Category Archives: Economics

Restating the Case for Free Trade

The case for free trade needs to be restated frequently. Politicians keep pushing the same protectionist policies, as though maybe this time the results will be different. President Trump copied Herbert Hoover’s Smoot-Hawley tariffs. President Biden is copying Trump’s trade policies. They do this in part because voters want them to. As economist Bryan Caplan has documented, most people have anti-market bias and anti-foreign bias, and vote for candidates who cater to those biases.

That means that year after year, market liberals need to keep making the case for free trade’s benefits for prosperity, peace, and its importance for resiliency against crises and shortages. Lasting change comes from the bottom up, not the top down, so that’s where we need to focus our efforts. The latest attempt at popular persuasion, “The (Updated) Case for Free Trade” by the Cato Institute’s Scott Lincicome and Alfredo Carillo Obregon, is worthy of its task. It consists of both a paper and a fantastic website that is worth a scroll.

They hit on several fronts, first by making the economic case for free trade: “The payoff to the United States from expanded trade between 1950 and 2016 was $2.1 trillion, increasing GDP per capita by around $7,000 and GDP per household by around $18,000.” With an economy still feeling the effects of COVID-19 and inflation at a 40-year high, trade’s benefits are essential for millions of families.

They then make the geopolitical case for free trade, as have thinkers from Montesquieu in the 18th century to former Secretary of State Cordell Hull during World War II. Countries that trade with each other rarely go to war with one another. This, not boosting GDP, was the animating principle behind the post-war rules-based international trading system anchored by General Agreement on Tariffs and Trade and then the World Trade Organization. Deep trading relationships are also essential for building diplomatic alliances, which are needed today against Russia and China.

Most importantly, they make the moral case for free trade. Too many economists ignore trade’s moral goodness; Lincicome and Obregon emphasize it. Post-WWII trade liberalization was a significant factor in reducing worldwide extreme poverty from 2.2 billion people in 1970 to 705 million in 2015. That’s a two-thirds reduction in absolute terms, even as global population roughly doubled. In percentage terms, the change is even starker. Extreme poverty was 42.6 percent of world population in 1981 and 8.6 percent in 2018. That’s a four fifths reduction in the proportion of people in extreme poverty, in less than 40 years. Never in human history has anything like this ever happened before, and trade is one of the engines behind it.

That progress is measured in dollars, but it’s not really about money. It’s about reducing infant mortality, and sending kids to school instead of to work in the fields. It’s about access to sanitation, electricity, and medical care. It’s about each generation finally living better than the one before it, even in the poorest places on Earth. Hans Rosling’s book Factfulness shows how deeply trade-enabled growth has improved people’s lives. Trade gives people hope, opportunities, and progress.

The authors then make the case against protectionism, which has guided trade policy for both the Biden and Trump administrations. In addition to puncturing myths about manufacturing, the balance of trade, and self-sufficiency, they point to good policies that policy makers should adopt.

Free trade is about more than removing obstacles. It is about creating an institutional structure under which people—not politicians and special interests seeking protection—can cooperate, compete, and resolve disputes in ways that they choose.

Cato’s web team put together an excellent website summarizing the case for free trade; Lincicome and Obregon’s paper is also a good read.

These are not the only resources for people interested in the case for free trade. Iain Murray and I wrote the report “Traders of the Lost Ark” a few years ago. Pierre Lemieux’s What’s Wrong with Protectionism?is a fantastic short book. The magnum opus of America’s complicated relationship with free trade is Doug Irwin’s Clashing Over Commerce, the paperback edition of which blurbs my review on the back cover.

Trade, Mission Creep, and the Indo-Pacific Economic Framework

President Biden announced this week a major economic agreement with a dozen countries in the Indo-Pacific region, to be called the Indo-Pacific Economic Framework (IPEF). Its goal is to provide a larger diplomatic and economic counterweight to China and increase America’s presence in Asia.

At first glance, it seems like an odd move. President Obama had already negotiated the Trans-Pacific Partnership (TPP) with many of the same countries in IPEF. President Trump pulled out of the TPP when he took office, but all the other member countries continued on without U.S. involvement under the renamed Comprehensive and Progressive Agreement for Trans-Pacific Partnership (CPTPP).

