Inflated Expectations, Sunk Trade & The Tariff Tango

Let me start with one of the plainest economics truisms in the whole subject of trade; if a country makes things more expensive to produce domestically, it becomes less competitive, increases trade deficits with other countries, and confers an advantage on countries that produce those equivalent things less expensively.

Consequently, it shouldn’t be hard to get the Brexiters/Remainers debaters to concur that, as UK costs are in pounds and, say, French costs are in Euros, what determines the exchange rate between them is, among other things, the cost of producing things. We can put aside here that while inflation reduces the value of the pound, it doesn’t always translate to reduced demand for UK goods if the exchange rate adjusts appropriately (remember that in the cases when inflation leads to a depreciation of the pound, whereby it can initially boost foreign demand for UK goods due to their relative cheapness, the very same inflation will also raise production costs domestically, which will have a cancelling effect of the competitiveness gains from currency depreciation). But the upshot here is, it is always the case that economic policy errors that increase the cost of producing things for your own domestic citizens are counter-productive and inimical to healthy trade.

For ease, let’s forget about all the other trades that UK and France make with other nations, and make the point with a simple trade flow between these two nations (and for further ease, we can put aside the fact that because multiple countries use the Euro as their currency, this complicates the relationship between production costs and exchange rates, and just focus on a simple case, which could be applied to any 2 currencies).

In this model, the only reason Brits want to buy Euros with pounds is to buy French goods, and the only reason France want to sell Euros for pounds is to buy British goods. If Brits try to buy more Euros than the French want to sell, the price of Euros in pounds goes up. If the French want to sell more Euros than Brits want to buy, the price goes down, as it does in other markets. The price of Euros in pounds, the exchange rate, ends up at the price at which supply equals demand, which means that Brits are importing the same pound (and Euro) value of goods that they are exporting.

Suppose the UK government mistakenly decides to impose a tariff on French imports. French goods are now more expensive to Brits, which is obviously bad for Brits. Since they want to buy less from France, they don’t need as many Euros, so the demand for the Euro goes down, and the price of Euros in pounds goes down, which reduces the cost of French goods to Brits (remember this is just a consideration of UK and France – for this exercise, forget that other European nations use the Euro)*.

Suppose the UK becomes less good at making things due to bad political policies (a scenario that, sadly, doesn’t need much imagining). Pound prices of UK goods in the UK go up, which makes UK goods more expensive to French purchasers, so they buy fewer of them, decreasing the demand for pounds on the pound/Euro market. This shifts the exchange rate, where pounds are now less valuable, so their price falls. This doesn’t mean we are less competitive in the short term, but it does erode domestic purchasing power, which is particularly problematic in an import-dependent economy like the UK.

One of the main follies of getting trade wrong, especially uttered by bombastic politicians who want to give the impression of ‘putting our country first’ is that language is distorted, so terms like competition are often confused with combative ‘zero sum’ language, inaccurately framing trade as a “them vs. us” scenario. When that happens, political attempts to apply tariffs or regulations to confer domestic advantage are confused due to bad analogical thinking, which usually ends up reducing domestic productivity and thinly spreading costs of bad policies onto domestic citizens.

And finally, of course, the sure fire way to devalue the pound even more is to inflate the currency, which has happened off the scale in recent years in the UK. What that does is lower the value of the pound in international trade, but it does not make our goods more attractive to foreigners — they get more pounds for their currency, but need more of their currency to buy our goods, since prices have gone up – which is a bad thing for just about everyone.

*It’s true that exchange rates are influenced by more than just trade flows and production costs (especially capital flows and interest rate differentials) and inflation’s effects on exchange rates and competitiveness are complex, but that doesn’t undermine the argument above, and is beyond the scope of this article.