International Trade Policy: Insights from a General-equilibrium Approach

By Edward J. Balistreri

It is easy to convince Iowa farmers that the trade war with China has substantial costs, as current agricultural commodity prices reflect reduced export demand. Rather than bear the burden of retaliatory tariffs, China moved toward other sources and substitutes for soybeans (see related article by Chad Hart and Lee Schultz in this issue). The adverse export-demand shock is absorbed within the US market by inventory (and eventually production) adjustments and price reductions, and farm revenues fall as a result. This narrative might well outline the primary mechanism by which many Iowa farmers feel the pain of the trade war, but it is woefully incomplete.

In an effort to explain the impacts, economists often adopt simple market models of supply and demand. However, looking at the market for soybeans (or any other export good or service) in isolation provides an incomplete picture that fails to identify the adverse impacts of the US tariffs on Iowa’s farmers, independent of China’s retaliation. Perhaps more importantly, it fails to provide a compelling argument against the trade war beyond the farm. Under the same isolated construct, one might argue that from the perspective of steel and aluminum workers the trade war is exactly what America needs, and the longer it lasts the better.

In this article, I highlight some general-equilibrium principles for thinking about international trade and argue that a general-equilibrium perspective is essential for understanding the impacts of trade disputes. Only from this perspective can we consistently evaluate the benefits and costs of trade policy. The overwhelming conclusion from this perspective is that international trade is net beneficial—the benefits from international trade outweigh the costs when evaluated across all markets.

The principles that dominate our modern study of international trade were established by David Ricardo over 200 years ago (Ricardo 1817). Ricardo’s guidance on how to think about international trade might be viewed in two ways—a great theory that endures because it is correct, or an antiquated idea that needs revision. Skepticism around Ricardo’s ideas is understandable, especially the strong conclusion of the gains from trade. Does free trade really generate positive outcomes for everyday people, or is it something the elites promote because it benefits them?

Among economists, Ricardo’s theory of trade is best known by the subtle idea that a pattern of comparative (as opposed to absolute) cost advantages is sufficient for gains from trade. That’s fine, but what does it have to do with everyday people and does it add to the current policy debate? Frustratingly, a clear statement of comparative advantage requires an almost cartoonish characterization of the economy. We most often adopt Ricardo’s construct of a model where the whole world is reduced to two countries (England and Portugal) and two goods (wine and cloth). For the average Iowan, it is probably sufficient to say that Iowa is a good place to grow corn and soybeans and there is international demand for these goods. Similarly, China is a good place to produce photovoltaic solar panels and there is international demand for these solar panels.

So what can we get out of Ricardo’s theory that is relevant? First, Ricardo takes a clear general-equilibrium approach. We cannot consider international trade in wine without thinking about how this interacts with other markets. Second, the Ricardian model takes a distinct barter approach to international trade (e.g., England trades cloth for Spanish wine or Iowa trades soybeans for photovoltaic solar panels). Again, this is a bit cartoonish, but the barter approach provides an important simplification that facilitates a deeper understanding of critical issues like trade deficits (as discussed later) and the distribution of the gains from trade. Clearly, the gains from trade will not be distributed equally among countries or people within those countries. Modern extensions of general-equilibrium theory, in fact, show clear groups of winners and losers (Stolper and Samuelson 1941). A general-equilibrium model only shows that within a country the benefits to the winners are greater than the costs to the losers. In an ideal world we could redistribute the gains through a clever tax policy. While international trade clearly has distributional impacts, trade restrictions are a poor choice for redistribution—the general-equilibrium approach clearly shows that direct subsidies achieving the same level of production are less costly than tariffs.

The general-equilibrium approach is also particularly useful in dispelling some popular misconceptions about trade. The following statements are easily falsified under the most basic general-equilibrium trade models:

1. Exports are good, and imports are bad.
2. Trade is a zero-sum game.
3. Countries lose when they trade with low-wage countries.
4. Countries lose when they trade with distorted or planned economies.
5. Small countries lose out to large countries in trade.
6. Trade deficits will be reduced by tariffs.
7. Trade deficits represent a country’s losses from trade.
8. The gains from trade are higher for a country that has a trade surplus.
9. Trade wars can be won.
10. It is easy to win a trade war.

