Fears about tariffs causing a recession are high right now. Betting markets pretty clearly favor the claim of a forthcoming recession.
Businesses do have a lot to fear – tariffs tend to increase input prices which would make them less competitive on foreign markets. It would also increase prices for domestic consumers and thus reduce sales. Tariffs also have effects on exchange rates that end up making exports harder. Finally, and more generally, when domestic production expands due to import taxes, producers must use resources that are less efficient or better suited to other uses. This raises opportunity costs, as increased output in one sector comes at the expense of producing other valuable goods and services. This leads to price increases for consumers.
These costs of tariffs, however, are only the tip of the iceberg. Focusing solely on them suggests that the American economy would contract temporarily before returning to its previous growth rate — a scenario known as a “level shock,” not a “trend shock.”
But protectionism — the broader policy goal tariffs are meant to serve — does produce a trend shock by slowing long-run growth. This is because protectionism functions like a disease on institutions, undermining their effectiveness over time.
Industries seeking protection have reasons to do so – they profit even if the wider society is made poorer. They must, however, overcome two problems. The first one is to successfully organize politically to lobby for protection. Members of the industry are not always perfectly aligned and may disagree. They also have to expend considerable fixed costs to set up the lobbying operations and develop contacts with politicians and their staff.
The second is that they must be able to find politicians who will act on their behalf – in exchange for some political rewards (or outright bribes). This process, developed by Anne Krueger and Gordon Tullock and known as rent-seeking, is essentially one where resources are expended to lobby to redistribute wealth without creating any. In fact, there is a net loss in the process.
If industries cannot organize because the costs of organizing are too high, even if there is a willing politician, rent-seeking will not happen. If politicians are constrained from giving rents – either because of ferocious political competition or constitutional limitations – then there is no point in organizing.
Once an industry succeeds in organizing and convincing a politician, however, a vicious and pernicious cycle starts. At the sight of exceptional profits, other industries enter the bidding game with politicians, and more and more resources are spent lobbying to reallocate increasingly smaller levels of wealth. In the end, society is poorer. Entrepreneurs are no longer in the business of thinking about consumers as much as they are in the business of thinking about patrons in political offices.
In practical terms, this means less will be spent on innovation, research and development, new products, or the adoption of improved production techniques. Entrepreneurs, fixated on political favor, lose sight of the importance of these choices. This is what slows down economic growth.
When a politician signals openness to tariffs, interest groups quickly line up to argue why tariffs should be set at level X or Y, or structured in way A or B. Justifications — political covers, to use a less Orwellian term — will be crafted in the name of national interest, security, cultural prestige, or moral imperatives. In short, the politician who signals openness to tariffs signals that the rent-seeking bar is open. That helps sets the rent-seeking process in motion.
At the same time, politicians are rewarded for redistributing wealth rather than for adopting policies that generate it. Instead of addressing issues traditionally within the state’s purview — such as policing, courts, pollution, or the provision of public goods, all of which can foster economic growth — they focus on redistribution, which contributes nothing to growth. Institutions end up being geared to extract rents rather than create wealth. Corruption, as Toke Aidt and others note, becomes a natural byproduct.
To illustrate the point, consider Canada and Argentina at the turn of the nineteenth century. Both countries were perceived to be the promised lands of the twentieth century. They had great economic potential in terms of natural resources, decent levels of human capital, and similar levels of income. The big difference is that Canada went down the free trade route (with some minor violations in the grander scheme of things) and Argentina went down the protectionist route.
When one considers the type of costs of protectionism that are most frequently discussed in the wake of President Trump’s announcement of “Liberation Day,” one would not have predicted anything about Argentina’s institutions after going down the protectionist route. But that route included the creation of powerfully entrenched interest groups that resist reform and spend considerable resources doing so. It comes with politicians who act as patrons of industry rather than as serving the essential functions of the state. Corruption became a byproduct of this entire process, further worsening things.
This is part of why Argentina, in pretty much all rankings of institutional quality, scores low. Quite low compared to Canada. It also helps explain why Argentina experienced an entirely different trend than Canada. While Canada gradually closed some of the gap with the United States (starting at roughly 50 percent of the income per person seen in America and going to 82 percent on average since the 1960s), Argentina grew more slowly than the United States and Canada. It is now a relatively poor country.
Protectionism is an economic poison because it not only hurts upon ingestion but leads to lingering side effects that weaken the economic body over time.
