Trade protectionism has been getting a lot of exposure in the media lately, with strong proponents of both sides of the issue. This analysis seeks to better understand:

• What are the various forms of trade protection?

• What are its advantages and disadvantages?

• What are the big issues surrounding trade protection?

Trade Statistics

Let’s start by examining a few trade statistics. As seen in Figure 1, total world trade as a percentage of world production has generally been increasing over time. Noteworthy is the large dip in trade after the recent financial crisis.

Figure 1

Figure 2 shows that there are large cross—country differences in trade as a percentage of GDP. In particular, larger countries, tend to have more diverse domestic production and thus engage in relatively less trade with foreign countries.

Figure 2

Source: https://data.oecd.org/trade/trade-in-goods-and-services.htm

Figure 3 shows that there are three major global hubs of trade: the US, Europe, and China. The figure also shows that countries tend to trade more with nearby countries.

Figure 3

Figure 4 shows the growth in various categories of trade. Trade in services exhibited the highest growth rates between 2012 and 2014.

Figure 4

A country’s trade elasticity is the change in the country’s trade with increases in the country’s GDP.

Product groups are defined as follows:

• Consumers: Consumer goods, that is, final products

• Intermediaries: Intermediate goods, that is, production inputs

• Primary: Raw materials

• Investment: Financial investment

• Services: The largest categories are transportation, travel, and other business services

Free Trade: In Theory

In my previous blog post, “Why Do Economists Think Freed Trade Is So Wonderful, While Many Others Do Not?” I explain why Economists are such strong proponents of free trade. Basically, the argument is this (taken from my previous post):

Economists’ basis for touting the benefits of free trade comes from David Ricardo’s Theory of Comparative Advantage, developed in 1817: Countries can do better by specializing in producing what they do well and trading for goods in which other countries do well. Specialization will lead countries to maximize the size of the global output pie. Then, theoretically, everyone can be made better off by redistributing some of the income from those who gain to compensate those who lose.

So, theoretically, free trade enables maximization of total global production.

Forms of Trade Protectionism

Trade Protectionism may be defined as follows: “Trade protection is the deliberate attempt to limit imports or promote exports by putting up barriers to trade.”

Tariffs and Quotas

Perhaps the most well-known forms of trade protection are tariffs and quotas.

• Tariffs “are taxes, or duties, on imported goods designed to raise the price to the level of, or above the existing domestic price.”

• “A quota is a limit to the quantity [of imports] coming into a country.”

Both tariffs and quotas end up decreasing the amount of imports that would enter a country in their absence. The difference between tariffs and quotas is that in the case of tariffs, the government collects taxes from importers, while in the case of quotas no taxes are collected. The higher domestic prices associated with both tariffs and quotas benefit producers of import-competing products by lessening competition, but at the expense of domestic consumers, who are forced to pay higher prices.

Non-Tariff Restrictions on Trade

There are also a variety of non-tariff restrictions on trade, as presented in Figure 5, including

• Measures that ensure imports meet minimum standards of health (in the case of plants, animals, and food), safety, and quality (measures [1] and [2] in Figure 5);

• Measures that counter illegal practices, such as dumping (measure [4]);

• Measures that set price or quantity restrictions on imports (measures [5], [6], and [11]);

• Measures to grant special privileges to specified groups (measures [8] and [13])

• Measures that force technology transfer ((measure [9]). In World Economic Forum, “The Shifting Geography of Global Value Chains: Implications for Developing Countries and Trade Policy,” Karan Bhatia from IBM notes the increasing use by domestic governments of forcing technology transfer on foreign companies that want to do business in domestic markets

An increasingly significant challenge in value-chain decision-making is the growing array of government policies designed to force the transfer of technology (e.g., “Indigenous Innovation” policy) or production/services (e.g., local content or “buy national” policies) as a condition for access to government procurement or other markets.

• Measures that protect intellectual property (measure [14])

• Measures that promote or inhibit exports (measures [16])

Non-tariff restrictions on trade have similar effects as tariff and quotas in decreasing domestic supply and/or increasing prices of domestic goods, thereby increasing the welfare of domestic producers at the expense of domestic consumers.

