IAS Baba

Published on Jul 18, 2016

IASbaba's Daily Current Affairs

IASbaba’s Daily Current Affairs – 18th July, 2016

NATIONAL/ECONOMICS

TOPIC:

General Studies 2

Effect of policies and politics of developed and developing countries on India’s interests, Indian Diaspora.

General Studies 3

Effects of liberalization on the economy, changes in industrial policy and their effects on industrial growth.

Is protectionism a problem?

Will the next USA President be committed to free trade?

Democratic candidate has given lukewarm support to free trade as well as Trans-Pacific Partnership.
Republican candidate is hostile towards trade deals that throw open US markets.
Trump envisages a 35% tariff on imported cars and parts produced by Ford plants in Mexico and a 45% tariff on imports from China. Such a step is called as Tariff protection

Tariff protection policy means that a duty is imposed on imports to raise their price, making them less attractive to consumers and thus protecting domestic industries from foreign competition

Implications

Economists are of the opinion that such ‘tariff protectionist’ measures may prove to be macroeconomic disasters.

Would repudiate free and open trade
Reduce confidence of the stakeholders/investors and decrease investments
Other countries would retaliate by imposing their own import tariffs

History: Such step had been taken in USA by Smoot-Hawley Tariff Act in 1930s.

Is such step advisable?

When a country is facing deflation and experiencing liquidity trap, tariff protection can be considered-

Upward prices during deflation are needed as higher prices encourage firms to raise production, households to increase their spending.
Due to low inflation, they can also reduce their debts and US Fed need not also raise the interest rates owing to depressed macroeconomic condition.

Deflation: Fall in prices, lower productivity, loss of jobs, thus slower economic growth. It increases value of money in a sense that goods are cheaper, but people save more in hope of further price reduction. Thus, there is slowdown in economic activities and ultimately, people end up earning less. Great Depression is an example. (Advantage is increased exports due to inflationary trends in other countries)

Liquidity trap: Consumers prefer saving in banks than other investment options even when central bank is infusing more money to stimulate economy. Low interest rates spur low-risk and high-liquid investments. In such situations, the bondholders sell off their bonds and prioritize cash savings.

However, tariff protection in normal circumstances will impact the global trade negatively.

Consider an example

Product A costs= $100

Step taken:

Now, President Trump announces 50% tariff on Chinese imports used in the product.
The new price of product A= $150
So, the US manufacturers will turn to domestic producers and thus put upward pressure on US prices. The revised price of product A comes to $120. Hence, this will help during deflation.

China’s Reaction:

However, President Xi Jinping retaliates with a Chinese tariff. This means that US goods become more expensive abroad and thus, there will be decrease in US exports.
Consequently, the domestic producers will raise the domestic prices to sustain and hence, the final price of product A will be more than $120

Overall Effect: From the viewpoint of American consumer, any product they buy, whether Chinese (now subject to tax) or US produced substitute, it will be more costly than before.

Alternate to Tariff Protectionism—

There are other alternates to raise prices and stimulate economic activity by

Tax cuts
Increase in public spending

The tariff protection is not a macroeconomic problem during deflationary condition; similarly, free trade is not a solution for stagnation.

(Stagnation: Prolonged period of little or no growth in economy (less than 2-3% annually))

The Smoot-Hawley Act

The Smoot-Hawley Tariff Act is a U.S. law enacted in June 1930 which caused an increase in import duties by as much as 50%.

Goal: To increase U.S. farmer protection against agricultural imports

Other sectors got wind of it and they also increased their tariffs

President Hoover: Signed it despite requesting him not to do so. Hence, as a sign of disapproval to the act, other countries retaliated and also increased their tariffs. Though it did not cause the Great Depression, it certainly did ignite other damaging consequences—

Disrupted international financial system operation

Free trade and free international capital flows hand in hand.
Countries that import have to export to pay off their debts
The foreign relations soured because of this act, due to widespread defaults on foreign debts, financial distress and collapse of international capital flows

Geopolitical tensions due to trade wars

France: Outraged by American taxation of French speciality exports—urged economic war against US
UK: Taxed imports from US; gave special preference to Commonwealth nations
Canada: The then PM warned of outbreak of ‘border warfare’ and deteriorated political relations

Thus, such diplomatic conflicts created a setback to efforts made for stabilizing the international financial system and end to the global decline. The result was that banks in foreign countries began to fail and international trade declined drastically (world trade decline of 66% between 1929 and 1934).

IASbaba’s Views

The need was: All the country governments should have worked together and focussed on the rising Nazi threat and German re-militarisation.
Thus, tariff protectionism might not be a bad macroeconomic policy in liquidity trap situation and should be limited to need-based economic conditions. But, it is not a good foreign policy either, hence should be used cautiously.

Connecting the dots: