--:-- Host: The question is, does free trade with China advance free markets or does it distort and wreck our free market? We have treated free trade as the natural extension of free markets. If you attempt to be for free trade with a non-market economy, you are not actually advancing free markets in any significant way at all. You're actually dramatically hindering them.
--:-- Noah Smith: China is pretty much the only competitive threat we face, which all our allies are facing at the same time. And we're fighting with our allies instead of pooling our resources to stand up to China.
--:-- Oren Cass: At the end of the day, if the goal is not to make America the assembly hub of the world, but to actually re-industrialize, you have to actually create incentives to bring back those intermediate supplies.
--:-- Host: The U.S. is rethinking its economic playbook on tariffs, trade, manufacturing, and what it really means to support family, community, and industry. In this episode, I'm joined by Oren Cass, founder of American Compass, and Noah Smith, author of *No Opinion*, for a debate on industrial policy, reshoring, and whether tariffs help or hurt American manufacturing. We get into the data behind recent trade policy, the short versus long-term effects on domestic industry, and whether the U.S. should double down on protectionism or scale up with its allies to compete globally. Along the way, we talk about factory construction, global supply chains, economic modeling, and what both sides need to see to actually change their minds. Let's get into it.
--:-- [Discussion begins]
--:-- Host: We're really excited to have you on because we've been talking about some topics over the past few months that you've been thinking a lot about, that you've been writing a lot about, that you're thinking is, in fact, informed and inspired and encouraged some of what's actually happened. Before we get into some of the specifics, I wanted for some of our audience who may not be familiar, especially on the a16z side, to give you an opportunity to introduce your platform, so to speak, or introduce the main topics and ideas that you're affiliated with. We'll link to the book and some of the articles about a newer conservatism, but maybe you can help define it in broad strokes and we'll get to some specifics.
--:-- Oren Cass: Sure. I'll try to keep it short. Let me know if you want me to say more about anything. I founded American Compass back in 2020 with the mission to restore an economic consensus that emphasizes the importance of family, community, and industry to the nation's liberty and prosperity. From one perspective, you'd say that seems self-evident and unnecessary. But from another, it represents a fairly dramatic departure from the way economics has been conducted, and economic policy has been conducted, especially on the right of center, but probably including the center left as well. It has really given shape to our economic trajectory over the past generation.
--:-- Our view is that we have seen a sort of excessive faith in markets and an excessive assumption that whatever produces efficiency, whatever maximizes corporate profits, will also be best for everybody. That has failed in two respects. First, that is in fact not best for everybody. You can get very unequal and distorted outcomes. Second, even if you had the economic system operating the way you might ideally wish it would, that's not actually going to take care of a lot of the things that matter most to people.
--:-- That pairing of family, community, and industry maybe seems a little bit odd. Those aren't three things that always get paired together, but we see them as three things that are incredibly important to flourishing—both human flourishing at the micro level and national flourishing at the macro level—that markets simply don't guarantee. Markets can uphold those things, but there's nothing in economics that says that markets will. The core of our argument is that if those are things that anybody, and especially conservatives, care about, then they have to be willing to think about an approach to economics and markets that goes beyond just trusting that whatever comes out of the market is going to be good. That leads toward all sorts of interesting policy conversations that have been absent for about a generation now.
--:-- Noah Smith: I would like to know how restoring manufacturing—because I've been calling for restoring manufacturing for a long time for various economic purposes, higher growth, national security, things like that—but I want to know how restoring manufacturing would strengthen family and community in America. That's a nexus that I really haven't seen much evidence on. I know observing countries like Germany and South Korea, where the manufacturing share of industry has remained remarkably high, I see them with extremely low fertility rates, low rates of family formation, skyrocketing divorce rates, and in Korea's case, an extreme suicide problem. So if we could restore manufacturing, which I would like to do, how will that restore the family?
--:-- Oren Cass: I guess those are questions at very different levels of specificity. Let me say a little bit more about the broader question first, and then if we wanted to dive into the manufacturing piece, certainly we can. To your point, Eric, about this being Econ 102 that I find myself on, it seems to me that a lot of the gap is between the quite oversimplified models that we teach in an Econ 101 or an Econ 102 and the set of factors that are actually relevant in a modern economy.
--:-- To give one example, if you are learning comparative advantage in Econ 101 and the wonders of free trade, you are almost certainly talking about an economy with two markets and two goods. They're almost invariably agricultural goods or something relying on natural resources. You're going to see that if you change how much of each country produces and you trade some of one for some of the other, then both can be better off. That's great. Totally agree. No issue with that.
--:-- The problem in the real economy is twofold. One is that most of what's being traded is not natural resources where maybe you're a place that grows a lot of avocados or maybe you're a place that has a lot of fish, but it's manufactured goods. Advantages in manufactured goods are a lot less likely to emerge from some sort of natural endowment of a country and much more likely to emerge from the explicit policy choices that the country makes. A good example is there's no special silicon on Taiwan's beaches that make it the best place to fabricate advanced semiconductors. If you are expecting to just see everybody have a natural advantage in something, and that's what we trade, you'll be very disappointed. You'll find that the countries that strategically attempt to develop an advantage in something get to excel in that. And some things are more economically valuable, have more spillovers, have more security implications than others.
--:-- The second problem is that you don't actually have to trade goods for goods at all. You can have the situation we have in the American economy today, represented by a trillion-plus-dollar trade deficit in which you are exchanging goods for assets. If you imagine going back to your happy little Econ 101 class—in my class, it was fish and sweaters—and you imagine that one country catches the fish and makes the sweaters and the other country just issues treasury debt to buy fish and sweaters, it's not nearly as obvious to me that is actually a welfare-enhancing exchange, certainly over the long run. That's one concrete example in the trade space where I think there's a big problem.
--:-- The one other thing I'd add that's even more conceptual, that I think we've really failed to grapple with until recently, is to your point about being free market enthusiasts. I, too, am a free market enthusiast. The question is, does free trade with China advance free markets or does it distort and wreck our free market? We have treated free trade as the natural extension of free markets. If you are for free markets, you are for free trade. But I think what we've learned is if you attempt to be for free trade with a non-market economy, you are not actually advancing free markets in any significant way at all. You're actually dramatically hindering them.
