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"Rules of Origin" Show Why Trade Agreements Aren't Free Trade

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Tags Global EconomyProtectionism and Free Trade

Ludwig von Mises famously argued that people must choose between outright socialism and unfettered capitalism, because there is no coherent “middle ground” between the two. The allegedly reasonable compromise of a highly interventionist state — where the authorities retain nominal private property but issue edicts regulating how legal owners may use their property — is unstable. Mises argued that one round of interventionism invites consequences that are even worse than the original problem, leading to yet more interventionism.

During the debates over Obamacare, I pointed out just how relevant Mises’s lesson was: we couldn’t get the “good parts” of Obamacare (such as universal coverage) without the “bad parts” (such as the individual mandate and massive tax hikes). When it comes to today’s controversies over trade with China, once again Mises’s insights are valuable. You can’t levy punitive tariffs on China but leave other trading routes relatively free, because then the Chinese will simply ship their exports via a more circuitous route. China hawks need to decide if they are going to abandon attempts to coercively manage trade, or if they are prepared for even more extensive top-down planning of global commerce.

Mises and Milk

Mises’s standard example for the phenomenon of one intervention leading to another was a price control on milk. Suppose the government wants to make milk more affordable for poor families. It can enact strict price controls on milk. But if this isolated price ceiling is imposed in the context of an otherwise free market economy, the immediate result will be a shortage of milk. Now, rather than poor families struggling to afford milk for their children, the stores won’t carry any milk, period. At this point, the government can either admit its error and retreat back to pure laissez-faire, or it can impose further price controls, this time on cattle feed etc. in order to coax dairy farmers into once again supplying the market with milk. Yet this second round of intervention leads to even more undesirable consequences, and so on.

Mises’s Lesson Applied to International Trade

In the debate over free trade, we see a similar phenomenon. The Trump administration has been engaged in a low-level trade war with China, levying targeted tariffs on its imports in an effort to bring Beijing to the bargaining table. Yet the remaining pockets of free(r) trade are stymying the effect, because of the phenomenon of “transshipment” — in which China exports its goods to a third country, from which they can be sold to the United States without penalty. As a recent article in the WSJ, entitled “American Tariffs on China Are Being Blunted by Trade Cheats,pointed out,

Billions of dollars' worth of China-made goods subject to tariffs by the Trump administration in its trade fight with Beijing are dodging the China levies by entering the U.S. via other countries in Asia, especially Vietnam, according to trade data and overseas officials.

And thus we see the relevance of Mises’s warning. The goal of the initial intervention — the levying of tariffs on Chinese imports — was to hurt Chinese exporters and thereby convince Chinese government officials to concede to American demands. But much of the intended effect has been muted because of transshipment.

At this point, American officials can admit that their approach was ill-advised, and stop using taxes as a way to make America great again. Or, they can expand the trade war with China to include an extensive monitoring of the content of goods coming from every other country on Earth.

“Rules of Origin” in Trade Agreements

This isn’t hyperbole on my part. As Ryan McMaken explained on this site over the summer, special trade agreements — such as the US pact with Central America — have clauses signifying that only qualified goods can escape duties. McMaken linked to this relevant passage from an FAQ on the CAFTA-DR (Central America-Dominican Republic-United States-Free Trade Agreement):

How can my product qualify to take advantage of the CAFTA-DR?

The product must qualify as an “originating” good under the terms of the Agreement. This means that the product must have sufficient U.S., Nicaraguan, Guatemalan, Honduran, Salvadoran, Costa Rican, and/or Dominican content or processing to meet the criteria of the Agreement. If goods contain only U.S. or Central American or Dominican Republic inputs, they qualify. If they contain some inputs from other countries, they still might qualify if they meet specific criteria set out in the Rules of Origin of the Agreement. Each product has a unique rule, based on its tariff classification. Most of the rules require either that the non-originating inputs undergo a specified transformation through processing in the United States or one or more of the other signatory countries (tariff shift method) and/or that they have a sufficient level of originating content as determined by a formula (regional value content method).

And now we see why a “free trade agreement” in practice isn’t simply an index card declaring, “Tariffs on Country X are 0 percent, three cheers for Bastiat!” These are managed trade agreements, with hundreds of pages devoted to detailed regulations that smack of top-down Soviet planning.


As Mises stressed time and again, people must decide whether to embrace capitalism or socialism. There is no third way, where we can enjoy the dynamism of markets while avoiding their “excesses” through strategic interventions. In the case of tariffs, particularly when the goal isn’t a broad-based revenue source but rather the achievement of a bargaining position with a particular country, a simple policy will soon break down, because the targeted country can simply ship its exports via other channels. (This same problem occurs in the case of “carbon tariffs” levied on countries that don’t punish greenhouse gas emitters to the same extent as the original country.)

The only logical end point is a country having to keep track of the entire network of trade flows, and levying the appropriate tariffs accordingly. Rather than this byzantine nightmare, trade hawks would be wiser to throw in the towel and try another strategy to achieve their goals. Unilateral free trade would make Americans richer, and our example might eventually inspire other governments to allow their own people more economic freedom as well.


Contact Robert P. Murphy

Robert P. Murphy is a Senior Fellow with the Mises Institute. He is the author of numerous books: Contra Krugman: Smashing the Errors of America's Most Famous Keynesian; Chaos Theory; Lessons for the Young Economist; Choice: Cooperation, Enterprise, and Human Action; The Politically Incorrect Guide to Capitalism; Understanding Bitcoin (with Silas Barta), among others. He is also host of The Bob Murphy Show.

Note: The views expressed on Mises.org are not necessarily those of the Mises Institute.
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