Negotiating costs for rejoining TPP/CPTPP would likely be minimal, while the economic benefits of more open trading relationships will help offset America’s high monetary inflation. As a political bonus, President Biden would be undoing a major part of the Trump trade agenda. So why is Biden starting with a new agreement from scratch? I argue that it’s part of a long-term evolution in how governments are treating trade policy.

One difference is that IPEF has a different regional focus. The TPP/CPTPP focuses on the Pacific Rim, so it has members in South and Central America, not just Asia. IPEF focuses on China’s neighbors, most significantly India. America is IPEF’s only non-Asian member. So, the different diplomatic focus explains part of it.

Another factor for choosing IPEF over rejoining TPP/CPTPP is political: It will not require Senate confirmation. That is a large hurdle at any time, but with Republicans likely to take over the Senate, they would be unlikely to give President Biden a victory, despite their sharing a protectionist trade outlook.

But the broader reason, about which I am more concerned, may be mission creep. I will hold off on further judgments on IPEF until more details become public, but the point about trade policy’s loss of focus on trade is important enough to discuss now.

The North American Free Trade Agreement (NAFTA), which went into effect in 1994, was accompanied by side agreements on non-trade issues, specifically environment and labor. This was a first for major trade agreements. Those side agreements are why CEI originally opposed NAFTA. Our analysts at the time favored the free trade parts of the bill, but they did not like the precedent set by the trade-unrelated side agreements. They had a point. In the years that followed, trade-unrelated issues took on greater prominence in new agreements, and their page lengths ballooned accordingly.

By the time President Trump replaced NAFTA with the United States-Mexico-Canada Agreement (USMCA), NAFTA’s non-trade side agreements were folded into the main agreement, which is now more than 2,000 pages long. During the Obama era, trade agreements began to lose the word “free” from their names. President Trump took it even further. As I pointed out at the time, “USMCA’s name does not contain the words ‘free’ or ‘trade.’ This is symbolism, but also important.”

It also accurately reflected the contents. This shift in emphasis is why Iain Murray and I came out against USMCA. We liked that it would mostly preserve NAFTA’s zero-tariff relationships with Mexico and Canada, but those were already in place, and all the new trade-unrelated provisions meant more net burdens and more opportunities for cronyism.

IPEF represents the next logical step in that process. Again, details to come. But the administration’s early remarks make it seem that rejoining TPP is not on the agenda and that IPEF will have little to do with trade. At least TPP treated trade relations seriously. USMCA’s bad precedent has likely borne bad fruit.

We’ll soon see what IPEF contains. But if it is a multi-issue thicket of ideological wish list items and special favors for politically connected interest groups, its member countries may end up bickering about small provisions when they should be cooperating on the big picture of building together a counterweight to China.

On the TV: Baby Formula

Newsy interviewed me recently for a segment on baby formula. The video and accompanying article are here.

Baby Formula and Regulatory Failure

A lot of people are blaming free markets for the baby formula shortage. As the economist Jagdish Bhagwati might say, the problem with this is that the invisible hand is nowhere to be seen. The baby formula market is filled with sweetheart government contracts, protective tariffs, barriers to entry, and other regulations. Government has so insulated the industry from competition that it’s a minor miracle the industry isn’t even more concentrated than it already is. Critics do not have a free market to point to.

In an op-ed being syndicated to newspapers by Inside Sources, I go through some of these regulations, then point out how absurd it is that many proposed solutions to the mess these regulations caused is to add still more regulations.

First, parents receiving WIC [Special Supplemental Nutrition Program for Women, Infants, and Children] assistance are allowed to choose only certain brands. Second, consumers must pay a 17.5 percent tariff on any imported formula, which prices countless brands out of the U.S. market. It’s a nice arrangement for the companies—and for their lobbyists—but it raises prices for families and makes it difficult to boost supplies during shortages.

When new formulas enter the market, regulations forbid sellers from letting anyone know about them for 90 days, even as manufacturers may advertise existing formulas all they like. Those first months on the shelf are make-or-break for many new products, which is why existing producers like this otherwise pointless regulation. At times like this, parents might appreciate hearing about new options.

One of those options is toddler formula, which in many cases meets the Food and Drug Administration’s nutritional requirements for infant formula. However, FDA regulations prohibit many manufacturers from recommending this option.

That is just the beginning of the government-created mess. The whole piece is here.

