Building trade barriers

Populist pledges to protect domestic jobs by restricting free trade proved a key feature of both the Brexit campaign in the UK and the presidential election race in the US. Although such rhetoric can seem very appealing, history suggests protectionist policies ultimately do far more harm than good.

Construction worker walking past coils of wire

Edward Smith, Asset Allocation Strategist, Rathbones

Budgetary dynamics aside, the influence of politics on markets has rarely been profound during the past quarter-century or more. Look at a long-term chart of the S&P 500 or the FTSE 100 and you would struggle to pick out even major geopolitical events such as 9/11 or 7/7.

Lately, however, there has been little mistaking the political and ideological roots of a marked spike in economic uncertainty — one that has been reflected in everything from business confidence and media headlines to expected exchange-rate volatility and predicted earnings from domestic equities. It is not war or terrorism that has propelled doubt and insecurity to levels last experienced in the global financial crisis of 2008 and 2009. The cause is a gathering backlash against capitalism and, maybe more pertinently, globalisation.

Much of the rhetoric behind the Brexit debate and in the US election was about raising barriers to trade and “protecting jobs”. Many economists thought this was an argument that was decided many years ago.

The benefit of trade is perhaps most easily understood at an individual level. Despite some of our River Cottage escapist fantasies, most of us do not produce a fraction of what we consume. We specialise in a certain activity, earn some income and use it to buy the things others can produce more efficiently. Add to that the slightly more complex notion of ‘comparative advantage’ and the benefits of international trade are really quite that simple still.

Comparative advantage is the concept that trade is driven by the comparative rather than absolute costs of production, first spelled out by 18th-century economist David Ricardo. Although a country may be twice as productive as its trading partners in making clothing, say, if it is three times as productive in making electronics, it will benefit from making and exporting electronics and importing clothes.

Its trading partners will gain by exporting clothes — in which they have a comparative but not absolute advantage — in exchange for these other products. The clothes manufacturers now have a larger market in which to sell their wares, and their people can have access to cheaper electronics. The electronics producer can concentrate on producing products to which it adds considerable value without needing to divert manpower and investment capital to producing its own clothes at a much lower value-add. In this way the living standards of both countries will rise as each country can earn a higher income.

Image showing various examples of bizarre world of tarrifs.  E.g. Peanut butter 12.8% in EU and 155% in US

Unfortunately, politicians frequently use protectionism as a political expedient, proclaiming that it “saves jobs” as certain industries lose out to comparative advantage. But the idea that protectionism saves jobs is misleading. Study after study shows that trade plays a negligible role in the number of employees in a country. Protectionism saves the wrong kind of jobs, preventing comparative advantage from maximising national income.

Moreover, free trade is invariably in the consumer’s interest, protectionism in the producer’s (and even then only in the short term). When an import is restricted, the product becomes scarcer in the domestic market, driving up the price.

In this way protectionist barriers act as a direct transfer of wealth away from the consumer. Where protectionism takes the form of tariffs or duties, consumers must shoulder three burdens: first, the tariff revenue itself; second, an implicit tax or transfer of funds from consumers to producers, reflecting the increased prices of protected domestic products; third, what we call “dead-weight losses”, caused by the misallocation of resources that trade barriers encourage.

The duplicity of protectionism has been noted for centuries. Adam Smith reviled the mercantilist cronyism of his era, in which the consumer’s interests were “duped” into subservience to the producer’s. In 1776 he wrote: “In every country it always is and must be the interest of the great body of the people to buy whatever they want of those who sell it cheapest. The proposition is so very manifest that it seems ridiculous to take any pains to prove it; nor could it ever have been called in question had not the interested sophistry of merchants and manufacturers confounded the common sense of mankind. Their interest is, in this respect, directly opposite to that of the great body of the people.”

And yet, arguably, it is the great body of people that is driving the protectionist debate. This is a populist movement in every sense. Free markets may have lifted billions worldwide out of poverty, but there is no denying that many people have been left behind; and it is these who are now finding an ever-louder voice amid a groundswell of conspicuously attention-grabbing, grievance-appeasing, vote-winning alternatives to the neoliberal political consensus that has ruled developed market democracies for the past four decades.

