A couple of days ago I posted at Cafe Hayek this letter to a former student of mine. I believe this letter to be basically correct, but I realized after talking yesterday to Phil Gramm about the relationship between protectionism and inflation that I overlooked an important fact – namely, as we Americans import less we also export less.
Think of the extreme case in which all imports are kept out. As a result, the prices of domestically produced import-competing products will rise. But the resources once devoted to producing goods and services for export will now be reallocated to producing goods and services exclusively for domestic consumption. Some of these resources will be reallocated into the production of import-competing products, thus moderating, although not eliminating, the rise in the prices of these products.
Now here’s what I overlooked: Other of these resources will be reallocated into the production of non-import-competing products. The increased supply of these products will push their prices lower. It’s possible that this increased domestic supply of non-import-competing goods and services will be large enough to cause the nominal prices of these goods and services to fall far enough to offset the higher prices of the import-competing goods.
If we had inflation measures that were God-like in accounting for changes in quality, those measures would unambiguously show that the elimination of imports caused a one-time increase in the price level. The economic welfare contained in the bundle of goods and services available to Americans would, as a result of the trade restrictions, be lower than was the economic welfare in the bundle of goods and services available with free trade. We Americans would, in short, get less economic welfare in exchange for each dollar that we spend.
But inflation measures are not close to being this perfect. They are reasonably good at measuring quantities, but not very good at measuring qualities. It’s quite possible that in the real world the inflation measures would detect and report no increase in the price level as a result even of a total exclusion of imports from our market.
Now consider an even more extreme case: The government not only cuts us off from all commerce with non-Americans but also arranges for us to produce only bags of gruel and bottles of water. Nothing else. Clearly, our economic welfare would be severely diminished. But with a constant supply of dollars – dollars that can be spent only on bags of gruel and bottles of water (because that’s all that’s produced and sold) – the nominal prices of gruel and of water would have to reflect the supply of money. If the demand for money doesn’t increase – and if there continues to be full employment of workers and resources – the result must (?) be a price level that’s unchanged from what it was before the government cut us off from global commerce and arranged for us to produce and purchase only gruel and water.
The bottom line is that economically destructive policies such as protectionism can inflict great inefficiencies on the economy and commit people to much economic deprivation without these consequences showing up as inflation.
…..
UPDATE: The problem with the example of output consisting only of gruel and water is that it is tripped up by the law of diminishing marginal utility: people simply wouldn’t buy the stuff beyond a certain point and, if the government really and effectively prohibited the production and sale of anything else, unemployment would arise and persist. Q would fall and P would correspondingly rise.
But I think that if the example is loosened to allow the production of whatever is possible to produce domestically – gruel, water, hamburger, beer, shoes, MAGA caps, golden statues for the Oval Office, and on and on – then the resulting quantity (as in MV≡PQ) would be unchanged from before the trade restriction, showing no increase in the price level.
Of course, again, if the inflation measure could accurately account for changes in quality, the price level would rise enormously as a result of such a trade restriction.
I especially thank David Henderson, Bob Higgs, Roger Koppl, Liya Palagashvili, and my intrepid Mercatus Center colleague, Veronique de Rugy for their feedback – and pushback.
