Trade and Tariffs: What Would Adam Smith Say?
Amidst recent supply chain challenges, export restrictions for medical treatments, and geopolitical instability, a greater political push for protectionist trade policies have taken root. Although the roots of a protectionist trade agenda long precede the pandemic, it has become more salient and entrenched in political discourse in recent years, both on the left and right of the political spectrum. U.S. President Joe Biden’s “Buy America” agenda, which seeks to limit government purchases to domestic firms, represents a continuation of the tariffs and trade wars initiated by President Donald Trump. At the core of this new trade agenda is the idea that restricting imports can increase national wealth and the gains from trade. This is not a new idea — as far as the 18th century, European nations sought to have a favourable trade balance by exporting as much as possible and limiting their imports. Adam Smith, the founder of modern economics, writing in this period of mercantilism argued that foreign trade, not the mercantile system, increases the real revenue and wealth of a society. Drawing on Smith’s 1776 book, An Inquiry into the Nature and Causes of the Wealth of Nations, I highlight that Smith saw free trade as the best way for nations to create wealth and prosperity. However, Smith was also a realist about power and understood that, in certain circumstances, nations should restrict trade for the purpose of national defense.
Smith’s support for free trade stemmed from his belief that private vices lead to public virtues. Specifically, the self-interest of individuals to produce what is of the greatest value directs capital towards industries that maximize national wealth (Smith, 1776: 477). In pursuit of productivity and maximal wealth, individuals specialize, leading to a division of labour in society. This division of labour necessitates the exchange of products and services; the tailor must exchange with the shoemaker and the farmer at a price of a part of his output. A country thus becomes a market society as individuals make products or deliver services of value at a cost lower than had they not specialized. Smith notes that as individuals are made richer through the division of labour and exchange, a nation can also increase its wealth through specialization and foreign trade (Smith, 1776: 479). By specializing in areas where a nation has natural or acquired advantages and purchasing foreign goods it requires at a price lower than what it costs to make at home, the industry of a society increases its capital and wealth.
Smith explains that although good wines can be made in Scotland, it would be absurd to turn to employment much costlier than the price at which it can be imported (Smith, 1776: 478). A simple model of trade of two goods between two countries illustrates this point. With a fixed capital stock, Stockland can make 15 bottles of wine or 45 pounds of potatoes and Portugal can make 40 bottles of wine or 60 pounds of potatoes (Table 1).
If Scotland is seeking to maximize its wealth, it should specialize in making potatoes and buy its wine from Portugal. It costs Scotland 1/3 a bottle of wine per pound of potato, while it costs its neighbour Portugal 2/3 a bottle/pound. With its comparative advantage, Scotland could sell the potatoes it does not consume at home to Portugal at a price higher than it costs to make potatoes in Scotland and lower than the cost for Portugal. Scotland could also buy wine at a lower price than had it made wine at home. For example, if Scotland consumes 20 potatoes and sells 25 to Portugal for 0.6 bottles of wine per potato, a price lower than what it costs Portugal to make potatoes, Scotland acquires 15 bottles of wine, the equivalent number of bottles it would have made had it just concentrated on wine production. Portugal also benefits because it sells its wines to Scotland at a price higher than it cost to make. As Smith notes, both countries benefit and are made richer through specialization and trade. He writes, “as long as the one country has those advantages, and the other wants them, it will always be more advantageous for the latter, rather to buy of the former than to make” (Smith, 1776: 478).
Smith wisely advocated against tariffs, because of their disorienting effect on capital. As the capital of a country is fixed, a tariff does not create wealth, rather it creates an incentive to divert capital into an industry which it might not have gone (Smith, 1776: 481). By substituting an invisible hand for an intervention by a statesman, the market incentives of individuals would lead some market actors to make wine when it would be more productive to make potatoes. Smith says that tariffs have a cost to society, as they create a monopoly in the home market, allowing industries that would have not been competitive in a global market to survive. Protecting inefficient domestic firms through these policies increases prices and diminishes the national wealth, making the country poorer than it would have been had the tariff not been implemented (Smith, 1776: 481). As such, Smith would disagree with the recent rise of protectionism, viewing it as a policy contrary to the accumulation of the wealth of nations.
Smith’s theories on free trade do not exist in the abstract; the pursuit of free trade has made individuals and nations more prosperous. Due to increased trade liberalization since 1945, U.S. annual incomes are $1 trillion higher or $9,000 per household. It is estimated that removing additional trade barriers in the U.S. can increase incomes by $4,500 per household (US Trade Representative, 2008). In Europe, the creation of a single market has saved the average European consumer €600 a year, not counting the gains from lower prices (WTO, n.d.). And in Canada, incomes are higher by 15 to 40 percent thanks to free trade (Bank of Canada, 2020). It is no coincidence that the largest increase in wealth, as witnessed over the past 70 years, has corresponded with reductions in tariffs and an increase in global trade. Protectionist policies, while beneficial to a few domestic firms, seek to reverse the trade and investment deals that have expanded global trade, and would thereby make the average citizen poorer.
While Smith goes to great lengths to defend free trade and rally against tariffs, his views on protectionism are not one-sided. Smith also argues that trade should be restricted when an industry is necessary for the defense of a country (Smith, 1776: 485). At the time Smith was writing, Britain had measures to protect its power in the seas through the Act of Navigation of 1651. Parts of the act required imports of products to be done through British ships. These were efforts to protect British shipping against its competitors, the Dutch (Smith, 1776: 486). Smith acknowledges that this policy is not favourable to trade and the creation of wealth, but given defense is of greater importance than opulence, he argues that such regulations are wise, as they protect a domestic industry from foreign competition.
Few protectionist policies in recent years correspond with Smith’s limited scope of permissible tariffs. In 2018, President Trump introduced 25% tariffs on imported steel and 10% on imported aluminum, arguing that these were necessary for national security. The Trump administration said that the steel and aluminum sectors are critical for the US military and that the flooding of steel into the market by China was hurting the domestic industry (CNBC, 2018). The policy had the intended outcome of reducing imports, but it also hurt downstream sectors, like manufacturers which rely on low steel and aluminum prices to remain globally competitive. Higher prices in the manufacturing sector have been attributed to 75,000 fewer American jobs (PBS, 2020). Although the tariffs led to job losses and price increases, Smith would have likely supported these tariffs, recognizing that no country can strive for economic prosperity with a weakened national defense.
Nonetheless, most protectionist policies are driven by political impulses and lobbying by merchants and individuals who benefit from trade protection, as Smith acknowledges (Smith, 1776: 493). After living through a prosperous post-war period of free trade that contributed to immense wealth creation, nations are increasingly seeking to impose more tariffs and withdraw from trade agreements. Proponents of protectionist policies today employ the language of mercantilists from centuries past, arguing that restricting imports and promoting exports is how wealth is created. Using Smith’s theories, we can conclude that protectionism is a bad policy that hurts the average citizen. The heavy-handed role of the statesman distorts the private interest of individuals, turning away capital from producing the highest-value goods and services to what is of a lower value. To create wealth, nations should pursue more free trade, not less.
This article won the 2nd prize in the Fraser Institute’s 2022 Student Essay Contest.