--:-- That's one example of an area. We do a lot of work also on industrial policy, on financial markets and investment flows, on labor policy, on competition policy. But all of it ultimately follows the same template of asking: if we look at the world as it actually is, if we look at what economics actually can and cannot promise, where are the places where policy is probably going to have to play a role if we want to get the kinds of outcomes we would actually say are good outcomes?
--:-- Noah Smith: Just to follow up on that point, your proposed policy is reduced immigration, trade protectionism via tariffs, policy to increase domestic industry manufacturing, policies to increase fertility. Is your policy playbook actually similar to China's, or kind of turning us into China, or mimicking or mirroring their strategy?
--:-- Oren Cass: I don't think so. Just because China is doing something doesn't make it bad. But virtually everything you just described were also policies that were the American tradition until very recently. America had very high tariffs and built its domestic industry behind a wall of protectionism. America aggressively restricted immigration. America had quite aggressive industrial policy, and so on and so forth. Conversely, China—I believe maybe just last week they announced they might be doing some sort of pro-fertility policy—but historically, China has been the poster child for extremely unwise anti-fertility policy. I wouldn't characterize anything of what we're doing as saying we should become more like China. I would say to the extent that we are going to operate in a global economy, we need to have policy that accounts for the existence of China. That is unfortunately something that we have declined to do.
--:-- Erik Torenberg: Oren, I have a question. Do you think that Trump's tariffs overall will increase U.S. manufacturing output and employment?
--:-- Oren Cass: In the long run, I think it definitely will, because I think it—
--:-- Erik Torenberg: How long is long?
--:-- Oren Cass: Well, let me answer the question. I think if the long run is anywhere upwards of a few years, I think it will. The question is how long does it take to actually change investment decisions and then how long does it take investments to come online. I would expect to see the results of some of the investments we're already seeing being made come online in the next few years. I think a good proxy is how long did it take Japanese automakers to set up in the U.S. after their imports into the U.S. were badly constrained. From there, a lot of it comes down to what we do on policy. Can we actually create a credible, long-term, consistent commitment to a tariff policy that makes people believe they should invest? And can we do the other complementary things? On the supply side, the industrial policy to actually support investment, the workforce development. I think there are other things that we need as well.
--:-- Noah Smith: To be clear, since Trump announced his Liberation Day tariffs, we've seen deterioration in manufacturing PMIs, purchasing orders, investment plans. Every indication of manufacturing you've had is slumping now, notably beginning directly after Trump's announcement of those big tariffs. We have a pretty good idea from surveys of people who run manufacturing companies. They say exactly what basic economic theory would say: they're having a very difficult time sourcing intermediate inputs. There are all kinds of things from supply chains they can't source. As a result, they're cutting back on building factories, cutting back on investing and ordering more manufactured goods. People aren't ordering as many manufactured goods, et cetera.
--:-- If I'm hearing you correctly, the idea is that this is temporary and that once we reestablish entirely within-country supply chains, this will reverse and manufacturers will start investing a bunch and we'll have a manufacturing boom. The manufacturing bust we're seeing now, apparently as a result of the tariffs, is simply temporary pain for long-term gain. We just have to stay the course. Is that an accurate summary of what you're telling me?
--:-- Oren Cass: I'd prefer to answer questions you ask instead of giving a yes or no to your statement of a case.
--:-- Noah Smith: I would like you to evaluate this. Tell me what you think about the fact that all the manufacturing indicators in the economy are flashing red directly after the announcement of Trump's tariffs.
--:-- Oren Cass: First, I would dispute your characterization that they're all flashing red. I think the distance between the overheated rhetoric we have gotten from economists and the actual performance of the economy has been pretty dramatic on almost every front. There have certainly been a number of manufacturers who have said this has made life harder. There have been others who have said this is inducing us to make substantial additional investments. We've already seen TSMC as one example say that they are slowing investment in Japan to invest more quickly in the U.S. There's a very good story on drug makers in the Wall Street Journal last week saying that they actually thought the effect of the pharmaceutical tariffs under consideration would lead to significant reshoring of drug manufacturing.
--:-- If I look at both the economy's actual performance over the last six months and the more anecdotal evidence, I would say it's absolutely too soon to tell one way or the other. What gives me a significant amount of optimism is that I do think you're seeing companies, generally speaking, respond to the incentives in front of them by thinking about how they would adjust their businesses accordingly. The intermediate goods piece of it is definitely an important one that creates short-term challenges. But at the end of the day, if the goal is not to make America the assembly hub of the world, but to actually re-industrialize, you have to actually create incentives to bring back those intermediate supplies. You can't just say we want cheap intermediate supplies so that we can assemble for re-export.
--:-- I'd be very interested to know what data sources you're looking at when you're evaluating the state of America's manufacturing in the last few months. You said all the manufacturing signs are flashing red. That has not been my perception of the economic coverage over the last month or two.
--:-- Noah Smith: Well, there's manufacturing employment. There's one number I'm very interested to look at that we won't have for a little bit longer is Q2 capital investment, which I believe will come out later in August. There are various manufacturing sentiment indications. There is actual industrial output capacity utilization, these kinds of measures. We do an awful lot to measure the performance of the manufacturing sector. I think certainly we saw in the immediate aftermath of the tariff announcements a lot of downturns and a lot of concern. But I'm not sure how much of that has actually been borne out at this point several months later.
--:-- Oren Cass: You know what PMIs are, right?
--:-- Noah Smith: Yeah, but so what are—
--:-- Oren Cass: Well, it's appropriate to educate me.
--:-- Noah Smith: The Institute for Supply Management, which is a consortium, they survey manufacturing companies. They call them up and ask them, are you investing? How much are you investing? Do you have more orders? They do these surveys. It's pretty rigorous data. Let me read from a Bloomberg article from the first of this month: "U.S. factory activity contracted in June for a fourth consecutive month as orders and employment shrank at a faster pace, extending the malaise in manufacturing. Bookings contracted by the most in three months and have been shrinking for the past five months. An index of backlogs..." The employment index, which measures manufacturing employment, has fallen significantly. The purchasing managers index, the PMI, is also below 50, which signals contraction in the industry.
--:-- Bloomberg reports on this, the Wall Street Journal reports on this. Everyone reports on this as a reliable first indicator of how manufacturing is doing. It's not perfect, but over the long term, it's pretty correlated with government statistics on how manufacturing is doing. I'm wondering, where are the alternative statistics? Where are the numbers I'm not seeing that show good news in the manufacturing sector since Trump's tariffs? Where is it?
