The Choice Isn't Free Trade Or Protectionism

If a foreign country can supply us with a commodity cheaper than we ourselves can make it, better buy it of them with some part of our own industry, employed in a way in which we have some advantage.

--Adam Smith

In the more than 200 years since the publication of The Wealth of Nations, belief in free trade became a canon of the economic clerisy. Economists who agreed on almost nothing else were willing to accept that free trade left almost everyone better off. Even if other countries played unfair, the U. S. still would come out ahead by keeping its barriers down. American consumers could buy videocassette recorders or steel ingots at a cheaper price. A belief in free trade became the foundation underlying postwar American trade policy.

That foundation has eroded in recent years, as an influential group of economists rejected the old free-trade arguments in favor of what they call "strategic trade." They argue that many industries are dominated by a handful of players, enabling them to exploit profits and experience. They can also gain from protected home markets or subsidized export markets to compete abroad. "A view which was iconoclastic in 1981 is now the new orthodoxy," says Paul R. Krugman, an economist at the Massachusetts Institute of Technology. "We won the intellectual battleground on how you think about trade."

Krugman is not a hard-core protectionist, but he and other like-minded economists are likely to find a ready audience among protectionists these days, as President Bush tries to create a Canadian, U. S., and Mexican trade union. These theorists could also provide a rationale for ignoring the General Agreement on Tariffs & Trade talks. Indeed, some examples cited by the strategic-trade theorists are enticing. Japan's dominance of the memory computer-chip market and its success in establishing a computer industry are favorite examples. Then there is Airbus Industrie, Europe's four-country, heavily subsidized airplane maker, which has become a formidable competitor to U. S. aircraft producers.

Should the U. S. follow suit, protecting and subsidizing key industries? No. The case against protectionism, on both economic and political grounds, is still strong. The lesson from the strategic-trade theorists is that there may be other beneficial policies that an activist government can follow.

Economically, the difficulty with any long-term strategy of subsidies and protection is that such moves sap capitalism's inherent dynamism. The essence of capitalism is the free flow of resources from atrophying uses to tomorrow's advances. And in Europe, hefty government spending on computer and semiconductor industries has not resulted in world-class competitors.

In the U. S., in particular, the politics of protection rarely end up nurturing industries of the future. Capitol Hill inevitably ends up sheltering politically powerful special interests. Examples: the auto makers, steel mills, peanut farmers, and sugar growers. The result, economists agree, has been to make the industries less competitive while costing consumers a bundle.

Government shouldn't abstain from intervening in international trade, though. American industry needs open markets abroad. It hurts our economies of scale if a Japanese manufacturer sells its products both at home and abroad, while a U. S. competitor can sell only to its domestic market. The Japanese company gains an irreversible price advantage. Quick and tough retaliation against foreign competitors that deny access to their markets is good policy.

RUSTY RELIC? Even though the U. S. government shouldn't protect individual industries, the market alone won't promote enough innovation to keep the U. S. competitive. Government can create economic incentives to encourage innovation and technology. Some possibilities include more grants and more generous tax credits to support commercial research by all kinds of companies, and higher investments in human capital to make workers smarter and more productive. As MIT economist Rudiger Dornbusch puts it: "A science and technology policy is part of any trade policy."

Free trade is no rusty relic of another age. Protectionism is not an unalloyed evil. Simple dichotomies--free trade vs. protectionism--can be misleading. Just as with the constant tension between the rights of individuals and the demands of society, the wise choice is not in selecting one of two polar opposites. The secret is balancing two competing values. So it is with trade: There's a middle ground between laissez-faire and beggar-thy-neighbor government intervention.

Before it's here, it's on the Bloomberg Terminal. LEARN MORE