Figure 5

Finally, countries can depreciate their currencies to promote their exports by making them cheaper in importing countries. More specifically, Currency Depreciation or

Monetary protection involves countries deliberately devaluing their exchange rate to stimulate exports and deter imports.

In the case of a depreciating currency, exporters gain by having lower prices in foreign markets. However, domestic consumers of imports lose because import prices go up.

Advantages of Protectionism

Job Retention

Recently there have been calls for protectionism from countries globally. From September 6, 2016 news:

• Fortune’s Geoffrey Smith and Alan Murray noted that, “Populism and protectionism are rearing their heads around the world;”

• Financial Times’ Martin Wolf noted, “The tide of globalisation is turning: Trade liberalisation has stalled and one can see a steady rise in protectionist measures;”

• and Li Xuanmin, from The Global Times noted that in China, “Domestic steel output headed for further contraction: Weak demand, protectionism hitting producers.”

These recent calls for protectionism have been primarily provoked by massive job losses, as domestic producers either outsource production to lower-cost countries or are forced out of business from lower-priced imports. One report, by Heather Long from CNN Money, claims that “U.S. has lost 5 million manufacturing jobs since 2000” to automation, outsourcing, and imports. Another report by Michael Mandel and Diana G. Carew from the Progressive Policy Institute estimates that

rising real imports are responsible for approximately 1.3 million of the jobs lost between 2007 and 2011, or almost one-third of total private non-construction job loss.

These calls for protectionism hope that restrictions on imports will relieve competition in domestic US markets, thereby enabling job recovery.

In addition to the potential for job retention and/or creation associated with lesser degrees of competition, Mr. Lawrence Low provides other advantages of protectionism in “9 Reasons For Protectionism,” which I’ve summarized below.

Protection of Infant Industries

This is the classic argument for tariffs on imported goods: a country has an undeveloped industry that wants to develop. However, the industry cannot compete with foreign imports because the domestic industry has not yet developed the know-how and size to achieve economies of scale. In theory, it will be beneficial to the country to protect the infant industry until it grows strong enough to compete.

In reality, unfortunately, once an industry has managed to extract protection from the government, it is unlikely that the industry will ever give up that protection in the future. Such industries thus generally end up receiving perpetual protection, which enables them to wallow in inefficiency.

Protection of Sunset Industries

Analogous to the infant industry argument is the sunset industry argument in favor of protection. Industries in the process of collapsing will lead to chaos and unemployment unless the government protects the industry by enabling a gradual decline.

The problem with this argument is that rather than letting the industry collapse and free up resources for more productive uses, government ends up supporting the continued inefficient use of resources.

Revenue Generation

Tariffs enable governments to generate revenues from foreign producers.

National Security

For national security purposes, even though a country is not an efficient producer of certain goods, the industry must be supported to ensure a constant supply of the goods, in case imports of the goods becomes jeopardized.  For example, the US protects the production of agriculture and steel, while Japan protects the production of rice.

Producers will sometimes claim products should be protected for reasons of national security, when there is, in fact, no security threat. Rather, the producers are simply seeking protection from competition by imports.

Protect Consumers from Unsafe Products

Minimum standards protect domestic populations from imports of potentially dangerous, unhealthy, or low quality imports.

As with protection for national security reasons, producers may claim imports are unsafe, simply to garner protection. For example, Europe bans imports of genetically modified (GM) products and beef and milk from cows injected with hormones, claiming they’re unsafe. However, the US insists there is no hard evidence to support these claims.

Discourage Unethical Practices

Countries might impose restrictions on imports coming from countries that support unjust or unethical practices, such as employing child labor, sweatshop labor, or engaging in other human rights violations.

Protection from Dumping

Countries might impose trade restrictions on imports being dumped into domestic markets, to protect domestic industries from being forced out of business.

Narrowing of Balance of Payments Deficit

Countries might impose restriction on imports so as to improve their balance of payments accounts (i.e., surpluses of imports over exports). However, this is a short-term solution to what is usually a longer term underlying problem in the domestic country.

Cultural Preservation

Countries might impose restriction on imports so as to prevent imported goods from diluting the domestic country’s culture.

Disadvantages of Protectionism

There are two significant disadvantages in particular of engaging in protectionism.