--:-- Oren Cass: I just gave you a long list of other economic indicators we have that all seem to be holding up quite well.
--:-- Noah Smith: They're not. Manufacturing employment is not doing well. We're not seeing a rise in manufacturing employment. We're not seeing a rise in manufacturing industrial production. We're not seeing this.
--:-- Oren Cass: Those are exactly the things I said I didn't think you would expect to see over the initial months of a policy like this. It literally takes several years to do capital investment and actually build things out. One thing that really frustrates me in a lot of these discussions is that I think back to the argument from the other side. When the argument was, we're going to aggressively expand free trade. We're going to embrace China. And we got a lot of initial negative results from that. But that's okay. Anybody who focused on those doesn't understand the long run and the way that everybody is going to actually end up better off someday.
--:-- But then when we go in the other direction and say, reshoring is going to be a process. You have to shift incentives. There's going to be disruption. Here's the better thing we might build toward. You just get stuck on a podcast with somebody reading you the results of last month's phone survey data. We have to evaluate a little bit more what were the things that we did or did not expect to happen over the initial months versus what were the things we did or did not expect to happen over several years. Most of the economists' predictions of everything that was going to go wrong initially have essentially been wrong.
--:-- Noah Smith: What about the data I just read you? What about that? That was an economist predicted tariffs would interfere with supply chains, trade in intermediate goods, and this would lead to contraction in manufacturing. That's exactly what we're seeing now. I don't understand how that prediction has gone wrong.
--:-- Oren Cass: I meant more broadly everything from the direction of the dollar to the performance of the stock market to the level of retaliation we should expect. There was a consensus model of here's what's going to happen if you impose tariffs and why it's extreme, it's all folly. That world has not played out. I do think it's important for those who were sure they knew exactly what tariffs were going to do because they took Econ 101 to step back and recognize that the world is a little bit more complicated than that.
--:-- Noah Smith: I agree that the world is complicated, and I agree that there's a lot of uncertainty over the impact that tariffs will have. I can also tell you the predictions that I know that economists got most wrong are about the direction of the dollar. That is one prediction that went the opposite way. However, if we're talking about important effects of tariffs, the effect on manufacturing has got to be an important one. The whole idea of Trump's tariffs—maybe not Biden's tariffs—but the whole idea of Trump's tariffs is that this is going to lead to a renaissance in manufacturing. I understand that in five years you could see something different. If that's the argument, if that's what we're placing our hopes on, then let's be explicit about that. Let's say we expect to see short-term pain for long-term gain. But I will say that economists predicted pain in the manufacturing sector, and that's exactly what all the data are showing us now.
--:-- Oren Cass: I've been extremely explicit throughout in discussing tariffs that there is short-term pain associated on various axes. I'm frankly surprised that we haven't seen more pass-through to consumer prices than we've seen. I would certainly expect to see an impact there as well. The long-term gain here—a few minutes ago I said I would expect to see this over the long term. You said how long. I think I said three to five years. That's a reasonable range in which to expect to actually see a manufacturing sector that is performing differently. The good news is that there are other dimensions on which we should see things sooner. Capital investment, construction, and so forth are going to be a leading indicator of that.
--:-- I'm not sure who out there was saying that if you impose tariffs, manufacturing employment will magically materialize in factories that haven't been built yet. Maybe someone was saying that, but it seems a little bit unfair to take that as the pro-tariff argument when it's obviously not the actual basis on which the argument is made.
--:-- Noah Smith: I'm saying that economists were right about this. The problems in the manufacturing sector that we're now seeing—it was a correct prediction by economists. That sentiment would turn down in the initial months. I'm not sure that anyone gave a month timeline for it, but the idea that this would be generally bad for manufacturing, would cause a contraction in the sector—that's what we're seeing. And we know the mechanism by which this happens, which is disruption of intermediate goods trade.
--:-- Erik Torenberg: Go ahead, Eric. I think Oren is saying that, acknowledging that there would be some short-term pain for long-term gain, as you described it, Noah. I think he's also acknowledging that—feel free to edit this, Oren—that, yeah, it does make sense that economists predicted some decrease in employment because the factories haven't been built yet, et cetera. But you're also saying that economists didn't get right what would happen in the broader market and with the dollar, to which Noah also sort of acknowledged, especially the part around the dollar.
--:-- I have a broader question for both of you. What would cause you to change your mind about the long run? What would need to happen or occur such that you have a different view of the long-term effects of these tariffs?
--:-- Oren Cass: For me, the intermediate question that I'm most interested in is what happens to capital investment. At the end of the day, the sequence of events that you're trying to influence with tariffs is to induce relatively more capital investment domestically to expand domestic production capacity. If we see that—and frankly, in a lot of ways, that was already at elevated levels because of other things that Noah and I agree on, like the CHIPS Act, which I've often highlighted was dollar for dollar an extremely effective way to start boosting investment—if we start to see those kinds of investments now in other sectors of the economy also, if we see that at a sustained elevated level over an extended period of time, that would be the kind of sign over the next year to three years that this is actually doing what we want it to do.
--:-- The benefit that we would get if it actually works out is that we would see in the longer run a significant expansion of manufacturing capacity. We would see that in output. We would see that in manufacturing as a share of GDP. We would see that in employment. And what I'm most concerned about, if it's working, we need to see it in the productivity data, because manufacturing productivity has actually been falling over the past decade, which is a huge problem. If we are actually seeing investment in a renewed and revitalized manufacturing sector, that absolutely is going to be—and we better expect will be—much more automated than the kind of manufacturing we've had in the past. That should show up in the productivity data as well.
--:-- Erik Torenberg: I have another question here. You've often talked about what you see as the shortcomings of economics as a discipline for predicting the effects of tariffs and economic policy in general. When you're predicting the effects of tariffs, what do you rely on? How do you make those predictions? Do you have some theories? Do you have other countries' examples, historical examples, some other discipline like sociology, or perhaps just some stuff you thought of on your own? Where are your predictions coming from?
--:-- Oren Cass: I'm happy to answer that in detail. I figured, Noah, that you were going to touch on the prior question also, but I'll just add—
--:-- Erik Torenberg: What's the prior question?
