The Misery of Mercantilism
- Capital Risk
- May 12
- 7 min read
A return to Renaissance thought appeals to artists and scientists, not so much to economists. That a country forged in a revolt against tariffs would endeavor to return to mercantilism highlights the extent of change in the global economic order. Multiplying this choice is the venture away from free markets and ideas to one of state-controlled regulation. Indeed, the reign of the US as the world’s consumer of last resort is in peril, as rent-seeking dissuades consumption. The paradox is the incongruence of these policies with the global dominance of US companies, which extract monopolistic rents from foreign consumers. A return to mercantilism risks their profits and domestic consumption. Two hundred years of global growth may disappear at the whim of pen and paper.
The Smoot-Hawley Tariff Act in 1930 led to a global decline in trade and contributed to the onset of the Great Depression. Despite this evidence, the US seeks the logical fallacy of growth and reindustrialization through tariffs.
The decision overlooks competitors' strategic responses and the tactical limitations of replacing forgone goods and services. Common sense should prevail less US growth is liberated.
A Turning point. While the economy continues to grow, the impact of high interest rates is beginning to show (Exhibit 1). Investment declined for the first time in four years. The worrisome sign is that the decline was broad-based: all sub-categories declined except structures (both private and residential), which were only modestly positive. Indeed, high interest rates impair investment to some degree, and an investment slowdown in artificial intelligence further magnifies the impact. While an investment retrenchment preceded every recession in the last seventy years, many investment slowdowns have not resulted in a recession. It is only when other sectors are falling simultaneously that a recession is foretold.
Exhibit 1. GDP Contribution by Component
The Fed’s challenge is to achieve a soft landing of the economy, where policy loosens before employment declines. Unequivocally, investment is slowing. The trouble is that monetary policy is only loosely linked to consumption. Indeed, higher financing costs reduce the marginal borrower, yet housing real estate investment continues apace. The Fed’s concern is how inflation limits consumer spending and impacts employment. When consumer spending changes, the Fed’s policy must change. The critical indicator is goods consumption, whether domestic or imported.
Deficit Dilemma. The US is not unfamiliar with deficits: it has run one for over 50 years, except for a brief period in the late 1990s during the tech bubble (Exhibit 2). The choice for deficit reduction is one of two paths: reducing spending or increasing taxes. Since the infamous “Read my lips: No new taxes” mantra derailed a presidential re-election, the focus is on spending control. This focus did not preclude spending from increasing due to the complexity of budget accounting. While the US budget situation is in a perilous position in absolute terms, at approximately $2 trillion, the deficit relative to receipts does not appear extraordinary.
Exhibit 2. Federal Deficit as a Percentage of Current Receipts
The challenges are the timing and starting point. First, a deficit of this magnitude is unprecedented during an expansion, which could limit the ability to respond should the economy face a recession. More critical is the level of debt, which stands at 120 percent of GDP. This level was only reached during World War II, while the period from 1970 to 2010 averaged about 50 percent. This level has two implications: the capacity to borrow may be limited, and the cost to service the debt may not only preclude further expenditures but require reductions and tax increases.
Unbalanced. As the Department of Government Efficiency (DOGE) attempts to eviscerate the Federal Government, it found that there are few limbs available for chopping. The largest single category is $4.5 trillion in transfer payments, including social security and payments to state and local governments (Exhibit 3). The challenge for DOGE to cut $2 trillion was that the Federal government’s consumption accounts for a mere $1.4 trillion of the $7.4 trillion of expenditures. Over $6 trillion is effectively mandatory spending that can’t be changed without losing political capital. One can’t get there from here.
Exhibit 3. Federal Government Revenue and Expenses
On the revenue side, it’s become apparent where the overriding issue resides. Social insurance receipts total $1.9 trillion, yet expenditures amount to $3.4 trillion, and an additional $782 million was drawn from the social insurance savings account. The problem arises on two fronts: a pay-as-you-go system is in severe deficit, and they are borrowing from its balance to cover other expenditures. A related concern includes the issuance of more than $1 trillion of new debt (i.e., Other Savings) and the elephant in the room, interest payments. The continuation of deficits will result in higher debt payments, both from the amount of issuance and the rate of interest paid on the debt.
