Nations Cannot Win or Lose Trade Wars

Nation-states have no resources of their own. They redistribute the resources of their citizens. Nation-states can neither win nor lose when they play with other people’s resources. Tariffs and other weapons of trade wars disrupt normal trade; helping one group at the expense of another.

Illusion of Trade Deficits

The concept of trade wars begins with the illusion of trade deficits. When looking at the economy as a whole, trade deficits simply cannot exist. An economy, as a single unit, does not exist. An economy consists as a network of individual transactions. Thus, any comments about “an economy” require that we look at the nature of those individual transactions.

When a consumer acquires any good or service, by voluntary means, he always gives something in exchange — something he values less than what he gets. Thus, because the parties to an exchange leave with more value than they enter, no deficit can exist in any individual transaction. To make an hypothetical accumulation of all consumer transactions in an economic system the same logic must apply.

Buyers will always give money for the products they buy, whether from a local supplier or from a supplier in another country. Consequently, no deficit exists.

What Happens to the Money?

If a buyer always pays money for goods that he receives from overseas, what happens to that money?

One of three different things can happen to that money:

  • That money pays for products from the country of origin. Those purchases count as exports from the country of origin and thereby reduce the trade “deficit.”
  • That money acquires investments in the country of origin. Those investments, although not included in the GDP, have future benefit for that country.
  • That money buys government debt, which provides money for government giveaways. Those giveaways add to consumption and thereby the GDP. Not a bad thing from the policy-makers’ perspective.

How Do Tariffs Help Nation States Win War?

Only nation-states engage in “trade wars.” Peaceful traders have no incentive to engage in unhealthy activities.

The people involved in actual exchange do so voluntarily and peacefully. If they don’t like the terms of the exchange, they either renegotiate or abandon the transaction.

Since nation-states have no resources of their own, their actions — either through trade restrictions or tariffs — simply redistribute the resources of their own citizens. Nation-states have no weapons of their own for the conduct of trade wars; thus, they have no way of either winning or losing.

Trade Wars Cause Economic Disruption

The trade wars between nation-states disrupt the economies that they profess to help. In an effort to assist one part of the economy they always cause disruptions in other parts of the economy. The policies used in “trade wars” ignore the complexity of the markets with which they deal. For every player their policies help, multiple parties get hurt.

A couple of diagrams will give a very simple idea of the disruption caused by trade wars using tariffs.

Before Tariffs

This first diagram shows the situation before the implementation of tariffs. The consumer buys good G from supplier F (a foreign supplier) instead of buying the same good from supplier A (an American supplier) because it costs less money.

With the money the consumer saves he can buy products from other suppliers. The money earned by those other suppliers can, in turn, buy additional goods from an undetermined number of other suppliers (depicted by the cloud at the bottom).

The consumer gets more benefit and part of that benefit gets passed on to the rest of the economy.

After Tariffs

After the imposition of a tariff, which makes the price of good G from supplier F higher than the price from supplier A, the consumer will have to pay a higher price for the same product. This causes a chain reaction of negative results.

The consumer no longer has the extra money saved. He reduces his spending with other suppliers. The revenue of these other suppliers declines, and they spend less money with their suppliers. An indeterminate number of people in the economy get hurt as a result of the imposition of tariffs.

Please keep in mind the extreme complexity of international trade. A small intervention at one point in the trade process will have effects that ripple throughout the national economy and the international economy. We have no way of measuring the effect of these interventions. Because they always cause a disruption the normal trade process, these interventions will always have negative consequences.

Conclusion

Nation-states can gain only one thing by engaging in trade wars: political power. Some politicians think they are doing good things for their constituents by engaging in trade restrictions and tariffs. They base the activities of “trade war” on the false premise that trade deficits actually exist and they must be cured.

International markets, just like to domestic markets, are entirely too complex to be effectively managed. Messing with otherwise free markets only causes damage to the participants. In particular, it causes damage to those the politicians have sworn to protect.

 

A Pricing Model

No one can build a model to either determine or predict prices, despite the useful information that prices provide. Attempts to predict prices will always prove fruitless.

Knowing prices in advance would prove useful to owners and managers in all businesses. Imagine the profitability a company that could accurately predict the future prices of its products. I will show that the best that we can do is interpret price patterns in order to make subjective judgments about market opportunities.

I will step through three different levels of models and explain their relative usefulness:[1]

  • Events
  • Patterns of Behavior
  • Market Structure

Events

Models to Determine Prices

Despite what they teach in basic economic classes a person cannot predict individual prices by finding the intersection of supply and demand curves. If you think about this for about 12 seconds, you will realize that no one has ever seen a supply or a demand curve. Economists draw these curves, after the fact, in an attempt to explain the behavior of buyers and sellers.

The fact remains that buyers act based on their scale of preferences and sellers must make reasoned guesses about what buyers might pay for their products. Business schools teach managers to make sophisticated models to develop offering prices based on their cost structure. That exercise, however, provides no guarantee that buyers will pay that price.

Patterns of Behavior

Models to Interpret Prices

Over a period of time patterns develop that indicate the prices upon which buyers and sellers agree. These patterns do not provide any prediction, but, based on the assumption that the past is an indication of the future, these patterns do provide some useful information.