--:-- Oren Cass: It was basically Noah, and then let's go back to Noah's question after this. But yeah, let's hear your take on what would cause you to be excited about the long run for tariffs. What would need to change or you need to see for you to be like, actually, it's having a long-run positive effect?
--:-- Noah Smith: A boom in manufacturing investment for sure. If we see that, if we see the U.S. manufacturing sector actually get revitalized in a major way, that'll be exciting. So far, we're seeing the opposite. And if that turns around at some point, that'll be great.
--:-- Erik Torenberg: Imagine a world in which it does turn around. What needs to happen for that to happen?
--:-- Noah Smith: I think one thing would be industrial policy. I also think that in terms of tariffs, we should have essentially entirely free trade with allies. I think that would be a wise thing to do because Japanese manufacturing and European manufacturing don't actually threaten America. In fact, we gain much more from pooling our markets so that we can attain scale similar to what China enjoys. China is pretty much the only competitive threat we face, and which all our allies are facing at the same time. We're fighting with our allies instead of pooling our resources to stand up to China. That's a bit of a sidetrack for me right there.
--:-- I wrote about all these things pretty extensively during the Biden years, and I thought this is what we ought to be doing. I think industrial policy is a big missing piece. Also, there are various capacity-building policies like infrastructure, education. We need to train a manufacturing workforce. One really reliable thing we see is when we have really good vocational schools, you get better factories. Just train people to work in factories. Tim Bardic has done a lot of work on that. I think it's pretty clear what to do to affect a manufacturing revival right now.
--:-- One of the big indicators that I look at is factory construction. Factory construction has to be adjusted for the price of building new factories because we don't want to just make a chart of inflation. When you look at real factory construction, you saw it basically flat at a fairly low level for decades and decades. Then you saw this enormous boom during the Biden years. All the factories concentrated in the areas where Biden's industrial policy was incentivizing factories—chips, batteries, and other things like that. Just this enormous boom. Now, since Trump got into office, you've seen that boom go into reverse. You're seeing the pace of new factory construction falling since Liberation Day. That's a bad sign to me. But I accepted that in five years we may see something else.
--:-- Oren Cass: I'm genuinely curious, because that was when I mentioned I'm very interested to see in August what the Q2 factory construction data looks like. What data is out there already on that?
--:-- Oren Cass: It's called Total Construction Spending on Manufacturing in the United States. You can look at that on FRED, you can look at that anywhere, and it shows the, you know, just in dollars. Right. You can also look at it as a percent of GDP if you want, but I prefer to look at it in dollars. And then you have the Producer Price Index for new industrial building construction, which is the appropriate price of factory construction. PPI for new industrial building construction. You can see that under Biden, this increased a huge amount. And then under Trump, it has decreased a bit so far. We'll see if it keeps decreasing, but to me that's a bad sign so far.
--:-- Oren Cass: Yeah, I think I would just echo some of what Noah had just said about some of these other factors that are really important as well. Because I think both in terms of what it takes on tariff policy, if you really want these tariffs to work, stability and certainty is incredibly important. This is a criticism I've had of the Trump tariffs since the beginning. What matters is not what people think the tariffs are going to be this week versus next week. What matters is if people actually believe these are what the tariffs are going to be three years from now when the investments would start to pay off. So that's where I think both stability in the tariffs, ideally needing to actually legislate some of this instead of having it both subject to legal challenges and a lot of changes in executive orders, are both really important. And then as Noah said, the industrial policy side and the workforce side are incredibly important as well.
--:-- So, if you ask me, do I think tariffs are an important positive step toward reshoring manufacturing, I would say, yes, absolutely. If the question is, how far are we toward the policy package that's going to get us maximum bang for our buck, I would say there's certainly a lot of work still to do.
--:-- And that maybe connects to Noah's other question about how do you evaluate these things. In my mind, the right way to evaluate them is that a lot of the frameworks that economics provides us in terms of thinking about incentives, particularly thinking at the margin, are exactly the right way to assess economic policy. I think where economics as a discipline has really gone off the rails is in over-reliance on a set of assumptions that don't necessarily hold, and then over-reliance on a set of models that require those assumptions.
--:-- This is where I think we've seen a lot of very bad forecasts come out of, for instance, the prediction that free trade with China will benefit American workers and that we will be making and selling more to them than ever before. That assumed a certain policy environment in China that did not exist. The right perspective is to look at things from the perspective of a business owner, look at it from the perspective of capital, and ask, what are the best opportunities to earn a lot of money? This goes all the way back to Adam Smith and the Wealth of Nations and the invisible hand. His argument about the invisible hand is not that this somehow automatically works by magic. His argument is that if you actually have incentives aligned—and the first one he lists is if you have people preferring to invest domestically over investing overseas—then their pursuit of private profit will also advance the public interest.
--:-- So for me, the question is, what are the incentives for people pursuing private profit? If we have policies that make it the incentive to offshore, to try to bring in cheaper labor, to try to use financial markets to extract additional capital out of firms, then those are the things that people will do. At the margin, we have to ask, are the policies we're pursuing ones that are pushing incentives in better directions or pushing them in worse directions?
--:-- Noah Smith: So let's go back to this idea of where you get these ideas. The idea that tariffs will do this and that to help manufacturing. Where does this idea come from? Did you just sit there and think common sense-wise it makes it sound legit? Or are you using an analogy to America's early growth in the 1800s when we had high tariffs, and just saying, well, we grew fast then and we had high tariffs then, so high tariffs will increase growth now? Where do you get this idea that tariffs will help manufacturing and the incomes and prosperity of the average American?
--:-- Oren Cass: Well, there are a few ways to answer that question. One, as you noted, there have certainly been times in the past when we have used a much more robust tariff agenda. Conversely, our decision to drop tariffs and forego them has produced a lot of the things that I think we've been a lot less happy with. If you look at somebody like Paul Samuelson's work, I often point out that in his seminal textbook *Economics*, he goes through the arguments for and against tariffs and basically acknowledges that any country could pursue a beggar-thy-neighbor strategy. The core case for the United States to embrace free trade—and Fred Bergsten makes the same point in the 70s—isn't an economic case, it's a foreign policy case.
