Economic Statecraft and Trade

The General and the Economist

The Hoover economics and national security teams have had a productive discussion coming from two very different starting points. The national security folks are pursuing the idea of “economic statecraft,” that our government should use tariffs, subsidies, export controls, sanctions, and more as tools to fight a global “economic competition,” primarily with China. H. R. McMaster and Andrew Grotto have a nice recent essay, Economic Statecraft describing the approach. Luis Garicano takes up these issues in a lovely essay “Trading with Bullies” on his Silicon Continent blog (Luis is on fire. Subscribe to Luis’ substack!) that listens, reaches out to find some common ground, and offers concrete guidance.

What is “economic statecraft?”

The General

Instruments of Economic Statecraft:

Import policies relating to the entry of goods (including raw materials, components, and finished goods), services, financial capital, and people into the country...

Export policies relating to the exit of goods, services, financial capital, and people from the country…

Industrial incentives policies relating to inducements, mandates, or the elimination of restrictions on frms originating primarily in the domestic market, such as domestic tax, subsidy, and regulatory policies…

Financial infrastructure policies relating to global payments systems, including SWIFT, ACH, Fedwire, ACI, and CHIPS. Examples of financial infrastructure policy instruments include financial sanctions and related measures.

As you can imagine, many economists had some issues with the ideas. This sounds like a military takeover of the whole economy. The Soviet Union was, after all, one big marshaling of national economic resources to the state’s aims.

To their credit, however, McMaster and Grotto really listened to the economists’ complaints and integrated them to the document. For example,

The Trump administration must recognize, however, that interventionist economic statecraft policies will result in trade-offs and risk inefficiencies, increased costs, less innovation, and other market distortions. Moreover, special interests can capture aspects of policies to advance protectionist or other parochial interests. An overarching framework of principles, objectives, and metrics—a strategy—is therefore essential to help policymakers decide among competing trade-offs and ensure that actions align with the president’s agenda and vision.

They recognize that Soviet style, or Mao style statecraft didn’t work out so well in the end; that the Jones act, Smoot-Hawley act, two generations of steel protection, the Chicken tax (25% on light trucks) and so forth have not worked out so well. Fundamentally, they recognize that we must be better than China, not sink into protected sclerosis.

The practice of economic statecraft should achieve these goals:

• Reinforce the rule of law….

• Pursue realistic and clear goals. …

• Unleash market forces….

• Refect data-driven decisions….

• Foster multinational cooperation….

• Communicate strategic intent….

• Adapt to changing circumstances….

With President Trump nearly simultaneously announcing 25% tariffs on Mexico and Canada, I can’t wait to needle H.R. on “how’s that statecraft working out for you?” Let’s see, “reinforce the rule of law, realistic and clear goals….”

The economist’s complaint is really not so much that “statecraft” can’t work in theory, but that centuries of experience haven’t worked out so well. Beyond the ever present danger of special interests wrapping themselves in the flag, it sure would help to have more concrete guidance on when “economic statecraft” interventions might help, and more crucially, when they will not.

The Economist

In “Trading with Bullies” Luis Garicano offers some concrete guidance. (Most of Luis’ examples are European, and I encourage European readers especially to read the original for that.)

Luis frames the basic question as an externality, a classic “market failure,” partially remediable by the blunt and rent-seeking prone instrument of government interventions.

Private companies decide whether to source chips from Taiwan or produce them at home, choices that have strategic implications beyond their commercial calculations.

The national security externality exists because private actors do not account for how their decisions affect their government's bargaining power through resilience to conflict. When a US company imports cheap Chinese chips and builds infrastructure dependent on them, it creates a strategic vulnerability — a cost not reflected in market prices.

Once we account for this security externality, standard economic thinking gives us clear guidance. Markets underinvest in resilience because they fail to price the strategic value of certain productive capabilities. Society overall would accept lower economic returns for investments that only pay off in crisis scenarios, but businesses do not (Murphy and Topel, 2013). Excess capacity in healthcare or defense appears inefficient in normal times but is invaluable during emergencies.

