COVER STORY AMERICA'S WAR ON IMPORTS Congress is talking tough tariffs. But they wouldn't shrink the trade deficit much. Worse yet, the most competitive U.S. industries would get bruised.
By Sylvia Nasar RESEARCH ASSOCIATE Margaret A. Elliott

(FORTUNE Magazine) – ALARM OVER the continuing flood of imports is spreading from a few zealots in the auto and steel industries to nearly every corner of the economy. Pressure is building, from both business and labor, for Congress to do something. More than 400 trade bills have been introduced this year, many to protect specific industries and bash specific countries. As emotions rise, Congress is toying with ever broader measures, dangling the tantalizing prospect in front of Americans that tough laws -- including high tariffs -- can narrow the trade gap, trim the budget deficit, and best of all, get foreigners to pick up the tab. Who wouldn't want the neighbors to pay? The trouble is, it won't work. The quick argument against tariffs has always been that they trigger retaliation and trade wars nobody can win. But even if no trading partner fired back, the U.S. would be shooting itself in the foot, if not the gut. The trade gap wouldn't shrink much, and perhaps not at all. Inflation, rather than employment, would rise. To the extent that new tariffs raised revenue to lower the budget deficit, Americans would be paying the bill in the form of a hidden tax on consumers. Most startling of all, the legislative proposals bouncing around Capitol Hill would hurt some of the most competitive U.S. industries. The Democrats in Congress are trying to turn trade wars into a major issue that can carry them victoriously through the next election. But the spirit is bipartisan: plenty of Republicans are pushing for protectionism too, even though the White House regularly and solemnly speaks out against it. None of the major bills flapping around the congressional corridors seems likely to pass this year. And the Administration says President Reagan will veto any tariff-containing trade bills that do pass. If the trade deficit, now at $140 billion, is still in the stratosphere at the start of the 1986 congressional election year, some kind of tough legislation is likely. The shape of those laws is foreshadowed in this year's proposals. Republican Senator John Danforth's bill, which asks the President to restrict imports from Japan unless the Japanese open their markets wider, is now in the Senate Finance Committee. It is expected to emerge in even harsher form under the tutelage of Senator Bob Packwood, the Republican who heads the committee. The most sweeping proposal yet has come from the Democrats -- the Trade Emergency and Export Promotion Act of 1985. It was introduced in the Senate late last month by Lloyd Bentsen of Texas and in the House by Dan Rostenkowski of Illinois and Richard Gephardt of Missouri. The bill calls for the President to get the dollar and the budget deficit down -- in the cause of shrinking the trade gap -- but the centerpiece is a complicated system of 25% tariffs that would be levied against imports from Japan, Taiwan, South Korea, and Brazil. The common thought behind all these blunderbuss bills is that the trade deficit is primarily the other guy's fault. Everyone involved allows that many factors have contributed to the trade deficit. But increasingly, U.S. business and labor leaders -- and the Congressmen who listen to them -- seem to believe that foreign export subsidies and barriers to U.S. imports are major causes. The Japanese, it's agreed, are the worst offenders. Even as the Reagan Administration brandishes veto threats, it hasn't rejected such arguments out of hand. The dismal truth is that the trade gap is rooted in complex causes that won't be blown away by a couple of well-placed shots from Washington. The trade problem is tied to the budget deficit, the strong dollar, and a gaggle of other trends, big and small, and no easy escape routes are visible. Despite popular notions, there's no convincing evidence that Japan is substantially more protectionist than the U.S. A preliminary study by William R. Cline and C. Fred Bergsten at the Institute for International Economics in Washington shows that both countries protect roughly one-third of their markets for manufactured goods with tariffs and other overt barriers. Nor is there much evidence that other countries have become sharply more protectionist recently. Indeed, America's trading partners didn't need more protectionism, since the soaring dollar gave them a price advantage both in their home markets and in the U.S. Japan does have the largest absolute trade surplus with the U.S. -- about $37 billion last year, one-third of the total -- and that surplus has grown more in total dollars than that of any other country. But Japan is also the U.S.'s second-largest trading partner after Canada. Japan's surplus with the U.S. as a proportion of total trade between the two countries has grown less than that of 18 of the top 24 U.S. trading partners, including France, Italy, and West Germany. If anything, trade barriers in Japan have been lowered in the last few years for such items as semiconductors, citrus fruit, and even cars, according to industry analysts. (Though so far Japanese are not stampeding to buy American cars.) As for Korea and Taiwan, says Alice Amsden, an expert on Pacific countries and an assistant professor of economics at the Harvard Business School: ''U.S. perceptions haven't caught up with reality. These countries are $ much less protectionist now than they were five years ago.'' The zippy American economy has added to the deficit. U.S. imports have grown more rapidly than exports since 1981 because the economy has