--:-- You can also look at the policies of a lot of other countries around the world today that have obviously had a lot of success promoting manufacturing and industry. They certainly tend to do it in a more protectionist way. So I think there are a lot of signals all pointing in the same direction. I might ask you the converse: what would be the reason to believe that free trade with a country like China was going to be good for our manufacturing sector?
--:-- Noah Smith: Well, I don't necessarily know people who did predict that. I was a kid, and when I look back at economics papers on the topic, I don't see much. I don't see many economic papers saying free trade with China will be good for the manufacturing sector specifically.
--:-- Oren Cass: But then is the implication that tariffs on China would be better for the manufacturing sector?
--:-- Noah Smith: What I'm saying is that I don't know. So when you're asking me to justify the supposed predictions of people, I don't know who made those predictions. And I don't know economic models that do predict that. For example, if you take the dumbest, simplest Econ 101 model of trade in existence, which is the comparative advantage model of David Ricardo, that would predict that trade with China would be bad for our manufacturing sector. The idea is if China has comparative advantage in manufacturing, we have comparative advantage in services, or maybe agriculture, we'll trade the things that we're good at for the things they're good at. It's not a very smart model, it's pretty basic. It describes some things that happened, but not a lot of things.
--:-- If you use a slightly more advanced model called the Heckscher-Ohlin model, which predicts that capital-intensive countries like America will do more capital-intensive things, and labor-intensive countries like China in the 1990s and 2000s will do labor-intensive things, that predicts that we'll lose lots of manufacturing jobs to China. So those basic models would predict that the U.S. manufacturing sector, or at least U.S. manufacturing employment, would do poorly in the face of China due to free trade with China, but that America overall would become enriched because of other effects in the service industry, in other industries.
--:-- So when you're talking about these predictions that free trade with China would be beneficial for our manufacturing sector, I have to say, I don't know where they are. I don't know who made them. I don't know why they would have made them.
--:-- Oren Cass: I'm just making the point more thinking about it as a counterfactual. We could either take the view that tariffs are probably helpful in protecting a manufacturing sector, or no, they're counterproductive. You were asking me, why would you believe that these things help? I'm saying, I think there are a lot of sources that would point to them potentially helping. What I'm less clear on is what is the argument from the other side. What is the argument that we should get rid of our tariffs to help the manufacturing sector? Because presumably one or the other has to be true. Either tariffs are good for the manufacturing sector or tariffs are bad for the manufacturing sector. I'm suggesting they're good for the manufacturing sector. I took you to be saying you think they're bad for the manufacturing sector, but I'm not sure.
--:-- Noah Smith: That's where it breaks down for me. At least vis-a-vis China, as you were just saying, I don't know who is saying they're bad for the manufacturing sector. So, whether tariffs on China could have been used to help the US manufacturing sector in the face of Chinese competition in the 90s or especially the 2000s when the China shock happened—I don't know any analysis of that. There are definitely reasons why tariffs would have hurt the manufacturing sector and reasons why it could have helped.
--:-- For example, if you had used tariffs as a bargaining tool to force China to stop undervaluing the yuan, which it did to a significant degree in the 2000s, that might have worked. In fact, I think we should have done that. But notice that that's using tariffs not as a policy in and of itself whose direct effects encourage manufacturing, but as a bludgeon, a tool, a threat, a tool of economic warfare to force China to stop doing something that harms our manufacturing sector. The best outcome would have been us using the threat of tariffs to force China to not undervalue the yuan, but then not actually following through with the threat because the threat worked.
--:-- When you look at Paul Samuelson's work on strategic trade, he talks about this: using the threats of something that would harm both countries, but harm them more than us. Using the threat of that, but not the actual thing because the threat works. So using tariffs as a threat and using tariffs as an actual protectionist policy to grow our own manufacturing industries behind protectionist walls—which Alexander Hamilton certainly did talk about—those are two very different things.
--:-- If you're asking me what I would personally have gone back and done if I could do the 2000s over again, I would have said threatening China to not undervalue their currency would have been a good idea for our manufacturing industry and for us in general. But that doesn't mean that tariffs are a policy that, if actually implemented, help manufacturing.
--:-- Oren Cass: But surely you can't use tariffs as a credible threat unless you're willing to actually impose them.
--:-- Noah Smith: That's right. The idea is they hurt us, but they hurt them more. That's why they are a credible threat in the strategic trade idea.
--:-- Oren Cass: But it hurts ourselves. It hurts us.
--:-- Noah Smith: Right. But if we take China today, which clearly is not playing by any of the rules of free trade and shows no openness or willingness to do so, how then are we supposed to react to that in your framework?
--:-- Noah Smith: Well, the idea of game theory is that actors are rational and that if you have a credible threat, the threat doesn't need to be used in equilibrium. Because if you make the threat, then the other person will back down because they're rational actors who give a best response to a best response. However, if you have irrational actors and you make a threat to harm them by double the amount they harm us, but to harm both people, and then you end up carrying through on the threat, the fact is everybody gets hurt. Even if they get hurt more, in a war, that's what you want. In a war, you take casualties in order to inflict greater casualties upon the enemy.
--:-- If we're looking at economics as a war, where hurting China is more important than helping ourselves get rich or have higher living standards, then fine. That's certainly an argument you can make. But if we're talking about helping our manufacturing sector, helping our people's living standards in general, hurting them double the amount we hurt us is not a particularly attractive proposition as I see it. Americans don't think of trade with China as a war where hurting them is more important than helping us. They just want stuff. They want prosperity. The short-term effects of tariffs have been bad. If we're going to say stay the course five years, ten years, eventually things will get better, okay. But that's what the communists said and it didn't end up working out.
--:-- Oren Cass: My understanding of your view was that you were more sympathetic and maybe even in support of some targeted tariffs towards China, but that the tariffs towards our allies to you just didn't make any sense. Is that right?
--:-- Noah Smith: Exactly. That's right. The reason is very simple to explain. It's the reason of scale. You won't get this in Econ 101 or even 102, but you will get this from Paul Krugman's Nobel Prize-winning work, where he talks about the importance of scale for manufacturing industries, and for industry in general, but manufacturing is the most important industry that this works for. The more stuff you can sell, the more units you can make, the lower your costs go. If you can make a million cars, you can make cars a lot more cheaply than if you only make 10,000 cars. The more you can make, the better you get at making stuff.
