Why they happen, and why they’re bad

Cry “Havoc!” and let slip the dogs of trade war.

Donald Trump’s “Liberation Day” tariffs aren’t just the biggest trade shock in history. They’re also in clear violation of U.S. international agreements, including the General Agreement on Tariffs and Trade (the GATT), a multinational, reciprocal trade agreement that has governed most nations’ trade policies since 1947. In effect, Trump has set fire to a finely balanced mechanism that has fostered the growth of international trade by constraining how countries can set tariffs. In so doing, Trump has set the stage not just for his own tariffs but for retaliatory tariffs by other countries. That is, he has started a global trade war.

This week’s primer will explain why trade wars are bad, and why they can happen anyway. I’ll address the following:

1. The case for low tariffs even if other countries have high tariffs, and the caveats to that case

2. The monopoly power theory of trade wars, which makes economic sense but probably isn’t what’s going on

3. The interest-group theory of trade wars, which most international trade economists probably subscribe to

4. Do we also need a stupidity theory of tariffs?

Rocks, harbors and retaliation

Every introductory economics student learns about the theory of comparative advantage, which says that countries should concentrate on doing what they do relatively well while importing other stuff. Tariffs, according to this theory, are a bad idea because they divert resources away from their most productive use. For example, Trump’s 37 percent tariff on imports from Bangladesh will make our principal import from Bangladesh, clothing, more expensive and divert American capital and labor toward clothing production and away from the advanced technology sectors that are our real strength.

The theory of comparative advantage underlies the case for free trade: letting markets decide what you export and import.

There are caveats to that case. You do want to maintain industries that are essential to national security. You also want to promote industries that generate valuable technological spillovers. So you don’t want to be a free trade purist. There’s a very good case for carefully targeted nationalistic industrial policies like those embodied in the Biden administration’s CHIPS Act and Inflation Reduction Act.

However, “Other countries have tariffs!” is not a good reason to impose tariffs of our own. Joan Robinson, part of John Maynard Keynes’s inner circle and a formidable economist in her own right, made this point pithily in a 1937 essay titled “Beggar-My-Neighbor Remedies for Unemployment.”:

The popular view that free trade is all very well so long as all nations are free-traders, but that when other nations erect tariffs we must erect tariffs too, is countered by the argument that it would be just as sensible to drop rocks into our harbours because other nations have rocky coasts.

Robinson went on to argue that this view needed qualification under depression conditions. But her qualification has nothing to do with Trump’s crude mercantilism. For Trump’s sweeping “reciprocal” tariffs are entirely based on the proposition that we must counter other countries’ high tariffs against the U.S., full stop. This would be bad economics even if his claims about foreign protectionism were true. Furthermore, in reality most of our trading partners other than China — the EU, the UK, Canada, Mexico — impose few barriers to U.S. exports.

But if it’s in nations’ interest to keep tariffs low regardless of what other nations do, why do we need trade agreements like the GATT? One answer is market power. Another, probably more important, answer is the problem of special-interest politics. And I’d argue that trade agreements have played a crucial role in limiting the economic damage from stupidity masquerading as common sense.

Tariffs and market power

Free trade is (with the caveats I’ve mentioned) the best policy for small economies that have little ability to affect world markets. If Denmark were setting its own tariffs on U.S. goods, its best policy would probably be free trade no matter how badly America behaves — in fact, even if we invade Greenland.

But Denmark doesn’t set its own tariffs. It’s part of the European Union, which like the United States has free trade within its borders and sets common tariffs against the rest of the world. And the EU is not a small economy; it’s a very big economy, about 2/3 as big as the U.S. economy.

Why does size matter? Because big economies can affect prices of the goods and services they buy and sell, because they have big effects on supply and demand. Crude oil prices have dropped on fears of a U.S. recession, not just in America but globally, because we’re such a big consumer of oil. Worldwide olive oil prices surged in 2024 because of drought and bacterial infections in Europe, which produces much of the world’s supply.

This ability to affect prices also means that nations with big economies can use tariffs to reduce the prices they pay for imports. This is known as exploiting a nation’s “market power,” and tariffs designed to exploit market power are known as “optimum” — or sometimes optimal — tariffs.

For example, a U.S. tariff on imported oil would reduce our oil demand and lead to a lower price for oil imports. Less directly, tariffs normally strengthen the dollar, so that even if foreign producers don’t cut their prices denominated in their own currencies, they cut them denominated in dollars. Either way, the U.S. has exploited its market power to extract lower prices from countries that sell to us, increasing our purchasing power.

