8.4 The Political Economy of Trade Protection

We have seen that international trade produces mutual benefits to the countries that engage in it. We have also seen that tariffs and import quotas, although they produce winners as well as losers, reduce total surplus. Yet many countries continue to impose tariffs and import quotas as well as to enact other protectionist measures.

To understand why trade protection takes place, we will first look at some common justifications for protection. Then we will look at the politics of trade protection. Finally, we will look at an important feature of trade protection in today’s world: tariffs and import quotas are the subject of international negotiation and are policed by international organizations.

Arguments for Trade Protection

Advocates for tariffs and import quotas offer a variety of arguments. Three common arguments are national security, job creation, and the infant industry argument.

The national security argument is based on the proposition that overseas sources of goods are vulnerable to disruption in times of international conflict; therefore, a country should protect domestic suppliers of crucial goods, with the aim to be self-sufficient in those goods. In the 1960s, the United States—which had begun to import oil as domestic oil reserves ran low—had an import quota on oil, justified on national security grounds. Currently, Canada imposes import restrictions on agricultural products to protect Canadian farmers, ensure a stable domestic supply of food, and prevent price fluctuations.

The job creation argument points to the additional jobs created in import-competing industries as a result of trade protection.2 Economists argue that these jobs are offset by the jobs lost elsewhere, such as industries that use imported inputs and now face higher input costs. But non-economists don’t always find this argument persuasive.

Finally, the infant industry argument, often raised in newly industrializing countries, holds that new industries require a temporary period of trade protection to get established. For example, in the 1950s many countries in Latin America imposed tariffs and import quotas on manufactured goods, in an effort to switch from their traditional role as exporters of raw materials to a new status as industrial countries.

In theory, the argument for infant industry protection can be compelling, particularly in high-tech industries that increase a country’s overall skill level. Reality, however, is more complicated: it is most often industries that are politically influential that gain protection. In addition, governments tend to be poor predictors of the best emerging technologies. Finally, it is often very difficult to wean an industry from protection when it should be mature enough to stand on its own.

The Politics of Trade Protection

In reality, much trade protection has little to do with the arguments just described. Instead, it reflects the political influence of import-competing producers.

We’ve seen that a tariff or import quota leads to gains for import-competing producers and losses for consumers. Producers, however, usually have much more influence over trade policy decisions. The producers who compete with imports of a particular good are usually a smaller, more cohesive group than the consumers of that good.

An example is trade protection for eggs: Canada has a limit on how many eggs can be imported, which on average causes our domestic price to be higher than the world price, so Canadian families pay more for the eggs they consume. For example, according to the National Post, a carton of eggs cost about $3.19 in Vancouver but only $2.09 in Washington State in 2012 (the higher price was mostly caused by an import quota and supply management policies). This quota is difficult to rationalize in terms of any economic argument. However, consumers rarely complain about the quota because they are unaware that it exists. According to Agriculture and Agri-Food Canada, Canadian egg consumption was 16.1 dozen per person in 2009. At that rate, the average Canadian would pay about $18 more a year for eggs than an American with similar egg consumption would, a difference small enough to not attract notice. But, according to Egg Farmers of Canada, although there are only a few thousand egg farmers in Canada, the Canadian egg industry employs 16 800 people across the country and contributes $1.4 billion to Canada’s output. They are very aware of the benefits they receive from the quota and they make sure that their interest in the matter is heard in Parliament.

Given these political realities, it may seem surprising that trade is as free as it is. For example, Canada has low tariffs, and its import quotas are mainly confined to clothing and a few agricultural products. It would be nice to say that the main reason trade protection is so limited is that economists have convinced governments of the virtues of free trade. A more important reason, however, is the role of international trade agreements.

International Trade Agreements and the World Trade Organization

When a country engages in trade protection, it hurts two groups. We’ve already emphasized the adverse effect on domestic consumers, but protection also hurts foreign export industries. This means that countries care about one anothers’ trade policies: the Canadian lumber industry, for example, has a strong interest in keeping U.S. tariffs on forest products low.

International trade agreements are treaties in which a country promises to engage in less trade protection against the exports of other countries in return for a promise by other countries to do the same for its own exports.

