Boombustology: Spotting Financial Bubbles Before They Burst

Boombustology: Spotting Financial Bubbles Before They Burst

This is an edited extract from Boombustology: Spotting Financial Bubbles Before They Burst, by Vikram Mansharamani (Wiley, 2019). Enter below for the chance to win a copy!

Tariffs and Trade Wars

A tariff is a type of tax applied to a specific category of goods that are traded between nations. In America, tariffs have been more like a historical novelty than a tool of modern policy, until recently.

Tariffs as we know them in the modern economy grew out of a nation’s desire to protect its domestic industry. Colonial European powers used them to protect and support the domestic industry of the home countries. This policy made it more expensive for goods to be imported to the colonies, thereby protecting specific industries. In the case of the British American colonies, for instance, tariffs were levied by London on imports into the colonies of Caribbean sugar and molasses—because they were products of French and Spanish colonies. This helped ensure that British sugar companies had a profitable market for their production.

Later, the United States and other countries tended to use tariffs to protect growing domestic industries from foreign competition. One argument used to justify these tariffs is that they would eventually increase competition, once the domestic industry matured and the tariffs were removed. The result might be more jobs, lower prices, and better products for consumers. The problem with these “infant-industry” tariffs was their execution, as Austrian-American economist Gottfried Haberler described:

Boombustology: Spotting Financial Bubbles Before They Burst

Nearly every industrial tariff was first imposed as an infant industry tariff under the promise that in a few years, when the industry had grown sufficiently to face foreign competition, it would be removed. But, in fact, this moment never arrives. The interested parties are never willing to have the duty removed. Thus temporary infant-industry duties are transformed into permanent duties to preserve the industries they protect.1

So why are tariffs harmful? They are another form of political intervention in the markets that inflate prices for some things and deflate them for others. Tariffs are inefficient in that they generally make things more expensive and misdirect resources that might be more productively deployed elsewhere.

Consider why we use specialists for all sorts of domestic projects. If you want a closet built in one of your rooms, it is very reasonable to expect that a carpenter could build a fine-looking functional closet with basic raw materials: a hammer, nails, lumber, sheetrock, and paint. However, unless you’re a carpenter, you will have to make a financial trade-off at least indirectly of something of value to you.

For instance, rather than studying carpentry, you might add skills to your own career that would in turn boost your earning power. Or perhaps you need to take time off from work, surrendering your income to build your closet. While you may pay a carpenter more in direct dollars to build a closet for you, it is likely cheaper if you include all the direct, indirect, and opportunity costs you would incur if you did the project yourself.

The same is true for countries, and the theory of comparative advantage helps explain how trade produces economic gains. In many ways, some countries have different strengths and capabilities than others, which means it’s less expensive overall to have another country sell, for instance, coconuts into the United States than to undergo a large replanting of American farmlands to growing coconuts domestically.

The land is likely more valuable being used for other desirable plantings that thrive in the U.S. climate and may sell for more per equivalent unit, such as oranges in Florida or almonds in California. David Ricardo articulated the principle of comparative advantage in 1817: every nation, however inefficient in its overall production structure, can always profitably export some goods to pay for its most desired imports.2

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Not only do tariffs raise costs and curtail comparative advantage, but they also compound the problem by effectively levying a tax on a country’s own citizens. They pay the tariff through the higher prices on the goods and services of the imported item, or they pay a higher price for a domestically produced item that is being protected by tariffs.

But cheapness of goods and services is in the extreme isn’t beneficial for an economy, either. There is an inherent, if harder to quantify, value in providing jobs for a country’s citizenry, even if that would mean higher costs for some items. This is the very argument that leads to trade wars, where one country’s imposition of tariffs results in retaliatory tariffs, which in turn lead to successive rounds of escalation.

Tempting as it is to punish another country to protect domestic jobs, history has shown that tariffs and the trade wars they frequently spawn are on the whole destructive processes in which all parties lose. Consider the trade spat (which at the time of this writing appeared to escalating toward a trade war) between the United States and China, in which America imposed a tariff on steel and aluminum imports from China.

The move was welcomed by domestic steelmakers but raised the prospect of shutting down companies that use imported metal by making them uncompetitive against those importing finished goods that competed with domestic production. Regardless of how this specific story plays out, the unintended complications and increased expense of grappling with tariff ramifications are clear.

Notes

1. Gottfried von Haberler, The Theory of International Trade (London: William Hodge, 1936), 281, https://www.cato.org/publications/commentary/truthabout-trade-history.

2. David M. Gould, Roy J. Ruffin, and Graeme L. Woodbridge, “The Theory and Practice of Free Trade,” Federal Reserve Bank of Dallas, https://www.dallasfed.org/~/media/documents/research/er/1993/er9304a.pdf.

This is an edited extract from Boombustology: Spotting Financial Bubbles Before They Burst, by Vikram Mansharamani (Wiley, 2019)

About the Author

Vikram Mansharamani is an experienced global equity investor and a lecturer at Harvard University, where he teaches students on how to use systems thinking approaches to address the world’s toughest problems. Previously, he taught a seminar called "Financial Booms and Busts" to undergraduates at Yale University. Mansharamani has a PhD and MS from the MIT Sloan School of Management, an MS in political science from the MIT Security Studies Program, and a BA from Yale University.

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