‘A Discussion as to whether protectionism can be justified, by evaluating the economic effects of selected protectionist instruments on any country of choice’
Main Text Word Count: 3,502
Introduction
The fact that trade protection hurts the economy of the country that imposes it is one of the oldest but still most startling insights economics has to offer. The idea dates back to the origin of economic science itself. The Wealth of Nations has already contained the argument for free trade: by specializing in production instead of producing everything, each nation would profit from free trade. In international economics it is the direct counterpart to the proposition that people within a national economy will all be better off if all people specialize at what they do best instead of trying to be self-sufficient.[1] Economists argue, instead, that protection would be an inappropriate way to correct for most market failures. For example, if wages do not adjust quickly enough when demand for an industry's product falls, as was the case with U.S. autoworkers losing out to foreign competition, the appropriate government intervention should be in the labor market, directly aimed at the source of the problem. Protection would be an inefficient way of correcting for the market failure. Thus, protectionism arises in ingenious ways. As free trade advocates squelch it in one place, it pops up in another and protectionists seem to always be one step ahead of free traders in creating new ways to protect against foreign competitors. [2]
Protectionism
Protectionism is the economic policy of restraining trade between nations, through methods such as high tariffs on imported goods, restrictive quotas, a variety of restrictive government regulations designed to discourage imports and anti dumping laws in an attempt to protect domestic industries in a particular nation from foreign take-over or competition.[3] The term is mostly used in the context of economics, where protectionism refers to policies or doctrines which protect businesses and living wages by restricting or regulating trade between foreign nations:[4]
Subsidies - to protect existing businesses from risk associated with change, such as costs of labour, materials
Protective Tariffs - to increase the price of a foreign competitor's goods on par or higher than domestic prices
Quotas - to prevent dumping of cheaper foreign goods that would overwhelm the market
Tax cuts - alleviation of the burdens of social and business costs
Intervention - the use of state power to bolster an economic entity
Free trade and protectionism
Free trade means that there are few and ideally, no barriers to the international exchange of goods and services. Protectionism refers to policies that restrict trade, either through taxes on trade (tariffs) or through numeric control (bans and quotas). Trade has been a prominent subject of economic theory since the classical discussions of comparative advantage by and others. The subject has grown in importance for social scientists of all kinds, as the well-being of individual societies comes to depend increasingly on the structure and health of the world economy.[5] The theoretical advantages of free trade are straightforward: each country can import goods that would be costly to produce domestically, while exporting goods that would be costly for other countries to produce. In principle then, each country can acquire a set a goods and services with fewer resources than if it tried to produce them all domestically. While it may be true that a country gains from trade on average, opening up an economy has differentiated effects across sectors. There are also a range of situations in which a country may benefit from a strategically chosen restrictive trade policy.[6]
In theory, free trade is the best policy for countries that exercise little to no control over world prices. Since they cannot affect prices to their own benefit, free trade allows them to achieve the maximum national consumption. However, if a country possesses some degree of monopoly power in exports, it can increase its own welfare through trade restrictions. Most evidence suggests that domestic interests and political concerns are more often the source of protectionism than such tariff considerations.[7]One argument often made in favor of protection concerns infant industries, or those that are deemed essential to the national interest, which may not be able to compete on an international level and such protections are often associated with national fears of dependency on the international economy in such areas as agriculture and defense in which developing countries attempt to recoup the competitive advantage gained by countries that were quicker to achieve a given technological or infrastructural level.[8]
Free trade raises aggregate world production efficiency because more of both goods are likely to be produced with the same number of workers. Free trade also improves aggregate consumption efficiency, which implies that consumers have a more pleasing set of choices and prices available to them.
The simple theory of comparative advantage makes a number of important assumptions: [9]
Ø There are no transport costs
Ø Costs are constant and there are no economies of scale
Ø There are only two economies producing two goods
Ø The theory assumes that traded goods are homogeneous
Ø Factors of production are assumed to be perfectly mobile
Ø There are no tariffs or other trade barriers
Ø There is perfect knowledge, so that all buyers and sellers know where the cheapest goods can be found internationally.