--:-- China has unprecedented internal scale because they're a country four times the size of America. They can make tons of units of stuff. America can't match that with just our domestic market. We can pay more per car, but in terms of the scaling effects, the scaling effects depend on how much you make, how many cars roll off your assembly line. We are just such a small country compared to them, one quarter their size. This is like us trying to match China is like Germany trying to match us. Germany can make really high quality stuff, but they can't match us volume for volume. They'll never be able to get the scaling just from only their internal market that we get. That's why Germany focused on exports, exports, exports.
--:-- So what we need to do is find some other countries where we can say, our manufacturers get scale from exporting to you and your manufacturers get scale from exporting to us, and we both get scale. Then we have this mutually beneficial agreement to scale our manufacturing industries such that we're not playing only in this tiny domestic market, such that we have a large market too so we can compete with the Chinese because we can match them for scale.
--:-- The only way to do that, given our small size, is to get other countries to pool their market with us so we can get scale. We need Europe and Japan and Korea and maybe India, which is the biggest country of them all, to partner with us so that we can scale. But that requires some reciprocity. We need to have our manufacturers be able to scale by using their markets, but their manufacturers also need to be able to scale by using our markets. Then, as Krugman showed, our manufacturers and their manufacturers make similar things, but slightly different things, slightly different versions of the same things. We'll make Harleys, they'll make Kawasakis. Competition happens by differentiation. That's fundamental to Krugman's model, and it's what we actually see in, for example, US-Japan trade. We make broadly similar stuff, but not exactly the same, and both can flourish.
--:-- So that's drawing from advanced economic theory, not the basic stuff you get in Econ 101. That's what I would do to resist Chinese manufacturing. I would get scale by pooling our markets with our friends. If you look at what Elon Musk has said, he said, we need a complete free trade zone with Europe so that we can all scale. If there's one American who actually does know about manufacturing, it's Elon Musk, who's the only entrepreneur who's been able to successfully scale manufacturing in America even in the face of international competition. His supply chains are far more domestically sourced than most manufacturers. When he says we ought to combine our markets with Europe's markets so that we can all scale together, that's directly out of Krugman's theory. It's directly out of lived experience in manufacturing. So that's what I would do. And then penalize China.
--:-- Oren Cass: I agree with almost all of that and would like to see that as the American trade strategy. The concern I would have is that those three countries that you rightly focused on—Germany, Japan, and Korea—relative to their GDP, our trade imbalance with them is as large as it is with China. When you describe Germany's strategy as export, export, export, that is, of course, Japan's strategy and Korea's strategy. Vis-a-vis the U.S. Just talking about the size of the trade balance in goods between the U.S. and Japan, Japan in turn imports a lot from China and others. But it seems to me a fundamental problem that the U.S. is dealing with in ideally constructing that sort of trade model is that these key countries that we want to be our allies in scale are themselves pursuing this kind of export, export, export but don't import model.
--:-- That's why I think it was very interesting to see the EU in the start of the agreement that they've been announcing with the US. You heard the EU leaders say quite explicitly, we acknowledge that we are going to have to do some rebalancing here. I don't know. Noah, maybe you just disagree that there is an imbalance there. But it seems to me that as we move toward that model that you're describing, if it is going to work for the US, there is going to have to be a significant shift in the behavior of these trading partners.
--:-- Noah Smith: Right. I actually have an important response to this, which is something I think that almost everyone in these trade policy discussions gets wrong. They focus on net instead of gross exports. Let me give you a concrete example. If we export zero to Germany and Germany exports zero to us, and then we go to exporting 10 billion to Germany and Germany goes to exporting 12 billion to us, we have opened a trade deficit with Germany. We now have a 2 billion dollar trade deficit, but our exports have gone up by 10 billion. This is a good outcome for us because it allows our exporters to scale, scale, scale. What matters is the gross amount, not the net amount.
--:-- People focus obsessively on the trade deficits and surpluses, on the imbalances, on the net amount. But if they both grow and Germany's grows a little bit more, that's actually a good outcome, even though we have a trade deficit, from the perspective of scaling our manufacturing industries and increasing GDP. For scaling our manufacturing industries and getting manufacturing power, the deficits and surpluses matter less than the total market size available to our manufacturers.
--:-- Obviously, trade deficits are always a sore spot because people have an inherent sense of fairness and they worry about this stuff. I understand that. We need negotiations and we can try to rectify those things. It's complicated because there are also financial effects on trade deficits. But the more important effect is the gross, the total amount of exporting that we're able to do. In that sense, trade between us and Europe is positive sum without trade being balanced. Trade is positive sum. I'm not talking about comparative advantage, your standard Econ 101 stuff. I'm talking about advanced Paul Krugman stuff. I'm talking about what Elon talks about. I'm talking about manufacturing and scale economies. The total amount we export to these allies is more important than the delta at the edge.
--:-- Oren Cass: But it seems to me that assumes that the active trade itself is somehow expanding total demand for manufactured goods. Not certainly by one to one. If we talk about cars as an example, and you ask, in which case do US car manufacturers have a bigger market—in the zero-zero case or when the US is exporting 10 billion of cars to Germany, but Germany is exporting 12 billion of cars to the US—unless you've created an extra 2 billion dollars of demand for cars, you've just reduced US car sales.
--:-- Noah Smith: No. Well, the point is that you do. If we export 10 billion worth of cars to Germany—I'll talk in dollars, but let's assume it's all the same price. If we export 10 billion more to Germany and Germany exports 12 billion to us, what matters for the total amount of cars our manufacturers can make is whether the induced reduction in domestic sales is larger than the induced increase in exports to Germany. If Germany exports 12 billion cars to us and our domestic car sales go down by 6 billion, our exports go up by 10 billion. Our total car manufacturing has gone up by 4 billion, even though we're running a trade deficit and Germany's car exports to us have destroyed some domestic demand for American-made cars. But the amount they destroyed was not sufficient to balance out the amount our exports gained.
--:-- The point is that when you have two countries and they start trading, does the number of cars that people consume go up? Absolutely.
--:-- Oren Cass: Why does the number of cars go up?
