What are the likely Economic Implications of a Rise in Protectionism?

Barry Reeves of Sir George Monoux College reviews the concerns if there is a retreat from the principle of global free trade.

Exam Board AQA Edexcel OCR WEJC CCEA Int. Bacc.

AS

Unit

A2

2883 (5.3.4) 3(G) 4 Standard 4.2

Unit 6(15.4) 6

et

M ARCH

2007

rotectionism is the imposition of barriers to reduce imports from other nations. There are four main forms: tariffs, quotas, non-tariff barriers and subsidies. Tariffs are taxes imposed on imports as a percentage or a fixed sum per unit and work by making imports dearer than home produced goods. Quotas are fixed limits on the amount of imports, by quantity or value. These are certain in their effects and defendable where a small annual increase in the quota allows a steady rundown of an old industry giving time for resources to leave gradually to higher value sectors (the sunset or senile industry argument for temporary protectionism). Non-tariff barriers (ntbs) are hidden and administrative controls, possibly spurious health and safety reasons when the real aim is to reduce imports. Finally subsidies are trade barriers as they distort free trade as domestic suppliers gain a cost advantage not based on efficiency. Economic theory argues strongly for free trade as it allows each country to specialise where it has the greatest efficiency and advantage over others, not just a simple advantage. This is the principle of comparative advantage. Comparative advantage increases world output and living standards and it reduces monopoly power as firms face competition from abroad. In contrast protectionism endangers comparative advantage and reduces world output as fewer countries can specialise where they have the greatest efficiency. Instead they concentrate resources where value and productivity is low. From free trade principles broadly speaking we should welcome the latest phase of globalisation the rise of many newly industrialising nations. Their wave of cheap imports helps to lower our inflation and in turn allows us to have lower interest rates and still meet our inflation targets. The opportunity to export to rich markets has produced economic growth and rising living standards for the worlds poor and cheaper imports of textiles, toys and electrical goods for us. Rising protectionism would, on the other hand, tend to increase our inflation and therefore need higher interest rates and higher unemployment rates to control inflation if cheaper imports are not allowed to do the job. The rise of China, India, South East Asia, Turkey and elsewhere have brought trade benefits to us all but these multiple benefits are threatened now by growing calls for
M ARCH
2007

protectionism from the Developed countries. If we are concerned to end poverty, for instance the 400 million lifted out of poverty by Chinas growth alone, and if we gain from comparative advantage, why do we impose tariffs and quotas? Quite simply it is because governments react to self-interested pressure groups as well as media induced concerns. Exports from low wage countries are seen as unfair competition. Farmers and textile manufacturers and steel lead the campaign for protectionism. The US imposed high steel tariffs in 2002 and gives millions of dollars to defend 25,000 American cotton farmers replacing the livelihood of 10 million

very poor African farmers who can produce at a lower cost. Europe tightened quotas on clothing and underwear imports in 2005 (bra wars) and 20 anti China protectionist bills have been put to the US Congress in the last few years. The huge US trade deficit is now partly financed by Chinese funds of $200bn a year. If the current US housing slowdown causes a drop in consumer confidence then world slowdown or recession could follow and we will see a rise in protectionist sentiments. Thus free trade faces dangers and we now examine these. We can identify three levels of concern from greater protectionism. Firstly, the standard textbook analysis

American cotton farmers, like these in Arizona, are protected to the detriment of poor African farmers.

Figure 1: The Impact of a Tariff

A Sd (Domestic Supply)

H Pw+t D G E World Price + Tariff

Pw B

World Price

Dd (Domestic Demand)

that protectionism damages free trade and comparative advantage, mainly affects the supply side. The second concern relates to damage to world aggregate demand and finally, the harm to the worlds developing economies and their poor. We now consider these in turn.

Protectionism and Free Trade Principles

Recent protectionist actions have included extra EU or US tariffs and subsidies and then retaliation between the two super economies. Billions of Euros have been poured into European Airbus so it could compete with Boeing. The US increased farm subsidies and set tariffs against steel imports in 2002. Each time minor, and not very damaging, trade skirmishes with the EU followed. However this protectionism is of little importance compared to the extremely damaging impact a tide of protectionism would have on the development of the poorest countries. The illogical consequences of protectionism is clear when we look at EU and US taxpayers and consumers paying billions for costly farm subsidies for fixing agricultural prices. Developing countries have factor abundance in land and labour and so can supply us cheaply and save us the more than 3 extra per person that EU food costs compared to buying it on open world markets. There is also a high opportunity cost of state money being diverted from better alternatives for example healthcare or dealing with global warming. There is increasing hidden protectionism. The US has declared a concession
8

