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Chapter 17 International Trade and Finance
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Thus the case for free trade is a subtle one. As always, special-interest group --
entrepreneurs, labor organizations, consumer groups -- will pursue their individual
interests, competing for favors and benefits the same way they compete in the
marketplace. Yet if all are to be treated equally by government, we must make the choice
between free trade for all and protection for all.
Economists generally choose free trade for all, because of its obvious benefits to
the nation as a whole. There are some legitimate exceptions to that rule, such as the
required domestic production of public goods, which are discussed below. Yet even
trade restrictions necessary for the public good are abused by those who would secure
protection for private purposes.

FIGURE 17.5 Effects of Tariff Protection on Individual Industries: Case 2
In this more realistic case, the auto industry gains from tariff protection, even if both sectors are protected
(cell IV). The textiles industry’s income falls from $20 (cell I) to $17 (cell IV), but the auto industry’s
income rises from $30 (cell I) to $31 (cell IV). Thus the auto industry has no incentive to agree to the
elimination of tariffs.

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The Case for Restricted Trade
Proponents of tariffs rarely argue publicly that they will serve private interests, raise
prices, and reduce the availability of goods. Instead, they typically advocate tariffs as the
most efficient means to accomplishing some national objective. Any private benefits that
would accrue to protected industries are generally portrayed as insignificant side effects.
Although most arguments in favor of tariffs camouflage the underlying issues,
one is partially valid. It has to do with the maintenance of national security.

The Need for National Security
Protariff arguments based on national or military security stress the need for a strong
defense industry. If imports are completely unrestricted, certain industries needed in time
of war or other national emergency could be undersold and run out of business by foreign
competitors. In an emergency, the United States would then be dependent on possibly
hostile foreign suppliers for essential defense equipment. (The nation could convert to
production of war-related goods, but the conversion process might be prohibitively
lengthy and complex.) Tariffs may create inefficiencies in the allocation of world
resources, but that is one of the costs a nation must bear to maintain military self-
sufficiency and hence a strong national defense.
Given the unsteady popularity of U.S. foreign policy and the uncertain support of
allies, this argument has some merit. Other nations, like Israel, have found that they
cannot count on the support of all their allies in time of war. Because France disagreed

with Israeli policy in the Middle East, it held up shipment of spare parts for planes it had
sold to Israel earlier. The United States could conceivably find itself in a similar position
if it relies on foreign firms for planes, firearms, and oil.
Special-interest groups can easily abuse the national defense argument for tariffs.
The textile industry, for example, promotes itself as a ready source of combat uniforms
during wartime. Even candle manufacturers have petitioned Congress for increased tariff
protection, on the grounds that candles are “a product required in the national defense.”
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In years past, U.S. oil producers, contending that a healthy domestic oil industry is vital
to the national defense, have lobbied for protection from foreign oil in wartime, the
effects of a tariff are not entirely straightforward as might be thought. By making foreign
oil more expensive, a tariff increases consumption of domestic oil. Since oil is a finite
resource, a tariff can ultimately make the United States more dependent on foreign
energy sources in time of emergency.
Recent history illustrates the danger of dependence on foreign suppliers. In 1973,
the OPEC oil cartel used U.S. dependence on its oil reserves as a bargaining tool in its
efforts to reduce U.S. support for Israel. President Gerald Ford responded in 1974 by
supporting a tariff on imported oil, to stimulate exploration for new domestic energy
reserves. If the United States could become energy, independent by the end of the 1980s,
Ford argued, it would reduce the threat of political blackmail from the Middle East. In

6
“Petition of the Candlemakers—1951,” in Readings in Economics, ed. Paul Samuelson (New York:
McGraw-Hill, 1973), 7
th
ed., p. 237.
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1983, for the same reason, the Reagan administration granted tariff protection to specialty

steel products, which are used extensively in high-technology defense systems.

Other Arguments
Most of the other arguments in support of tariffs are weak from a practical as well as a
theoretical perspective. In fact, while protectionism is a growth industry in recent years,
the costs to society exceed the benefits. It is sometimes argued that because workers are
paid less in foreign countries, U.S. industries cannot hope to compete with foreign
imports—but trade depends on the relative costs of production, not absolute wage rates in
various nations. U.S. wages may be quite high in either absolute or relative terms. If
U.S. workers are more productive than others, however, the costs of production can be
lower in the United States than elsewhere.
The important point is what tariffs do to trade. In an earlier example of trade in
textiles and beef, the United States was more efficient than Japan in the production of
both products. That is, generally speaking, fewer resources were required to produce
those goods in the United States than in Japan. Very possibly, the incomes of textiles and
beef workers would be higher in the United States than in Japan, but because Japanese
firms had a comparative cost advantage in textiles (measured in terms of the number of
units of beef forgone for each textiles unit), they were able to undersell textiles firms in
the United States. If the U.S. imposed tariffs or quotas on imported textiles because
Japan had a comparative advantage in that product, it would destroy the basis for trade
between the two nations. Reducing imports will tend to reduce exports, at least in the
long run.
A second questionable argument for tariffs is based on the faulty idea that the
United States loses when money flows overseas in payment for imports. As Abraham
Lincoln is reported to have said, “I don’t know much about the tariff, but this I do know.
When we trade with other countries, we get the goods and they get the money. When we
trade with ourselves, we get the goods and the money.”
Lincoln was clearly right when he said he did not know much about the tariff. He
failed to recognize the real income benefits of international trade, which are reduced by
tariffs. He seems to have confused the nation’s welfare with its monetary holdings. It is

true that if Americans buy goods from abroad, they get the goods and foreigners get the
money.
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What are foreigners going to do with the money they receive, however? If they
never spend it, Americans will be better off, for they will have gotten some foreign goods
in exchange for some paper bills, which are relatively cheap to print. At some point,
however, foreign exporters will want to get something concrete in return for their labor
and materials. They will use their dollars to buy goods from U.S. manufacturers. Again,
trade is a give-and-take process, in which benefits flow to both sides.
A third argument often made is that foreign nations impose tariffs on U.S. goods;
unless we respond in kind, foreign producers will have the advantage in both markets.