--:-- Noah Smith: Because cars are cheaper. Because we're scaling, scaling, scaling. That allows us to make cars more cheaply. When cars are cheaper, people buy more. You get that second car, that third car for your family. Even people who don't own a car could now have a car. You can also get more expensive cars, but that's another story. If we drive those costs down by increasing the size of the market, then people are buying a lot more cars overall. If you look at vehicle ownership in America during the time that Detroit was facing this incredible competitive pressure, you actually saw Americans buying more cars and you saw people in these other countries buying more cars.
--:-- Oren Cass: But you also definitely saw a decline in demand for the American-made cars. You saw a decline in domestic demand for the American-made cars.
--:-- Noah Smith: No, total. While you're looking that up, let me make two related points. One is that this strikes me as a classic example of what goes wrong in our economics dialogues.
--:-- Oren Cass: GM's total sales were going up and up and up. Total sales, even despite the competitive pressures from Japan, from Germany. GM's total global sales.
--:-- Noah Smith: No, no, no. Domestic production in American factories. That's final assembly, by the way. You've also got to look at component production. Total output. If you look at total manufacturing output in the American auto industry.
--:-- Oren Cass: It seems to me there are two problems here. One is that we have the intuitive view that if you have a trade deficit, that's probably bad for domestic producers. You have the seemingly thoughtful and nuanced economist view that no, no, no, we have to focus on gross, not net, because we're expanding the pie. And then you realize that, well, actually, that was relying on a bunch of assumptions about expansion in total demand which aren't necessarily actually true. In the aggregate, they are definitely not true. The way that we know they're not true is just by looking at the trajectory of US industrial output, which has essentially flatlined since 2007.
--:-- Noah Smith: Since 2007, that's right. But during the time of the China shock, it didn't actually flatline. It actually rose.
--:-- Oren Cass: There was still a period of increase there. That's during the time when we lost the most jobs to China.
--:-- Noah Smith: Oh, I agree. There were a number of different things going on. I'm just talking about the actual trajectory of the American manufacturing base. It is not that demand for manufactured goods suddenly fell off. It is that virtually all of the increase in demand that historically a substantial share would have gone to domestic production has instead gone to imports. That huge trade deficit we see does, in fact, map directly to a decline in domestic output. That's the thing that people are rightly quite concerned about.
--:-- Noah Smith: But if you look at when our trade deficit was big, our trade deficit was much bigger before 2008 and then shrank dramatically after 2008. That's just a fact. Our trade deficit shrank enormously after 2008. However, that is when our manufacturing productivity flatlined. That is when our industrial output flatlined, after 2008. But when we're looking at the 90s and the 2000s, this era of hyper-globalization, we see industrial output rising, manufacturing productivity rising, but we see the biggest trade deficits we've ever had. That's a big fly in the ointment of your thesis. The timing there just doesn't line up at all for the naive idea that trade deficits destroy US manufacturing.
--:-- I searched and found an Economic Policy Institute report on the US auto industry and I see a chart reproduced from Gould, Bean, and Kruger 2015 showing seasonally adjusted lightweight US vehicle sales. I'm seeing an increase over the course of the 80s and 90s. Employment fell here, but output appears to have risen and risen as you got robots and machine tools. US manufacturing grew and grew during the era of hyper-globalization and during the increase in competition from Germany and Japan in the 80s. Even during the initial increase of competition from China and the new Asian industrialized countries in the 90s and 2000s, our manufacturing even grew a little bit during the China shock when our manufacturing employment fell. Our industrial production actually rose a bit. That was during this era when trade deficits were much larger than now. That timing doesn't fit the naive story that trade is a zero-sum game and that trade deficits destroy American manufacturing output. It just doesn't line up.
--:-- I think this is a case when actually thinking about the economic ideas deeply is a little more helpful in explaining some of these patterns than simply doing the common sense thing of saying, well, we're selling 10 to them, they're selling 12 to us, we're losing, and therefore our manufacturing industry must be getting destroyed.
--:-- That said, I do think trade deficits present a problem. If they're too large, if they're for the wrong reasons, if we're just borrowing to consume, it's a short-termist consumption loan that we don't need. I do think trade deficits are a problem, and it violates people's innate sense of fairness and reciprocity. So I think that when we have trade with allies, we should work to make sure trade imbalances are minimized.
--:-- Oren Cass: How would you do that?
--:-- Noah Smith: How would I do that? Just negotiations. Say, you know what? We'll open our markets to you if you help us rectify some of these imbalances.
--:-- Oren Cass: But what if our market's already open and that, in fact, is contributing to the imbalance? I mean, what?
--:-- Host: Well, we can offer a lot of other incentives to these countries. So, but the argument is we should offer. I just want to understand the logic.
--:-- Noah Smith: Okay, so we agree there are imbalances. We agree that's a problem.
--:-- Oren Cass: We could defend them militarily. Well, it seems to me we've been doing that.
--:-- Noah Smith: Right. We could say, all right, we'll step up our commitment to your defense if you help us do this. Or we'll, you know, various other things.
--:-- Oren Cass: Our markets.
--:-- Noah Smith: No, no.
--:-- Oren Cass: This fascinates me, right? Because it seems to me that we're like, if you think about, okay, what the Trump administration posture has been.
--:-- Noah Smith: [laughs] Are you giggling because you're imagining a world of free trade between the U.S. and its allies and you're very enticed by the possibility of the scale this would offer our manufacturers?
--:-- Oren Cass: No, I love those things. I'm giggling because it is an interesting inversion of what we are seeing happening today where the Trump administration argument is, wait a minute, we have an extraordinarily open market. We have been defending these countries, and the result has been these imbalances. If we are going to sit down and negotiate with them over that, Noah, exactly to your earlier point about game theory, we should use market access and our commitment to their defense as tools to force them into a position that we like better. And based on everything you'd said up until the last minute or two of the discussion, that would seem to me to be a position very consistent with your views. But then when we got to the point of actually saying, great, what should we do about Europe? It was sort of like, well, what else can we bribe them with? Can we offer them even more market access? Can we promise to spend even more on their defense? And I'm just not sure why that's the approach we would take.
