Protectionist Follies

Those mean foreign sheep, munching on our grass

Solutions that at first blush appear obviously reasonable often turn out to be damaging when applied. Think of minimum wages to prop up low-earners. Or protectionist measures when the economy feels threatened.

And yet, as CESifo Researcher Mario Larch and his colleague Wolfgang Lechthaler remark in their latest CESifo Working Paper, politicians instinctively resort to such measures when a recession hits and jobs are imperilled.

During the Great Depression of the 1930s, many countries tried to protect their economies by building trade barriers. Today, the “Buy American” policy in the US continues that tradition. The US is not alone in this: since the beginning of this crisis, 17 of the G20 countries have implemented measures to restrict trade, according to some authors cited in the study.

One would think that the WTO rules leave little room for protectionism, but it appears that there is currently ample leeway for raising tariffs without violating such rules. For instance, most developed countries could increase tariffs by as much as 100%, because they have already set their tariffs lower than obliged.

But the real question is: do these measures really help countries mitigate economic downturns? Many economists think they do not, but Nobel laureate Paul Krugman, for one, argues that there is a short-run case for protectionism, at least in the US.

So, this paper attempts to provide a more definitive answer by thoroughly analysing the effects of protectionism as a short-run response to an economic downturn. To do this, the authors apply a carefully developed model that is well suited for the analysis of the current crisis, since it allows for recessions, explicitly studying transitional dynamics and taking care to consider adjustments both at the extensive margin, i.e. the set of firms, and the intensive margin, i.e. the size of firms, as both are important ingredients for an in-depth analysis.

What exactly happens when a country imposes protectionist measures in response to a temporary negative shock? Taking the US as an example, the authors analyse three scenarios: 1) The US, where the shock occurs, raises trade barriers (“Buy American”) in order to shift demand from imported goods to home products. 2) The trading partner (labelled here “Canada”) raises trade barriers to protect itself from the recession in America (a sort of “Buy Canadian” response). 3) Retaliation and its consequences.

For the first scenario, the authors assume that the increase in trade costs is not due to an increase in tariffs but rather to non-tariff barriers, which is very much in line with the empirical facts of the current crisis. The effects for Canada are a reduction of its exports, output and consumption. But the notable thing is that the drop in GDP is now about four times larger than it was without US protectionism. And for America things get much worse too. The decrease in consumption almost doubles. The recession last much longer and bites deeper when the country raises trade barriers. And, note, this is true even if Canada does not react with retaliation.

In the second scenario, Canada raises trade barriers but, say, the US does not change its trade policy. Again, both countries are hurt. Although Canada succeeds in turning the trade deficit into a surplus, this comes at a high cost. Consumption plunges and the recession becomes deeper and much more persistent. Worse, the boom that typically follows such a recession never occurs. The country initiating the protectionism is hurt by changes in relative prices, while the trading partner by the increase in trade barriers. Exports and imports go down in both countries, and high productiviy firms produce less, while low-productivity ones produce more.

Retaliation is a fairly common response to the erection of protectionist barriers by trading partners. The authors show that retaliation only makes matters worse for both parties. At first sight, the retaliatory actions seem to offset each other. But hidden behind this zero net effect on the trade balance is a huge decrease in exports in both countries, deepening the inefficient redistribution of output between relatively unproductive domestic firms and highly productive exporting ones.

So, why raise protectionist barriers at all? Here, the authors test their model to see whether there could be any rationale for considering protectionism a good idea at all.

They come up with two explanations: one, the lobbying of domestic, non-exporting firms, and two, the relationship between vulnerability and the degree of openness to trading partner countries. Given that non-exporting firms will benefit if their home country raises import barriers, they will lobby enthusiastically for protectionism; provided that the profits of exporting firms are not too heavily affected, politicians may reason that the measure could well pay off.

A second argument for politicians to lean towards protectionism is the perception of globalisation amongst voters. On the one hand, globalisation brings higher income and fancy foreign products at cheaper prices, but it also increases income volatility. Furthermore, behavioural studies show that losses are felt more keenly than gains, and that people prefer more immediate payoffs over later ones. Thus, the immediate losses caused by the current recession are felt more strongly than the potential gains of trade liberalisation occurring in the future. As the authors say, “it is easy to be pro-globalisation when you are in the middle of a boom, but if recession hits, opinions may change all too quickly.”

Still, these arguments do not detract from the overall finding of this study: a beggar-thy-neighbour policy does not work, period. A country not only cannot shield itself from an economic downturn by temporarily imposing higher trade barriers: it hurts itself in the process.

So there.

Mario Larch and Wolfgang Lechthaler: Why "Buy American" is a Bad Idea but Politicians still Like it, CESifo Working Paper No. 3207

• Other CESifo Working Papers by Mario Larch
• Other CESifo Working Papers dealing with protectionism
• Other CESifo Working Papers dealing with trade
• Other CESifo Working Papers dealing with shocks
• CESifo Working Papers published in the past three months