This month marks the 250th anniversary of the publication of Adam Smith’s masterpiece, The Wealth of Nations. The Freedom Fund print edition is 950 pages long (excluding material added by the editors), and nearly every page is filled with wisdom. Despite some flaws, we rightly praise this book as a monumental leap forward in human understanding.
As a trade economist, I tend to focus on Volume 4, “Systems of Political Economy.” There, Smith expertly analyzes and rebuts the mercantilism and protectionism debate. At the end of Volume 4, Smith claims:
“Therefore, when all institutions of preference or restraint are completely removed, a clear and simple institution of natural liberty establishes itself.Every man is free to pursue his interests in his own way, and to produce his own goods, so long as he does not violate the laws of justice. The sovereign is left with complete freedom to bring both industry and capital into competition with other men or orders of men.The sovereign is…completely freed from the obligation to supervise private industry and direct it to society’s interests.
Smith was a very free trader. He was categorically opposed to tariffs aimed at destroying the natural flow of trade (paid tariffs were less unpleasant, but still not great). However, Smith’s approach allows for some exceptions. He discusses them on pages 463-471 (much has been written about these exceptions; see, for example, my collection of Adam Smith’s works, Did Adam Smith Support the Jones Act?, and Don Boudreau’s discussion in his book Globalization). Among these exceptions is a “matter of deliberation” as to whether tariffs that restrict freedom of trade are beneficial. Smith argues that temporary tariffs may be desirable if they can be used as retaliation for opening up trade with other countries (i.e. eliminating tariffs).
“There may be good policy in this type of retaliation, if it involves the possibility of reimposing the high tariffs and prohibitions accused. In general, the recovery of great foreign markets will more than compensate for the temporary inconvenience of paying high prices for certain goods in a short period of time” (p. 468).
However, Mr. Smith argued that if such abolition is not possible, it is best to continue without tariffs (ibid.). Negotiations like this are difficult. After all, negotiations are not conducted on the basis of principles, but rather “on the basis of the abilities of that insidious and cunning animal, commonly called statesman or statesman, whose councils are directed by the temporary fluctuations of circumstances” (ibid.). World conditions, personal interests, and other factors influence the outcome of tariff negotiations.
The argument Smith develops here has also come to be known as “clover theory” or “positive unilateralism.” Under certain conditions, it may work. If country A is large enough, it can impose a tariff on country B, which improves A and B’s terms of trade. Since B and A’s terms of trade are reciprocal, an improvement in A’s terms of trade necessarily means a deterioration in B’s terms of trade. Company B, seeking to avoid this beggar-your-neighbor outcome, will have an incentive to negotiate with Company A. Almost every trade economist who has considered this theory has dismissed it as a viable alternative for much the same reasons as Smith: political self-interest often overrides the principle: tariffs may not be adjusted, Company B may retaliate purely out of malice, etc. Rather than relying on tariffs, it is far better to keep them low and address any problems that may arise at their source. Trade-distorting tariffs.
Historically, however, aggressive unilateralism has had a mixed track record of success. In many cases where tariffs have been used as cloud bars to pry open markets, they have failed miserably, leading to trade wars and, in some cases, shootouts. Two examples immediately come to mind. Smith cites the war between France and the Netherlands in the 1670s as a failure of aggressive unilateralism. More recently, Italy tried to use tariffs to force France to open its market, resulting in the Franco-Italian Tariff War of 1887-1898. It ended in Italy’s economic crisis.
Nevertheless, Franklin Delano Roosevelt succeeded in using aggressive unilateralism to defuse the trade war started by the Smoot-Hawley tariffs. Indeed, steps taken in the late 1930s led to the general rise of free trade and free trade agreements that would come to define the second half of the 20th century.
Why did Roosevelt succeed when so many others failed?I think the answer can be found in Adam Smith. In a future research paper, I will argue that Smith is ultimately making an institutional point. The success or failure of active unilateralism depends on the institutions in which negotiations take place. In other words, how does the system coach the skills of “that insidious and cunning animal” to ignore temporal matters and follow liberal principles?
Let’s think about things from a game theory perspective. Trade negotiations can be modeled as a simple prisoner’s dilemma problem. The two negotiators at the table each choose between cooperation (lower tariffs) or default (higher tariffs). The figure below is a simplified visualization.
If both countries work together, it will be the best outcome (+,+). Both countries benefit from lower tariffs. If A becomes defective while B cooperates, A’s situation improves significantly (++) and B’s situation worsens significantly (-). If B loses power while A cooperates, that is, if B loses power while A cooperates, B is better off and A is worse off. If they both fall out of power, the situation for both will get worse (there is a trade war going on).
The formal outcome of the Prisoner’s Dilemma problem is that the selfish individual will choose the default no matter what the other players choose. As a result, the positions of both parties deteriorate, creating a stable but suboptimal equilibrium.
Proponents of aggressive unilateralism use the logic of the prisoner’s dilemma to justify tariffs: cooperation is the best outcome. Therefore, a negotiation can occur if both sides agree to cooperate (a binding agreement is one way out of the Prisoner’s Dilemma).
But that argument breaks down when we consider the actual model. With active unilateralism, the first move already indicates that he will defect (or have defected). So we’re firmly in column two. Country B has a choice. Do I work together and hope that Country A keeps its word? Otherwise, we will be in a worse situation than if we just defected. If B cannot expect A to ultimately cooperate, B’s logical action is to retaliate. Thus, aggressive unilateralism collapses and a trade war begins.
But if B can get a credible promise from A to de-escalate, the calculus changes. B Now you have an incentive to cooperate. A credible commitment to de-escalation comes from A’s organizational context.
In 1933, representatives from 66 countries met in London to discuss how to defuse a trade war that had engulfed the country. They left without making any deal. But by 1934, FDR was trading left and right. Between 1934 and 1939, FDR signed 19 trade agreements. What has changed in that one year? The organizational structure in which FDR operated.
In 1934, Congress passed the Reciprocal Trade Agreements Act (RTAA). Prior to the RTAA, tariffs were generally considered a tax system and were set by Congress without foreign policy considerations. If a tariff is used to pry open a market, it becomes a treaty and must be ratified by two-thirds of the Senate. Partisan concerns, special interests, and other public issue issues could easily derail any tariff cuts negotiated by the president. In other words, there may not be a credible commitment to de-escalation. But Congress delegated some of that power to the president. This allowed tariff negotiations to become executive agreements, subject to a simple majority in Congress. The corresponding burden will be much lower and it will be much harder for special interests to interfere. The RTAA changed the institutional framework and established a credible commitment to de-escalation.
Mr. Smith was understandably concerned about the prospects for free trade. Political self-interest would be too strong. But as we saw in 1934, the institutional framework can change those outcomes.
Read more:
“The Trade War: A Comparative Study of the Angle-Hanse, French-Italian, and Hawley-Smoot Conflicts,” by Douglas Irwin, “Trade Wars: A Comparative Study of the Angle-Hanse, French-Italian, and Hawley-Smoot Conflicts,” by John Conybeare. World Politics, 38(1) 1985, pp147–172. The Institutional Roots of American Trade Policy: Politics, Coalitions, and International Trade, by Michael A. Bailey, Judith Goldstein, and Barry R. Weingast. World Politics, 49(3) 1997, pp. 309-338.
Source link
