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The (Il)Logic of Retaliatory Industrial Policy and Protectionism

In my latest column for AIER, I use a 2X2 matrix that my son, Thomas, generously drew for me to help me explain the (il)logic of adopting tariffs and subsidies at home in response to tariffs and subsidies adopted abroad. A slice:

On the north-south axis and in blue is the U.S.A. On the east-west axis and in red is China. Each of the four boxes contains two numbers, each one a measure of a country’s economic performance. (For simplicity, you can think of the numbers as monetary figures.) The blue number in each box’s northwest corner shows U.S. economic performance. The red number in each box’s southeast corner shows Chinese economic performance. The absolute value of these numbers is meaningless. What matters is the value of one number relative to any of the others.

In this simplified example, each government pursues one of two policies: free market or industrial policy. If each country’s market is free, economic performance in each country is 1,000. This outcome – the best one possible – is shown in the box in the upper left of the figure.

Now, however, suppose that Beijing pursues industrial policy. That policy will significantly worsen the performance of China’s economy. But because the U.S. and Chinese economies are somewhat integrated with each other through trade, the degree to which China’s economy suffers depends upon what happens in the U.S. If America sticks with free markets, some of the benefits of these free markets continue to be shared with the Chinese people. Beijing’s use of industrial policy will thus cause Chinese economic performance to fall ‘only’ from 1,000 to 500.

But if the U.S. government retaliates with its own industrial policy, the performance also of the U.S. economy will worsen. And this worsening of U.S. economic performance will further worsen the performance of China’s economy. Industrial policy pursued in both countries causes economic performance in each country to be 200, as shown in the box in the lower-right-hand-corner.

When pundits and politicians in America insist that Beijing’s use of industrial policy creates the need for industrial policy in America, they see only the harm that Beijing’s policy inflicts on Americans. That is, they see only the reduction in American economic performance from 1,000 to 900 (as seen when moving from the northwest box to the northeast box).


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