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Trade Tariffs Won’t Crash the World Economy, Monetary Policy Will

Tags Global EconomyMoney and BanksProtectionism and Free Trade

As the Trump administration announces 25% tariffs on over $50bn of Chinese goods, and Europe and China prepare retaliation measures, The Economist concludes that “Rising tariffs are the worst of many threats to the world economy”, because, among other things, “Tariffs temporarily push up inflation, making it harder for central banks to cushion the blow.” This statement displays a deeply entrenched confusion—if not utter misunderstanding—of some basic economic concepts. Most important, many people fail to correctly distinguish between the causes and effects of price inflation and those of monetary inflation.

Monetary inflation is the increase in the quantity of money in an economy. This inflation causes the purchasing power of money to fall, which brings about price effects—a general rise in prices of goods and services—which we can refer to as price inflation. However, this general rise in prices following monetary inflation is disproportionate and staggered: prices will rise at different times and to different extents as money reaches a lower purchasing power. 

But monetary inflation also has non-price effects. One of these is the transfer of wealth between the last receivers of the new money toward the first receivers.

Another—and even more important—is the distortion of the pattern of investment and production, as the new money being created through credit expansion reaches stock markets and businesses—thus artificially reducing the interest rate. This latter effect explains the occurrence of production booms misaligned with consumer preferences, and the later, inevitable economic bust or crash. These price and non-price effects of monetary inflation are general and underline every possible economic activity.

Trade tariffs, on the other hand, affect only some markets and bring about increases in some prices in the economy. As this happens, our consumption patterns change: if we consume fewer imports, prices of domestic substitutes will rise. If our consumption of imports rises or does not change, we will have a reduced income to spend on other goods, whose prices will now fall. Whatever the result, it does not engender a ‘general’ rise in prices, or a depreciation of the currency as a result.

Moreover, even if tariffs were applied to every good and service, there would be no systematic, inter-temporal distortion of the structure of production. A stalling of productive activity and a rise in production costs is likely to occur, as capital goods—e.g. steel or aluminum—will now be more expensive. But capital is now underutilized, not squandered. There may be less investment, but no malinvestment.

Understanding this, it is easier to see then that trade tariffs, as bad as they are, cannot produce an economic bust in the same sense as occurs in the business cycle (just as simple domestic taxation, albeit reducing welfare, does not cause an economic crisis). As Rothbard (1963) explained,

“declines in specific industries can never ignite a general depression. Shifts in data will cause increases in activity in one field, declines in another. [...]

The problem of the business cycle is one of general boom and depression; it is not a problem of exploring specific industries and wondering what factors make each one of them relatively prosperous or depressed. […]

In considering general movements in business, then, it is immediately evident that such movements must be transmitted through the general medium of exchange — money. Money forges the connecting link between all economic activities. If one price goes up and another down, we may conclude that demand has shifted from one industry to another; but if all prices move up or down together, some change must have occurred in the monetary sphere.”

It would be remarkably futile, then, to endeavor to cushion the blow of trade tariffs with loose monetary policy. The worst thing, by far, for a world economy of interconnected financial and capital markets, is monetary inflation and credit expansion. It is never a cure, and always a curse. Trade tariffs are, however, the second worst threat to a global market—often likely to make the bust much worse and the recovery slower, and to diminish our hopes for peace.


Contact Carmen Elena Dorobăț

Dr. Carmen Elena Dorobăț is a Fellow of the Mises Institute and Senior Lecturer (Associate Professor) at Manchester Metropolitan Business School in the United Kingdom. 

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