by Atriya dey 4 March 2019
Economists from all across the spectrum have mainly been favorable to free trade and have argued that free trade is theoretically far more superior to trade protection. Contrary to this commonly academic perception among economists, history demonstrates that since the global economy started to get integrated protectionist policies have proliferated and dominated the behavior of many states and till date remain a main obstacle in the way of trade liberalization, which is obvious from the ongoing situation in the landscape of the global economy that is stuck up in the midst of a fierce trade war between the United States and the People’s Republic of China.
This essay primarily tries to understand the possible reasons behind such protectionist tendencies that lead up to problematic situations like the ongoing trade war between the US and China which is ripping apart the global economy. Contrary to the protectionist argument of ‘unfair trade practices’ of other nations to be a principal reason of a country’s trade deficit , in this essay I seek to argue that a country runs into a trade deficit due to its spending patterns and when it fails to keep up with the structural changes of the global economy. I feel this misconception about the reason behind a trade deficit lies at the heart of people proposing protectionist policies which lead up to a constant repetition of problematic incidents like the U.S building protectionist barriers on Japan, in the last century when the Japanese economy was expanding and capturing the U.S. market leading to a trade deficit or the ongoing trade war. This essay is an attempt to demonstrate this misconception, by trying to analyze the ongoing trade war and locate possible solutions of a trade deficit elsewhere instead of protectionist policies.
In order to do so, a brief discussion on the logical arguments of the proponents of both free trade and protectionism needs to be taken into account as a major deal of what we see in practice is a result of it. Proponents of free trade for the major part of their argument build upon the seminal works of the classical British economists, Adam Smith and David Ricardo. The principle of comparative advantage plays a major role in their argument. Comparative advantage briefly conceptualized would mean that a country should produce goods depending upon its factor endowments and trade with other countries following the same principle in a free global economy leading to prosperity.[i] The main focus of such an argument is that free trade would maximize consumer choices, reduce prices and facilitate the efficient use of resources. Protectionism, they argue on the other hand would lead to a negative impact on income distribution as a tariff creates a monopolistic situation thereby shifting income from consumers and unprotected sectors to the protected sector.
The only logical argument in favor of trade protectionism was rightly articulated by the German nationalist economist Frederich List, who built upon Alexander Hamilton’s Thesis and argued that all countries needed to protect their infant industries by tariff measures and protectionist policies till the point they reach a degree of competitive efficiency. Going by this logic protectionism is a weapon of the weak and liberalization of the strong. Nevertheless as many economists have argued the main problem with this line of argument is the fact that there is no convenient benchmark to understand exactly when an industry becomes competitive globally. Apart from this a host lot of political, environmental and security issues are cited to defend protectionism.[ii] For the major part of the theoretical evolution of the discipline of economics, most economists have convincingly refuted all the major claims of protectionists by arguing that protectionism undermines the theory of comparative advantage, reduces incentives to innovate and subsequently prevents the fullest utilization of resources. Despite such a comprehensive set of logical arguments, in practice the world has largely been dominated by protectionist practices.
Before any discussion on the ongoing trade war and its effects, the key theories that are considered as valid explanatory paradigms of global trade have to be taken into consideration. There are two principal theories that are considered as standard models of explaining global trade, namely conventional trade theory and strategic trade theory which later emerged as a challenge to Conventional trade theory at the backdrop of recent developments in the structure of global political economy.
Conventional trade theory, or Heckscher-Ohlin Theory (H-O theory) argues that a country will specialize in the production and export of those goods in which it has a comparative cost advantage over others. Constant returns to scale, universal availability of production technologies and determination of its comparative advantage and trade pattern by factor endowments are its underlying assumption. In brief this implies , a country will look to export products depending on its factor endowments, although there will be absolute gains in trade there will be parallel distributive consequences, trade in factors and goods will mean the same thing and under certain circumstances trade in goods will over time equalize in the return for each factor of production[iii].
This sort of an explanatory paradigm had gone a long way in explaining trade patterns in the first part of the twentieth century, but over time it became problematic because of some fundamental changes in the global economy.
