Tariffs Are as American as Apple Pie

Listening to hysterical commentary from the mainstream media about President Trump’s tariff proposals, one would think his policies were in violation of the U.S. Constitution. Nothing could be further from the truth.

In fact, tariffs are as American as apple pie.

America grew rich and powerful from 1787–1962, a period of 175 years, using tariffs, subsidies and other barriers to trade to nurture domestic industry and protect high-paying manufacturing jobs.

The passage of the U.S. Trade Expansion Act in 1962 authorized the White House to reduce those tariffs in rounds of international negotiations. Such tariff reductions marked the unilateral surrender of U.S. jobs to foreign competitors, first in Japan, then later in South Asia and finally in China.

Your correspondent and a Chinese computer scientist wearing lab coats inside the highly secure Huawei research facility near Nanjing, China. Huawei is China’s national champion in the fields of networking and telecommunications. Huawei has been banned from making tech acquisitions in the U.S. because of suspected ownership and control of Huawei by the People’s Liberation Army and other elements of the Communist Chinese government. The U.S. has not explicitly supported national champions in the postwar era, but that policy may be changing with U.S. rejection of the takeover of U.S. smartphone chipmaker Qualcomm by Chinese-controlled Broadcom.

By the 1970s, cheap Japanese automobiles were flooding the United States and decimating U.S. auto manufacturing jobs in Detroit. In the early 1980s, Ronald Reagan imposed steep tariffs on Japanese, German and other auto imports to the U.S. This resulted in Japanese manufacturers like Honda and Toyota moving their manufacturing operations to Kentucky, Indiana, Alabama, Texas and other parts of the United States.

German car manufacturers such as BMW did the same, building large auto plants in South Carolina.

As mentioned above, the architect of those tariffs on Japanese and German cars in the 1980s was Robert Lighthizer, a trade adviser to Ronald Reagan. Lighthizer is now back in the Trump administration. Except this time he’s the U.S. trade representative, a Cabinet-level position with the rank of ambassador.

Lighthizer is running the Reagan playbook again for Trump. It is the same basic playbook that predominated in U.S. policy from George Washington forward.

Washington’s secretary of the Treasury, Alexander Hamilton, drafted a report to Congress called the Report on Manufactures presented in 1791. Hamilton proposed that in order to have a strong country, America needed a strong manufacturing base with jobs that taught skills and offered income security.

To achieve this, Hamilton proposed subsidies to U.S. businesses so they could compete successfully against more established U.K. and European businesses.

These subsidies might include grants of government land or rights of way, purchase orders from the government itself or outright payments. This was a mercantilist system that encouraged a trade surplus and the accumulation of gold reserves.

Hamilton’s plan was later proposed on a broader scale by Kentucky Sen. Henry Clay. This new plan began with the Tariff of 1816. Clay’s plan was called the American System. Abraham Lincoln adopted the American System as his platform in the election of 1860, and it became a bedrock principle of the new Republican Party.

The 19th and early 20th centuries were a heyday of the American System. This period was characterized by enormous economic growth and population expansion by the U.S. The American System was also accompanied mostly by low inflation or even deflation (which increases the purchasing power of everyday citizens) despite occasional financial panics and some inflation during the Civil War.

Against this mercantilist system was a theory of free trade based on comparative advantage as advocated by British economist David Ricardo in the early 19th century. Ricardo’s theory said that trading nations are endowed with attributes that gave them a relative advantage in producing certain goods versus others.

These attributes could consist of natural resources, climate, population, river systems, education, ports, financial capacity or any other factor of production. Nations should produce those goods as to which they have a natural advantage and trade with other nations for goods where the advantage was not so great.

For example, if the U.K. had an advantage in textile production and Portugal had an advantage in wine production, then the U.K. and Portugal should trade wool for wine.

The problem with this theory of comparative advantage is that the factors of production are not permanent and they are not immobile.

If labor moves from the countryside to the city in China, then suddenly China has a comparative advantage in cheap labor. If finance capital moves from New York banks to direct foreign investment in Chinese factories, then China has the comparative advantage in capital also.

Before long, China has the advantage in labor and capital and is running huge trade surpluses with the U.S., putting Americans out of work and shutting down U.S. factories in the process.

Worse yet, countries such as China can pull comparative advantage out of thin air with government subsidies, exactly as Hamilton proposed 227 years ago. The most famous example of this is Taiwan Semiconductor.

In the 1970s, Taiwan had no comparative advantage in semiconductor production. But with government subsidies to a national champion, today Taiwan Semiconductor is the largest supplier of semiconductors in the world.

Beginning in 1962, the U.S. turned its back on a successful legacy of protecting its jobs and industry and embraced the free trade theory. This was done first through the General Agreement on Tariffs and Trade, or GATT, one of the original Bretton Woods institutions in addition to the World Bank and IMF.

Beginning in 1995, the World Trade Organization, WTO, displaced GATT and has been the main venue for U.S. free trade policy ever since. China became a member of WTO on Dec. 11, 2001, but has notoriously broken many WTO rules since joining.

The switch in U.S. policy from quasi-mercantilism to free trade was driven partly by academics who embrace the simple version of free trade without understanding the flaws (exemplified by China and Taiwan).

The other supporters of free trade are globalists who understand the flaws well enough but value world jobs over U.S. jobs. If two or three jobs are created in China for every job lost in the U.S., the globalists consider that a form of progress toward their “one world” utopia.

Globalists are often supported by major international firms in the pharmaceutical and other businesses that profit from global supply chains even as Americans lose their jobs.

(I refer you to Charles Hugh Smith convincing case that classical free trade theory no longer applies in today’s hyper-connected markets).

Trump is different. Trump focuses on restoring lost U.S. jobs even if the cost to China is high. That’s China’s problem, not ours. Trump’s policy is “America First,” and he means it.

The globalist approach might work if everyone were a free trader and no one resorted to tariffs, subsidies, nontariff barriers to trade and theft of intellectual property. Unfortunately, that’s not the world we live in.

We live in a world where the U.S. is a free trade sucker and everyone else breaks the rules. In a world where a few parties are free traders but most are mercantilists, the mercantilists win every time. They are like parasites sucking the free traders dry.

Trump intends to put a stop to this and restore American manufacturing and technological innovation. He will use five main channels:

1. Impose tariffs on imports that are subsidized by trading partners.

2. Subsidize U.S. industries to help them compete globally.

3. Use nontariff barriers such as regulation and inspection to block certain foreign imports.

4. Penalize trading partners for theft of intellectual property.

5. Block the takeover of sensitive U.S. technology using the Committee on Foreign Investment in the United States, CFIUS, to block such deals.

Taken together, this five-point plan will result in the anointing of certain companies as U.S. national champions in certain industries.

In steel production, the national champions are U.S. Steel and Nucor. In aircraft production, our national champion is Boeing. In semiconductors, the new national champion is Qualcomm.

Investors who selectively invest in these national champions at the right entry point will earn outsized returns as the trade wars drag on and escalate.

Regards,

Jim Rickards
for The Daily Reckoning