Arguments for and against free trade
While foreign trade isn't as emotionally loaded as say, taxes and government spending, like most topics in economics it stirs the blood of certain people those whose livelihoods and lifestyles are most affected by exports and imports. These people have very real concerns, but those concerns are specific to their individual lives. Economists almost universally believe that foreign trade in a free global marketplace will create the greatest good for the greatest number of people.[10]
The following table below shows one example:[11]
Table 17.3
Food
Computers
Possibility C:
United States
6,000
6,000
Japan
2,000
6,000
Total
8,000
12,000
Total production = 20,000 units
With Specialization:
United States
12,000
0
Japan
0
12,000
Total
12,000
12,000
Total production = 24,000 units
Specialization generates the highest level of production of the two goods. Then, through trade, each nation can consume the amount of the good that it wants to consume. In this way, production is maximized because each nation is doing what it does most efficiently. Today, most arguments against free international trade are mounted by special interest groups. Both labor unions and management oppose free trade when they believe sometimes correctly, sometimes incorrectly that it will make them worse off. What they conveniently ignore is that free trade will make everyone else better off.[12]
The arguments most often heard are:[13]
Ø It's important to keep jobs in the United States
Ø They don't want money leaving the country
Ø National security is at stake.
Ø Other nations don't treat their workers fairly.
Ø Other nations are dumping and don't open their market to us.
When other countries practice protectionism, the preferred method is to work toward free or at least fair trade through a process of negotiation. These processes have been quite useful in recent years and have brought the world into an age of much freer international trade.[14]
Exchange rates
During the previous decade, Mainland China's Currency was pegged to the U.S. dollar at 8.28 RMB. On July 21, 2005, it was revalued to 8.11 per U.S. dollar, following the removal of the peg to the U.S. dollar. The revaluation resulted from pressure from the United Stated and the World Economic Council. The People's Bank of China also announced that the Renminbi would be pegged to a basket of foreign currencies, rather than being strictly tied to the U.S. dollar and would trade within a narrow 0.3 percent band against this basket of currencies. China has stated that the basket is dominated by a group of international currencies including the U.S. dollar, euro, Japanese yen and South Korean won, with a smaller proportion made up of the British pound, Thai baht and Russian ruble.[15]
The government has resisted pressure to increase the value of the RMB, out of concern that it would cause mainland Chinese jobs to disappear and would also expose domestic banks to currency risks that they are not prepared to handle. Many economists believe that only fixed exchange rates or floating exchange rates are stable over the long term, because a one time change in exchange rates might cause speculators in the future to take positions on possible exchange rate fluctuations which would lead to pressure to completely float the currency.[16] Furthermore, many economists have pointed out that manufacturing jobs have been declining in the United States for decades. Some people have suggested that blaming the lack of job growth on the value of the RMB is merely a convenient misdirection on the part of the vested interests, including Bush administration, inefficient businesses and labor unions fearful of competition.[17]
The impact of exchange rate fluctuations
After analyzing the relationships between the exchange rate and foreign trade, there is a need to assess properly the role of exchange rates in the economy. Although exchange rates play a key role in adjusting a market economy, there are so many variables that influence the economy that we cannot put excessive emphasis on the importance of any of these, especially the impact of exchange rate on trade payments and employment. Exchange rate distortions will damage the economic structure, while excessive exchange rate fluctuations may trigger financial turmoil. The relationship between the exchange rate and monetary policy is currently at its closest, perfecting the market-oriented exchange rate forming mechanism is a target of our reforms. This is not only of significance to promoting China's industrial structural adjustment and harmonizing the situation between different regions and sectors, but is also of practical importance to achieving macro management targets.[18]