This is a subtle argument. It is not true of standard economic theory that “Society overall would accept lower economic returns for investments that only pay off in crisis scenarios, but businesses do not.” In a crisis, the price of chips would spike. Stock prices should reflect the extreme profits that companies can make in rare events. You may complain that they don’t, that people behaviorally overlook low probability events and so on. But that behavioral complaint is equally if not more true of the government, who always seems to fight the last war. And the first question is whether there is a fundamental economic incentive problem that even perfect markets would not solve.

One underlying problem is that the company and stock holders know that in a crisis the government won’t let the price of chips spike. There would be price controls, anti “price-gouging” prosecutions, “windfall profits” taxes if not outright nationalization. It’s the same story with natural disasters. Companies do not keep extra stock on hand in part because they know they can't reap the full profits. The ideal market solution then would be for the government to precommit to allow companies to profit from resilience investments. But that’s not going to happen.

But Luis’ argument is much more sophisticated.

The problem of national security is therefore often not about the application of force but the exploitation of potential force (Schelling, 1960). The core problem is strengthening one's bargaining position — one of the benefits of having a large military is that you may never need to use it.

His original quote was “private actors do not account for how their decisions affect their government's bargaining power.” Building extra capacity that will never actually be used is something that markets typically won’t reward. In economics lingo it’s an “off-equilibrium threat” that deters and sustains the no-war equilibrium. Private parties aren’t going to pay for that.

private actors do not account for how their decisions affect their government's bargaining power through resilience to conflict.

But how much “resilience” do you need? Pure autarky, cutting off the US from all world trade, would so tank the economy that we would also lose any war, and lose our ability to deter war.

policy interventions should target sectors where production capacity would become scarce during the conflict, as measured by potential price increases relative to peacetime… during the specific conflict being prepared for.

A measure: how much will the price increase and in a specific conflict scenario. The latter is a big frustration to me. Explain exactly what war you will be fighting and at what point we actually run in to problems because we imported all our bicycles from China?

Big price increases happen (only)

when the demand for the final output is itself inelastic or when few substitutes are available. For instance, semiconductor capacity during a Taiwan crisis would see dramatic price increases due to their critical role as inputs, limited substitutability, and concentrated production. The same is not true of corn.

I might add, when military consumption is a large fraction of the market. Military demand for corn might rise, but it’s a tiny fraction of the market.

no sector is inherently ‘strategic’ in an absolute sense. Instead, what makes a sector strategically important depends entirely on the specific conflict scenario being considered. …

The economic approach instead requires policymakers to think clearly about specific conflict scenarios, model the resulting price effects across different sectors, and target resilience-building investments accordingly.

A trade war with Canada requires different resilience than a shooting war with China.

Resilience is nonlinear. You need to make sure you have the crucial o rings, even at inflated prices. One or two alternative suppliers, at high prices, can be enough.

…even modest diversification of critical dependencies can yield ‘much economic security with little overall fragmentation’ (Clayton, Maggiori, and Schreger, 2024).

For instance, if one country controls almost all of a vital input, losing access to it is extremely disruptive. But introducing just one or two alternative suppliers dramatically decreases vulnerability because it prevents the dominant supplier from dictating terms or coercing others by threatening supply cutoffs. Hence, rather than reshoring everything, the goal should be avoiding extreme dependency on any single foreign supplier for essentials. This approach preserves most of the efficiency gains from global trade, while effectively addressing strategic vulnerabilities.

I often ask, “are we trying to deter, or trying to fight a war?” In deterrence, you try to show the adversary the advantages of peace. In war-fighting, you want to destroy the adversary even if it hurts you. A lot of China commentary seems to mix up the two.

deeper economic integration can sometimes be the best strategic response. A ‘conditional free trade strategy’ suggests that if a country can credibly threaten punitive trade sanctions in a future conflict, it should promote integration in peacetime (Becko and O'Connor, 2025). Deeper trade ties make potential adversaries more dependent on you, increasing your leverage.