So there is a case, based on completely orthodox economics, for large economies to impose tariffs to exploit their monopoly power. However, this case assumes that other countries won’t retaliate. Yet if America were to try to exploit its market power by imposing tariffs, other large economies like the European Union would do the same thing. This would almost certainly leave everyone worse off.

So how do you avoid a mutually destructive trade war between big economies? Through agreements like the GATT, in which each country promises not exploit its market power.

That said, most analysts, again myself included, don’t think that the market power story is either the main explanation of protectionism or the main reason we need trade agreements. For example, Irwin and Soderbery tried to decompose the factors behind the Smoot-Hawley tariff, the pre-Trump peak in tariff rates, and found that market power considerations explained only about 5 percent of the jump in tariff rates. The rest was political — that is, the power of domestic special interests to influence tariff policy.

Tariffs and special interests

Now that Trump has set our trade agreements on fire, we’re heading back to the bad old days that culminated in Smoot-Hawley, in which tariff rates were driven by intense lobbying by domestic special interests.

Why is this bad? After all, everyone is in a sense a member of a special interest group, so why doesn’t interest-group lobbying end up reflecting the interests of the nation as a whole?

The answer is that some interest groups are more equal than others, because they’re better organized, usually because they involve a small number of players with the greatest financial firepower. This means that domestic producers with deep pockets can lobby effectively to prevent competition from imported goods, while consumers and less powerful producers who benefit from affordable imports can’t.

In my tariff primer I use the example of sugar. U.S. sugar producers are a well-organized lobby that has managed to get the government to impose an import quota (similar in effects to a tariff) that makes sugar much more expensive in the United States than elsewhere. The vast majority of consumers, who are hurt by this policy, have no idea that the quota even exists. As I noted, the sugar import quota is the reason Mexican Coca-Cola, made with cane sugar, tastes better than U.S. Coca-Cola, made with high-fructose corn syrup.

So how, given the power of special interests, did we get to the low tariffs that prevailed before Trump set the world on fire? The credit goes to FDR, who passed the Reciprocal Trade Agreements Act of 1934, which in turn became the template for the GATT. This system is based on reciprocity: each country keeps its tariffs low in return for commitments by its trading partners to keep their tariffs low. And it works politically because it uses the special interests of domestic export industries, which want lower tariffs, to counter the special interests of industries that want higher tariffs.

Now, less than three months into the second Trump administration, that 90-year-old system lies in ruins. It’s only a matter of time before we return to tariff policies dictated by special interests that hurt the economy as a whole.

To be fair, however, special interests didn’t dictate the tariffs announced on “Liberation Day.” There wasn’t time for them to do that, given that Trump reportedly didn’t decide on a tariff plan until three hours before his big Rose Garden speech.

Yet Trump’s tariff rates were driven neither by an attempt to exploit monopoly power nor by special interest lobbying. Rather they are the result of malignant stupidity. How should this affect our understanding of the consequences of Trump’s trade war?

MAGA malignant stupidity and the current trade war

Up to this point I’ve been describing well-established ways to think about trade wars. Unfortunately, they fall short of addressing the current moment. Why? Because they assume that tariffs are set in a game in which all the players are rational — they understand how trade works and act in their own interests, even if the collective effect of these actions is destructive.

But do we really think that Donald Trump’s actions are rational in that sense?

Trump’s world view is based on crude mercantilism. Any economist who has tried to talk about international trade with non-economists knows that crude mercantilism has a lot of gut appeal. The idea that we win when foreigners buy our stuff and lose when we buy their stuff seems like common sense to many people. So does the idea that the reason for our trade deficits must be that other countries aren’t playing fair, that they are somehow taking advantage of our naïve commitment to free trade.

Arguing against these ideas is hard. It’s especially hard to counter the mercantilist ideas of successful business leaders, whose business success renders a false sense of expertise on economic policy. It was not surprising that, in his Rose Garden speech, Trump invoked the memory of Lee Iacocca, the famous auto executive of the 1980s. Iacocca was indeed a great businessman, who held mercantilist views on tariffs similar to Trump’s.

Such views are, however, all wrong. International trade is not a zero-sum game. The idea that it’s always better to produce goods at home is as nonsensical as the view that we should all make our own pasta or raise our own chickens.

By repudiating all of our trade agreements, Trump has made stupidity — his own and, eventually, others’ — great again. He has returned us to a world in which crude, destructive mercantilism can flourish.

In fact, it’s arguably misleading to say that Trump has started a trade war. It might be more accurate to say that by demolishing the world trading system he has unleashed chaos. And the whole world will pay the price.