In the UK, of course, this counterattack spectacularly revealed itself in the outcome of the referendum on membership of the European Union. In the words of Professor Angus Laing, dean of Lancaster University Management School, the vote for Brexit represented “the revenge of the disenfranchised” — a seismic reprisal drawn from “a wellspring of discontent, of anger... the lived experience of those for whom globalisation, the tech revolution and financial capitalism haven’t worked”.

Moreover, it is now all too possible that other countries might follow the UK’s lead. The Organisation for Economic Co-operation and Development warned ahead of the vote that success for the “leave” lobby could constitute a significant step towards the EU’s disintegration and that only a landslide “remain” victory would calm tensions in other nations under mounting internal pressure to hold referenda of their own. Radical, nationalistic parties are already riding high in the polls in the likes of Austria, Hungary, the Netherlands, Sweden, Denmark, the Czech Republic and Poland.

And then there is the US, where protectionism was a defining theme of arguably the most unedifying race for the White House ever witnessed. Republican and Democrat candidates alike advocated forcing US companies to “bring manufacturing home” and vowed to tear up America’s existing trade agreements. Donald Trump, who greeted the news of Brexit by remarking that Britons had shown their desire to “have a country again”, called for tariffs of up to 45% on Chinese goods. Bernie Sanders described free trade as “a race to the bottom”. Hillary Clinton expressed her opposition to a trade deal she had previously hailed as a gold standard.

Tellingly, the would-be “leaders of the free world” were able to use such isolationist rhetoric almost entirely unchallenged. Small wonder: jingoistic tub-thumping of this ilk has seldom found a more unquestioningly sympathetic ear. In many cases it is exactly what the disenfranchised want to hear. With its ever-attendant commitment to “save jobs”, protectionism is, as previously stated, a reliable and powerful political expedient.

Yet it is also a dangerous one. Taken at face value, it provides a sizeable, easy-to-quantify gain that is enjoyed by a small but often vocal minority; but it simultaneously delivers a modest, hard-to-quantify loss that is diffused throughout a large but frequently silent majority. A substantial body of academic literature demonstrates as much; so, too, do the lessons of history — both distant and recent.

“Nearly all economists say protectionism is a beast that will gore us if set loose,” says David Brodwin, co-founder of the American Sustainable Business Council. “But the downside is that protectionism is complicated and not well understood by the public, whereas the call for tariffs is simple and emotionally resonant. Hence the problem: in political communications it’s well known that if a falsehood isn’t promptly and effectively countered by senior public figures it tends to become accepted by the public at large, regardless of the damage it may cause.”

Those who fear the prospective scale of this damage customarily cite the events that followed the Wall Street Crash as the ultimate warning from the past. The Great Depression of the 1930s was characterised by a severe outbreak of protectionism, the domino effect of which eventually all but destroyed trade.

Although it is commonly thought the trigger was the introduction of the Smoot-Hawley tariff, conceived by the US in 1929 to protect farmers and factory workers, the tariff war did not start in earnest until the autumn of 1931, after the UK came off the Gold Standard. As the pound devalued, France, Canada and Germany imposed heavy duties on UK imports in order to protect the market share of their own producers. As more countries left the Gold Standard, more tariff barriers to trade were erected by countries that stayed in the currency regime.

The worrying lesson for today is that when monetary stimulus is not an option — whether due to a currency union or the constraints of low interest rates — voters and politicians may turn in desperation to protectionism. Reflecting on the example of the 1930s, Barry Eichengreen, a professor of economics and political science at the University of California, Berkeley, notes: “The benefits of competitive advantage were lost, and recrimination over beggar-thy-neighbour policies made it more difficult to agree on other measures to halt the slump.”

Pascal Lamy clearly had such a catastrophic scenario in mind when, as director-general of the World Trade Organisation, he cautioned against the perils of protectionism by quoting Mahatma Gandhi: “An eye for an eye makes the whole world blind.” By way of recognising protectionism’s enduring and far-reaching appeal as a political weapon, it is well worth noting that Lamy was speaking in 2009 and that his words were in part a reaction to a controversial “Buy American” clause inserted in an economic package overseen by a politician not normally associated with blinkered insularity: Barack Obama.

Like the chaos of the 1930s, Obama’s nod to the populist bent for autarky would prove counterproductive. The raising of tariffs on Chinese tyres — a move the president later claimed had saved more than a thousand jobs — offers a classic case study of protectionism’s unintended consequences.