of no trade restrictions on 97% of the categories of possible exports from developing countries at the WTO (World Trade Organisation, set up to reduce trade barriers). In reality the poor countries are free to export the 97% of goods they find it impossible to produce like aerospace. The 3% remaining they are prevented from exporting are sensitive products especially textiles and food, the very things they have a comparative advantage in. In these ways we prevent the poor world exporting their way out of poverty and trap ourselves in low value industries. We give up our comparative advantage and we lose productive efficiency by overprotecting our firms and large monopolies behind tariff walls. Economic growth and living standards suffer in all countries. Britain is in a better position than some to cope with cheap imports, ironically because we have deindustrialised faster than our rivals! We now have little left of textiles, shoes or toy manufacturing and have moved resources into high value services and manufacturing. However most of the feared imports are manufactured goods and it will be the unskilled work in Britain and other developed countries that is most at risk from unrestrained free trade. The best answer is training so workers can find employment in services and other skilled industries that will remain competitive. Financial services, cultural and knowledge based industries, chemicals, pharmaceuticals and aerospace remain our strength and with our supply side reforms and efficient demand management we should suffer less job losses or danger of

prolonged structural unemployment from cheap manufactured imports. The more southerly EU nations like France, Italy, and Portugal have more to fear with larger, old and low value sectors like farming, textiles, shoes and leather goods. But by limiting imports southern Europe will limit its growth if it fails to shift out of old industries and into the new. The UKs main problem, like the US until recently, is our strong currency. To enable more of our industries to compete and exploit their comparative advantage and for UK manufacturing to recover, the UK needs a lower currency. US exports have already risen strongly after the dollar depreciated. Currency adjustment is preferable to protectionism for the world economy as currency adjustments strengthen the role of comparative advantage and increase world output rather than distort and weaken trade and specialisation as tariffs and quotas do. The UK, with low unemployment, supply side efficiency and little desire for protectionism encourages the growth of hi-tech industries and financial services in the City, now the worlds top financial centre. The EU however fights to keep too many workers growing wheat and maize and making shirts with high opportunity cost of high value goods foregone that could be traded abroad to buy much more food and textiles from poorer regions. There is a cost for protectionism of old industries in the developed world as there is a cost of adjustment including some short run unemployment. However to try to freeze a countrys outdated industrial structures merely builds up pressures for change and dangers of a crisis later. Temporary protection to allow long run supply side reforms and structural adjustment is better. We can see the distributional effects of a tariff on consumer welfare and producers on a simple diagram. Consumer surplus (the difference between the price consumers would be prepared to pay and the price they have to pay) is shown in Figure 1 by ABC at the pre-tariff world price (Pw). At the tariff price Pw+t, consumer surplus falls to the area ADE, so consumers lose welfare of DECB. Correspondingly the producer surplus improves from OBF to ODG as it is the difference between the price at which they are happy to sell shown by their supply curve and the actual higher price they gain, which now rises after the tariff. Rising protectionM ARCH
2007

et

ism would hurt consumer real income and welfare through higher prices but increase producer profits.

Possible Demand Side Effects

Protectionism threatens the worlds circular flow of income. Country A may protect jobs by a tariff on goods from Country B, but this shifts unemployment to B which then gets a second wave of unemployment as the multiplier effects from falling exports spreads through their economy. The 1930s depression became deeper and more prolonged because of these beggar my neighbour policies. The 1930s trade wars destroyed industries and brought a sustained drop in world spending and deep structural unemployment that expansionary monetary policies could not cure. Similar, but less deep effects could recur today. Since 1945 the WTO (previously GATT) has held rounds of negotiations between member nations aiming to avoid the most damaging trade wars and recessions by ensuring international trade stability. Dangerously the system has come close to breaking down. The WTO struggles to stop all countries breaking trade rules.

A wave of protectionism would rebound on the developed world as lost foreign earnings for the developing world would mean they would cut back purchases from the developed world. If Chinese and Indian exports were curtailed their growth rates of 8-10% would rapidly slow and so would their spending in neighbouring south East Asia and their purchases of African commodities that has brought Africa 5% growth for the first time. Even worse, Chinas growth is based on poorly developed financial and legal systems with poor property rights. A financial crisis like that of 1997/8 in South-East Asia and political instability is possible in China. China is now so significant in world trade that a severe setback there would have world significance. The multiplier effects from a trade war followed by financial crisis would spread and redouble as poor countries cut back sharply on capital goods purchases. Germanys new recovery would falter with its specialism in machinery and capital goods. If Germany, Europes largest economy slows, then so will the rest of Europe. Via international multipliers,

recession could spread. More countries would struggle with third world debt and defaults would threaten the danger of an international financial crisis. Britain too is vulnerable as our strength in the City lies with our investment banks raising loans for capital hungry emerging economies. Far fewer City workers would earn large wages and Christmas bonuses of 1 million and above (4300 last Christmas). Falling City earnings will produce less spending and tax revenues to spread around Britain. We would suffer directly and indirectly from any protectionism that dislocates the world economy. The worlds long post war international and economic stability is at risk.

