June 2, 2020 Reading Time: 5 minutes

As I and other economists never tire of pointing out, the case for free trade at home does not depend on other governments allowing free trade abroad. Economic prospects of the home country rise whenever the home government adopts a policy of free trade regardless of the policies of other governments. As Paul Krugman – who’s no one’s idea of a libertarian – wrote in 1997,

The economist’s case for free trade is essentially a unilateral case: a country serves its own interests by pursuing free trade regardless of what other countries may do. Or, as Frederic Bastiat put it, it makes no more sense to be protectionist because other countries have tariffs than it would to block up our harbors because other countries have rocky coasts.

Repetition of this truth is necessary because it seems never to sink in. So I here again try my hand at making the argument.

The Kernel of Truth

The kernel of truth in the case against unilateral free trade is that interventionist economic policies of foreign governments can cause negative economic consequences in the home country. For example, suppose Beijing adopts industrial policy which includes tariffs on American exports of machine tools. By reducing the number of buyers in China of American-made machine tools, American manufacturers are discouraged from enlarging the scale of their operations. It makes no sense under these circumstances to build factories as large and as ‘efficient’ as would be profitable were the number of buyers in China greater. Operating at smaller scales might, in turn, mean higher per-unit costs of production of machine tools and, hence, higher prices paid by American buyers of machine tools.

And so (the argument against unilateral free trade continues) because retaliatory imposition of our own tariffs can inflict on foreign countries the kinds of damage that interventionist policies abroad inflict on us, our use of tariffs might pressure foreign governments to abandon their economic interventions.

This conclusion is then drawn: For our government to adopt free trade unilaterally is for it to foolishly renounce a policy option that might be useful for pressuring foreign governments to stop harming us.

Precisely because international trade makes people in different countries economically dependent upon each other, trade does indeed transmit from country to country some of the ill consequences of bad policies pursued by different governments. And as a matter of logic, retaliatory tariffs imposed by the home government might then prompt foreign governments to lower their tariffs and, thus, improve economic performance both abroad and at home.

But government policy is carried out according to a logic quite different from that which guides individuals operating in private markets. Government intervention into economic affairs is almost always driven by economic ignorance mixed with interest-group pressures. It’s a mistake to think of any government as a logical leader pursuing in a well-informed manner maximum possible well-being for citizens.

Governments impose tariffs, dole out subsidies, and use other pieces of industrial policy in large part because these policies create significant benefits that are captured by a relatively small number of politically influential interest groups. But because the always-greater costs of these policies are spread out over the whole of the country’s population, these costs are unseen and unnoticed.

The indiscernibility of these costs is further assured by the fact that the interventions that create them are sold to the public – and swallowed by the public (and by many public intellectuals) – as ones that make the economy and populace richer. Widespread economic ignorance virtually guarantees that whatever economic discomforts ordinary people do experience are blamed, not on the interventions that cause them, but on markets that manifest these problems.

The (Il)Logic of the Interaction

The accompanying figure distills the “logic” of the governments of two countries interacting with each other over their respective economic policies.

On the north-south axis and in blue is the U.S.A. On the east-west axis and in red is China. Each of the four boxes contains two numbers, each one a measure of a country’s economic performance. (For simplicity, you can think of the numbers as monetary figures.) The blue number in each box’s northwest corner shows U.S. economic performance. The red number in each box’s southeast corner shows Chinese economic performance. The absolute value of these numbers is meaningless. What matters is the value of one number relative to any of the others. 

In this simplified example, each government pursues one of two policies: free market or industrial policy. If each country’s market is free, economic performance in each country is 1,000. This outcome – the best one possible – is shown in the box in the upper left of the figure.

Now, however, suppose that Beijing pursues industrial policy. That policy will significantly worsen the performance of China’s economy. But because the U.S. and Chinese economies are somewhat integrated with each other through trade, the degree to which China’s economy suffers depends upon what happens in the U.S. If America sticks with free markets, some of the benefits of these free markets continue to be shared with the Chinese people. Beijing’s use of industrial policy will thus cause Chinese economic performance to fall ‘only’ from 1,000 to 500.

But if the U.S. government retaliates with its own industrial policy, the performance also of the U.S. economy will worsen. And this worsening of U.S. economic performance will further worsen the performance of China’s economy. Industrial policy pursued in both countries causes economic performance in each country to be 200, as shown in the box in the lower-right-hand-corner.

When pundits and politicians in America insist that Beijing’s use of industrial policy creates the need for industrial policy in America, they see only the harm that Beijing’s policy inflicts on Americans. That is, they see only the reduction in American economic performance from 1,000 to 900 (as seen when moving from the northwest box to the northeast box). 

But what American industrial-policy proponents don’t see is much more important. They don’t see that industrial policy pursued in China inflicts far more harm on the Chinese economy than on the U.S. economy. And their failure to see this reality blinds American industrial-policy advocates also to the reality that use of industrial policy by the U.S. will only further worsen American economic performance.

If the U.S. retaliates against Chinese industrial policy with American industrial policy, both countries end up in the box in the lower right-hand corner – for each, the worst possible outcome.

But won’t American industrial policy – by further worsening Chinese economic performance – pressure Beijing into abandoning industrial policy? Again, logically this possibility exists. Yet when the reasons for adopting industrial policy are revealed, the practical answer becomes ‘no.’

Beijing’s reason for adopting industrial policy is a mix of two notions. One is a sincere belief that this policy improves the performance of China’s economy; the second is the itch to bestow privileges on certain producers. And so although America’s retaliatory adoption of industrial policy will indeed further worsen China’s economy, there’s no cause to think that Chinese officials will come to understand that they would improve their economy by abandoning industrial policy. Even less is there cause to think that favored Chinese producer groups would lose their political influence. Beijing will stick with industrial policy.

The figure above shows what are in practice the relative values of free trade and industrial policy. Each country is indeed harmed by the other pursuing industrial policy. Nevertheless, the best course for each government – if it truly wishes to ensure maximum economic performance at home – is to keep its market free regardless of policies pursued abroad. 

Donald J. Boudreaux

Donald J. Boudreaux

Donald J. Boudreaux is a Associate Senior Research Fellow with the American Institute for Economic Research and affiliated with the F.A. Hayek Program for Advanced Study in Philosophy, Politics, and Economics at the Mercatus Center at George Mason University; a Mercatus Center Board Member; and a professor of economics and former economics-department chair at George Mason University. He is the author of the books The Essential Hayek, Globalization, Hypocrites and Half-Wits, and his articles appear in such publications as the Wall Street Journal, New York Times, US News & World Report as well as numerous scholarly journals. He writes a blog called Cafe Hayek and a regular column on economics for the Pittsburgh Tribune-Review. Boudreaux earned a PhD in economics from Auburn University and a law degree from the University of Virginia.

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