The proposals outlined in Warren’s plan are wide-ranging. Broadly speaking, it jettisons “free market principles” in favor of protectionist trade policies to “defend American jobs” and other “aggressive interventions” aimed at curbing wealth inequality and corporate power.
Surprisingly, the plan has received some bipartisan support. Tucker Carlson endorsed the broad strokes of the plan, arguing that Warren’s proposal “sounds like Donald Trump at his best.” Despite some (in most cases, cosmetic) differences, the plan essentially constitutes a progressive rebranding of President Trump’s “America First” policies. Both denounce laissez-faire and call for strategic tariffs and steep penalties for corporations that move jobs and factories overseas.
President Trump began imposing multilateral tariffs in January 2018. Over the past 18 months, the self-proclaimed Tariff Man has doubled down as other nations responded with retaliatory tariffs on U.S. products. In May, the president announced steep new tariffs on China and Mexico.
As I have explained in the past, higher tariffs (and the dwindling supply of foreign goods that result from such tariffs) amount to a negative supply shock. Much like a natural disaster, tariffs force Americans to devote higher-cost resources to produce the goods previously purchased from foreigners. The prices of tradable goods increase. The prices of many “domestic” goods increase as well, since many of the intermediate goods and services that go into making domestic goods are produced abroad.
How the Fed responds to higher tariffs depends, in part, on the economic indicator it chooses to target. If the Fed continues to primarily target inflation, the higher prices caused by trade restrictions will require it to engage in contractionary monetary policy, reducing nominal spending and exacerbating the fall in real GDP.
If the Fed, instead, were to adopt a nominal GDP target, the results would be less dire. The price level would rise and real GDP would fall in line with the negative supply shock (i.e., tariffs), but no additional reductions in real GDP would follow.
In both cases, output declines. The trade war reduces production. But the fall in real GDP is much smaller under a nominal GDP target than it would be if the Fed were focused narrowly on inflation. Unfortunately, Fed officials seem intent to maintain an inflation targeting regime. Although nominal GDP targeting has gained enormous support over the past decade, the increased intellectual support has had little effect on Fed policy.
In considering the appropriate course of action for the Fed, one should not ignore the root problem. We would be much better served by avoiding a trade war altogether. Trade is a type of technology. It allows us to do more with less. The ultimate effect of protectionist policies is to erode the global division of labor that has so greatly enriched the world. Protectionism stunts economic growth. Individuals, both foreign and domestic, will be poorer under protectionism than they might otherwise be.
Alas, a new protectionist order seems likely, as both the current president and those hoping to defeat him in 2020 are leaning in that direction. So, while we should continue to warn of the dangers of protectionism, we should also think seriously about how the Fed should operate in a more-protectionist world. The Fed’s current framework, which puts too much emphasis on inflation, will tend to exacerbate the damage done by a trade war. Nominal spending targeting is a superior and, yet, feasible alternative.