been growing almost a percentage point faster than those of other industrialized countries. In addition, the Latin American debt crisis has all but shut down a market for U.S. exports that was once almost as large as Europe's. According to the 1985 Economic Report of the President, these two factors accounted for one-quarter of the trade gap over the last five years. The rest of the gap can largely be attributed to a low national savings rate in the U.S. and to the strength of the dollar. ''The trade balance is being driven by a fundamental inadequacy of savings in this economy,'' says Robert Lawrence, senior fellow at the Brookings Institution. Most economists agree. The underlying economic theory is fairly complex and most politicians ignore it when they talk of doing something about the trade gap. But an understanding of the trade problem is impossible without mastering the theory. In a market economy with floating interest and exchange rates, two relationships are crucial. Savings (by individuals, businesses, and government) must equal investment (in plant and equipment, inventories, and housing). And the flow of capital into the country from abroad must equal the deficit in the current account balance, defined as the trade balance plus net interest payments. Governments contribute to savings by running a surplus, and take away from savings by running a deficit. If domestic savings falls short of investment, savings from abroad have to fill the gap. The U.S. today is running short of savings because of the federal government's $215-billion deficit, because individuals are consuming a lot, and because business is spending a bundle on new plant and equipment. Last year total domestic savings were $550 billion while investment was $640 billion. That left $90 billion to be covered from abroad, an amount about equal to the current account deficit. The savings- investment gap tends to raise interest rates until investment weakens or enough foreign funds flow in to fill it. That in turn raises the value of the dollar and increases the trade deficit. Those who would slap a tariff on imports often argue that its effect will be similar to a dollar depreciation. A tariff, the argument goes, raises the price of imports, reducing the demand for them; since exports hold steady, the trade balance improves. But it wouldn't work for long. Any effect of an import tariff on the trade deficit would be negligible and transitory, says Avinash Dixit, professor of economics at Princeton. ''As long as the gap between savings and investment remains, the inflow of capital will have to continue, sustained if necessary by even higher interest rates and a stronger dollar. So the trade deficit has to remain.'' The tariff proposed by the Democrats has further failings because it singles out just a few countries that account for about a third of U.S. imports. Other countries would take up the slack. Taiwan could ship more machine tools to Europe, which wouldn't be affected by the tariff. The Europeans could then boost their shipments of machine tools to the U.S. A tariff against selected countries would mainly reshuffle trade surpluses with only a small effect on the deficit. IN ANY CASE, trying to balance trade country by country -- an underlying theme in much of the proposed legislation -- is a silly idea. ''It would turn us back from a monetary international economy to a barter international economy,'' says Robert Lawrence of the Brookings Institution. ''Just think of that notion applied to an individual. What if I had to balance my services with my doctor's?'' If the U.S. tried to balance its trade with OPEC countries, it would either have to buy less oil than the country needed or somehow get OPEC trading partners to buy more U.S. goods than they wanted. Both sides would lose. Nor is the concept consistent with other U.S. international economic objectives. To service their debts to U.S. banks, Brazil, South Korea, and other developing nations must run trade surpluses with the rest of the world. The case against a balanced flow of trade with Japan is less obvious, but the goal is equally ludicrous. Japan has an extraordinarily high savings rate -- 30% of gross national product, compared with 17% in the U.S. All that money piling up lowers interest rates in Japan, where business borrowers pay only 6.5%, and weakens the yen. This in turn encourages capital to flow out of the country and produces a correspondingly large trade surplus. The U.S. Treasury Department helped along the process in 1984 when it pressured the Japanese into liberalizing their capital markets. The result was that Japanese investors have been sending $5 billion a month overseas, much of it to the U.S., further weakening the yen against the dollar. Consider the effects of the proposed tariff on the U.S. economy. If foreign exporters absorb the tariff and don't raise their prices correspondingly, nothing happens. If they pass it along to U.S. consumers in higher prices, the volume of imports will fall by some amount -- depending on how hooked consumers are on imports. If the action stopped there, the trade deficit would indeed decrease. But if imports fall, the supply of dollars held by foreigners will also shrink -- and that will put upward pressure on the dollar. As the dollar appreciates, imports regain some lost ground but U.S. exports actually fall. Both exports and imports end up lower than they would have been with no tariff. So, the total volume of trade is lower but the trade balance is little changed. Assuming Congress wouldn't find new ways to spend the money -- a heroic assumption perhaps -- the tariff, like any tax, would reduce the federal budget deficit. If imports from Japan, South