Because countries care about one anothers’ trade policies, they enter into international trade agreements: treaties in which a country promises to engage in less trade protection against the exports of another country in return for a promise by the other country to do the same for its own exports. Most world trade is now governed by such agreements.

The North American Free Trade Agreement, or NAFTA, is a trade agreement between Canada, the United States, and Mexico.

Some international trade agreements involve just two countries or a small group of countries. As we mentioned in the opening story, Canada, the United States, and Mexico are joined together by the North American Free Trade Agreement, or NAFTA. This agreement, signed in 1993, will eventually remove all barriers to trade among the three nations. In Europe, as of July 1, 2013, 28 nations are part of an even more comprehensive agreement, the European Union, or EU. In NAFTA, the member countries set their own tariff rates against imports from other non-member countries. The EU, however, is a customs union: tariffs are levied at the same rate on goods from outside the EU entering the union.

The World Trade Organization, or WTO, oversees international trade agreements and rules on disputes between countries over those agreements.

There are also global trade agreements covering most of the world. Such global agreements are overseen by the World Trade Organization, or WTO, an international organization composed of 151 member countries, accounting for the bulk of world trade. The WTO plays two roles. First, it provides the framework for the massively complex negotiations involved in a major international trade agreement (the full text of the last major agreement, approved in 1994, was 24 000 pages long). Second, the WTO resolves disputes between its members. These disputes typically arise when one country claims that another country’s policies violate its previous agreements.

The WTO is sometimes, with great exaggeration, described as a world government. In fact, it has no army, no police, and no direct enforcement power. The grain of truth in that description is that when a country joins the WTO, it agrees to accept the organization’s judgments—and these judgments apply not only to tariffs and import quotas but also to domestic policies that the organization considers trade protection disguised under another name. So in joining the WTO a country does give up some of its sovereignty.

Trade disputes among countries usually take a long time to get resolved. By the time a settlement or a resolution has been reached, a significant amount of costs or hardships may have been incurred. As seen in the For Inquiring Minds on the next page, countries may not follow the intent of the agreements. Having an agreement and abiding by that agreement are not necessarily the same thing.

SOFTWOOD LUMBER DISPUTE

The softwood lumber dispute between Canada and the United States has a long history. Since 1982, there have been several points of contention between the two nations, but at the core of the dispute have been American claims regarding Canada’s system of stumpage, a fee that provincial governments set and charge logging companies for the right to harvest lumber from public land (the logging right). The United States has argued that the fee is too low and has viewed it as a subsidy to Canadian-based lumber producers. According to this view, Canadian lumber producers could sell lumber at a price lower than the American lumber producers, constituting unfair trade and hurting the American lumber industry.

In response to these complaints from the U.S. lumber industry, the U.S. Department of Commerce imposed countervailing duties on Canadian softwood lumber.3 At the Canadian government’s request, a dispute-resolution panel of five experts was selected according to the Canada–U.S. Free Trade Agreement. Rulings were in Canada’s favour. However, the U.S. government challenged the rulings and delayed the removal of the countervailing duties. On May 29, 1996, Canada and the United States finalized the Softwood Lumber Agreement 1996, covering the five-year period to March 31, 2001. The essence of this agreement was a tariff rate quota administered by Canada whereby 14.7 billion board feet of lumber could be shipped duty-free to the United States annually. Amounts over 14.7 billion board feet were subject to increasingly prohibitive tariff rates. Also, exports from Atlantic Canada were unrestricted.

As the agreement approached its end in 2001, the U.S. lumber industry lobbied to the U.S. Department of Commerce again for the imposition of countervailing duties. This time the United States imposed a 27% duty on Canadian softwood lumber based on the claims that Canada unfairly subsidized lumber producers and that Canadian lumber was sold at a lower price in the United States than in Canada (referred to as dumping in international trade). Once again, Canada appealed this 27% duty to NAFTA and WTO panels, and again, many of the rulings were in favour of Canada. The settlement breakthrough came in 2006, when Canada and the United States reached an agreement to provide a resolution to the softwood lumber dispute. In the 2006 Softwood Lumber Agreement, the United States was to remove the countervailing and anti-dumping duties, and to return over US$4 billion in duties collected from Canadian importers since 2002. The agreement had a seven-year term, with a possible two-year extension.

