Beginning in April 2025, the Trump administration levied a variety of tariffs on virtually every country on earth, at a variety of levels, and with a variety of stated legal rationales. The latest range from 10 percent to 12.5 percent on goods from sixty different countries. One of the administration’s many justifications for tariffs is that they are necessary to counter threats to U.S. national security. Even Adam Smith, usually a critic of tariffs, conceded that in some instances national security concerns can justify the use of tariffs or other policies that limit trade. Modern proponents of using tariffs to address national security concerns often claim that such tariffs are simply addressing the national security externality. They overstate their case.
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Economic theory holds that a national security externality may arise when firms and consumers do not adequately account for the impact their trade with foreign parties has on national security. As London School of Economics professor Luis Garicano puts it:
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 U.S. company imports cheap Chinese chips and builds infrastructure dependent on them, it creates a strategic vulnerability—a cost not reflected in market prices.
As an example, a car manufacturer imports steel from China to make cars, but it does not account for the fact that importing steel from China weakens the domestic steel industry. Since countries need steel to make tanks, planes, and guns to defend themselves, a weaker domestic steel industry creates a national vulnerability that is not accounted for when firms decide how much steel to import. As a result, too much Chinese steel is imported.
It is true that trade can create strategic vulnerabilities. Even if Chinese companies could make guns, ammunition, tanks, and fighter jets cheaper than every U.S. company, it would be a mistake to import our military equipment from a potential adversary that could cut off our supply of weapons. A similar, though weaker, argument can be made for things like steel, rare earths, magnets, certain pharmaceutical ingredients, or computer chips.
The existence of these vulnerabilities, however, does not tell us anything about how to address them. In “The Problem of Social Cost,” economist Ronald Coase described how the assignment of property rights and subsequent negotiation between parties can alleviate externalities.
One of Coase’s key insights is that externalities are reciprocal. Coase uses the example of a farmer and cattle rancher to illustrate his point. The two are neighbors, and there is no fence between them. Absent the fence, the cattle tend to wander into the farmer’s fields and eat his crops. If the rancher does not take this damage into account when considering how large his herd should be, he will make his herd too large. If instead he were forced to compensate the farmer for the damage to his crops, he would internalize this additional cost, and the result would be a smaller herd.
This situation can be reversed. Suppose the farmer wants to increase the land he uses for crops, so he decides to erect a fence to keep the cattle out. Since the fence will prevent the cattle from grazing in the farmer’s field, the farmer is increasing costs for the rancher. If the farmer does not account for these higher costs, then he may enclose an area that is too large.
The optimal size of the fence from society’s standpoint depends on how much the farmer and rancher each value access to the land. Coase realized that if the farmer and rancher could negotiate, they would have incentives to reach the efficient solution regardless of which person controlled the decision about the fence. The only difference would be who must compensate whom, which depends on who controls the decision or has property rights over it.
The existence of an externality does not tell us how to, or who must, deal with it. The Trump administration argues we should curtail trade to address strategic vulnerabilities. If national security experts control the decision, then trade will be restricted, and businesses and consumers will have to bear the cost of addressing the externality, as they are doing with many of the recent tariffs. If instead commercial interests have the decision rights, while the national security community wants to restrict trade, the security community, presumably coordinated by the federal government, would have to compensate those domestic defense-sector firms harmed by the relative absence of trade restrictions. This has usually taken the form of a subsidy or a set-aside for firms in the defense sector.
Security analysts tend to invoke the externality argument, so perhaps that is why discussions of the defense externality typically assume the security community has the decision rights. But it is just as easy to argue that commerce should be prioritized instead. After all, people get satisfaction from creating new products and businesses that solve problems. Entrepreneurs and workers alike get satisfaction from using their incomes to provide for their families. Commerce—production and consumption—is foundational to a thriving society.
One could also argue that commerce makes national security possible in the broader sense by creating the wealth used to make tanks and pay soldiers. Countries that prioritize their military over their economy, such as the USSR, tend to fail because weak economic growth impedes their long-term ability to sustain their military.
Reasonable people can disagree over whether commerce or security should be prioritized in trade policy, and thus which group should bear the cost of addressing the security externality. Someone must bear the cost, though, and this is often left out of the discussion. One way to make the cost clearer is to incorporate the national security externality into the analysis of national trade policy, where it belongs.
In Garicano’s example above, the externality is at the firm level. Firms do not account for the strategic vulnerabilities they create through trade, so they trade too much. In economic jargon, the marginal social cost of the decision to trade exceeds the marginal private cost of the decision. The gap between the two needs to be closed so that firms internalize the vulnerability. So far so good.
At the national level, however, where the decision about overall trade policy is made, the strategic vulnerability costs are no longer external to the relevant decision. To determine the optimal amount and composition of trade, national policymakers need to compare the national marginal benefit of trade to the national marginal cost of trade. The national marginal benefit includes lower prices, a greater variety of goods, and the positive impacts of international competition on innovation, among other things. The national marginal cost includes the domestic adjustment costs borne by workers and firms, as well as the costs of any strategic vulnerabilities. When properly accounted for, the firm-level national security externality is a component of the national marginal cost that should be considered along with other costs and benefits, including positive externalities from trade. One example of a positive externality is that importing goods allows America to export dollars, which helps maintain the U.S. dollar’s reserve currency status that enables us to borrow at lower interest rates, a benefit that could be worth as much as $33 trillion.
The mistake people often make is jumping from the firm-level security externality to the conclusion that national trade should be restricted. Demonstrating a firm or even an industry-level national security externality exists is not the same thing as demonstrating that at the margin, the national cost of trade exceeds the national benefit. To answer the latter, more important question, national security proponents need to quantify the total amount of the firm-level national security externalities and provide an estimate, or range of estimates, to policymakers who can incorporate these costs into the national costs of trade so they can be compared to the national benefits.
This may be complicated, but it is not impossible. One recent study by Olivier Kooi, an economist at the London School of Economics, develops a framework to estimate the size of strategic vulnerabilities from lost domestic productive capacity and the impacts of various policy solutions. He finds that the presence of a national security externality does not necessarily justify restricting trade.
Good-faith estimates of the national costs and benefits of trade allow taxpayers, through their elected officials, to determine optimal trade policies. Accurate information empowers taxpayers to reveal their preferences about national security and trade through their buying and selling decisions, elections, lobbying, and other forms of political advocacy.
These signals are not perfect. They can be distorted by numerous factors, including rent-seeking and the rational ignorance of voters. Politicians also campaign for office, and govern, on a bundle of policy positions. This means voter preferences about any one issue, such as national security, can get dominated by other concerns. Recent tariff policy has been no exception, and it has certainly been shaped by many factors outside the scope of this essay.
These challenges are real, but they are not an excuse to use a firm-level externality to justify a national trade remedy. Since taxpayers care about both national security and commerce, and since they are ultimately responsible for funding whatever solution emerges from the political process, the costs each activity imposes on the other can and should be accounted for in the national-level analysis. With this information, taxpayers could analyze the costs and benefits of trade and consider a variety of solutions to address vulnerabilities, including more defense spending, stockpiles, import controls, purchase guarantees, or subsidies to spur domestic production.
A firm-level security externality only identifies a possible divergence between private and social incentives. It does not establish that national trade is excessive, determine the optimal composition of trade, or identify tariffs as the lowest-cost remedy. These answers require a national analysis that compares the total marginal costs, including security costs, to the total marginal benefits of trade. Absent this analysis, we are unlikely to implement policies that mitigate real security vulnerabilities without unduly restricting trade.