China has been implementing and will continue to implement a market-driven managed floating exchange rate system, which fits well with the rules of the market economy, perfecting the exchange rate forming mechanism is a comprehensive reform, and there are never simple adjustments to the exchange rate levels. Perfecting the exchange rate mechanism should not be confined to broadening the floating range. It should also include things like steadily propelling the convertibility of the renminbi and improving trading patterns in the forex market.[19] Aside, China is a developing country, its currency is not an international clearing currency, its financial markets are not fully developed and the financial system is relatively fragile. If major fluctuations occurred in its exchange rate, this may cause a financial or even economic crisis. The international coordination needs to be enhanced.[20] In order to prevent financial risks and possible impact that may result from interest rate fluctuations and protect regional and international currency and financial stability, the international community needs to strengthen co-operation in currency and financial arrangements. The international community, especially developed countries, should not just emphasize the benefits of financial liberalization but ignore the huge risks it may bring.[21]
China has achieved sustained and rapid economic growth, markedly enhanced overall national strength and constantly improved people's life since its adoption of the reform and opening-up policy. China has become a positive force for the economic development of Asia, Europe and the world as a whole. The private sector is driving growth and can be strengthened further as their private ownership has become substantial, producing well over half of GDP and an overwhelming share of exports.[22] Private companies generate most new jobs and are improving the productivity and profitability of the whole economy. The government has restructured the state-owned business sector, resulting in a massive loss of jobs. Still, a large part of the state sector remains to be restructured; policies to facilitate this process have been identified and are being expanded.[23] The performance of the business sector could be strengthened more through a further modernization of the business framework and better enforcement of laws in the economic sphere for intellectual property rights. A more flexible exchange rate would support a stable macroeconomic environment while fiscal policy has been run in a establishing the outcome of monetary policy has been considerable volatility of inflation.[24]
Furthermore, greater flexibility of the exchange rate would allow the authorities to guard against any further increase in inflation in both product and asset markets, more easily adapt monetary policy to domestic concerns, and allow market forces to determine bank interest rates to a greater extent. Wide-ranging reforms have improved the capacity of banks to make market- based lending decisions.[25] The policies appear to have been successful, as new loans have been of much higher quality, even using the new, more realistic, classification system for non-performing loans. Further progress will require a continued focus on improving governance and increasing private ownership and policies designed to expand and further deregulate capital markets would improve the allocation of capital, lower the risk of further waste of savings, and minimize systemic risk.[26] The pace of economic change in China has been extremely rapid since the start of economic reforms such an increase in output represents one of the most sustained and rapid economic transformations seen in the world economy in the past years. It has delivered higher incomes and a substantial reduction of those living in absolute poverty.[27]
Many industries have become completely integrated into the world supply chain and on current trends China could become the largest exporter in the world by the beginning of the next decade. Underlying this growth there has been a profound evolution of economic policies that has transformed the efficiency of enterprises. This extraordinary economic performance has been driven by changes in government economic policy that have progressively given greater rein to market forces. While price controls were being abolished, the government introduced a pioneering company law that for the first time permitted private individuals to own limited liability corporations.[28] The government also rigorously enforced a number of competition laws in order to unify the internal market, while the business environment was further sharpened by allowing foreign direct investment in the country, reducing tariffs, abolishing the state export trading monopoly and ending multiple exchange rates. The momentum towards a freer economy has continued this decade with membership of the World Trade Organization resulting in the standardization of a large number of its laws and regulations and the prospect of further tariff reductions.[29]
In addition, fundamental changes were made to the constitution in 2004, stressing the role of the non-state sector in supporting economic activity in the country and protecting private property from arbitrary seizure. In 2005, regulations that prevented privately-owned companies entering a number of sectors of the economy, such as infrastructure, public utilities and financial services were abolished these permitted the emergence of a powerful private sector in the economy.[30] China’s exchange rate system is a work in progress. The accelerating pace of change makes efforts to analyze it like attempting to hit a moving target. In July 2005, following more than a year of intense discussion, the government announced that it was revaluing the renminbi by 2.1 per cent, switching from the dollar peg to a basket, and allowing the currency to float more freely.[31] In August it expanded the forward market by allowing all banks, including foreign banks, with licenses to trade in the inter-bank foreign exchange market to transact renminbi forward and swap contracts with clients as well as in the inter-bank market, and it allowed the banks to determine forward rates independently. In September the authorities eliminated an inconsistency between its rules for fluctuations against the dollar and fluctuations against the basket.[32]