After I sent in the article, President Biden invoked the Defense Production Act to import more baby formula. It would do this by requisitioning commercial aircraft to fly in formula from abroad. But the only imports allowed would be from factories that meet all FDA regulations, which are designed in part precisely to keep foreign formula out of the U.S. market, so it wouldn’t do much good without some regulatory relief. And those imports would start happening on their own the minute such relief is offered. Either way, this Defense Production Act action is performative at best, and disruptive at worst, since those aircraft have other uses.

Image credit: Chris Freiman.

The better solution would be something called mutual recognition. If a competent regulator with similar standards to ours, like Europe, Japan, Australia, and the like, approves something, then it should automatically be approved in the U.S. In return, those regulators should give similar approval to U.S.-approved products.

Domestic baby formula producers will howl at having to face honest competition, but the next time a factory goes down, parents won’t be left scrambling, and even during normal times, actual market competition will help lower prices.

The op-ed is here. The Cato Institute’s Gabriella Beaumont-Smith and Scott Lincicome have also done excellent work on the baby formula shortage.

What Is Core Inflation?

The new inflation numbers are out, and they aren’t pretty. The Consumer Price Index (CPI) went up 0.3 percent during April, and is up a total of 8.3 percent over the last year. This is a slight improvement over last month’s 8.5 percent. More troubling is the core CPI reading, which increased 6.2 percent over the last year. What is this core inflation number, and why is it useful to know?

Core CPI is calculated the same way as standard CPI—take a hypothetical basket of goods and track their prices over time. The difference is that Core CPI removes the food and energy parts of the basket. The reason for this is that, contrary to popular belief, CPI doesn’t directly measure inflation.

Inflation is monetary; it has to do with the money supply growing at a different rate from real goods and services. The trouble is that non-inflation price changes are happening at the same time. These can be due to supply and demand shocks, changing tastes, seasonal patterns, and other factors. The CPI can’t tell how much of a price change is due to monetary inflation and how much is due to non-inflation factors like supply and demand. It just tracks price changes in a hypothetical basket of goods without asking what caused them.

Food and energy prices are notoriously volatile, which means that a lot of those changes have nothing to do with inflation. Grocery stores and gas stations change their prices every day. They can take enormous swings for reasons that have nothing to do with the money supply, such as Putin’s invasion of Ukraine or new regulations.

Taking food and energy out of the equation, as Core CPI and similar core inflation measures do, helps to keep the focus on inflation-related price increases. It isn’t perfect, because other goods are constantly subject to non-monetary price changes, too. But for those interested in tacking monetary inflation, core inflation is an improvement on the standard CPI.

It’s possible that inflation is at or near its peak right now. There is a lag time of up to a year and a half between the Fed’s monetary moves and their taking effect throughout the economy. The Fed increased the money supply by nearly $5 trillion during the pandemic, which caused most of the inflation we’re seeing now. The Fed stopped its big bond buy in March, and in June will begin slightly selling bonds. It will take some time before that shows up in any data.

Time will tell, but given that lag, it is possible we’re at or past the very worst of the current inflation, though it likely won’t significantly ease up until well into next year. Core CPI and other core-style indicators will help to give a more accurate picture of that process as it happens than will the standard CPI headline number.

Biden’s Inflation Speech: Top Domestic Priority

President Biden gave remarks on Tuesday declaring inflation his top domestic priority. Like many people, he seems not to understand that inflation is a monetary issue. Biden’s proposals each have their pros and cons, such price controls on insulin, antitrust action against the meat industry, and higher spending on renewable energy. But none of them have anything to do with inflation because they don’t have anything to do with the money supply.

Inflation is happening because the money supply is growing faster than real economic output. The Federal Reserve engaged in rapid money creation during the pandemic, and the result is today’s inflation. It will go back down once the Fed draws back some of that increase and money supply growth starts to better match the real economy’s growth. That’s on the Federal Reserve, not on Congress or the White House.

The political branches’ bipartisan deficit spending binge is likely responsible for a percentage point or so in the inflation rate, but one percentage point out of eight does little to explain today’s mess.

Biden does deserve some credit for the brief time he did discuss monetary policy. The Federal Reserve, not the political branches, runs monetary policy in the U.S. President Biden’s promise to “never interfere with the Fed’s judgment or tell them what to do” is a welcome change from his predecessor’s frequent public threats to Fed officials—assuming he keeps this promise. Some of his ideologically charged Fed nominees call into question his commitment to the Fed’s independence.