The tariff was raised from 4% to 39% between 2009 and 2011 in a bid to safeguard America’s own tyre manufacturers. Yet these had long since exited the low-cost market favoured by the Chinese, meaning gains were duly enjoyed not by US companies but by producers from Mexico, Indonesia and Thailand — all of whose prices were around 50% higher than China’s. Consumers ended up worse off, and research by the respected Peterson Institute for International Economics subsequently calculated that each “saved” job had effectively cost $1 million a year and that in reality, on balance, the US economy suffered a net loss of at least 2,500 jobs.

“Misinformed policy leads to large numbers of losers,” says Richard Kneller, a professor of economics at the University of Nottingham’s prestigious Globalisation and Economic Policy Centre. “It’s widely accepted that the people who lose out from free trade are usually lower-skilled workers in more labour-intensive industries and that these naturally agglomerate regionally, so the disadvantages tend to be concentrated among certain groups in certain locations. Protectionism helps these groups, but the rest of us have to pay with higher costs, higher taxes and less innovation.”

In 2008 Professor Kneller co-authored an influential report on the economic corollaries of offshoring, the practice of sending jobs abroad. One imagines the findings would not have sat comfortably with the US presidential candidates or, for that matter, many proponents of Brexit. The research, which focused on the UK, concluded that offshoring results in more exports, more employment, increased turnover and improved productivity — hardly an empirical basis for a drive to “bring manufacturing home”, shred longstanding trade agreements and impose tariffs left, right and centre.

“What’s consistently overlooked is that in the longer term the number of people in employment is determined by the deeper characteristics of a country’s labour market rather than by trade, although that may have some short-run effects,” says Professor Kneller. “Relatedly, it’s vital to acknowledge just how significant ‘normal’ turnover in the labour market is. Our research indicates that in the UK around 50,000 jobs are lost and around 50,000 created every single week, with sending jobs abroad accounting for only a tiny percentage of that figure. Accordingly, although there are always winners and losers from free trade, the notion that protectionism saves jobs is at best misleading and at worst bogus.”

With the spectre of a return to protectionism looming ever larger, our greatest comfort, however perverse, might just lie in the fact that politicians habitually fail to keep their promises. It is easy enough to win votes with bellicose tirades that strike a chord with those who are tired of prevailing political philosophies and ache to regain some control over the forces that shape their lives; but it is much more difficult to translate pledges into action, especially when those pledges invite disaster.

Professor Kneller sees parallels in the “mutually assured destruction” ethos that has long been central to what students of nuclear war strategy call “the balance of terror” — the supreme, overriding dread that undue aggression will inevitably culminate in a conflict from which no winners can possibly emerge.

“Look at what happened when China was accused of dumping steel on world markets earlier this year,” he says. “In that instance the UK, for one, wasn’t particularly keen to seek anti-dumping measures. The government was obviously concerned about the bigger picture, aware that China would almost certainly respond by imposing restrictions of its own.

“Similarly, suppose the US went down the protectionist road. Why would we allow the Americans an unfair advantage in terms of selling their goods here? And why would anyone allow the UK an unfair advantage if it did the same? The reality is that no-one could expect to impose such forms of protectionism without creating a world with more trade ‘friction’ and more tariff barriers, a world without genuine competition, a world in which companies have no incentive to innovate or reduce costs — in effect, a world full of losers.”

It is true that the preservation of jobs is a deeply emotive issue. Polls suggest most American voters support free trade — but only if the question is not framed in terms of protecting US workers, whereupon their views change dramatically. It is true, too, that the gains that have flowed from globalisation and the creative destruction that has accompanied the process have been distributed very unevenly and that successive governments have shown themselves sadly incapable of nurturing an environment in which some people, many of them hard-grafting workers, are not outstripped by rapidly shifting patterns of supply and demand.

Yet eradicating foreign competition is not the answer. It never has been. Protectionism might well bring short-term relief — and with it a few million handy votes — but in the fullness of time it serves only to disincentivise productivity, arrest economic growth and raise the cost of living; and nobody, irrespective of their personal circumstances or their political leanings, stands to benefit in such potentially ruinous circumstances.

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