Under the new regime instituted in July daily fluctuations against the dollar were supposed to be limited to 0.3 percent per day, while at the same time daily fluctuations against the basket were supposed to be limited to 1.5 per cent. The problem was that if the dollar moved against other currencies by 2 per cent in a day, a not unprecedented event, it might prove impossible to respect both rules at the same time.[33] On September 23rd the People’s Bank of China therefore announced that henceforth the renminbi would be allowed to fluctuate by 3 percent a day against the euro, yen and other non-dollar currencies, essentially relaxing this constraint. On November 25th, exchange regulators announced that they were going ahead with a system of market makers to trade the renminbi against foreign currencies and the PBOC enhanced the ability of the banks to hedge foreign currency exposures by conducting its first domestic currency swaps, selling $6 billion to 10 domestic banks at the current exchange rate with an agreement to buy them back in a year’s time.[34] The argument for protectionism may sound appealing, supporters of protectionist laws claim that keeping out foreign goods will save jobs, giving ailing domestic industries a chance to recover and prosper, and reduce the trade deficits. Are these claims valid? Protectionist laws raise taxes on imported goods and/or impose limits on the amount of goods governments permit to enter into a country. They are laws that not only restrict the choice of consumer goods, but also contribute greatly both to the cost of goods and to the cost of doing business.[35]
So under protectionism people end up poorer with less money for buying other things they want and need, protectionist laws not only force them to pay more taxes on imported goods but also raise general taxes as well. This is because governments invariably expand their Customs Department bureaucracies to force compliance with their new rounds of trade restrictions.[36]
Protectionism: Who Gains?
Those who gain from protectionist laws are special-interest groups, such as some big corporations, unions, and farmers' groups all of whom would like to get away with charging higher prices and getting higher wages than they could expect in a free marketplace.[37] These special interests have the money and political clout for influencing politicians to pass laws favorable to them. Politicians in turn play on the fears of uninformed voters to rally support for these laws. "Protectionism is a misnomer. The only people protected by tariffs, quotas and trade restrictions are those engaged in uneconomic and wasteful activity. Free trade is the only philosophy compatible with international peace and prosperity."[38] Senior Economist, Fraser Institute (Canada)
The Solution: Free Trade
During the 20th century, journalist made a similar observation:[39] society thrives on trade simply because trade makes specialization possible and specialization increases output and increased output reduces the cost in toil for the satisfactions men live by that being so, the market place is a most humane institution as the protectionist is not against the use of every kind of force even warfare to crush his rival. Aside, exchange rate fluctuations have once again become the focus of the market, following significant appreciation in Asian currencies like the Japanese Yen and Korean Won against the US dollar, accompanied by similar upward pressure in the values of China's Renminbi which recently broke through at a level of NTD33.8 to USD1.[40] Therefore, the observation of exchange rate fluctuations over the last two years shows that how the NTD fares are linked to what is happening to other nations within Asia. In short run, the electronic components industry is vulnerable to impact from exchange rate fluctuations.[41]
Conclusion
In conclusion, the premises of protectionism concepts causes higher prices for consumers because domestic producers are not exposed to foreign competition and can therefore keep prices high and that in a way domestic exporters may suffer because foreign countries tend to retaliate against protectionism with tariffs and barriers of their own sanctions. Thus, in the long run exchange rate fluctuation is never a critical factor affecting the competitive strength of the industry. Technical competence, production technique upgrades and reduction of general production costs should be considered the most critical factors affecting local manufacturers and success while fending off impact from changes in the greater environment, including exchange rate fluctuations, must also be included in management considerations.
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