The first of the changes happened when Wassily Leontiff discovered that the United States had a comparative advantage in exporting labor intensive goods, for example agricultural products which ran contrary to the then prevailing belief in the economic community that the US, a capital rich country had a comparative advantage in exporting capital intensive goods. Eventually, this anomaly was resolved by the introduction of the concepts of human capital and economies of scale into trade theory and neoclassical economic theory. Recognition of the impact of training, education, skill enhancement and technical knowhow enriched both the theories but made the H-O theory less robust.[iv]
Simultaneously, since the reconstruction of the global economy after the war, it has been noted that most trade has been intra industry trade and has taken place between the advanced nations with similar factor endowments thereby running contrary to the postulates of the H-O theory.[v]
Another development of the later part of the twentieth century has been the continuous rise in the power and impact of MNCs, who control the largest amount of FDI in the form of direct FDI or Portfolio investments. Business economists tend to argue that MNCs are above politics and they are utility maximizers but on the contrary most critics point out the extensive global impact of today’s largest MNCs and the immense amount of political power they command.[vi]
The last change was introduced when there was shift from comparative advantage to competitive advantage. International specialization based on competitive advantage focusses on increasing returns instead of factor endowments. [vii]
In response to this changes which have made the H-O theory less robust, strategic trade theory emerged as an alternative explanatory paradigm. Before an analysis of strategic trade theory, a brisk discussion on strategic behavior of firms is a must. Strategic behavior of firms refers to their ability to strategically decide policies, dumping for example aimed at altering the behavior of competitors to get maximum returns. Such an approach is impossible under situations of perfect competition. However in situations of oligopolistic competition, firms do indeed have a capacity to alter the behavior of others through strategic policies[viii].
Strategic trade theory primarily argues that apart from firms, governments can and do have the capacity to create positive externalities and shift profits from foreign firms to national firms. The basic assumption of such an argument is in simple words, some sectors are more important for national interest than others and hence require protection.[ix] Dual use technology or technology with more than one purpose, for example nuclear technology, biotechnology are generally considered as the most important for any country’s national interest and hence states tend to protect these sectors. Strategic trade theory has been subjected to immense criticism, with proponents of free trade alleging it to be a guise of protectionist ventures. For the purpose of this essay, I need not go into a further details of strategic trade theory as such, but the fact that it has been a source for the proliferation of protectionist policies is beyond doubt.
The following discussion on protectionism would reveal how the reasons cited by proponents of trade protection have nothing to do with free trade. Proponents of trade protection do have multiple agendas, some are misguided and others have economic interests. For example many proponents of trade protection have historically blamed a country’s trade deficits on the unfair practices of its trading partners. A basic understanding of economics shows us that trade deficits occur due to a nation’s spending patterns and can be resolved through fiscal or monetary policies. Blaming this on the behavior of a country’s trading partners is nothing but unfortunate. Similarly protectionists cite income disparities and unemployment as negative consequences of free trade. Trade liberalization does create winners as well as losers, but unemployment and income disparities or loss of jobs occur when a country fails to keep up with the structural changes of the global economy. With the recent changes in the global economy and the subsequent rise of information technology that demand a specific level of skill, individual nation states need to bring in policies aimed at skill enhancement instead of blaming free trade.[x] Failing to do so would inevitably lead to loss of jobs. Therefore interest groups like organized labor, who might be affected by the negative consequences of free trade need to realize that solutions lie with governments, who might bring in policies to enhance skill and technical knowhow of the workforce. Apart from this there are sectorial interests who might and do have political agendas and a discussion on that is outside my scope.
