When Tariffs Make Good Common Sense

Economists don't typically think about national security; instead, they tend to think good policies are those that produce more growth, more employment, and so on. And if those are your objectives, there are definitely still some reasons why tariffs might be a good thing - at least, from a single nation's perspective.

The most common reason is all about national champions. Real-world markets aren't perfectly competitive - some big companies make a ton of profit, by leveraging what economists call increasing returns to scale.

Increasing returns to scale are just anything that gives big companies a cost advantage over smaller ones - maybe network effects, or big fixed costs, or a“superstar” effect that draws in top talent, etc. In a world of increasing returns, the winning companies make a lot of profit, and smaller companies don't.

A country might, therefore, be able to increase its wealth by using tariffs to guard its own“national champion” companies. Basically, the idea is to use tariffs to reduce the scale of foreign companies by denying them your domestic market.

This will allow your own country's national champions to outcompete their overseas rivals, which means they'll capture more of the profit to be had in the market. This is called“strategic trade” policy.

James Brander and Barbara Spencer pointed out this argument for tariffs back in the 1980s. Paul Krugman, who helped develop the leading theory of increasing returns and trade, summarized their work on this topic in 1987:

In fact, there's some evidence that free trade can make a country poorer by destroying its national champions. This is from Sampson et al. (2022) :

The implication here is that if the US had used tariffs to protect certain very oligopolistic industries from Chinese competition back in the early 2000s, America would have been a bit richer.

But again, this argument for tariffs doesn't apply to Trump's recent efforts. First of all, it only applies to industries where there are only a few winners, and thus a lot of profits to be made. That implies, again, that targeted tariffs are the way to go.

Broad, across-the-board tariffs will dilute the effect, through exchange rate appreciation. Trump would have put tariffs on agriculture - a highly competitive industry where there are very few profits to fight over. This approach just doesn't fit the theory of strategic trade.

Second, if you want your national champions to be able to scale up, you probably don't want to start a trade war with your most important allies and trading partners. They will almost certainly retaliate, denying market access to your own top companies.

Canada and Mexico would probably resort to retaliatory measures if their efforts to buy off Trump with symbolic concessions failed. This would limit markets for America's top companies and hurt them in their competition with Chinese rivals.

And finally, if you want to increase your national champions' scale, you can probably get a lot more mileage out of export subsidies than tariffs. Tariffs can hurt national champions by denying them access to cheap production inputs; export subsidies, although they cost more in fiscal terms, don't have this problem.

A lot of people have asked me to address the pro-tariff arguments in this recent blog post by Anthony Pompliano, link here .

Some of Pompliano's arguments in this piece are simply bad. For example, he cites the factory construction boom and the reshoring of the solar industry as examples of American industrial successes driven by tariffs.

But in both of those cases, while tariffs might have been a significant factor, we didn't really see much progress until Biden unleashed industrial policy with the CHIPS Act and the Inflation Reduction Act.

Pompliano also argues that tariffs are less distortionary than income taxes, which is generally true if you're talking about the same tax rate. But if you're talking about raising a set amount of revenue from either income tax or tariffs, then the tariffs are almost certainly much worse.

This is because tariffs are a lot easier to avoid than income taxes; you just buy similar products made elsewhere. Because tariffs are relatively easy to avoid, they don't raise a lot of revenue. And so if you want to use tariffs to raise, say, $1 trillion a year for the US government, you're going to need to set the tariff rates very high. And that will be very distortionary.

But anyway, Pompliano's strongest argument is that tariffs for infant industries were useful for America's economic development back in the 19th century:

This is what economists call an“infant industry argument”. Basically, American leaders in the early days of the republic wanted to promote the creation of new industries in the US Alexander Hamilton wrote his famous“Report on Manufactures” in 1791.

He argued that tariffs would allow domestic champions to achieve sufficient scale to compete with foreign companies - very consistent with the strategic trade theory that would be developed a century later. Hamilton also argued that sheltering new American industries from competition would give them time to learn more about how to compete with established foreign rivals.

Infant industry arguments are certainly plausible in some cases - Pompliano certainly exaggerates when says that tariffs built America, but they probably did help some key American industries get off the ground instead of being replaced by floods of British imports.

But here too, the specifics of Trump's plans are at odds with the economics. Once again, the economic argument is for targeted tariffs in very specific cases - in this case, new industries facing competition from big foreign incumbents. Trump's across-the-board tariffs are almost entirely targeting non-infant industries. (Also, in general, import quotas are more helpful for infant industries than tariffs.)

So those are the three basic arguments in favor of tariffs - national security, national champions, and infant industries. All of them are pretty solid arguments, though they all imply that Trump's preferred approach to tariffs is highly suboptimal. But there are some other interesting arguments about tariffs floating around, which deserve a mention.

One of these is Michael Pettis' theory that tariffs on China will help to correct global trade imbalances, and could force China to change its economic model to a more consumption-focused one. I wrote about this idea here .

Basically, I think this makes sense as a China-specific political-economic argument. The idea, I think, is that if tariffs force Chinese companies to focus more on their domestic market, then Chinese companies will quickly become unprofitable (due to overproduction and over-competition).

This unprofitability could prompt China's government to reduce its subsidies for industrial overproduction. That's my personal interpretation of Pettis' ideas, and I'm not sure how plausible it is, but it's certainly an interesting thought. I would note, however, that this is a purely China-specific idea, rather than a justification for tariffs on Mexico and Canada.

Another theory, courtesy of Sam Hammond , is that tariffs are the first step in a forced de-dollarization of the global economy:

I don't put much credence in this theory. The reason, as I've explained a number of times, is that tariffs make the US dollar more expensive, not less.

So anyway, I think national security, plus the classic economics justification for tariffs - strategic trade and infant industry protection - are still the best arguments in favor of tariffs. And all of them cast doubt on the kind of tariffs Trump is threatening to do. Even if some kinds of tariffs are good in some situations, Trump's threatened tariffs on Canada and Mexico are extremely unlikely to be those.

This article was first published on Noah Smith's Noahpinion Substack and is republished with kind permission. Become a Noahopinion subscriber here.

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