The New Rules for Trade: Protectionism vs. Compensatism

The benefits of free trade are well known. In an ideal world, it allows countries to specialize in their strengths, promotes competition, ensures businesses can increase their scale and efficiency, lowers prices, and maximizes consumer choice.

For free trade to work, labor must also be allowed to work freely in the participating countries. As countries focus on their specializations, their labor market becomes increasingly reliant on those specific industries they specialize in. This also sets them up for wrenching adjustments in the labor market, as the winds of demand can change from time to time. If labor cannot flow between the countries, which are freely trading with each other, people cannot follow these jobs as the changes occur, and many will be left without employment.

Specialization can be a positive when the goods and services that a country specializes in are doing well in the market. However, if a country is specializing in areas that are more volatile, this can lead to tremendously destabilizing booms and busts. This is particularly the case with countries that are rich in natural resources, such as oil. When the price of oil is high, oil-rich countries see the benefits of their specialization, and their resources start to revolve around this sector. It is the most efficient way for the economy to maximize its output at that particular moment, and economic diversification becomes an afterthought. It is only when the price of the resource inevitably plummets when diversification seems like it would have been a good idea in hindsight. The labor market can take an exceedingly long time to readjust to the new economic reality.

A country cannot find its comparative advantage unless it is given the opportunity to try (and potentially fail) in a variety of sectors (e.g., South Korea with support for its ship building industry). This is especially valuable consider for a country in its earlier stages of development. A country might already have a comparative advantage in an area, but it might have difficulty getting it off the ground due to the behavior of incumbents.

If a country decides that it is harmful, for example, to pollute in excess, it can choose to put in place laws (or taxes) to minimize it. The producers in that country are then at a disadvantage compared to foreign competitors which are not burdened by these rules. If the country allows imports from these competitors, without compensating for the burden that the domestic producers have, then the domestic companies will be unable to compete, and possibly fail. Meanwhile, the country will also fail to reduce pollution, as they will be importing the goods from the polluting country without penalty. Producers can face similar artificial disadvantages in other situations, for example, if a particular currency zone happens to be over an area rich in a natural resource, and the price of that resource rises steeply and suddenly. While this is likely to be a temporary scenario, the strengthening of the currency as a result of changes in the current account balance, may put other sectors out of business. When the price of the resource falls again, the economy is left with neither resource revenues, nor alternative sources of growth. The fact that a particular currency zone encompasses a region with this resource, was an artificial, manmade factor. With a tariff rate of 0, there is no compensation for these unfair, manmade disadvantages, and industries often fail due to these situations. In this case, it is difficult for a country to discover its natural specializations and strengths, and industries of particular national importance fail to materialize. With tariff rates too high, the opposite problem occurs. Countries are encouraged to produce goods they are ill-suited for, at high cost, gross inefficiency, waste, and with no little competitive pressure to reform.

When countries do decide to import goods and services from a subsidized origin, consumers do often benefit, at least initially, from low prices. Meanwhile, countries deciding to protect their industries from foreign competition are sometimes left with inefficient, uncompetitive industries, and consumers are burdened with the costs of higher prices.

Countries with natural resources, while blessed in some regards, are also cursed by them in others. By the sheer chance of having resources in the land within their borders, their currencies can rise and fall in value on the whims of commodities markets. A typical scenario that continues to present itself involves oil-rich countries’ economies increasingly revolving around this resource and failing to diversify. It also has the potential to create an overreliance on its revenues, as governments are tempted to dish out lavish subsidies and ignore an ineffective tax collection system, only to find themselves struggling when oil prices inevitably drop. High resource prices can dramatically strengthen the exporting country’s currency, putting a heavy burden on other export industries, flooding the country’s market with imports, and leaving domestic competitors struggling. Export tariffs on raw materials, just high enough to compensate for the economic instability, are essential. They must also be placed on goods deemed Basic Essentials (such as food), to ensure a true domestic price, reflecting local incomes and economic conditions.

Using tariffs (and other forms of trade protection) are often not completely effective, particularly in floating currency regimes. As import tariffs put upward pressure on the country’s current account balance, the currency tends to strengthen accordingly, and counteracts the effect of the tariff. The case of export tariffs has the same effect, in reverse.

However, by the funneling tariff revenues into the sectors they are supposed to serve, these revenues will lower their costs (thereby lowering the costs for consumers) and provide funding for these sectors.

Countries/regions/customs unions should have at least a limited degree of self-reliance in Basic Essentials (food, water, and housing; and potentially energy, essential infrastructure production, and clothing). Doing so:

• Provides protection against price shocks for imports (e.g., oil crises) and currency swings

• Means there is always baseline demand for these products, as opposed to fast changing sectors affected by technology

• Can create domestic market prices that are different from world market prices, to spin off other industries (e.g., France’s cheap electricity due to an abundance of nuclear energy)

• Realizes the strategic / security value of self sufficiency

• Recognizes that the increasing speed of creative destruction, reallocation of resources (especially labor) might be more costly than the inefficiency of not allowing pure comparative advantage (e.g., retraining older workers )

• Prevents complete hollowing out of industry as a result unfair trade, and Dutch disease

• Can be more true to comparative advantage, because it compensates for unfair trade, the arbitrary aspects of a nation / currency union’s borders

• Acknowledges that country’s propensity to be less diversified may be due to pure luck (natural resources) etc.

• Accepts that there will naturally be a certain class of people of people on the cutting edge who can easily switch jobs, and a certain class who can’t — retraining is ideal but has its limits.

• Can be combined with free-trade zones where companies can take their varied skills and expose them to tougher competitive conditions.

Rules:

• Set the majority of import tariff rates at a level that only compensates for unfair practices and differences in regulations, set by an independent body

• Extra protection for Static Sectors

• Export tariffs on raw materials and Basic Essentials

• X years of protective consumption tariffs for developing countries

• Directing tariff revenues into Sectoral Banks

• Temporarily applied, gradually reducing protectionist tariffs for undeveloped countries

• Government initiation of Basic Essentials industries with a rapid timeline to privatize them