If we try to study the ongoing trade war between the United States and China which has already resulted in tariffs on billions of dollars of goods already which is likely to increase rationally, the appeal of protectionism would seem hollow. Firstly US has accused China of unfair trade practices, which it feels has resulted in its bilateral trade deficit with China. The Trump administration wants China to buy more American goods in order to stabilize the trade deficit which it feels is a result of China’s trade practices. The core assumption of such an argument is extremely problematic because the Chinese government does not control the quantity and type of American goods demanded by the Chinese households. Secondly, many of America’s standard accusations related to Cyber enabled commercial theft by the Chinese military no longer appears to be a significant problem. According to 2016 data from China’s National Bureau of Statistics, the latest available, joint ventures accounted for about one quarters of China’s FDI compared to two thirds in 1997. The real problems which has made China look like a state engaging in unfair trade driven by the strategic trade theory is the role of the state and the scale of its activities in driving the Chinese economy. Whatever be the case, building up piles of tariff walls and pressurizing China to import more is not the solution, because experts have highlighted that the United States does not produce enough to stabilize its trade deficits with the PRC. It needs to search for alternate opportunities[xi]
There are three issues that both the parties have to understand. First the American demand that China has to buy more from the US, is inherently flawed simply because trade is not a multilateral affair and the US does not produce enough of the kind of high end consumer goods that the Chinese middle class, ever increasing in number demands. Added to this is the issue of hi tech products which Washington would refuse to sell citing that hi tech products are a category of dual use technology. Now if China has to buy other products from US, it would do nothing to moderate China’s bilateral trade surplus but shift the onus of adjustment to other countries, Brazil or Mexico for example. Secondly forced technology transfers, in case of which firms investing in China are required to form joint venture with Chinese firms like the case of Huwaei for example, are required to transfer technologies as part of the agreement. This is a globally established practice, but the size and scale of Chinese firms give them an immense bargaining power. This issue can be resolved if Beijing takes a flexible stand. The third issue is the most important. Beijing’s technological ambitions do have a legitimate point and it can certainly provide subsidies to its economic initiatives. However, the scale and all pervasiveness of the Chinese state, its sophisticated economic and financial system through which state subsidies are channelized make this issue extremely problematic. Technology in the PRC certainly cannot be considered to be an infant industry and there are key differences to the connotations subsidies have in developing nations like Pakistan and developed nations like China or the US. Indeed much of the debate in this trade war revolves around the proper form of state support to economic activities and Chinese behavior can be best explained by the paradigm of the strategic trade theory. But, again I would reiterate that this can only be resolved through multilateral norm based negotiations and protectionism is the worst response a state can take. The United States seems to make this mistake by dropping out of the Trans-Pacific Partnership and denigrating the WTO. [xii] The United States have gone one step further in this trade war and defied the age old principles of liberalism, as US tariffs on Chinese products would have a significant negative impact on its East Asian Allies like Taiwan and Korea for example who have a significant exposure to Chinese production.
Hence we can logically conclude that protectionism and tariff barriers are not the real solutions states should be looking for. The second part of the puzzle is a million dollar question, if not protectionism then what? Since global events are mediated by a wide range of factors, there are possibilities and no single Meta solution to any problem. For example a sudden impeachment of Mr. Trump might cause the trade war to vanish. Nevertheless, as it seems now the ongoing trade war will persist for some time. If it doesn’t, the debate over trade liberalization and trade protection certainly will. Hence any attempt to forecast its future would be at best speculative. Firstly, the United States, has to realize the obvious problems with trade tariffs and focus on restructuring its domestic economy to cope up with a trade deficit or issues like unemployment. Fiscal and monetary policies can go a long way in doing this. The People’s Republic of China on the contrary faces an entirely different situation. The Chinese government has a trade surplus, as already highlighted in the course of this essay. The trade war provides the Chinese government with a golden opportunity to try and aim at raising the incomes of ordinary Chinese people so that they can spend more. This will be a great service for balancing the shrunken Chinese economy. [xiii]
is clearly evident from our above discussion that the differentiation between
nationalist and liberal approaches to global trade is a matter of academic
convenience. We live in a world characterized by dual tendencies, firstly it is
divided into nation states, each of which have their own national economic
policies and conception of national interest. The national interest of every
state is further a derivative of its geopolitical context, history, culture,
polity, economy and a large number of other factors. Hence national interest,
domestic politics and subsequently international trade policy must be studied
together in order to understand their behavior. S
[i]Robert Gilpin, Global Political Economy: Understanding the International Economic Order (Princeton: Princeton University Press 2001), 198
[ii] Ibid, 201
[iii] Robert Gilpin, Global Political Economy: Understanding the International Economic Order (Princeton: Princeton University Press 2001), 206-07
[iv] Ibid, 208
[vi]Robert Gilpin, Global Political Economy: Understanding the International Economic Order (Princeton: Princeton University Press 2001, 210
[vii] Ibid, 211
[viii] Ibid, 215
[ix] Ibid, 216
[x]Robert Gilpin, Global Political Economy: Understanding the International Economic Order (Princeton: Princeton University Press 2001) ,206
[xi] Yukon Huang, “ The Unlikely, Obvious Solution to the Trade War”, New York Times, September 24, 2018
[xii] Yukon Huang, “ The Three Issues Trump and Xi Need to Iron Out, to End the Trade War”, South China Morning Post, November 29, 2018
[xiii] Michael Pettis, “China’s Best Option for Responding to a Trade War”, Baron’s. July 27,2018