Note:This is the latest entry in the Acton blog series, “What Christians Should Know About Economics.” For other entries inthe series seethis post.The purpose of the series is not to present a theology of economics, but simply to provide a basic level of understanding that will help Christians think more clearly about how to apply their mitments to economics and public policy.

The Term: Tariffs and Balance of Trade

What it Means:Balance of trade is the difference in value over a period of time between the goods and services a nation imports (brings into the country from other nations) and the goods and services a nation exports (goods and services sent to be sold in another country). If a nation’s exports exceed its imports relative to another country, the country is said to have a trade surplus. If a nation’s imports exceed its exports relative to another country, the country is said to have a trade deficit.

A tariff is a tax or duty imposed on a particular class of imports or exports, usually for the intention of “correcting” imbalances of trade.

Why It Matters: Most people don’t give much thought to the issue of tariff and balance of trade even though the concepts have led to some of the most harmful economic consequences in world history.

The field of economics was invented to refute destructive ideas, such as that tariffs benefit a nation and other misconceptions about balance of trade. Yet despite being refuted for hundreds of years, discredited misunderstandings about trade balances remain in the form of neo-mercantilism.

Neo-mercantilism is the revival ofthe economic ideas of mercantilism.As the Concise Encyclopedia of Economics explains,

Mercantilism is economic nationalism for the purpose of building a wealthy and powerful state. Adam Smith coined the term ‘mercantile system’ to describe the system of political economy that sought to enrich the country by restraining imports and encouraging exports. This system dominated Western European economic thought and policies from the sixteenth to the late eighteenth centuries. The goal of these policies was, supposedly, to achieve a “favorable” balance of trade that would bring gold and silver into the country and also to maintain domestic employment.

Neo-mercantilist policies are based on an intuitive, but incorrect, idea about trade. As Daniel Griswold explains, “The most important economic truth to grasp about the U.S. trade deficit is that it has virtually nothing to do with trade policy.” Because trade policies such as NAFTA or TPP are not the primary cause of trade imbalances, protectionist policies cannot “correct” them. A nation’s trade deficit is determined, says Grisworld, by the flow of investment funds into or out of the country. “And those flows are determined by how much the people of a nation save and invest—two variables that are only marginally affected by trade policy.”

To understand balance of trade, we must first understand balance of payments. A nation’s transactions with other nations do not just include goods and services, but also includes investments and payments received from investments. The balance of payments account therefore includes two sides of an equation: the current account (which includes trade in goods and services) and the capital account (which includes foreign investment). By definition, the balance of payments must equal zero (i.e., they have to balance), so that gives us the formula:

Savings – Investment = Exports – Imports

Exports minus imports gives us the trade balance, whether a surplus or a deficit. So if there is a deficit on the current account side (Exports – Imports) there must be a surplus on the capital account side (Savings – Investment). As economist Douglas Irwin explains, “If a country is buying more goods and services from the rest of the world than it is selling, the country must also be selling more assets to the rest of the world than it is buying.”

One other factor we have to consider is the exchange rate. “The transmission belt that links the capital and current accounts is the exchange rate,” says Griswold. “As more net investment flows into a country, demand rises for the dollars needed to buy U.S. assets.”

Based on our formula, what happens if we impose tariffs on imports? Tariffs are taxes on the American people to discourage the purchase of imported goods. If they work, the tariffs cause imports to decline, resulting in fewer dollars flowing into the international currency markets. This would cause the value of the dollar to rise relative to other currencies. As Griswold explains, “The stronger dollar would make U.S. exports more expensive for foreign consumers and imports more attractive to Americans. Exports would fall and imports would rise until the trade balance matched the savings and investment balance.” Because this would not change the levels of savings and investment, the trade deficit would remain largely unaffected.

This may plicated but the effect of tariffs is rather simple: Imports to America would decrease, but so would exports. Everyone—including the protected industries and workers—would be made worse off since fewer goods and services would be available, and those that remain would be more expensive than they would with free trade.

Neo-mercantilists tend to justify their positions by claiming that because of “unfair trade deals” we are “losing” to other countries. But again, this misunderstands the nature of trade and ignores the role of savings and investment. Bilateral trade (such as with Canada) or even trilateral trade (such as NAFTA) does not matter. As Greg Mankiw explains, a nation can have large trade deficits and surpluses with specific trading partners, while having balanced trade overall:

For example, suppose the world has three countries: the United States, China, and Australia. The United States sells $100 billion in machine tools to Australia, Australia sells $100 billion in wheat to China, and China sells $100 billion in toys to the United States. In this case, the United States has a bilateral trade deficit with China, China has a bilateral trade deficit with Australia, and Australia has a bilateral trade deficit with the United States. But each of the three nations has balanced trade overall, exporting and importing $100 billion in goods.

It’s easier to understand the irrelevance of bilateral trade when we think about trade between individuals. As the Nobel-prize winning economist Robert Solow once joked, “I have a chronic [trade] deficit with my barber, who doesn’t buy a darned thing from me.” What was true for Solow and his barber is true for countries like the U.S. and Canada.

Whatever the reasons neo-mercantilists promote their policies—whether out of of economic ignorance (i.e., they just don’t know any better) or because of more nefarious reasons (i.e., they are cronies or friends of cronies using government power to protect their narrow interest)—we have a duty to oppose them since such policies only lead to greater unemployment, increased poverty, and reduced human flourishing for everyone.

A note on bias: Economics is prone to a range of biases, from the moral to the political to the personal. Since I’m writing this series for a think tank dedicated to the study of religion and liberty, there will obviously be a particular point of view. I make no apologies for the biases I hold (which could be summarized as an “Acton bias”) but I do intend to try to present the concepts neutrally whenever possible.