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In Defence of Protectionism

In Defence of Protectionism

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In a controversial piece entitled Econ 101 is Killing AmericaMichael Lind and Robert Atkinson delivered a defence of mercantilism

"That trade always benefits both parties is perhaps the most fundamental dogma that people take away from their Econ 101 courses. In discussing trade theory with students and politicians, academic economists use fairy tales rather than history. There is the fairy tale about comparative advantage: England was good at producing wool, Portugal wine, so they trade and both are better off. There is the fairy tale about how because market transactions are always voluntary and always beneficial that trade, being simply a market transaction across borders, is always win-win.

But Econ 101 never explains how nations like America, Britain, Germany and Japan have used national industrial policies over the past century to become industrial powerhouses. And Econ 101 never explains how foreign mercantilist practices, like those China is embracing, can hurt the U.S. economy. Higher-level students are sometimes introduced to the complexities of real-world trade, but academic economists fear that sharing nuances with the general public would unleash an epidemic of know-nothing protectionism.

But for most of the production of traded goods and services, comparative advantage is meaningless – the Koreans and Japanese are not good at making flat panel displays because they have a lot of sand, they are good at it because their corporations and governments targeted it for competitive advantage. Moreover, corporations locate their subsidiaries in particular nation-states to take advantage of local government subsidies and tax breaks or increasingly because of government requirements to produce locally. Econ 101 to the contrary, the location of factories and innovative research complexes is not determined by comparative advantage. Increasingly it is the artificial outcome of negotiations among multinational corporations and territorial states.  And the outcome of this “free trade” can be detrimental to the U.S. economy if it hurts, as it has, key U.S. high value-added industries."

Broadly, I think Lind and Atkinson make some strong points. The justification for comparative advantage in the literature is a fairy tale. Economic models by definition are fairy tales, simplifications of complex, gross reality. Simplification can be useful both for the purposes of understanding, as well as policy advice, but not all simplifications are useful or accurate. Is comparative advantage useful? All else being equal, I think that comparative advantage is a useful story. In theory, by specialising in their comparative advantages — say, wool in England and wine in Portugal — total output over the two goods can be maximised, and both nations can satisfy their demand for both things through trade.

However in reality all else is not always equal. Let's imagine a model with two different goods, say, guns and butter. England specialises in  producing guns and munitions, and Portugal in butter and agricultural produce. For years, they trade and enjoy the benefit of maximising output through specialisation. Then, England starts a trade dispute with Portugal. They cease trading. England loses access to butter and various agricultural products from Portugal's large population of butter-producing cows, having to replace Portuguese butter with lower-quality and higher-priced Welsh butter. Portugal, however, loses access to guns and munitions. Although this is immediately recognised as a risk to national security, and Portugal quickly tries to start up its own domestic firearms industry, the trade dispute escalates into full-blown war and with their geostrategic advantage in guns, England swiftly triumphs and occupies Portugal.

And this is not necessarily an entirely otherworldly possibility. In the real world, China's monopoly on rare earth metals which have very many military applications may have national security implications for other nations including Britain and the United States whose ability to manufacture modern military equipment might be impeded by a trade breakdown.

And the empirical record on trade liberalisation does not match up to the Ricardian theory. As Dani Rodrik noted in 2001

"Do lower trade barriers spur greater economic progress? The available studies reveal no systematic relationship between a country's average level of tariff and nontariff barriers and its subsequent economic growth rate. If anything, the evidence for the 1990s indicates a positive relationship between import tariffs and economic growth.The evidence on the benefits of liberalizing capital flows is even weaker. In theory, the appeal of capital mobility seems obvious: If capital is free to enter (and leave) markets based on the potential return on investment, the result will be an efficient allocation of global resources. 

But in reality, financial markets are inherently unstable, subject to bubbles (rational or otherwise), panics, shortsightedness, and self-fulfilling prophecies. There is plenty of evidence that financial liberalization is often followed by financial crash — just ask Mexico, Thailand, or Turkey — while there is little convincing evidence to suggest that higher rates of economic growth follow capital-account liberalization."

There are a number of potential reasons why the theoretical promise of comparative advantage has not played out in reality.

First is graft and corruption. If countries are taking on loans from international institutions as part of a trade liberalisation deal and those loans are being deposited in the Swiss bank accounts of corrupt officials or businessmen instead of being spent on improving industry, skills or infrastructure, then what chance do developing countries have of developing?

Second is the danger of bubbles during the liberalisation process. Global capital flows into newly-liberalised countries can stoke bubbles in almost every sector (but especially equities, real estate, etc). When the bubble bursts, capital flows out, leaving the domestic economy deeply depressed.

Third is the social upheaval costs to labour, skills and institutions. As we have seen in the United States, manufacturing jobs and skills migrated abroad. Workers often cannot be retrained cheaply and easily, and often do not want or cannot afford to migrate to wherever their skills would be best-compensated. This stickiness can result in endemic unemployment.

So while specialisation in theory allows for the maximisation of output, it can also create fragilities and distortions. Decentralisation and non-specialisation may not be as theoretically efficient, and may not theoretically maximise output, but it may sometimes prove advantageous to many. This means that countries that wish to build and keep a manufacturing base, infrastructure, supply chains, access to resources and full employment may have some scope to enact restrictive trade policies to support domestic industries. This may lower output across the world. And to some degree it may foster inefficient and ineffective domestic industries and misallocate capital and resources. But the ultimate outcomes may be closer to the desires of many people. Free trade is suitable for the many industries where maximising output is desirable, but that is not necessarily every industry.

This does not chime with the simplified fairy tale that free trade always has superior outcomes. But the relative value of outcomes is simply a matter of one's criteria.

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"So while specialisation in theory allows for the maximisation of output, it can also create fragilities and distortions."

Fragility: Time of war. Lack of critical components and skill to gear up physical war machine and supply. Loss of critical skills and knowledge to take advantage of structural change and new opportunities.

Distortions: The Labour market becomes focussed on one area. Humans are diverse creatures. Genetics gives different traits and skills. You have a lot of long term unemployment, with subsequent depression, crime and welfare costs.

Comparative advantage = putting eggs into one basket, works against the principle of diversification and risk reduction. A daft idea !

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