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The world’s best and finest of financial experts and entrepreneurs mingle every year with important political leaders from all over the world in the small Swiss town of Davos. They met again this year with probably a one-point agenda — how to reverse the global slowdown. Unfortunately, despite much discussion and exhortations, Davos 2009 did not produce any novel ideas or breakthroughs. There was much talk about the imperatives for concerted or coordinated action, but no concrete plans were drawn up. There was not even any consensus among the major countries on the measures that they should adopt in the immediate future.
The failure to reach any agreement is dangerous precisely because it increases the attractiveness of unilateral actions designed to promote individual country interests. For instance, President Sarkozy of France has asked all French automobile companies to switch their production from east European assembly plants to France. But the most controversial example of this “beggar thy neighbour” policy is the “Buy American” clause introduced in the American stimulus package that has just been approved by the American Congress.
The original bill sought to ban the use of non-American steel in the many construction projects that are part of the stimulus package. The “Buy American” clause clearly violates American obligations under the rules of the World Trade Organization, and under the Nafta agreement with Canada and Mexico. This awareness, together with widespread threats to take retaliatory actions from its major trading partners, prompted the American Senate to soften some of the provisions of the “Buy American” clause, although it rejected the amendment introduced by John McCain, the defeated Republican candidate in November’s presidential election, to strike the provisions from the bill altogether.
Every recession, big or small, provokes protectionist tendencies in the form of increased tariffs on imported goods under the mistaken belief that this will help domestic industries to sell more goods. This tendency to protect domestic industries and, in the process, prop up domestic employment is understandable. After all, when industries at home are laying off workers because there is very little demand for their products, it is politically a smart move to take steps to reduce the extent of competition that domestic producers face. And is there a better way of achieving this than by erecting protective barriers?
Indians should be very familiar with the use of high rates of import taxes in order to protect domestic industries. We have practised this for several decades, and have stopped only recently. However, there is a significant difference between the Indian use of protective barriers and the current “Buy American” policy. A couple of decades ago, the rest of the world did not particularly care whether India employed protective barriers or not because Indian markets were relatively small. So our protective barriers did not really harm their export industries. Obviously, the American economy is several times bigger than the Indian economy of those days. Virtually every country in the world will be affected if the United States of America closes its markets.
A natural reaction when a major country tries to protect its own industries is for other countries to retaliate. That is why major countries embark on tariff wars against one another. Many people are drawing analogies between the current global meltdown and the Great Depression of the 1930s. Perhaps it is not a coincidence that a famous example of tariff wars was the one which occurred during the Great Depression. In 1930, during the early stages of that depression, the American Congress passed the Smoot-Hawley Tariff Act, named after the two Republican Congressmen who promoted the bill. It raised the US tariff on a huge number of imported goods to unusually high levels. President Herbert Hoover refused to veto the bill although many economists holding very different political views had urged him to do so. In addition to Smoot-Hawley, Congress and President Roosevelt in 1933 passed the first “Buy American” law that required the federal government to prefer US products in its purchases.
After Smoot-Hawley was passed, many countries retaliated with increased tariffs on American goods. An inevitable consequence was that American-European trade crashed quite soon after these tariff increases. Certainly, there is no reason to believe that the Smoot-Hawley tariff helped the US economy to mitigate the effects of the world-wide depression of the 1930s. In fact, it may even have worsened the situation by making it difficult for American firms to export their products to the rest of the world.
Apart from the unpleasant consequences of tariff wars, protectionist policies are bad because they distort economic incentives. Industries in an open economy are typically more efficient because they have to compete against the best in the world. Conversely, the incentives to innovate, to cut costs in order to lower prices are correspondingly lower for protected industries — this must be all too familiar to Indian consumers.
Of course, one could argue that a purely ‘temporary’ phase of protectionism cannot be so bad — surely, industries will not cease to be efficient if they know that the protective barriers will be brought down in the near future? Unfortunately, measures such as high tariffs create vested interests, and politicians are often reluctant to reverse these measures. So, they tend to exist in the statute books even though the original intention may have been to introduce them for a limited period.
Despite what seem obvious arguments against protective measures, the “Buy your country’s goods” clause in stimulus packages has its supporters. In fact, even this year’s Nobel laureate, Paul Krugman, has laid out a case for such a clause. He argues that an important component of the overall problem facing the world’s economies is that there are major policy externalities. One country’s fiscal stimulus helps other economies by helping them to increase their exports. But the rest of the world does not share in the home country’s addition to government debt. This “externality” will tend to lower the size of the aggregate stimulus package for the world as a whole. However, if each country adopted protectionist measures that ‘contained’ the effects of fiscal expansion within its domestic economy, then everyone would adopt a more expansionary policy. This, in turn, would take the world economy closer to full employment.
But, perhaps a more appropriate solution to the dilemma is to focus the stimulus package primarily on non-tradables — that is, those goods that are not bought or sold in international markets. An obvious example of such goods is construction of physical infrastructure — roads, bridges and housing. While some inputs into these products may come from abroad, most are of domestic origin. In particular, labour is an important input that is wholly domestic. An added benefit is that this will provide employment to a section particularly hard-hit during a slowdown: the unskilled workers.