The signing of the 2006 Softwood Lumber Agreement did not really end the softwood lumber dispute. In recent years, the United States has filed several cases to the London Court of International Arbitration regarding the implementation of the agreement by Canada. Some of the rulings from the London Court of International Arbitration favoured Canada and some did not, so the future of Canada’s softwood lumber industry remains uncertain.

New Challenges to Globalization

The forward march of globalization over the past century is generally considered a major political and economic success. Economists and policy-makers alike have viewed growing world trade, in particular, as a good thing. We would be remiss, however, if we failed to acknowledge that many people are having second thoughts about globalization. To a large extent, these second thoughts reflect two concerns shared by many economists: worries about the effects of globalization on inequality and worries that new developments, in particular the growth in offshore outsourcing, are increasing economic insecurity.

Globalization and Inequality We’ve already mentioned the implications of international trade for factor prices, such as wages: when wealthy countries like Canada export skill-intensive products like aircraft while importing labour-intensive products like clothing, they can expect to see the wage gap between more educated and less educated domestic workers widen. Thirty years ago, this wasn’t a significant concern, because most of the goods wealthy countries imported from poorer countries were raw materials or goods where comparative advantage depended on climate. Today, however, many manufactured goods are imported from relatively poor countries, with a potentially much larger effect on the distribution of income.

Trade with China, in particular, raises concerns among labour groups trying to maintain wage levels in rich countries. Although China has experienced spectacular economic growth since the economic reforms that began in the late 1970s, it remains a relatively poor, low-wage country. In 2012, wages of Chinese manufacturing workers were only about 14% of their Canadian counterparts’ wages. Meanwhile, imports from China have soared. In 1992, only 1.67% of Canada’s imports came from China; by 2012, the figure had risen to 11%. There’s not much question that these surging imports from China put at least some downward pressure on the wages of less educated Canadian workers.

Outsourcing Chinese exports to Canada overwhelmingly consist of labour-intensive manufactured goods. However, some Canadian workers have recently found themselves facing a new form of international competition. Outsourcing, in which a company hires another company to perform some task, such as running the corporate computer system, is a long-standing business practice. Until recently, however, outsourcing was normally done locally, with a company hiring another company in the same city or country.

Now, modern telecommunications increasingly makes it possible to engage in offshore outsourcing, in which businesses hire people in another country to perform various tasks. The classic example is call centres: the person answering the phone when you call a company’s 1-800 help line may well be in India, which has taken the lead in attracting offshore outsourcing. Offshore outsourcing has also spread to fields such as software design/programming and the financial sector. In April 2013, the Royal Bank of Canada (RBC) came under fire when the public found out the bank had outsourced 45 of its information technology (IT) jobs to foreign workers. Although the number of positions being outsourced seems small, it was sufficient to cause concerns among Canadians. According to International Data Corporation (IDC) Canada, this recent outsourcing of 45 IT jobs by RBC is just the tip of an iceberg. An IDC Canada survey found that 6 out of 10 Canadian firms would use outsourcing as a means to cut costs. It is not surprising then that some economists have warned that millions or even tens of millions of North American workers who have never thought they could face foreign competition for their jobs may face unpleasant surprises in the not-too-distant future.

Offshore outsourcing takes place when businesses hire people in another country to perform various tasks.

Concerns about income distribution and outsourcing, as we’ve said, are shared by many economists. There is also, however, widespread opposition to globalization. In 1999, an attempt to start a major round of trade negotiations failed in part because the WTO meeting, in Seattle, was disrupted by antiglobalization demonstrators. However, the more important reason for its failure was disagreement among the countries represented. Another round of negotiations that began in 2001 in Doha, Qatar, known as the “Doha development round,” stalled in 2008, mainly because of disagreements over agricultural trade rules. No significant progress has been made since then.

To some extent, the antiglobalization movement is motivated by the sweatshop labour fallacy.