President Biden instead argued that inflation has two non-monetary causes: the pandemic and Putin’s war on Ukraine. Neither of these has much to do with inflation, because neither of them affects the money supply.

Biden then contrasted his own inflation plan with Sen. Rick Scott’s (R-FL) Republican economic plan. Sen. Scott’s plan also has little to do with inflation. A text search for “Federal Reserve” throughout the Scott plan’s economic planks on its website turned up zero hits. Scott’s plan has little support even in his own party. It has zero chance of becoming law, even if Republicans retake Congress. But as Grover Norquist pointed out, Scott’s plan is a political gift to Democrats, so one understands why Biden kept invoking it. It’s smart politics.

You can see why many economists find today’s inflation speech a little frustrating. It wasn’t actually about the thing it was about.

Still, President Biden did say plenty about faster-than-inflation price increases in gas, food, and other goods that almost everyone uses. Again, the faster-than-inflation components of those price increases are not inflation. That doesn’t mean that those prices increases aren’t real or that they aren’t hurting family budgets. They deserve policy action. But they are separate from inflation, and should be treated separately. As I’ve written before and will write again, supply and demand changes are not inflation. If isn’t monetary, it isn’t inflation.

One of President Biden’s energy proposals is to make more ethanol to reduce the need for imported oil. However, he did not mention the tradeoff: higher food prices. Farmers have planted only a certain amount of corn this season (planting season is typically late April to early May). Diverting more corn to ethanol leaves less left over for food and livestock feed. The increased ethanol might shave a penny or two from the price of a gallon of gas, based on the amounts involved. The tradeoff is higher prices for meat and for any food made from corn, such as chips, tortillas, and many cereals and sweets.

To fight rising food prices (counteracting his ethanol proposal), Biden proposed an antitrust investigation against meat producers. Realistically, this is Biden looking tough while doing nothing. Considering the likely policy alternatives, that’s not necessarily a bad thing. Antitrust cases take years, and inflation will likely be long gone before any case is resolved.

Biden’s response to food prices should instead involve trade liberalization. When asked about ending the China tariffs after his remarks, Biden said, “we’re discussing it, and no decision has been made on it.” On the merits, that decision should have been made long ago. Tariff relief would lower, by an average of almost 20 percent, the prices of thousands of goods worth hundreds of billions of dollars, from clothing to medicine to electronics. Combine this with the Fed finally getting its monetary house in order, and Biden would have a substantial accomplishment to brag about—and even better, for political purposes, it would involve undoing one of his predecessor’s signature policies.

While Biden did point out the importance of ports and trucks in opening up supply networks, he offered no concrete proposals for liberalizing them. Dockworkers’ unions have long resisted automation, around-the-clock operations, and other improvements that ports in most other countries adopted years ago. Convincing unions to join the current century would be a good start, though this likely requires more political will than anyone in the White House or Congress currently has.

Biden would like to see more truckers on the road. That is an easier lift, since many of the obstacles are in Washington, and under Biden’s control. Good ideas there include lowering the federal age requirement for truckers down to 18, giving truckers more control over their own hours, and getting rid of the 220 percent tariff on truck chassis, which forces small owner-operators to pay more than triple the world price for one of their truck’s most important components. Biden did not mention these ideas, but they would help ease prices on many goods (though again, separately from inflation, because these don’t affect the money supply).

President Biden gave his speech in the first place because the public wants to see him doing something about the country’s problems. This is problematic even in good times. The president has little control over inflation, and most of his proposals harm more than they help, while leaving inflation unaddressed.

Even a serious liberalization agenda on trade, labor, and regulation would have only a small effect on taming inflation, because those policies wouldn’t affect the money supply. They would have substantial economic benefits and are worth pursuing, but it would be misleading to say they affect inflation.

President Biden is hardly alone in not knowing what causes inflation. But when your starting point is in error, there is a very good chance your policy conclusions will also be in error. There is plenty he can do to fight inflation-unrelated price increases, but aside from a glimmer of hope for tariff relief, few of those options appear to be on the table.

U.S. to Lift Tariffs against Ukraine for One Year: China Next?

In 2018, President Trump enacted a 25 percent tariff on Ukrainian steel, on what he claimed were national security grounds. They remained in place throughout Trump’s subsequent (and unrelated) Ukraine drama over withheld military aid. President Biden left the Ukraine tariffs in place even as he undid other Trump administration policies. They even stayed in place for more than two months after Vladimir Putin invaded Ukraine. Now the Biden administration finally announced it will lift the tariffs—but only for one year. Possible relief on the China tariffs may also be on the way.

