ‘inadequate savings’ or ‘excessive demand’ in the US. This view is a false Keynesian analysis that ignores the supply-side forces of strong investment in technology reducing unit costs of production to gain a competitive advantage in international trade. Germany and China were just outcompeting US industry through increasingly superior technology and productivity growth. Indeed, even on the adjusted (A) Western measures of labour productivity growth during the COVID period, China has done way better than the US.

Over the last 30 years, China’s savings rate rose 25.8%, but its investment rate rose more, 26.8%; so no ‘savings glut’ there, at least over the long term. Indeed, in the global boom period of 1990s, China’s investment rate rose much faster than its savings rate and there were no large surpluses on the current account. Only in the short period of 2002-7 did China run a large net savings surplus when the US has a credit-fuelled consumer boom before the global financial crash.

In their book, Klein and Pettis argued that: “The rest of the world’s unwillingness to spend — which in turn was attributable to the class wars in the major surplus economies and desire for self-insurance after the Asian crisis — was the underlying cause of both America’s debt bubble and America’s deindustrialisation.” But this is historically inaccurate. Since the 1970s, the US had been losing market share in manufacturing and trade and running current account deficits, not just after the Asian crisis. The cause of this decline was down to the relative weakness of US productivity growth, not Asian ‘excess savings’. Moreover, US manufacturing companies had shifted their production abroad during the 1980s.

Ironically, in trying to defend his pro-tariff policy from his orthodox critics, Pettis reversed the view in his book. He replied: “Contrary to Cowen’s claim, US business investment is not constrained by a lack of American savings. Just look at what US businesses say. They argue that if they are not investing in increased manufacturing, it is more likely because they do not believe they can produce profitably in the face of intense global competition, particularly from countries like China, Germany, South Korea and Taiwan, whose trade surpluses reflect a competitive advantage achieved at the expense of weak domestic demand. Another way to assess this is by looking at what businesses do with retained earnings. If US companies were eager to invest domestically but constrained by a lack of savings, they would not be sitting on massive cash reserves or spending heavily on share buybacks and dividend payments. This suggests that the problem is not a shortage of capital but a lack of profitable investment opportunities in the US.”

Apart from the reference to ‘weak domestic demand’, what Pettis says is right. American capital did not invest to sustain its manufacturing superiority because the profitability of that sector had fallen too mcuh. Instead, they switched to investing in financial assets and/or shifting their industrial power abroad. In the last couple of decades they hoped to sustain an advantage in hi-tech and information technology including AI. Now even that is under threat.

But this is not the fault of China running an ‘unfair’ industrial trade policy that is based on suppressing the living standards of its people; on the contrary, it is the failure of US capital to sustain its hegemony, just as Britain did in the late 19th century. Pettis attacks China’s success and calls for the US to protect its ailing industries with tariffs. If anything, that is likely to reduce the living standards of Americans instead.