Adam Smith and Reciprocal Tariffs

This month marks the 250th anniversary of Adam Smith’s magnum opus, The Wealth of Nations. The Liberty Fund print edition is 950 pages (excluding material added by the editors) and just about every page is chalk full of wisdom. While there are some flaws, we rightfully celebrate this book as the monumental leap forward to human understanding that it is.

As a trade economist, I tend to focus on Book IV, Of Systems of Political Œconomy, where Smith skillfully dissects and refutes the arguments for mercantilism and protectionism. At the end of Book IV, Smith claims:

“All systems either of preference or of restraint, therefore, being thus completely taken away, the obvious and simple system of natural liberty establishes itself of its own accord. Every man, as long as he does not violate the laws of justice, is left perfectly free to pursue his own interest his own way, and to bring both his industry and capital into competition with those of any other man, or order of man. The sovereign is completely discharged from a duty…of superintending the industry of private people, and of directing it towards the employments most suitable to the interest of the society” (pg 687).

Smith was very much a free trader. He staunchly opposed tariffs designed to disrupt the natural flow of trade (revenue tariffs were less objectionable, but still not great). However, Smith’s approach allows for some exceptions. He discusses them on pages 463–471 (much has been written on these exceptions. For example, see my Adam Smith Works piece “Would Adam Smith Have Supported the Jones Act?” or Don Boudreaux’s discussion in his book Globalization). Among those exceptions, there is “a matter of deliberation” as to whether tariffs restricting freedom of trade are beneficial. If tariffs can be used in retaliation to open trade with another country (that is, remove their tariffs), then Smith argues temporary tariffs may be desirable:

“There may be good policy in retaliations of this kind, when there is a probability that they will procure the repeal of the high duties or prohibitions complained of. The recovery of a great foreign market will generally more than compensate the transitory inconveniency of paying dearer during a short time for some sorts of goods” (pg 468).

However, if no such repeal would be possible, Smith argued that it would be best to just continue with no tariffs (ibid). Negotiating in this manner is difficult. After all, the negotiations are conducted not by principle but rather “as to the skill of that insidious and crafty animal, vulgarly called a statesman or politician, whose councils are directed by the momentary fluctuations of affairs” (ibid). World affairs, personal interest, and other factors will influence outcomes of tariff negotiations.

The argument Smith lays out here has come to be known as alternatively the “Crowbar Theory” or “Aggressive Unilateralism.” Under certain conditions, it can work: if Country A is sufficiently large, they can impose tariffs on Country B that will cause A’s terms of trade with B to improve. Since B’s terms of trade with A is reciprocal, A’s terms of trade improvement necessarily means B’s terms of trade deteriorate. B, seeking to avoid this beggar-thy-neighbor outcome, would be incentivized to negotiate with A. Just about every trade economist who has considered the theory dismisses it as a viable alternative, for much the same reason Smith has: political self-interest will often override principles: the tariff may be miscalibrated, B could retaliate purely out of spite, etc. Far better to just keep tariffs low and deal with any problems that might arise at their source rather than rely on trade-distorting tariffs.

Historically, however, aggressive unilateralism has a mixed record of success. In many cases where tariffs were used as a crowbar to pry open markets, they have 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 aggressive unilateralism gone wrong. More recently, the Franco-Italian Tariff War of 1887–1898 occurred because Italy tried to use tariffs to force France to open their markets. It ended in economic disaster for Italy.

And yet, Franklin Delano Roosevelt successfully used aggressive unilateralism to wind down the trade war kicked off by the Smoot-Hawley Tariffs. In fact, the actions taken in the late 1930s would lead into the general rise of free trade and free trade agreements that would come to characterize the second half of the 20th Century.

Why was it Roosevelt was successful where so many others failed? The answer, I think, can be found in Adam Smith. In a forthcoming working paper, I argue that Smith is ultimately making an institutional point. The success or failure of aggressive unilateralism depends on the institutions under which the negotiations take place. That is, how do institutions direct the skills of “that insidious and crafty animal” so as to override momentary affairs and follow the principle of liberalism?

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

If both countries cooperate, that is the best possible outcome (+,+). Both countries benefit from lower tariffs. If A defects while B cooperates, A is made substantially better off (++) while B is made substantially worse off (–). The reciprocal result will follow if B defects while A cooperates—that is, if B defects while A cooperates, B is made better off and A is made worse off. If both defect, both are made worse off (we have a trade war).

The formal result of the prisoner’s dilemma problem is that, no matter what the other player chooses, a self-interested individual will choose to defect. Consequently, both parties are made worse off, resulting in a stable but sub-optimal equilibrium.

Proponents of aggressive unilateralism use the logic of the prisoner’s dilemma to justify the tariffs: cooperate, cooperate is the best outcome. Therefore, negotiations can come about where both parties agree to cooperate (binding agreements are one way to get out of a prisoner’s dilemma).

However, when we consider the model in play, that argument breaks down. With aggressive unilateralism, the first mover has already indicated he will defect (or has defected). Thus, 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 am made worse off than if I just defect. If B cannot count on A to ultimately cooperate, B’s logical action is to retaliate. And thus, aggressive unilateralism breaks down and a trade war begins.

But if B can get a credible commitment to de-escalate from A, then it changes the calculus. B now has an incentive to cooperate as well. The credible commitment to de-escalate comes from the institutional situation of A.

In 1933, representatives of 66 nations met in London to discuss how to wind down the trade war that had engulfed the war. They left with no deals. However, by 1934, FDR was doing deals left and right. Between 1934 and 1939, FDR would conclude 19 trade deals. What changed in that one year? The institutional structure FDR was operating under.

In 1934, Congress passed the Reciprocal Trade Agreements Act (RTAA). Prior to the RTAA, tariffs were generally considered tax policy and set by Congress without foreign policy concerns. If tariffs were used to pry open markets, that made them treaties, which required 2/3rds of the Senate to ratify. Sectional concerns, special interest groups, and other public choice problems could easily derail any tariff reduction a president negotiated. In other words, there could be no credible commitment to de-escalate. But Congress delegated some of its authority to the President. It allowed tariff negotiations to be an executive agreement, subject to a simple majority in Congress. A much lower burden to meet, and much harder for special interests to disrupt. The RTAA changed the institutional framework and created a credible commitment to de-escalate.

Smith, rightfully, was worried about the prospects for free trade. There would be too much political self-interest. But, as we saw in 1934, an institutional framework can change those outcomes.