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Actually, the transaction may not involve the transfer of paper money. It is more likely—as explained in
the next chapter—that payment will be made by transferring funds from one bank account to another. The
importer’s bank balance will drop, and the exporter’s bank balance will increase.
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This argument has a significant flaw. By restricting their imports, foreign nations reduce
their ability to sell to the United States and other nations. To buy Japanese goods, for
instance, Americans need yen. They get yen by selling to Japan. If Japan reduces its
imports from the United States, Americans will have fewer yen to buy Japanese goods.
So the Japanese are restricting their own exports with their tariffs. They harm themselves
as well as Americans. If Americans respond to their actions by imposing tariffs of their
own, they will reduce trade even further. The harm is compounded, not negated.
One sound reason for increasing tariffs is to strengthen our bargaining position in
international trade conferences. By matching foreign restrictions, the United States may
be able to force a multilateral reduction of tariffs. To the extent that all tariffs are
reduced by such a strategy, world trade will be stimulated.
According to the fourth argument, tariffs increase workers’ employment

opportunities. If the government imposes tariffs on imported goods, the demand for
American goods will rise. More workers will have jobs and can spend their income on
goods and services produced by other Americans.
It is true that in the short run, more workers are likely to be hired because of
tariffs, but in the long run reduced imports will result in reduced exports. The market for
U.S. goods will shrink, increasing unemployment in the export industries.
Furthermore, if Americans reduce their demand for foreign goods to increase
employment in the United States, their domestic recession will be transmitted to other
nations. With fewer sales of foreign goods, fewer workers will be needed in foreign
industries. Foreign governments may retaliate by imposing tariffs of their own. Tariffs
will temporarily increase their employment levels and can be used as a bargaining tool in
trade negotiations as well. The end result will be a reduction in total worldwide
production and real income.
Finally, tariff advocates sometimes claim that new industries deserve protection
because they are too small to compete with established foreign firms. If protected by
tariffs, these new industries can expand their scale of production, lower their production
costs, and eventually compete with foreign producers.
It is very difficult, however, for a government to determine which new industries
may eventually be able to compete with foreign rivals. Over the long period of time that
an industry needs to mature, conditions, including the technology of production, may
change significantly. For a so-called infant industry to become truly competitive,
furthermore, it must develop a comparative cost advantage, not just economies of scale.
Moreover, the mere likelihood that a firm will eventually be able to compete with
its foreign rivals does not in itself warrant protection. Not until firms have become
established will consumers receive the benefit of lower prices. In the interim, tariff
protection hurts consumers by raising the prices they must pay. Proponents of protection
must be able to show that the time-discounted future benefits to be gained by establishing
an industry exceed the current costs of protecting it.
Finally, if a firm can expand, cover all its costs of production, and eventually
compete with it foreign rivals, private entrepreneurs are not likely to miss the opportunity

to invest in it. Through the stock and bond markets, firms with growth potential will be
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able to secure the funds they need for expansion. If a firm cannot raise capital from
private sources, it may be because the return on the investment is too low in relation to
the risk. Why should the government accept risks that the private market will not accept?

INTERNATIONAL FINANCE
People rarely use barter in trade. Exchanging one toy for two pens or three pots for the
rear end of a steer simply is not practical. Because the bartering seller must also be a
buyer, buyers and sellers may have to incur very substantial costs to find one another,
even in the domestic market. When people are hundreds or thousands of miles apart and
separated by national boundaries and foreign cultures and languages, as they are in
international trade, barter would be all the more complicated. We rarely see exporters
acting as importers, exchanging specific exports for specific imports.
In the domestic economy, money reduces the cost of making exchanges. The
seller of pots needs only to find a buyer willing to pay with bills, coins, or a check. He
does not have to accept goods that may be difficult to store, use, and trade. In the
international economy too, money facilitates trade, but well over a hundred different
national currencies are in use. The French have the franc; the Japanese, the yen; the
Americans, the dollar. To deal with this complication, a system of international
exchanges emerged in which importers pay for the goods they buy in their currency.
Before international trade can take place, it is usually necessary for the country buying to
convert to the currency of the trading partner. Importers demand foreign currency and
exporters supply it. How the international monetary system works, and the problems
inherent in it, are the subjects of this section.

The Process of International Monetary Exchange
Imagine you own a small gourmet shop that carries special cheeses. You may buy your
cheese either domestically—cheddar from New York, Monterey Jack from California—

or abroad. If you buy from a domestic firm, it is easy to negotiate the deal and make
payment. Because the price of cheese is quoted in dollars and the domestic firm expects
payment in dollars, you can pay the same way you pay other bills—by writing a personal
check. Only one national currency is involved.
Purchasing cheese from a French cheesemaker is a little more complicated, for
two reasons. First, the price of the cheese will be quoted in francs. Second, you will
want to pay in dollars, but the French cheesemaker must be paid in francs. Either you
must exchange your dollars for francs, or the cheesemaker must convert them for you. At
some point, currencies must be exchanged at some recognized exchange rate. Foreign
exchange is the monetary means or instruments used to make monetary payments and
transfers from one currency to another. The funds available as foreign exchange include
foreign coin and currency, deposits in foreign banks, and other short-term, liquid
financial claims payable in foreign currencies.