Too Little Competition in Domestic Industries

One of the most significant disadvantages of protectionism is the lack of competition it engenders. In particular, by protecting domestic producers from competition, a domestic government removes incentives for domestic producers to innovate and improve on their products. As a result, domestic consumers are forced to consume lower-quality and/or higher-priced goods than those available in other countries. Kimberly Amadeo describes this further in “Trade Protectionism: Definition, Advantages and Disadvantages”:

In the long term, trade protectionism weakens the industry. Without competition, companies within the industry won't innovate and improve their products or services… Eventually, consumers will pay more for a lower quality product than they would get from foreign competitors.

Likelihood of Retaliation by Exporting Countries

The other significant disadvantage of protectionism is its tendency to induce retaliation from exporting countries, resulting in trade wars.

Issues

Protectionism is Rampant

Global leaders often tout the benefits of free trade and suggest that any protectionism will limit free trade, as if global economies currently benefitted from free trade. However, in reality, protectionism is rampant across the globe. As Walter Wentz so eloquently describes in, “Economic Protectionism Ain't All Bad”:

Protectionism violates the law of natural advantage that says goods and services should be provided by whomever can deliver them most cheaply. This makes the global economic system efficient and all economists worship the God of Efficiency.

Let the truth be known: Every country practises protectionism to some degree, but none will admit it.

…

Protectionism is lousey economics and great politics. Citizens are interested in jobs, not macro-economic theory. Keeping foreign competitors out of the U.S. market may not go down well with the professors at Harvard and Yale, but it goes down a treat in the homes of Youngstown, Ohio, and Pitsburgh, Pennsylvania

In fact, in “Trade Protectionism Is Bad Policy,”the National Center for Policy Analysis, estimates that

Technical barriers affect 30 percent of international trade and more than 60 percent of international trade in agriculture products.

Another source provides estimates of country-specific average tariff rates, as provided in Figure 6.

Figure 6

Increases in Protectionism is Common after Economic Downturns

Citizen demands for trade protectionism commonly increase during recessions or hard times for specific industries, as people feel the effects of job losses and continued unemployment more bitterly. For example, The Tariff of 1828, otherwise known as the “Tariff of Abominations,” came in response by demands from people in the Northern Unites States who “were being driven out of business by low-priced imported goods.” From Wikipedia:

The "Tariff of Abominations" was a protective tariff passed by the Congress of the United States on May 19, 1828, designed to protect industry in the northern United States. Enacted during the presidency of John Quincy Adams, it was labeled the Tariff of Abominations by its southern detractors because of the effects it had on the antebellum Southern economy.

The major goal of the tariff was to protect industries in the northern United States which were being driven out of business by low-priced imported goods by taxing them. The South, however, was harmed directly by having to pay higher prices on goods the region did not produce, and indirectly because reducing the exportation of British goods to the U.S. made it difficult for the British to pay for the cotton they imported from the South.

Similarly, the Tariff Act of 1930, also known as “the Smoot-Hawley Tariff” was passed during the early stages of the Great Depression. From Wikipedia:

The Tariff Act of 1930, otherwise known as the Smoot–Hawley Tariff or Hawley–Smoot Tariff, was … signed into law on June 17, 1930. The act raised U.S. tariffs on over 20,000 imported goods to record levels.

The dutiable tariff level … under the act was the second highest in the U.S. in 100 years, exceeded by a small margin by the Tariff of 1828. The great majority of economists then and ever since view the Act, and the ensuing retaliatory tariffs by America's trading partners, as responsible for reducing American exports and imports by more than half.

…

As the global economy entered the first stages of the Great Depression in late 1929, the USA's main goal emerged to protect American jobs and farmers from foreign competition. Reed Smoot championed another tariff increase within the USA in 1929, which became the Smoot-Hawley Tariff Bill.

More recent calls for protectionism come several years after the Great Recession.  However, Mohamed A. El-Erian, in “The Lure of Protectionism Will Grow,” explains that the delay was due by specific G20 efforts to refrain from protectionism. Demands for protectionism are coming now, because other efforts to increase global economic growth have failed.

As output collapsed after the financial system's "sudden stop" in the fall of 2008, and as a damaging global depression loomed, there were fears that countries would give in to the temptation to adopt protectionist trade measures as a way to promote their own growth at the expense of others.