Korea, Taiwan, and Brazil -- a total of $94 billion last year -- didn't change much, a 25% tariff would raise about $20 billion in the first year. But the effect would be temporary. In any case, a speedup of inflation would likely vitiate any effect on the federal budget deficit. Price rises wouldn't be limited to imports from the countries affected by the tariff. Once prices of imported products start going up, exporters from other countries have room to jack up their prices too. The Federal Reserve's reaction is likely to be a tightening of monetary policy, judging by Chairman Paul Volcker's remarks last month about the inflationary dangers of a declining dollar. So interest rates might rise, dampening U.S. economic growth. This augurs ill for the employment gains promised by the tariff's proponents. Fewer jobs would be lost in industries protected from imports -- but the price would be paid in lost jobs in the rest of the U.S. economy. Who would fork over the revenue raised by the tariff? Popular belief has it that foreigners would, an appealing notion to be sure. But it rests on the assumption that foreign exporters will cut prices to avoid losing U.S. customers. Supporters of the tariff argue that foreign exporters can afford slimmer margins because they've been earning superprofits in the U.S. Though the dollar appreciated 12% last year, they observe, import prices declined by less than 1%. But according to Peter Pauly, an economist at the Wharton School, it's unlikely that any of the countries singled out by the tariff can absorb a 25% reduction in the price of its exports to the U.S. So exporters would have to raise prices to cover the tariff, and American consumers would pay. In a study of an across-the-board tariff, Michael Bryan and Owen Humpage, economists at the Federal Reserve Bank of Cleveland, concluded that 90% of the revenues raised by the U.S. government would come out of U.S. pockets. Stripped of its disguise, this comes down to a good old-fashioned tax hike. ''We're supposed to be reducing the deficit by cutting spending, not hiking taxes,'' says Melvyn Krauss, senior fellow at the Hoover Institution and professor of economics at New York University. Is it a good tax? Actually it's one of the worst: it imposes a high tax rate on a narrow class of people, those who buy imports from certain countries. American consumers would pay more than just the tax on imports. They'd also pay higher prices for American-made goods, since the protected domestic industries would be free to raise prices. The selective tariff also means that they're likely to pay more for European cars and shoes. That's pretty much standard wisdom. What's almost never acknowledged is that tariff barriers designed to keep out imports also hammer U.S. companies that depend on exporting. This is one of the major tenets of classical trade theory -- but it may come as a shock to the sponsors of an import tariff bill touted as an export-promotion act. Exporters get hurt by the dollar-strengthening effect of a tariff. But more important, the price increases triggered by a tariff would raise many of U.S. exporters' costs. Companies that compete against imports in the domestic market are also affected by these cost increases, but they are freer to raise prices. Exporters have to take their prices in international markets as they find them. That may not be true in aircraft, where the U.S. has a near monopoly, but what about agriculture, semiconductors, machine tools? ''If Congress wants to promote exports, they're going about it wrong,'' says Krauss. Adds William C. Niskanen, until recently a member of the Council of Economic Advisers, ''The import surcharge has the effect of penalizing our more productive sectors where we have the strongest advantages relative to the rest of the world and strengthening our weakest sectors.'' THE RISKS of retaliation from U.S. trading partners are more familiar. Says Wharton's Pauly, ''If other countries retaliate, the unambiguous outcome is lower world trade and growth.'' But familiarity has evidently bred contempt, gauging by the attitude of Congress. Representative John Dingell, the Democrat who heads the Energy and Commerce Committee, recently told a New York Times reporter that he wasn't worried about Japanese retaliation ''because their markets are effectively closed to us anyway.'' Laying aside for the moment Japan's position as the second-largest market for U.S. manufactured goods, Dingell could be right. Given the climate of opinion in the U.S., it may indeed be difficult for the Japanese or the other Pacific countries to mount a counterattack. (Brazil could retaliate by lobbing a debt bomb -- suspending foreign debt repayments, albeit at considerable risk to itself as well as the U.S.) But one important international repercussion would likely be the scuttling of prospects for a new round of multilateral trade talks. There's also the possibility of a copycat effect. Other countries that are feeling embattled by the Japanese and other importers could be emboldened to follow the U.S. down a tough protectionist road. If a tariff won't work, and will undermine the U.S. economy in the bargain, what will work? The dollar's recent slide will help some U.S. industries (see the following story). But the dollar will have to fall further -- and do so gently -- to narrow the trade gap substantially. For a country consuming more than it produces, beggaring the neighbors can only accomplish so much. Hard domestic choices about what the U.S. is prepared to give up to bring down the deficit -- lower taxes, or military hardware, or social security increases, or government pensions -- is the kind of tough trade policy the U.S. economy really needs.