China is still very export dependent, and troubled. Are we sure we want to cut them off, rather than keep them dependent on trade? Even sending them some equipment with military uses makes them dependent.

A Europe that faces increasingly transactional American trade policy, rather than decoupling, needs to look at which economic ties create leverage versus vulnerability. In sectors where European products are essential to American industries, deeper integration actually enhances strategic autonomy. The most obvious case here is industrial machinery, where German, Dutch, and Italian firms (Siemens, ASML, KUKA, Trumpf) dominate in high-precision industrial machinery, used in semiconductor production, aerospace, and advanced manufacturing. These tools are difficult to replace with U.S. or Asian alternatives.

I pass this example along to my American readers to remind them that two can play at this game.

The risk of security policies expanding into broad protectionism is significant. ...

What the mercantilists — so-called ‘post-neoliberals’ — want to do is use the existence of some legitimately strategic industries as justification for large-scale intervention across many sectors. The risk is that aiming to obtain votes, politicians are liable to find almost any investment — from agriculture to any high technology — as deserving protection on national security grounds.

Tariffs are the answer. The question keeps changing. Our China and Mexico tariffs are enacted under a national emergency for fentanyl exports.

Using economic analysis in a hard-power world helps in two ways. First, it explains the problem better. Those who think all trade with rivals is dangerous can't explain why Russia worked so hard to create energy dependencies through Nord Stream 2. Second, only economic models allow us to state the cost of these things accurately. Yes, the new mercantilists might tell you that you're justified in giving money to your chip industry, but soon, you'll find yourself billions of dollars deep trying to save a state-backed champion and wondering how you ended up there.

Or remember steel, 99% of whose output (made up number) is not defense, the perennial recipient of national security motivated protection, and now a basket case. Or shipbuilding, destroyed by the Jones act.

Objective criteria linking subsidies to expected price appreciations during conflicts provide a concrete, measurable standard that makes it harder to justify interventions based on vague security claims….Now is the worst moment to embrace the boondoggle.

Like much “market failure” analysis, the real use of Luis’ arguments is not how to say yes, but the many ways to say no. If you want to. Did I say that tariffs and subsidies are often an answer in search of a question? Will anyone do Luis’ analysis for the strategic crypto reserve?

One thought that Luis omitted: A central economic principle is that you should level the costs across alternative means to an end. Resources are limited, don’t waste them on inefficient projects. To that end, I have a standard response to arguments for national security subsidies, for chips, steel, mining capacity, etc. Fine. Put it on the defense budget.

One of our governments’ cardinal sins is mucking around with the economy to achieve something at triple the cost but without formally taxing and spending, by mandating actions or fudging with prices. If spare chip capacity, that produces chips at twice TSMC’s cost but more resiliency, is important for national security reasons, but costs $100 billion dollars — 10 aircraft carriers — put it on the defense budget. Let the generals decide, do you want chip factories or do you want aircraft carriers? “Economic statecraft” can be a way to drastically expand the defense budget in ways that are potentially far less bang for the buck efficient.

I close with a story. Long ago when I was an RA at the Reagan CEA I helped a bit with two trade cases: Goose down and screws. Both were brought under national security. Chinese goose down was being imported undercutting US producers. When our boys are fighting the Russians up in Canada we wouldn’t want them wearing inferior Chinese goose down, now would we? Chinese nails and screws were just hitting the hardware store shelves. We wouldn’t want F-15s falling apart because of cheap Chinese screws, no? Well, ludicrously, no. The military applications in both cases are tiny fractions of the civilian market. And aviation bolts and screws are already made of specialty steel made in US. You don’t run down to Home Depot to fix a Cessna 150 let alone an F-15. It was naked protectionism wrapped in the flag. Luis’ call for serious, scenario-based and quantitative analysis is the first step of a mechanism to say no to this sort of thing. If one wants to.

Update:

Luis references Olivier Kooi’s elegant paper “Power and Resilience: An Economic Approach to National Security Policy” which is a great starting point for further and more careful analysis.