Rising Prices

A pattern of rising prices provides significant useful information for entrepreneurs. A pattern of rising prices indicates relative shortages in a particular market and the possibility for profitable opportunity. If buyers willingly pay more and more for a good, it indicates that they have relative difficulty in finding that good. Entrepreneurs can exploit that opportunity. (See diagram below.)

Rising Prices

Declining Prices

Declining prices, on the other hand, indicate relative excesses in a specific market. Depending on the steepness of the decline entrepreneurs might decide to reallocate their capital to more profitable opportunities. (See diagram below.)

Declining Prices

Market Structure

Pricing Causal Loops

An accurate model of the market structure would provide the most accurate prediction of market prices. In the diagram below, I have sketched a conceptual model of a simple market structure. Briefly it would operate in the following sequence:

  1. Increases in production lead to increased inventory.
  2. Increased inventory leads to a reduction in production. These two steps create a balancing process. Additional reinforcing processes influence these two steps.
  3. Increased efficiency leads to reduced prices and increased production.
  4. Reduced prices lead to increased sales
  5. Increased sales reduce inventory leading to increased production.

If a modeler knew all these variables, he could accurately predict the behavior of the system.

Causal Loop

This model, however, has one fatal flaw. It represents a human system in which people act based on subjective judgments. As described in the section above no one can predict individual prices. We don’t know until after the fact what buyers will voluntarily pay for the goods in question.

When attempting to build models of markets, modelers make the mistake of assuming the patterns of behavior represent the mental models of buyers. (I.e. they confuse the map for the territory.) Prior to 2008 house prices rose consistently year after year for several decades. Market watchers mistakenly assumed that that trend would go on “forever.”

The preferences of individuals can shift suddenly, changing the structure of the market, creating entirely new patterns of behavior. No one can predict when these shifts in preferences will occur. No one can know when prices will change.

Conclusion

No reliable model for pricing can exist. Patterns of behavior provide the most useful models for interpreting market behavior. Rising prices generally signal shortages. Falling prices generally signal abundance. But, market participants must view these patterns with great caution.

In a free-market, buyers can shift their preferences relatively swiftly. But, in markets subject to intervention outside forces work to distort those preference scales, causing price distortions, misinformation, and the misallocation of resources.

  1. I base my statements on an assumption of no intervention in the market. I assume, for the sake of discussion, that fiscal redistribution, regulation, and monetary policy have no influence on market pricing. 

Relationship of Value to Price

Value and price have a very close and important relationship. Value exists entirely in the subjective realm, whereas price provides objective evidence of an economic transaction. The price results from action taken based on value. It does not, as many people believe, provide a measure of value.

Value

As I have laid out in previous posts, value only exists as a subjective inference in the minds of individuals. It has no objective unit of measure — indeed the individual cannot quantify his own measure of value. An individual exposes his value preference only when he makes an exchange. When the individual makes an exchange he exposes his relative value to himself and anyone witnessing the transaction.

Exchange

When an individual encounters a good (A) that he values more than a good (B) that he owns he will seek to make an exchange. If the owner of good B values good A more than good B, these two individuals will make an exchange. The consummation of this transaction provides the proof that each party values what he gets more than what he gives up. If they don’t make the exchange, the original premise about who values what proves false. In other words, an exchange amounts to individual actions based on individual values. The result of that transaction provides objective evidence of the relative values of the two individuals. Keep in mind it only indicates relative values — in terms of more or less — and never quantifiable values. That evidence of value results in what we refer to as a price.

Price

The word price refers to the ratio of what a person gives up to what he receives. In other words, if Bill exchanges eight apples for four peaches, we can say the Bill’s per peach price equals two apples. A price only appears with the consummation of an exchange. If the owner of the peaches offers them at a ratio of three apples per peach, that does not amount to a price. It only amounts to an offer — or, if you will, an offer price. An exchange must occur in order to create a price. I realize that these examples seem almost ridiculously simple and somewhat unrealistic. Most transactions occur with the use of money and the price stated in terms of dollars and cents. Keep in mind that money simply exists as another good used as a medium of indirect exchange. The interpretation of “price” remains the same whether the transaction consists of a direct exchange — as in the case of Bill and his apples — or an indirect exchange — as with the use of money.

Interpretation

The price resulting from an exchange creates an objective indicator of the relative values for Bill and his exchange partner. After the exchange we can say with certainty that Bill values peaches more than apples. But, we still cannot quantify how much more Bill values peaches. Objective price information provides the basis for the development of effective and efficient allocation of resources throughout a market. When a price pattern develops in the market that indicates the existence of many buyers willing to trade apples for peaches at roughly the same ratio (price), peach producers who want apples know that a market exists for their produce. Money prices contain precisely the same information, however it can apply to a multitude of products exchanged indirectly. This information provides the foundation for economic calculation fundamentally important to the operation of free markets.

Conclusion

Knowing that people value goods on a individual subjective preference scale provides the basis for a sound fundamental theory of free exchange. It does not, however, provide us with any useful objective information. For useful information we must have the ratio of goods exchanged—which we refer to as price. By aggregating price data we can develop definitive statements about the relative values of the players in a particular market. We now know, with certainty, who values one good over another. Keep in mind that price does not measure value; it simply indicates the range of relative value. The price does, however, provide sufficient information for the effective and efficient allocation of resources in an economy.