It is sometimes helpful to use an analogy to get a handle on difficult economic concepts. Assume for the moment that Indiana and California are two separate sovereign states. Indiana exports large amounts of corn to California, and California in turn exports large amounts of oranges to Indiana.
What if Indiana imposes tariff duties on oranges imported from California? The price of oranges in Indiana increases and the quantity consumed decreases. California orange producers and their employees suffer a loss in income, but high-cost producers of Indiana oranges, undoubtedly grown in greenhouses, benefit.
A trade war ensues when California retaliates by imposing a tariff on corn coming from Indiana. Californians pay higher prices for corn and meat derived from corn-consuming animals. Indiana corn producers and their employees suffer a loss in income, but California producers of corn or corn substitutes benefit.
In a trade war, consumers, in both regions, inevitably experience overall declines in their standard of living, even though certain less-efficient industries benefit. This encourages other less competitive producers to lobby for additional tariffs. Professional economists strictly concerned with increasing or maintaining living standards for a particular region invariably argue against tariffs.
How should California respond if the governor or the Indiana General Assembly unilaterally initiates tariffs on imports from California? Are there other options to an out and out tariff war?
California, assumed to be a sovereign state issuing its own currency, might consider currency manipulation. In current financial markets, if one California "sacramento" generally trades for one Indiana "hoosier," the California central bank could debase its currency, declaring that it would only trade one hoosier for two sacramentos.
Why would California do something that at first glance seems counter intuitive? Well, consider that after the currency devaluation any holder of Californian currency in effect now has to pay twice as many sacramentos to buy a bushel of Indiana corn and holders of Indianan hoosiers are able to purchase California oranges at half-price. California’s imports drop and its exports rise.
Admittedly, certain groups in both regions stand to gain from currency manipulation. However, as with tariff wars, economists warn of harm ultimately affecting both regions. Distortions in investment, debt repayments and currency swaps by corrupt officials anticipating currency changes are just a few of the harmful effects of currency manipulation.
Free trade and relative exchange-rate stability leads to higher levels of economic well-being. Since World World II, due to free trade agreements, we have witnessed increases in standards of living around the world and at least a billion people being raised from poverty.
The economics disadvantages of trade and currency wars are not academic but real. Why then are countries initiating trade wars and manipulating currencies? The only non-political answer is that groups of corporations and workers in sovereign nations believe that existing international trade agreements and practices abroad are biased in terms of their own and their country’s overall standard of living.
Maryann O. Keating, Ph.D., a resident of South Bend and an adjunct scholar of the Indiana Policy Review Foundation, is co-author of “Microeconomics for Public Managers,” Wiley/Blackwell.