America’s trade policy is overdue for a course correction, but the Ukraine liberalization is one of the smallest possible trade actions possible. Ukraine is only America’s 12th-largest source of steel imports. It will have only a small positive effect on steel prices in the U.S., which are currently the world’s highest, due in large part to the Section 232 metal tariffs, of which the Ukraine tariffs are a part—but it’s a start.

Tariffs are what we seek to do to our enemies during wartime. There is no good reason to impose them on allies—especially they are attacked by a common enemy. The Ukraine tariffs are an obvious example that is hopefully raising an outcry for further action. The Biden administration should also remove other tariffs against allies such as the United Kingdom, Europe, and others. In addition to the economic benefits for everyone involved, trade liberalization would strengthen diplomatic efforts in countering Russian and Chinese geopolitical influence.

It’s not just allies—tariffs are also ineffective against rivals. China, which will be the next big trade issue to come up on the agenda, is a case in point. President Trump’s China tariffs are required by law to expire after four years unless they get renewed.

U.S. Trade Representative Katherine Tai is pushing for President Biden to extend them, even though the tariffs are raising consumer prices on thousands of goods above what inflation is already doing (inflation is a separate issue that concerns the money supply, not trade).

Tai still believes in a “tariffs as leverage” theory, even though four rounds of tariffs plus the Phase One agreement failed to net a single substantive reform from Beijing; the real world has a lesser opinion of the leverage theory than Tai does. It is telling that among her few allies on the leverage theory are Trump officials such as her predecessor, Robert Lighthizer.

What should Congress do? In the short term, it should repeal as many tariffs as possible. During an election year where inflation is the top issue, tariff relief would lower prices on all manner of goods (though, again, inflation is a monetary, not trade, issue).

In the longer term, presidents should not be able to enact tariffs by themselves. In our system of government, taxing authority belongs to Congress. Congress should repeal Section 232 of the 1962 Trade Expansion Act, which delegated some of that authority away. Under Section 232, presidents may enact tariffs without Congress, so long as they cite national security reasons. The Ukrainian steel tariffs are Section 232 tariffs.

Congress should also repeal Sections 201 and 301 of the 1974 Trade Act, which give the president similar unilateral tariff-making authority on competitiveness or treaty violation grounds. The China tariffs were enacted under Section 301. Repealing these would mean that no future president could abuse these powers again. They are harming American economic and diplomatic interests.

Repealing national security tariffs against Ukraine, of all countries, is low-hanging fruit. There is much more waiting to be picked. We found out—the hard way—that tariffs provide no leverage in convincing Beijing to reform its unfair trade policies. It is time to cut our losses and move on to policies that work.

Fed Hikes Interest Rate: Bigger News on Bond Portfolio Mostly Neglected

The Fed this week announced a half percentage point hike in its federal funds rate. This is the right thing to do, but it will have only a small effect on inflation. Far more important is an announcement the Fed made the same day, but got far less coverage. It will finally begin winding down its balance sheet of government bonds in June. Buying and selling bonds is the Fed’s single most powerful inflation-adjustment tool, far more powerful than interest rate adjustments. It should have started selling off bonds months ago, but June is better than never.

Inflation (or deflation) happens when there is a mismatch between the money supply and real economic output. If one grows or shrinks, the other needs to grow or shrink by a matching amount, or there will be inflation or deflation. The Fed’s job is basically to play a matching game.

Buying bonds is how the Fed directly increases the money supply—which directly increases the inflation rate. When the Fed buys bonds, it pays for them with money that it newly creates. This new money then winds its way through the economy.

If the Fed wants to directly shrink the money supply—and directly reduce the inflation rate—it can sell bonds. The money it makes from the sales can then be retired from circulation. Interest rate adjustments, by comparison, have only indirect effects on the amount of money in circulation.

In ordinary times, the Fed should engage in some bond buying. If real economic output goes up by 3 percent, the money supply should go up by a matching amount to prevent deflation. Since the Fed has a 2 percent target inflation rate, the Fed would instead usually react to 3 percent growth, with a 5 percent money increase—3 percentage points to match real growth plus two extra percentage points to meet the Fed’s inflation target. (The Fed’s exact response should vary depending on other factors, but this simplified illustration tells the essential story.)