--:-- Noah Smith: I don't know. So if we're saying that we're going to use the threat of tariffs to establish a free trade zone, you know, that's – but because of game theory, because the idea that actors are rational and we won't have to use the threats and hurt both us and our allies, if that's the idea, then I have to say, well, it's not really a credible threat. It's only a credible threat if we're nuts. The idea that we would hurt ourselves and China, the idea that we would use tariffs as a threat against China, a country that we wouldn't mind seeing taken down a peg, seems rational to me because you could use that as a credible threat if we follow through and hurt China more than we hurt ourselves. That's a credible threat. But hurting Japan and Europe more than we hurt ourselves, but hurting both of us actually just lets China win. So it doesn't seem like a credible threat to me. I don't feel like putting, first of all, it doesn't seem like a credible threat. So this doesn't seem like a good negotiating tactic to me because if we go through with the tariffs, as we currently are going through with many of those tariffs, not all of them, but 15% or something on our allies. Okay, if we go through with that, even as we surrender to China, but that's another story. Even if we go through with that, okay, it just means China wins. And so it's not a credible threat. So that's my first point in response to this idea.
--:-- The second point is if this is your argument, we're back in the realm of tariffs are bad, but they're a good threat because we're threatening to shoot ourselves in the foot in order to get this free trade equilibrium that we like. So the idea is tariffs are bad, free trade is good with our allies, but we need tariffs. We need tariffs as this tool to threaten them to get to free trade with allies through the back door. That's very different than saying behind these sheltering protective walls, American manufacturing will regrow because economists don't know what they're talking about. And so those are two important points. The fact that this is a non-credible threat and the fact that tariffs as a threat are different than tariffs as a long-term actual policy. And we appear to be doing the latter. So those are two important counterarguments, I think, to what you're saying here.
--:-- Oren Cass: Yeah, I guess I would just say on the first point, first of all, it apparently, at least at the moment, is a credible threat. I mean, the administration is using it. And I think certainly the reporting on the EU negotiation indicates that they were quite frustrated by how credible the threat was and the extent to which it therefore forced them to make a lot of concessions. I do think the other way of looking at it, which is like, well, the U.S. has to kind of first and foremost be thinking about everybody's well-being. So these other countries can adopt policies that really are beggar thy neighbor. And we can't do anything about it. That was certainly the kind of post-World War II we must preside over a liberal world order argument. I don't know how much sense it makes now, given the costs that the U.S. is sustaining under the status quo. And so I do think the negotiations are not as sort of clear-cut a game theory as you were describing.
--:-- And then on the second point, I would just say it's interesting and quite satisfying, perhaps, to the extent to which we are landing in a very similar place at the end of this, which is, my view about certainly the so-called reciprocal tariffs and the way the administration has spoken about the reciprocal tariffs is that they, in fact, see them as negotiating leverage. And their goal was to strike deals with these countries, but to have these countries commit to balanced trade. I mean, that was quite explicitly, you go, but, I think Stephen Miran's remarks on this at the Hudson Institute are clearest.
--:-- Noah Smith: We seem to agree that tariffs on China do make sense and that our relationship with China. Not all, but tariffs on strategic industries with China. I don't think we need tariffs on Chinese clothes because if China makes clothes, that's not a national security threat to us.
--:-- Noah Smith: But that China is sort of a... Toys. I don't give a shit if China makes our toys. Let them make toys. I think that's fine. I think there remains a balance question there and a question of what core inputs still do and don't matter to us. But point being, China is sort of in a separate category. I think maybe where we would probably end up disagreeing the most is on the question of a sort of baseline tariff. And that's where my view has always been that a baseline tariff on the order of 10% is a sort of skewing of the playing field in international trade in a way that helpfully reflects a preference for domestic production. And if you could do it in a way that actually had long-term certainty and predictability, and if you could actually also then use it as a revenue source, which meant that, relatively speaking, you also need less revenue from elsewhere, that it would be a very good element of what is otherwise a quite skewed global trading system. And so that's sort of how I look at it. I think certainly we don't agree on all the pieces of it, but it seems to be there are pieces of it that we do agree on and also that the intuition of those who are pushing for this kind of approach, myself included, I think there's a lot to debate. But also that it is not the kind of baseless and unfounded and incoherent way of thinking of things that it sometimes gets presented.
--:-- Host: Assuming tariff policy gets pretty much continued and then we have somewhere around the 15 to 20 percent tariffs that we're going for right now. Suppose that continues. And suppose our manufacturing sector continues to not flourish. Manufacturing investment continues to weaken and deteriorate. Manufacturing orders continue to weaken and deteriorate. At what point, how many years will it take for you to say, oh, maybe I should have read an economics paper or two. Maybe economics isn't all just hooey and bullshit. Maybe the economists were on to something. How many years must I wait for you to sort of update your ideas there, assuming that all that continues?
--:-- Oren Cass: Yeah, I think it's an unfortunate way to end the conversation, given that we both know that I've read lots of economics papers on these topics.
--:-- Noah Smith: I was being figurative.
--:-- Oren Cass: Yeah, well, you also wrote a very long substack that wasn't at all figurative, making the same accusation. So I don't think that's a constructive way to conduct the conversation. On the substance of the question, what I would say is that I think we need a year or two to see whether or not you actually get the investment response. Secondly, and related to that, I think it's very important to see whether you get the useful accompanying policies. That is, if what people are saying is we really want to invest, but we can't because of workforce, we do need to actually address the workforce stuff. If a couple of years from now you are not seeing the investment response and either we can't do the workforce stuff or for political economy reasons it is not feasible for us to do that stuff, then I would be the first to admit this is apparently not an effective strategy for pushing toward reshoring.
--:-- Noah Smith: Got it. Well, that seems reasonable to me.
--:-- Erik Torenberg: No, I was going to ask if any of you wanted a last word, but I feel like this has been a constructive conversation as someone who's not an expert in these topics. I feel like being able to hear the discussion and debate kind of in real time and understand both positions better has been edifying. And I really appreciate you guys coming on and having a discussion. This was a lot of fun.
--:-- Noah Smith: Thank you for having me.
--:-- Erik Torenberg: Thanks for listening to the A16Z podcast. If you enjoyed the episode, let us know by leaving a review at ratethispodcast.com slash A16Z. We've got more great conversations coming your way. See you next time. As a reminder, the content here is for informational purposes only. Should not be taken as legal business, tax, or investment advice, or be used to evaluate any investment or security, and is not directed at any investors or potential investors in any A16Z fund. Please note that A16Z and its affiliates may also maintain investments in the companies discussed in this podcast. For more details, including a link to our investments, please see a16z.com forward slash disclosures.