What motivates the antiglobalization movement? To some extent it’s the sweatshop labour fallacy: it’s easy to get outraged about the low wages paid to the person who made your shirt, and harder to appreciate how much worse off that person would be if denied the opportunity to sell goods in rich countries’ markets. It’s also true, however, that the movement represents a backlash against supporters of globalization who have oversold its benefits. Countries in Latin America, in particular, were promised that reducing their tariff rates would produce an economic takeoff; instead, they have experienced disappointing results. Some groups, such as poor farmers facing new competition from imported food, ended up worse off.

Do these new challenges to globalization undermine the argument that international trade is a good thing? The great majority of economists would argue that the gains from reducing trade protection still exceed the losses. However, it has become more important than before to make sure that the gains from international trade are widely spread. And the politics of international trade is becoming increasingly difficult as the extent of trade has grown.

FREEING CANADA’S TRADE WITH THE WORLD

Prime Minister Stephen Harper and Chilean president Sebastian Pinera at the signing of the expanded CCFTA.

On December 5, 1996, government officials from Canada and Chile signed the Canada–Chile Free Trade Agreement (CCFTA). This bilateral trade agreement covering trade in both goods and services significantly liberalized trade between Canada and Chile. It was Canada’s first free trade agreement with a South American country and was Chile’s first comprehensive free trade agreement. The agreement, which was implemented on July 5, 1997, eliminated tariffs on 75% of the trade between the two countries and contained commitments to reduce non-tariff barriers.

Between 1997 and 2012, bilateral trade increased 350% and Canadian direct investment in Chile grew by over 300%. According to the Chilean government, Canada is the third largest investor overall in Chile—first in the mining sector—and the largest source of new direct investment in Chile in the past decade.

On April 16, 2012, Prime Minister Stephen Harper and Chilean president Sebastian Pinera signed an expanded CCFTA document. This amended agreement contains a section that will ensures Canadian financial services firms, such as banks and insurance companies, will enjoy preferential access to the Chilean market. It also contains new dispute settlement procedures and provisions on government procurement and customs procedures.

The government of Canada continues to negotiate other potential important trade agreements. For example, after years of negotiation, an agreement in principle on a CETA between Canada and the European Union (EU) was reached in late 2013. The EU is home to more than 500 million people and the world’s largest economy, producing more than $16 trillion worth of output in 2012. In the joint press conference with EU president Jose Manuel Barroso, Prime Minister Harper said that the CETA “is the biggest deal our country has ever made. This is a historic win for Canada.” Canada has also joined the Trans-Pacific Partnership (TPP), which consists of twelve Pacific nations: Australia, Brunei, Canada, Chile, Japan, Malaysia, Mexico, New Zealand, Peru, Singapore, the United States, and Vietnam. The TPP represents a population of almost 800 million people and a combined output of $27.5 trillion, more than 38% of the world’s economy. These countries have held 18 rounds of talks on the possibility of reaching a comprehensive free trade agreement among all 12 member countries.

Quick Review

  • The three major justifications for trade protection are national security, job creation, and protection of infant industries.

  • Despite the deadweight losses, import protections are often imposed because groups representing import-competing industries are more influential than groups of consumers.

  • To further trade liberalization, countries engage in international trade agreements. Some agreements are among a small number of countries, such as the North American Free Trade Agreement (NAFTA) and the European Union (EU). The World Trade Organization (WTO) seeks to negotiate global trade agreements and referee trade disputes between members.

  • Resistance to globalization has emerged in response to a surge in imports from relatively poor countries and the offshore outsourcing of many jobs that had been considered safe from foreign competition.

Check Your Understanding 8-4

CHECK YOUR UNDERSTANDING 8-4

Question 8.7

In Canada, over half of the steel consumed domestically is imported and steel is an input in many Canadian industries. The federal government has imposed import controls on steel and a variety of consumer goods. Explain why political lobbying to eliminate import controls on steel is more likely to be effective than lobbying to eliminate import controls on consumer goods such as clothing and eggs.

There are many fewer businesses that use steel as an input than there are consumers who buy eggs or clothing. So it will be easier for such businesses to communicate and coordinate among themselves to lobby against tariffs than it will be for consumers. In addition, each business will perceive that the cost of a steel tariff is quite costly to its profits, but an individual consumer is either unaware of or perceives little loss from tariffs on eggs or clothing.