The LDCs
Finally we should see protectionism in the context of globalisation. Free trade and all its benefits especially represents good globalisation with its potential to improve all economies. Globalisation has a bad name however as the rich world sets the rules which often benefit the self-interest of a few industries. The G8 countries demand that poor

The Pudong district of Shanghai. If protectionism caused Chinas 10% growth rate to slow there would be a major setback for the world economy.

M ARCH

2007

et

countries open up to free trade to increase markets for western companies, but then yield to the demands of G8 firms and workers to protect their home markets against low wage countries. This one-sided demand for free trade is the product of western power and is largely why the Doha round of WTO trade talks have almost collapsed. The arguments should be reversed. The poor countries should be allowed protectionism under a fairer trade system. The infant industry argument suggests the economic case for poorer countries to defend a few key industries that lack economies of scale so they can industrialise. Often they have a potential comparative advantage that stays undeveloped because free trade allows large western companies to destroy potential competitors at birth before they can establish enough size to compete. The self-interest of a few removes the chances for hundreds of millions to escape poverty through economic growth. We must be careful however not to allow the return of the predominantly closed economy approach seen in Africa and India in the last century. Across the board protectionism of that kind produced economic inefficiency and failure to develop their economies or any comparative advantage. The emerging economies should aim to support and protect a few carefully researched and selected key industries which would prosper naturally under free market forces once they are established. As they grow their local multiplier effects should create new supply industries, new infrastructure and consumer spending. This unbalanced growth from a few key sectors with previously unrealised comparative advantage should drag the rest of a developing nation forward just as the successful Asian Tigers did in the last century with spectacular results. A new wave of protectionism by the richer countries will have devastating effects on the emerging worlds chance of export led growth. Each country starts at the low wage and labour intensive stage and then moves to more modern sectors including services and then enjoys high income and high levels of consumption. This is what happened to Singapore, Taiwan and South Korea in the last 40 years. We should ensure that we do not pull up the trade ladder which allows poor countries to escape from poverty.
10

Questions for Discussion

1. What, without relying on protectionism, can governments do to reduce the large trade deficits in the UK and US and also reduce the large trade surpluses of the EU and China? 2. What are the links between moves to increase the school leaving age to 18 including more modern apprenticeships and responding effectively to competition from low wage countries? 3. What other reforms might a developing country need to gain rapid growth other than selective import controls and unbalanced growth? 4. In what ways is exploitation of cheap labour in developing countries good or bad and how could we soften its bad effects? What would happen if we all stopped buying from low wage countries on the grounds of exploitation?

Summary of Key Points

Protectionism is rising through fears of competition from China and India and others. The interests of a few powerful G8 industries threaten the welfare of consumers in the developed world and maintain poverty in the poorest countries. Protectionism may threaten a world economic slowdown or depression via multiplier effects and financial crisis. The limited and temporary cases for protectionism are managed decline of old sectors in the industrial countries and managed development of comparative advantage through protecting selective infant industries in developing countries. We need a strong WTO, stronger in its policing role and in reflecting the interests of the developing world. The dangers of protectionism are not just textbook fears, but represent peoples lives and chances of escaping poverty.

with Chief Examiner, Robert Nutter

1. (i)

Access the World Trade Organisation web site and investigate the role of the WTO in the global economy. (ii) Research the current state of the Doha Round of trade negotiations. (iii) Investigate the implications of Vietnams recent membership of the WTO. www.wto.org www.bbc.co.uk

2. Read a review of Sherrod Browns book Myths of Free Trade Why American Trade Policy has Failed, ISBN 978-1-59558-124-2. 3. Investigate the views of Sherrod Brown on why the USA should renegotiate its membership of the North American Free Trade Area (NAFTA). www.sherrodbrown.com 4. Research the current protection measures in place for textiles and footwear into the European Union. http://ec.europa.eu (trade issues/textile and footwear sector) 5. Investigate the extent to which the European Unions textile industry will be affected by the recent membership of Romania. See Enlargement and the Textiles, Clothing and Footwear Industry by Doris Hanzl-Wei, (2004), The World Economy 27 (6), 923-945.

et

M ARCH

2007