Q&A: Evidence that Financial Flows Determine the Overall Balance of Trade, Not Tariffs?

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I am grateful to Greg Mankiw and Doug Irwin for permission to share this email exchange with you on the impotence of tariffs to affect the balance of trade. 

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Miles to Greg Mankiw: 

Dear Greg, 

I have always really liked your model of international finance in your Principles and your Intermediate books. You may not know this, but I wrote a blog post to try to explain it,I have always really liked the the model of international finance in your Principles and Intermediate books. I wrote a blog post, “International Finance: A Primer,” to try to explain it. I use those principles all the time in blog posts as well as in class.

My undergraduate student, August Klatt (copied above) asked this excellent question: “Is there any empirical evidence to back up the prediction that a change in tariffs has no effect on net exports under flexible exchange rates (other things being equal)?”

Greg to Miles:

Thanks, Miles, for your note and kind words.

I do not know of a relevant study to cite off the top of my head.  But when I return from spring break, I will look around and let you know if I find anything.

Greg

Greg to Doug Irwin:

Hi Doug,

I was wondering if you could help me find a relevant paper or two.  You seem like you might be the right person to ask (in light of your great book, Free Trade Under Fire).

A lot of standard models predict that, under flexible exchange rates, trade restrictions do not affect the trade balance (because NX=S-I and the restrictions do not directly affect S or I).  Instead, the exchange rate moves so that a trade restriction reduces both imports and exports.

Do you know of any empirical studies that confirm or refute this?  Obviously, this topic is relevant for Mr Trump’s proposed policies regarding China.

Doug Irwin: 

Hi Greg,

I don’t know of any particular studies or papers to point you to, but theory and experience confirm it. The theory is the Lerner Symmetry Theorem, that a tax on imports is a tax on exports, so that imposing a tax on imports (to reduce imports) means that necessarily that exports will be taxed as well (resulting in a reduction in exports). The question is the mechanism by which this happens, which is obviously different under fixed and floating exchange rates.

In terms of experience, the US trade balance did not change appreciably after the imposition of the Smoot-Hawley tariff. In more recent decades, countries that have rapidly dismantled import restrictions (Chile, New Zealand) did not start running large trade deficits (although they often had fixed exchange rates and devalued or floated when they introduced their trade reforms). I don’t think China ran a large trade deficit when it unilaterally opened up its economy in the 1980s and 1990s, although as your know their current account began to balloon when you were at CEA (no causality suggested!). Another experience: I think Japan had a rough current account balance until they deregulated private capital outflows in 1980 at which point their CA surplus began to grow.

Regarding China - we do know that they retaliate immediately. Whenever Commerce and the ITC rule affirmatively on an antidumping case involving China, it is almost miraculous how China immediately finds that the United States has been dumping in their market as well.

I hope this helps a little. Let me know if you would like some elaboration.