[An updated version of this article can be found at Protectionism in the 2nd edition.]
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. Adam Smith's The Wealth of Nations, which gave birth to economics, 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.
It is important to distinguish between the case for free trade for oneself and the case for free trade for all. The former is an argument for free trade to improve one nation's own welfare (the so-called "national-efficiency" argument). The latter is an argument for free trade to improve every trading country's welfare (the so-called "cosmopolitan-efficiency" argument). Underlying both cases is the assumption that prices are determined by free markets. But government may distort market prices by, for example, subsidizing production, as European governments have done in aerospace, electronics, and steel in recent years, and as all industrial countries do in agriculture. Or governments may protect intellectual property inadequately, causing underproduction of new knowledge. In such cases production and trade, guided by distorted prices, will not be efficient.
The cosmopolitan-efficiency case for free trade is relevant to questions such as the design of international trade regimes. For example, the General Agreement on Tariffs and Trade oversees world trade among member nations, just as the International Monetary Fund oversees international macroeconomics and exchange rates. The national-efficiency case for free trade concerns national trade policies; it is, in fact, Adam Smith's case for free trade. Economists typically have the national-efficiency case in mind when they talk of the advantage of free trade and of the folly of protectionism.
This case, as refined greatly by economists in the postwar period, admits two theoretical possibilities in which protection could improve a nation's economic wellbeing. First, as Adam Smith himself noted, a country might be able to use the threat of protection to get other countries to reduce their protection against its exports. Thus, threatened protection could be a tool to pry open foreign markets, like oysters, with "a strong clasp knife," as Lord Randolph Churchill put it in the late nineteenth century. If the protectionist threat worked, then the country using it would gain doubly: from its own free trade and from its trading partners' free trade as well. However, both Smith and later economists in Britain feared that such threats would not work. They feared that the protection imposed as a threat would be permanent and that the threat would not lower the other countries' trade barriers.
The trade policy of the United States today is premised on a different assessment: that indeed U.S. markets can, and should, be closed as a means of opening new markets abroad. This premise underlies sections 301 through 310 of the 1988 Omnibus Trade and Competitiveness Act. These provisions permit, and sometimes even require, the U.S. government to force other countries into accepting new trade obligations by threatening tariff retaliation if they do not. But those "trade obligations" do not always entail freer trade. They can, for instance, take the form of voluntary quotas on exports of certain goods to the United States. Thus, they may simply force weak nations to redirect their trade in ways that strong nations desire, cutting away at the principle that trade should be guided by market prices.
The second exception in which protection could improve a nation's economic well-being is when a country has monopoly power over a good. Since the time of John Stuart Mill, economists have argued that a country that produces a large percentage of the world's output of a good can use an "optimum" tariff to take advantage of its latent monopoly power and, thus, gain more from trade. This is, of course, the same as saying that a monopolist will maximize his profits by raising his price and reducing his output.
Two objections to this second argument immediately come to mind. First, with rare exceptions such as OPEC, few countries seem to have significant monopoly power in enough goods to make this an important, practical exception to the rule of free trade. Second, other countries might retaliate against the optimum tariff. Therefore, the likelihood of successful (i.e., welfare-increasing) exploitation of monopoly power becomes quite dubious. Several economists have recently made their academic reputations by finding theoretical cases in which oligopolistic markets enable governments to use import tariffs to improve national welfare, but even these researchers have advised strongly against protectionist policies.
One may well think that any market failure could be a reason for protection. Economists did fall into this trap until the fifties. Economists now 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, if any, should be in the labor market, directly aimed at the source of the problem. Protection would be, at best, an inefficient way of correcting for the market failure.
Many economists also believe that even if protection were appropriate in theory, it would be "captured" in practice by special interests who would misuse it to pursue their own interests instead of letting it be used for the national interest. One clear cost of protection is that the country imposing it forces its consumers to forgo cheap imports. But another important cost of protection may well be the lobbying costs incurred by those seeking protection. These lobbying activities, now extensively studied by economists, are variously described as rent-seeking or directly unproductive profit-seeking activities. They are unproductive because they produce profit or income for those who lobby without creating valuable output for the rest of society.
Protectionism arises in ingenious ways. As free trade advocates squelch it in one place, it pops up in another. Protectionists seem to always be one step ahead of free traders in creating new ways to protect against foreign competitors.