This was avoided for two major reasons: the conviction that such beggar-thy-neighbor policies were likely to be ineffective, if not counter-productive, over the longer term, and the willingness and ability of Group of 20 leaders to adopt a comprehensive pro-growth policy agenda at their April 2009 summit meeting.

This protracted period of low growth and rising inequality is now threatening the consensus in favor of globalization and regional integration that has underpinned economic thinking for decades. As a result, progress on liberalization and cross-border integration is hitting a wall.

All of these events are heavily influenced by a broader common force: popular dissatisfaction with enduring low growth and rising inequality, both of which have fueled the popularity of anti-establishment movements that advocate nationalistic policies.

The weak version of this trend is to stress that trade needs to be fair and not just free. The stronger version is to promote import-substitution, as well as to consider other measures that discourage inflows of foreign goods and money.

The World Trade Organization

The use of various forms of protectionism, not to mention flagrantly illegal practices, begs the question as to whether or not there is an overseer out there coordinating trade flows and making sure everyone’s playing nice.

The World Trade Organization (WTO) is a global body that was established in April 1994 to facilitate trade among nations. From the WTO website:

The WTO’s overriding objective is to help trade flow smoothly, freely, fairly and predictably.

It does this by:

• Administering trade agreements
• Acting as a forum for trade negotiations
• Settling trade disputes
• Reviewing national trade policies
• Assisting developing countries in trade policy issues, through technical assistance and training programmes
• Cooperating with other international organizations

The WTO has about 160 members, accounting for about 95% of world trade. Around 25 others are negotiating membership.

Decisions are made by the entire membership. This is typically by consensus.

While the WTO does offer dispute settlement among participating nations, the settlements don’t always take place in a timely manner. From the WTO website on  WTO Dispute Settlement:

Dispute settlement is the central pillar of the multilateral trading system, and the WTO’s unique contribution to the stability of the global economy. Without a means of settling disputes, the rules-based system would be less effective because the rules could not be enforced. The WTO’s procedure underscores the rule of law, and it makes the trading system more secure and predictable. The system is based on clearly-defined rules, with timetables for completing a case. First rulings are made by a panel and endorsed (or rejected) by the WTO’s full membership. Appeals based on points of law are possible.

However, the point is not to pass judgement. The priority is to settle disputes, through consultations if possible. By January 2008, only about 136 of the nearly 369 cases had reached the full panel process. Most of the rest have either been notified as settled “out of court” or remain in a prolonged consultation phase — some since 1995.

What Is the Optimal Trade Policy?

So we know that there is a substantial amount of protectionism being practiced in global markets. The question then becomes: Given the current forms of protectionism currently in existence, what it the best trade policy for a country to undertake? This translates into the following decision problem:

The domestic government must

1. Choose Trade Policy to Maximize Domestic Welfare
2. Subject to
   1. Current Trade Policies (Protectionism) by Foreign Governments
   2. Expected Changes in Future Trade Policies by Foreign Governments associated with Domestic Protectionist Policies

The constraint in 2b. serves a game theoretic purpose. A domestic country might very well increase domestic welfare under current levels of foreign protection by increasing its own (domestic) levels of protection. However, if the (domestic) country thinks other (foreign) countries will increase their (foreign) levels of protection in response the domestic country’s increase in protection, then the domestic country might actually be better off with less protection. More succinctly, a country should impose fewer trade restrictions if it expects other countries to be more prone to trade wars.

Other questions to consider when choosing trade policy:

• To what extent does protectionism tend to be country-wide, as opposed to concentrated in specific industries?

• Are countries with higher levels of protectionist policies more likely to respond to protection from other countries by raising their own levels of protection?

• To what extent is protectionism “legitimate” as opposed to blatantly anti-competitive?
  • Is the global economy currently engaged in a prisoner’s dilemma, that is, would everyone be better off if levels of protection were reduced?
  • If most current protection is “legitimate” then lower levels of protection might not increase global welfare.
  • Conversely, If most current protection is blatantly anti-competitive, then lower levels of protection would probably increase global welfare.

• To what extent are special interests (domestic producers) gaining under current protectionist policies at the expense of domestic consumers?

• As automation replaces more jobs, will higher levels of joblessness promote more protectionist measures?