That is not what happened during the pandemic. The Fed’s bond holdings grew by 72 percent in three months, then grew some more. It was the largest bond-buying spree in the Fed’s history. The Fed’s bond holdings totaled about $4.1 trillion when COVID-19 hit in February 2020. Three months later, it was $7.1 trillion. It continued buying bonds until March 2022, and its portfolio now stands at $8.9 trillion.

The Fed’s announced selloff is modest in this context, and may not be enough to substantially reduce inflation when the lag time ends sometime next year. It will reduce its $8.9 trillion portfolio by $47.5 billion per month for three months, then $95 billion per month for an unspecified amount of time.

Winding down inflation comes with a risk of recession, which explains the Fed’s timidity, especially in light of last quarter’s GDP contraction. So, the Fed has its reasons, though they are not entirely convincing, considering the short-term and long-term pain that inflation causes.

Nor did the Fed’s initial buying spree come out of nowhere. When people stop spending money, the Fed’s typical response is to inject some new money into the economy as a form of stimulus. It can work in the short run, though usually with the tradeoff of some slowdown later on.

The trouble is that the Fed misread the situation during the pandemic. It wasn’t a typical recession. There was no financial crisis, housing bubble, or economic malady. A healthy economy shut down for a bit, then opened back up. The virus had to pass so people could safely open back up, and that’s it. The Fed used the traditional tools to fight a new battle, and that is the biggest driver of today’s inflation. Overspending by the political branches didn’t help, but that explains only about 1 percentage point of 8.5 percent inflation.

There is a lag time in bond-buying actions from about six 6 to 18 months, since it takes time for new money to move from bond sellers’ wallets out to the larger economy. The rise in inflation that began in 2021 was the result of the Fed’s 2020 bond-buying spree. Since the Fed isn’t trimming its bond portfolio until June 2022, even if inflation has already peaked, it will likely remain high at least until early 2023 and possibly longer, since the Fed’s more recent buyups haven’t yet worked through the economy, and the selloffs to counter them are both late and relatively small. Relief would come sooner had the Fed acted sooner and more boldly.

Despite last quarter’s GDP decline, economic output is already back to where it would have been if COVID had never happened. Because of today’s needless inflation, the Fed’s delayed response in fixing it, plus overspending and general policy bungling by Congress and two presidents, a recession that COVID couldn’t cause might happen anyway. While this week’s interest rate hike will get all the attention, the real news is the Fed’s coming bond selloff.

A subsequent post will explain why the federal funds rate has only a small effect on inflation, and why journalists and stock markets should pay less attention to it.

Sorting Out Some Confusion on Trade and GDP

While inflation is the biggest economic problem right now, trade policy is another reason why GDP shrank last quarter. It is also a common source of misunderstanding. This post attempts to clear some things up.

University of Central Arkansas economist Jeremy Horpedahl notes two overlooked factors in today’s bad GDP news: 1) a decline in government spending and 2) a decline in net exports.

The spending decline was expected, as temporary COVID spending programs have begun to expire, though other big spending bills will partially take their place as the infrastructure bill and other recent trillion-dollar packages begin paying out over the next several years. While this can cushion short-term GDP numbers, those government spending projects will create less value on average than alternative private uses of those resources. Short-term stimulus means long-term harm.

The decline in net exports is more complicated. The Trump-Biden tariffs and the retaliations they sparked put a damper on global trade even before the pandemic. They added to existing friction points in trade, such as excessive regulations on ocean shipping, ports, and trucking.

As things go back to normal, the supply network problems exacerbated by these policies are still being untangled. If Congress and the administration are looking for ways to boost growth without raising spending, they should liberalize trade and reform regulations.

GDP measures how much stuff people create. Trade regulations block people from making stuff, often for no good reason. Moving toward freer trade would boost GDP in both the short and long run.

Trade also confuses some pundits. There will be talk on economically illiterate cable news shows about how America’s trade deficit is causing today’s economic troubles. As usual, those pundits should be ignored. Economists going back to Adam Smith know that the trade deficit has nothing to do with economic health. It is neither good nor bad. For example, Russia’s economy may shrink this year by as much as 45 percent, but it has a massive trade surplus. In America, the trade deficit went up throughout the gangbusters growth of2021. It tends to be highest during booms and lower during recessions.