Trade imbalances are the most misunderstood and misused statistics in all of trade policy. Trade deficits sound bad, and some politicians leverage this for their benefit. Once we consider trade deficits through a general-equilibrium lens they are not so scary. International trade economists tend not to be worried about trade deficits, due to trade deficits being largely separable from tariffs and other trade policy distortions that are harmful.

So what is a trade deficit and what does it mean? First, we need to understand that the trade balance is a component of an important general-equilibrium accounting identity—the balance of payments. The balance of payments is essentially a ledger of a country’s international transactions, and just like standard accounting, every debit is accompanied by a credit. If I sell a zucchini at the local farmer’s market for $1 my CPA would say there is a $1 debit to my vegetable account and a $1 credit to my cash account. The balance of payments does this type of accounting for a country’s imports and exports, although it is a bit more complex because trade partners use different currencies.

Let us examine how the balance of payments works. Imagine the United States wants to buy a solar panel from China. Which currency is used in the transaction, dollars or yuan? Let us say that China is willing to accept payment in dollars. Solar panel producers in China, however, have to pay for inputs in yuan, so why would the Chinese accept dollars? There are really only two possibilities. First, China may want to buy something that dollars do buy, like US produced soybeans. Second, they may want to hold dollar denominated assets as an investment (e.g., a bond). If the original purchase was in yuan the outcome is the same—the US must acquire yuan by selling goods or services (soybeans) or an asset (bonds) to China. In this example, the balance of payments states that the value of US imports of solar panels minus the value of soybean exports must equal the number of bonds sold to foreigners. Imbalanced trade does not mean that some country gets something for nothing, and it does not mean that some country wins relative to another. Imbalanced trade simply means that a country is engaging in normal economic activities—borrowing from or lending to the rest of the world. Some may contend that borrowing is bad, but is it really? Are mortgages bad? What about equipment loans? Borrowing is only bad, even over a long horizon, if the interest you pay exceeds your discount rate, but if that were true the remedy is simple: don’t borrow.

In a general-equilibrium model, asking why the United States has a trade deficit is equivalent to asking why foreign countries like holding dollar denominated assets; or, equivalently, why the United States sells so many high-quality bonds. To the extent that aggregate US savings rates are relatively low, which is partially driven by the expanding government budget deficit, we will have a trade deficit. In Ricardo’s general equilibrium everything is connected; thus, soybean demand depends on Chinese tariffs, but it also depends on US import tariffs and how many bonds we need to sell to foreigners to finance our tax cuts.

These theoretical discussions are understandably tiring, so let’s look at some real numbers. In 2018, I joined a team of researchers in measuring the economic impacts of the trade war using a detailed general-equilibrium simulation model. See Balistreri et al. (2018) for the full study, including appropriate caveats associated with particular assumptions and results. To illustrate the findings, I reproduce here the impacts on real US Gross Domestic Product (GDP) decomposed into expenditure categories and income by sector (including tax payments). Table 1 shows that the overall impact is a loss of $67 billion in GDP. The sectoral income decomposition clearly shows the distributional impacts—gains in electronic equipment manufacturing and ferrous metals and losses in oil seeds (e.g., soybeans) and meat products (e.g., pork and poultry). The general-equilibrium perspective on international trade is particularly useful in this context because it considers all impacts of the new tariffs, provides a consistent assessment of the winners and losers, and measures the net loss in income.

References

Balistreri, E.J., C. Böhringer, and T.F. Rutherford. 2018. “Quantifying Disruptive Trade Policies.” CESifo Working Paper: No. 7382, November.

Ricardo, D. 1817. On the Principles of Political Economy and Taxation. London: John Murray, Albemarle-Street.

Stolper, W.F., and P.A. Samuelson. 1941. “Protection and Real Wages.” The Review of Economic Studies 9(1): 58–73.
 

Suggested citation:

Balistreri, E. 2019. "International Trade Policy: Insights from a General-equilibrium Approach." Agricultural Policy Review, Winter 2019. Center for Agricultural and Rural Development, Iowa State University. Available at www.card.iastate.edu/ag_policy_review/article/?a=89.