Controlling the process of trade

How tariffs affect the balanced forces of supply, demand and profit.

By Béla Lipták

Process automation applies to more than industrial processes. I've written about controlling self-driving cars and nuclear reactors. Here I describe the dynamic characteristics and controls of international trade.

Traditionally, gross domestic product (GDP) indicates a nation's total output, but one could argue that it’s outdated because it doesn’t reflect the value of services like free software updates or others by Facebook, Google, Twitter, Instagram, etc. Others say GDP reflects only production, but doesn’t consider social welfare or societal mood, which also affect the economy and are hard to predict or quantify.

Yet, for this article and simplicity, I'll use GDP growth to indicate health of the economy. This growth can be calculated by three methods: 1) production measure—increasing or decreasing production and use of services, 2) resource cost-income measure—increasing or decreasing expenditures, or 3) spending measure—higher or lower wages and income. The resulting GDP measurements will be the same, no matter which method is used to calculate it. Prosperity is usually defined as a yearly GDP growth of 2%.

Here, I'll use method #3, which determines GDP as the value of goods and services purchased by households, industry, commerce and government, including investment in machinery and buildings. This GDP calculation includes the difference between exports and imports, and I'll focus on trade and the effectiveness and consequences of methods of maximizing exports and minimizing imports.

First, let's look at how the economy works. Figure 1 illustrates how the desire of the consumer (demand) for a particular product ("consumer surplus") changes with the price and availability (quantity) of that product. The red demand line (D) shows that the lower the availability (Q) of a product, the more consumers are willing to pay for it. Inversely, the blue supply line (S) shows that the greater availability (Q), the more the producer is willing to sell at a lower profit ("producer surplus"). When supply and demand are balanced at point B, both consumer and producer are satisfied (both surpluses are zero).

Figure 2 illustrates the effects of tariffs on imports. It shows how a tariff reduces demand for imported goods as it increases their price. It also shows that adding tariffs result in a loss to consumers as "consumer surplus" is reduced (green). At the same time, it increases profits of the domestic suppliers by increasing "producer surplus" (yellow), and it also increases tax revenue for the government (blue area). Therefore, the tariff, while increasing employment by increasing domestic production, results in a net loss for society as a whole (pink areas).

The traditional view is tariffs stimulate and protect infant industries in underdeveloped nations (hence the name "protective tariff") only if the tariffs are high enough to allow domestically manufactured goods to compete with imported ones. Today, the situation has changed because developing countries can obtain advanced technologies from abroad (as did China), and can take advantage of low labor rates. From a process control perspective, the period during which protective tariffs are needed is short (fast process) because both new technologies and low labor rates are readily available.

In developed nations, this is not the case because labor rates are relatively high and can't be easily reduced. Therefore, developed nations can only make their industrial products competitive on the world market if their production costs are reduced by automation, which in the short range produces unemployment. In the long range, this unemployed workforce can be reemployed if its education is increased to handle design, operation and maintenance of robots and other equipment. From a process control perspective, this is a long (slow process) requiring years of dead time. During this transition, protective tariffs can be used, unless a sophisticated workforce can be imported. For example, Silicon Valley is successful because it sucks up talent worldwide.

Now, let's look at the trade among nations with different labor rates, such as the U.S. and China. In many ways, the flow of goods and the flow of liquids are similar processes because profitability is a driving force that's similar to a pressure difference. Figure 3 is a simplified illustration of U.S.-China trade, assuming (just for illustration) that this trade is free and not influenced by tariffs or subsidies.

China is the world's largest exporter, and about half of its exports go to the U.S. Figure 3 shows that four times as much Chinese imports (I) flow into U.S. as the flow of U.S. exports (E) to China. This is because the per-capita GDP in America (PPP) is 3.8 times that of China, and therefore products made in the U.S. much more expensive than imports. This price difference and the corresponding profits are the driving force (similar to the ΔP or pressure difference) of the flow of imports. This PPP difference (∆PPP) results in migration of people to the U.S. and migration of jobs to China. In the long range (decades), these migrations tend to equalize the living standards in both nations, which equalizes the sizes of imports and exports among them.

This equalization process is unavoidable, but if allowed to occur too fast, it can result in massive unemployment and migration into the developed countries. It's debatable what the right speed of equalization is, but it must be slow so societies can adapt to it.

Flow in a pipeline has a single degree of freedom. Therefore, the flow can be controlled either by throttling a control valve or by modulating the speed of a pump, but not both. Yet in Figure 4, two controllers are attempting to control the same flow: one nation tries to control the supply flow into the pipeline (exports), while the other nation attempts to control the exiting flow from that same pipeline (imports). This is a highly interacting, unstable configuration, because the two controllers are fighting each other (trade war), which is to the disadvantage to both nations because the importing nation will waste energy (profits) by throttling the "import control valve," while the exporting nation will waste energy (profits) by investing more energy to speed its "export control pump."

Figure 4 shows how isolationism can result in trade wars which are harmful to both nations, and why it’s in the interest of both nations to make trade among them as free as possible (open up the control valve). Naturally, global trade is not a single pipeline process (the exporting pump supplies a header feeding into many importing valves), but the fact remains that in the long range, free trade is more efficient, and isolationist trade (protective tariffs and subsidies) is wasteful to both sides.

In Figure 4, I didn't show the role of national debt because, in addition to the yearly U.S. trade deficit of $350 billion, China also owns $1.25 trillion worth of U.S. government bonds, which if sold, could cause runaway inflation and global instability. This, too, is an argument in favor of trade agreements like NAFTA and TPP instead of protective tariffs or trade wars. Also neglected in Figure 4 is the role of military expenditures, which have similar consequences as exports, except that they bring in no income. The yearly military expenditure of the U.S. is $600 billion, which sum exceeds the total expenditure of the next 10 nations (Russia, for example, spends only $66 billion).

This picture is rather bleak, but our automation profession can help solve these problems. U.S. products can compete with imported ones without the need for any tariffs when the goods are produced by high technology. A new Marshall Plan is needed to support this high technology by drastically improving domestic education, and by not only eliminating unemployment, but also creating an immense market through conversion to green energy.

Some will ask, where will the money come from to do all this? The answer is the same as was for the Marshall Plan at the end of World War II—it came from selling securities. Some will say this creates inflation, and most people automatically think of inflation as a bad thing, but that's not necessarily the case. Inflation is the natural byproduct of a robust, growing economy. Lack of inflation or worse, deflation (lowering prices) is actually a much more adverse economic indicator. My understanding is that in a healthy economy, wages and taxes also rise at the same rate as prices, but I will not go into this topic because I am only an engineer and could be wrong.