Financing the Past. Interest payment of federal debt tripled during the 1980s, despite the cost of debt dropping by more than half (Exhibit 4). The trouble with this prior period was that debt issuance was not necessarily funding an expanding government, but rather the result of reduced tax burden. In real terms, receipts on personal taxes were barely positive, and corporate taxes declined. Financing corporate profits with government debt produced stellar equity market returns. The current challenge is that rates are low by historical standards, and the debt level is materially higher. The starting point matters.
Exhibit 4. Federal Interest Expense ($, Billions)
The recent doubling of interest expense in less than five years will crowd out future government expenditures or require higher taxes. Difficult decisions are ordained as the interest expense approaches the level of total government consumption. The difficulty in reducing the deficit through budget cuts alone is patently unrealistic, even with changes to Social Security. Addressing the revenue side is equally important. Yet, the mantra in Washington is tax cuts, which appears untenable in the current environment, even if tariffs offset some of the lost revenue.
Insufficient Imports. Since 1980, goods imports have outpaced exports, with the divergence increasing since China joined the World Trade Organization (WTO) in 2001. Certainly, taxing imports could provide some revenue. The challenge resides in the magnitude of imports. To close the current deficit, a 100 percent import tax rate is required. If tax cuts exceed program cuts, then a higher rate is needed. The reality is that the consumer would bear a material portion of the tariff, since even a highly profitable company could not afford to absorb the entire tariff. The result would be cost-push inflation for the US, the same voter concern that contributed to a switch of party control of government.
Exhibit 5. Goods Exports and Imports
US exports face significant challenges during a trade war, as they remain at the same level as they were in 2018. While the US continues to export leading-edge technology, the recent exploits of China in electric cars, processors, and artificial intelligence serve as a warning. Europe and Japan also have products to offer. The outcome could result in lower US exports. The trade deficit could widen when combined with the difficulty of finding domestic substitutes for imports. US growth has led the world since the Pandemic: it’s not evident that voters will appreciate higher prices and lower growth.
Productive Employees. America led the industrial world into the twentieth century, which significantly contributed to the Allied victory in World War II. Despite the talk of decline in manufacturing employment, industrial production per employee has varied around $350,000 since the 1970s (Exhibit 6). Capital and industrial goods are the most significant export sectors, reflecting their high value added. These sectors include semiconductors, telecom, and electric appliances. Critically, this production highlights that the US did lose some manufacturing employees, yet it continued to produce at a very high level, where it had a comparative advantage.
Exhibit 6. Industrial Production per Manufacturing Employee ($ 000)
Source: U.S. Bureau of Economic Analysis, retrieved from FRED, Federal Reserve Bank of St. Louis.
Another critical dimension is the difference between the cost of labor production and the revenue generated. The average US manufacturing employee earns approximately $60,000 per year while producing over $300,000 worth of products. Other costs, including financing and capital investments, reduce the net difference of $270,000. Yet, these numbers highlight that the value added per employee remains exceedingly durable over time, even as the number of employees declines. US manufacturing continues to produce world-class goods, limited only when unexpected cost inflation (e.g., the 1970s and the Pandemic) occurs.
Durable Consumption. The American trade deficit is primarily a function of capital and consumer goods, the latter a prime export from China. Since 1980, durable goods consumption per manufacturing employee has increased sixfold (Exhibit 7). The level is consistent with the output per employee in industrial production at about $300,000. The implication is quite clear: the US consumer is availing itself to cheaper goods produced externally at the cost of losing those employment levels.
Exhibit 7. Durable Consumption per US Durable Manufacturing Employee ($ 000)
The US must choose between cheaper and more plentiful durable goods and restoring employment in the industrial sector. If it decides to burden its trading partners by taxing imports, it will also harm the US consumer, who relies on these goods. The cost will be a higher price that will erode the value of their wages and could lead to spiraling cost-push inflation. Much like the United Kingdom imposed mercantilism and made its colonies serfs, the US risks a similar outcome. The difference this time is that a duly elected president wishes to impose the suffering, not an indifferent and faraway monarch. Indeed, the terms of trade need improvement, yet not at the cost of impoverishing generations of Americans. E pluribus unum.
This excerpt is the macro view of the US Economic Outlook 25Q1. Read more here.
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