One way is by replacing restrictions on imports with what are euphemistically called "voluntary" export restrictions (VERs) or "orderly" market arrangements (OMAs). Instead of the importing country restricting imports with quotas or tariffs, the exporting country restricts exports. The protectionist effect is still the same. The real difference, which makes exporting nations prefer restrictions on exports to restrictions on imports, is that the VERs enable the exporters to charge higher prices and thus collect for themselves the higher prices caused by protection.
That has been the case with Japan's voluntary quotas on exports of cars to the United States. The United States could have kept Japanese car imports in check by slapping a tariff on them. That would raise the price, so that consumers would buy fewer. Instead, Japan limits the number of cars shipped to the United States. Since supply is lower than it would be in the absence of the quotas, Japanese car makers can charge higher prices and still sell all their exports to the United States. The accrual of the resulting extra profits from the voluntary export restraint may also have helped the Japanese auto producers to find the funds to make investments that made them yet more competitive!
The growth of VERs in the eighties is a disturbing development for a second reason as well. They selectively target suppliers (in this case Japan) instead of letting the market decide who will lose when trade must be restricted. As an alternative, the United States could have provided just as much protection for domestic automakers by putting a quota or tariff on all foreign cars, letting consumers decide whether they wanted to buy fewer Japanese cars or fewer European ones. With VERs, in other words, politics replaces economic efficiency as the criterion determining who trades what.
Protectionism recently has come in another, more insidious form than VERs. Economists call the new form "administered protection." Nearly all industrialized countries today have what are called "fair trade" laws. The stated purpose of these laws is twofold: to ensure that foreign nations do not subsidize exports (which would distort market incentives and hence destroy efficient allocation of activity among the world's nations) and to guarantee that foreign firms do not dump their exports in a predatory fashion. Nations, therefore, provide for procedures under which, when subsidization or dumping is found to occur, a countervailing duty (CVD) against foreign subsidy or an antidumping (AD) duty can be levied. These two "fair trade" mechanisms are meant to complement free trade.
In practice, however, when protectionist pressures rise, "fair trade" is misused to work against free trade. Thus, CVD and AD actions often are started against successful foreign firms simply to harass them and coerce them into accepting VERs. Practices which are thoroughly normal at home are proscribed as predatory when foreign firms engage in them. As one trade analyst put it, "If the same anti-dumping laws applied to U.S. companies, every after-Christmas sale in the country would be banned."
Much economic analysis shows that in the eighties "fair trade" mechanisms turned increasingly into protectionist instruments used unfairly against foreign competition. U.S. rice producers got a countervailing duty imposed on rice from Thailand, for example, by establishing that the Thai government was subsidizing rice exports by less than 1 percent—and ignoring the fact that Thailand also slapped a 5 percent tax on exports. We usually think a foreign firm is dumping when it sells at a lower price in our market than in its own. But the U.S. government took an antidumping action against Poland's exports of golf carts even though no golf carts were sold in Poland.
Therefore, economists have thought increasingly about how these "fair trade" mechanisms can be redesigned so as to insulate them from being "captured" and misused by special interests. Ideas include the creation of binational, as against purely national, adjudication procedures that would ensure greater impartiality, as in the U.S.-Canada Free Trade Agreement. Also, greater use of GATT dispute-settlement procedures, and readier acceptance of their outcomes, has been recommended.
Increasingly, domestic producers have labeled as "unfair trade" a variety of foreign policies and institutions. Thus, those who find Japanese commercial success hard to take have objected to its retail distribution system, its spending on infrastructure, and even its work habits. Opponents of the U.S.-Mexico Free Trade Agreement have claimed that free trade between the two nations cannot be undertaken because of differences in Mexico's environmental and labor standards. The litany of objections to gainful, free trade from these alleged sources of "unfair trade" (or its evocative synonym, "the absence of level playing fields") is endless. Here lies a new and powerful source of attack on the principles of free trade.
Jagdish Bhagwati is the Arthur Lehman Professor of Economics and a professor of political science at Columbia University. He has also been the economic policy adviser to the director general of the General Agreement on Tariffs and Trade. The Financial Times has called him "the doyen of economists working on international trade."
Bhagwati, Jagdish. Protectionism. 1988.
Bhagwati, Jagdish. The World Trading System at Risk 1991.