Adam Smith and Reciprocal Tariffs

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This month marks the 250th anniversary of Adam Smith’s magnum opus, The Treasure of Nations. The Liberty Fund print edition is 950 pages (not including editorial additions) and almost every page is chalk full of wisdom. Although there are some flaws, we rightly celebrate this book as a reminder that transcends human understanding.

As a trade economist, I tend to focus on Book IV, of Political Economy Systemswhere Smith dismantles and brilliantly refutes the arguments of mercantilism and protectionism. At the end of Book IV, Smith says:

Therefore, all systems of choice or self-restraint, as they are completely removed, the plain and simple principle of natural liberty does itself. Every man, so long as he does not violate the laws of justice, is left perfectly free to pursue his own interests in his own way, and to bring both his industry and money into competition with that of any other man, or private policy is entirely excluded from private industry. people, and to direct it to activities most suited to the public interest” (p. 687).

Smith was a very liberal trader. He strongly resisted taxes designed to disrupt the natural flow of trade (the revenue was less acceptable, but still not large). However, Smith’s approach allows for exceptions. He discusses them on pages 463–471 (much has been written about these situations. For example, see my book Adam Smith Works Episode “Would Adam Smith have supported the Jones Act?” or Don Boudreaux’s discussion in his book Globalization). Among the exceptions, there is a “debatable issue” about whether tariffs that restrict free trade are beneficial. If tariffs can be used in retaliation to open trade with another country (ie, to remove their prices), then Smith argues that temporary tariffs would be desirable:

“There may be good policy in reprisals of this kind, when there is a chance that they will receive the abolition of the high duties or the prohibition complained of. The acquisition of a large foreign market will often more than compensate for the temporary inconvenience of paying more in a short time for other kinds of goods” (p. 468).

However, if such repeal was not possible, Smith argued that it would be better to continue without taxes (ibid). Negotiating this way is difficult. After all, the negotiations were not made with a goal but rather “with regard to the ability of that hidden and cunning animal, called by slander the official or the politician, whose councils are guided by the temporary change of affairs” (ibid). World affairs, personal interest, and other factors will influence the outcome of tax negotiations.

The argument that Smith puts forward here is also known as “Crowbar Theory” or “Aggressive Unilateralism.” Under certain circumstances, it can work: if Country A is big enough, it can charge Country B tariffs that will make A’s terms of trade with B better. Since B’s terms of trade are the same as A’s, A’s trade terms improve means that B’s terms of trade deteriorate. B, wanting to avoid this beggar-thy-neighbor outcome, will be encouraged to negotiate with A. Almost all commercial economists who have considered this theory reject it as a viable alternative, for the same reason Smith has: political self-interest will often override principles: taxation may be unfairly distributed, B may be better able to retaliate, etc. for any problems that may arise at their source rather than relying on available trading capital.

Historically, however, aggressive unilateralism has had a mixed record of success. In many cases where tariffs were used as a crowbar to open markets, they failed miserably, leading to trade wars or, in some cases, shooting wars. Two examples come readily to mind. Smith cites the war between France and the Dutch in the 1670s as a violent conflict gone wrong. More recently, the Franco-Italian Tariff War of 1887-1898 occurred because Italy tried to use tariffs to force France to open its markets. It ended in an economic crisis in Italy.

However, Franklin Delano Roosevelt successfully used aggressive unilateralism to end the trade war started by the Smoot-Hawley Tariffs. In fact, the actions taken in the late 1930s would lead to the general growth of free trade and free trade agreements that would be seen in the second half of the 20th century.

Why did Roosevelt succeed where many others failed? The answer, I think, can be found in Adam Smith. In a forthcoming working paper, I argue that Smith ultimately makes an institutional point. The success or failure of aggressive unilateralism depends on the institutions under which negotiations take place. That is, how do institutions direct the faculties of “that wily and crafty beast” to transcend temporal affairs and pursue the principles of freedom?

Let’s consider things from a game theory perspective. We can model trade negotiations as a simple prisoners’ problem. Two negotiators at a table, each with a choice to cooperate (lower prices) or defect (raise prices). The figure below is a simplified illustration:

If both countries cooperate, that is a very good result (++). Both countries benefit from low taxes. If A is disabled while B cooperates, A is made better off (++) while B is made worse off (-). A reciprocal effect will follow if B has a problem while A is cooperating—that is, if B has faults while A is cooperating, B is made better off and A is made worse off. If both are disabled, both are made worse (we have a trade war).

A formal consequence of the prisoner’s dilemma is that, regardless of what the other player chooses, the individualist will choose to slack off. As a result, both parties are made worse off, resulting in a stable but less than optimal equilibrium.

Proponents of aggressive unilateralism use the concept of the prisoner’s dilemma to justify tariffs: cooperation, cooperation is the best outcome. Therefore, negotiations can occur where both parties agree to cooperate (binding agreements are one of the ways out of the prisoner’s dilemma).

However, when we look at the model in play, that argument breaks down. With aggressive unilateralism, the first reformer has already shown that he will be flawed (or flawed). So, we are firmly in column 2. Country B has a choice: do I cooperate and hope that Country A keeps their word? If they don’t, I’m in a worse situation than just making a mistake. If B cannot count on A to eventually cooperate, B’s rational action is to retaliate. Thus, aggressive unilateralism collapses and a trade war begins.

But if B can get ua reliable commitment to reduce from A, then it changes the calculus. B still has an incentive to cooperate with him. A credible commitment to lowering the standard comes from A’s institutional status.

In 1933, representatives of 66 nations met in London to discuss how to end the war-torn trade war. They left without any deals. However, in 1934, FDR was making deals left and right. Between 1934 and 1939, FDR would conclude 19 trade agreements. What changed in that one year? The institutional structure FDR was working under.

In 1934, Congress passed the Reciprocal Trade Agreements Act (RTAA). Prior to the RTAA, tariffs were generally viewed as tax policy and set by Congress without concern for foreign policy. When tariffs are used to open up markets, they are made into treaties, which require 2/3rds of the Senate to approve. Class concerns, special interest groups, and other public choice issues can easily derail any tax cuts the president negotiates. In other words, there can be no credible commitment to slowing growth. But Congress delegated some of its authority to the President. It allowed tax negotiations to become an executive agreement, subject to a simple majority in Congress. Very low burden of association, and very difficult for special interests to interfere. The RTAA changed the institutional framework and created a credible commitment to lowering the standard.

Smith, rightly, was worried about the prospects for free trade. There can be a lot of political self-interest. But, as we saw in 1934, institutional structure can change those outcomes.