Americans buy all those imports with dollars. Foreign sellers in China or Japan can’t use dollars at the grocery store—so they send them back to America. Some of those dollars buy American exports. Most of the rest goes to investments in American businesses and government bonds. Every dollar of trade deficit is a dollar of capital surplus. It’s a wash. People spend their dollars one way instead of another, but they get spent just the same. It doesn’t matter for GDP.

The only reason net exports are in the GDP equation is to avoid double counting. When an American buys a foreign import, she first has to earn the dollars to pay for it by making something here in America. That earlier production was already counted once in GDP. Similarly, exports count toward GDP, even though Americans don’t consume the final product. Exports are the price we pay for imports. Any imports beyond that are paid for by cash earned from other domestic production that doesn’t get exported, and was already counted in GDP.

As with most other issues, do not listen to hysterical, hair-pulling cable news pundits on trade deficit issues. The economy has serious problems, but the trade deficit is not one of them. Policy makers should instead focus on liberalization—perhaps starting with repeal of the Jones Act.

GDP Shrinks: The Good and the Bad

The advance estimate for 2022’s first quarter gross domestic product (GDP) is in, and the news is not good. Adjusting for inflation, GDP shrank 0.4 percent from the previous quarter. If GDP stays on its current path for the entire year, the economy would shrink by 1.4 percent. A revised estimate will come out on May 26, but likely won’t be much different. Let’s unpack some of what today’s news means.

The big news is that the economy is at a high risk of recession. The standard definition of a recession is when GDP shrinks for at least two quarters in a row. We may even be in one now, though we won’t know until next quarter’s results arrive in July.

The other big news is that the Fed’s inflation-fighting job just got more difficult. The reason inflation is high right now is because the money supply is growing faster than GDP. If they were growing perfectly in sync, inflation would be near zero. Right now they are mismatched because the Fed attempted to stimulate the economy during the worst of COVID with a flood of new currency. At a technical level, inflation is easy to fix. It’s a matching game—just match money supply growth with economic output growth.

The difficult part is that tapering back inflation risks causing a recession, and we’re now officially halfway there. The Fed has been criticized for being too timid about inflation, and in my opinion rightly so. But if you’re wondering why it’s been timid, there’s your answer.

Fortunately, today’s GDP numbers aren’t on the Fed. Changes in monetary policy have a lag time that ranges from six months to as long as a year and a half, and the Fed took no action on inflation until March, when the first quarter was nearly over. But going forward, that gives the Fed an excuse for inaction. While that might prevent some short-term harm during an election year, it comes at the cost of even greater long-term harm from sustained high inflation.

Fed Chair Jerome Powell recently indicated that the Fed will take more aggressive steps starting at its next Board of Governors meeting in May. But with today’s news, will he keep that promise?

That’s the bad news. But there are some good points. The big one is that the economy is already roughly back to where it would have been if the pandemic had never happened. Last year’s breakneck growth, which peaked at 7.0 percent, was mostly catch-up growth. It caught us up to where we were going to be anyway.

The economy was mostly healthy going into the pandemic. There was no housing bubble or financial crisis. People hunkered down when COVID hit, and they opened back up when they felt it was safe. So, 2021’s rapid catch-up growth makes sense. The COVID recession wasn’t a true downturn, so much as a pause. Slower growth is a sign that things are finally getting back to normal. That’s a good thing!

That said, a shrinking economy in real terms is never a good thing. Real GDP data go back to 1947. Over the last 75 years, average annual real growth has been a little over 2 percent. If we’re caught up after the pandemic shock, we should expect growth to slow down to that 2 percent ballpark. Since the economy is shrinking, something else is going on in addition to that expected catch-up slowdown.

In sum, GDP growth was going to slow down no matter what, because the economy is now largely caught up from the COVID shock. But the fact that it actually went negative is due to a mix of factors. Inflation is the biggest one, and today’s GDP news may make them more reluctant to fix the problem they caused, especially during an election year. That is a cause for concern.

Part of the GDP reduction is from expiring COVID spending programs, and is actually good in the long run. Even most of the COVID spending bills’ supporters did not intend for them to become permanent. Russia’s invasion of Ukraine is having a small negative effect on the American economy, but is only a small part of the story, and mostly restricted to energy prices. Illiberal trade and regulatory policies are a bigger issue, which the pandemic exposed. These have mostly not been fixed, and are dragging down the economy. Congress and the Biden administration can help by liberalizing trade and regulation and allowing the Fed to do its job of reining in inflation.