Question 8.8

Over the years, the WTO has increasingly found itself adjudicating trade disputes that involve not just tariffs or quota restrictions but also restrictions based on quality, health, and environmental considerations. Why do you think this has occurred? What method would you, as a WTO official, use to decide whether a quality, health, or environmental restriction is in violation of a free trade agreement?

Countries are often tempted to protect domestic industries by claiming that an import poses a quality, health, or environmental danger to domestic consumers. A WTO official should examine whether domestic producers are subject to the same stringency in the application of quality, health, or environmental regulations as foreign producers. If they are, then it is more likely that the regulations are for legitimate, non–trade protection purposes; if they are not, then it is more likely that the regulations are intended as trade protection measures.

Li & Fung: From Guangzhou to You

It’s a very good bet that as you read this, you’re wearing something manufactured in Asia. And if you are, it’s also a good bet that the Hong Kong company Li & Fung was involved in getting your garment designed, produced, and shipped to your local store. From Levi’s to Aéropostale to Walmart, Li & Fung is a critical conduit from factories around the world to the shopping mall nearest you.

The company was founded in 1906 in Guangzhou, China. According to Victor Fung, the company’s chairman, his grandfather’s “value added” was that he spoke English, allowing him to serve as an interpreter in business deals between Chinese and foreigners. When Mao’s Communist Party seized control in mainland China, the company moved to Hong Kong. There, as Hong Kong’s market economy took off during the 1960s and 1970s, Li & Fung grew as an export broker, bringing together Hong Kong manufacturers and foreign buyers.

The real transformation of the company came, however, as Asian economies grew and changed. Hong Kong’s rapid growth led to rising wages, making Li & Fung increasingly uncompetitive in garments, its main business. So the company reinvented itself: rather than being a simple broker, it became a “supply chain manager.” Not only would it allocate production of a good to a manufacturer, it would also break production down, allocate production of the inputs, and then allocate final assembly of the good among its 12 000+ suppliers around the globe. Sometimes production would be done in sophisticated economies like those of Hong Kong or even Japan, where wages are high but so is quality and productivity; sometimes it would be done in less advanced locations like mainland China or Thailand, where labour is less productive but cheaper.

For example, suppose you own a Canadian retail chain and want to sell garment-washed blue jeans. Rather than simply arrange for production of the jeans, Li & Fung will work with you on their design, providing you with the latest production and style information, like what materials and colours are hot. After the design has been finalized, Li & Fung will arrange for the creation of a prototype, find the most cost-effective way to manufacture it, and then place an order on your behalf. Through Li & Fung, the yarn might be made in Korea and dyed in Taiwan, and the jeans sewn in Thailand or mainland China. And because production is taking place in so many locations, Li & Fung provides transport logistics as well as quality control.

Li & Fung has been enormously successful. In 2012 the company had a market capitalization of approximately US$14.8 billion and business turnover of US$20.2 billion, with offices and distribution centres in more than 40 countries. Li & Fung employs more than 28 000 people worldwide and has access to a sourcing network of over 15 000 suppliers.

QUESTIONS FOR THOUGHT

Question 8.9

Why do you think it was profitable for Li & Fung to go beyond brokering exports to becoming a supply chain manager, breaking down the production process and sourcing the inputs from various suppliers across many countries?

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Why do you think it was profitable for Li & Fung to go beyond brokering exports to becoming a supply chain manager, breaking down the production process and sourcing the inputs from various suppliers across many countries?

Question 8.10

What principle do you think underlies Li & Fung’s decisions on how to allocate production of a good’s inputs and its final assembly among various countries?

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What principle do you think underlies Li & Fung’s decisions on how to allocate production of a good’s inputs and its final assembly among various countries?

Question 8.11

Why do you think a retailer prefers to have Li & Fung arrange international production of its jeans rather than purchase them directly from a jeans manufacturer in mainland China?

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Why do you think a retailer prefers to have Li & Fung arrange international production of its jeans rather than purchase them directly from a jeans manufacturer in mainland China?

Question 8.12

What is the source of Li & Fung’s success? Is it based on human capital, on ownership of a natural resource, or on ownership of capital?

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What is the source of Li & Fung’s success? Is it based on human capital, on ownership of a natural resource, or on ownership of capital?