How to think about free trade, tariffs and economic warfare as an intelligent adult

Say Atlantis and Borealis are two countries that trade with each other. Both have their own unique demographic and cultural traits – such as population size, age, education level and distribution, as well as history, customs, etc. They also have their own territorial aspects – their landscape features, climate, soil and relative distance to other markets, availability or access to natural resources, capacity and quality of basic infrastructure, etc. None of these attributes change very fast, but nearly all of them change over the course of decades or centuries. And from the perspective of capital investments that are not very iliquid and with a very long term horizon for returns, these attributes are typically assumed to be fixed – i.e. Atlantis is this way and Borealis is that way.

These differences can make Atlantis more convenient than Borealis for some industry. Say the soil there is very good for planting wheat, whereas the soil in Borealis is better suited for planting tobbacco. It makes sense then for Atlantis and Borealis to each specialize in their respective “natural talents” so to speak, rather than impose tariffs to protect an inefficient aspect of their domestic markets.

So here’s one thing where (I think) you and I agree – a tariff is always economically inefficient if the production in Atlantis and the production in Borealis are being charged similar taxes and constrained by similar regulations. In that scenario, investments would redistribute efficiently (i.e. such that the market marginal productivity was maximized), thus leading to economic surplus, and global capital formation. Furthermore, adding a tariff in this scenario becomes a subsidy to industry and labor that is non competitive. Farmers in Borealis start planting wheat, and those in Atlantis start planting tobbaco, and the result is more expensive wheat and tobbaco everywhere.

Here is another thing we agree – people are less inclined or otherwise capable to imigrate than capital. Even in abscence of policies that restrict their exit from or entrance into either country, there are tangible and intangible costs associated with packing their stuff and moving to a different place, and starting a new life there. Capital, on the other hand, has relatively low attachment to a given nation, thus being more inclined to go seek for better prospects of risk-adjusted profits, wherever they are.

Now assume Atlantis government decides to increase taxes on realized gross profits, unrealized capital gains, and to put more strict regulations, such as environmental protection codes, lower working hours, higher minimum wage, increased paid leave, healthcare and other entitlements. All of the sudden doing business in Atlantis becomes more expensive than doing it in Borealis, and that might shift the calculation for capital, that was previously deployed to efficiently lever the intrinsic advantages of each country.

Alternatively, the government from Borealis could have created a subsidy for capital. One way or another, that subsidy is paid for by a cost shift to the population. Maybe the form it comes is through higher taxes, inflation, or worse environment, work benefits, or social entitlements. It can also be in the form of constraining their ability to purchase imports, to invest abroad or even to simply move to another province or to emigrate from the country. And, for the same reason as the one listed above, doing business in Borealis becomes cheaper, so capital moves from Atlantis to Borealis.

So maybe the car industry in Atlantis moves its factories to Borealis, to avoid taxes and regulations. It can still sell to Atlantis, because there are no tariffs. And since people don’t want to move from Atlantis to Borealis, that causes an increase in wages in Borealis, and a decrease in Atlantis. And since wages move (because they are commanded by capital, which is relatively free), even when people don’t (because populations are more bounded to their homes), there is a net a wealth transfer, per capta, happening between the countries.

So here’s where we disagree – if you do have a situation in which domestic businesses are being more burdened by your taxes and regulations and therefore choosing to go elsewhere, or if your trading partner is forcing their own local population to subsidize capital by taxing and regulating them, then you can use tariffs on their products to offset the wealth transfer and create economic surplus. Tariffs can neutralize the tax and regulatory arbitrage, thus making capital indiferent to jurisdiction, vis-a-vis those costs, and revert to a more efficient allocation, vis-a-vis other comparative advantages.

It makes no sense for you to put more taxes on cars that are built in your country, and that create jobs in your country, and bring wages to your country, than you do on cars that are built elswhere but ultimately sold to your population. You are reducing your wage adjusted labor productivity, i.e. transfering human capital, to the other country, and trading off real wages for a false impression of cheaper costs or higher margins on capital. It’s dumb.

To summarize, when the tax and regulatory policies that affect capital and people in both countries are roughly consistent, free trade is the way to go because each country will specialize on its comparative advantages, and global welfare will increase. When they are very inconsistent – they can create net subsidies to capital migration, which causes net wage dislocation, from countries where policies are more pro-social to countries where policies are more pro-capital. And that is inefficient, because people are not migrating accordingly. That can create a net wealth transfer, which is exactly what China engineered.

If you say “oh ghee, but libertarians are not only against tariffs, they also want fewer taxes, regulations, social entitlements and open borders”, I will say great, that would be ideal but it is not the real world we live in, where things like nation states exist. Maybe one day it becomes like that. But in the real world we live in, nation states exist, and you cannot imposed a libertarian policy across the board everywhere. But you can use tariffs to counter the capital arbitrage dislocations and net subsidies that taxes, regulations and entitlements create.

And that is how the guys from Trump team think. And they are 100% correct. I used to think like you and it took me a while to see how this works out, but once you see it, it’s a fucking light bulb.