Why Protectionism Feels So Good but Is So Wrong

Trade protectionism is a policy that protects domestic industries from unfair competition from foreign ones. The four primary tools are tariffs, subsidies, quotas, and currency manipulation.

Protectionism is a politically motivated defensive measure. In the short run, it works. But it is very destructive in the long term. It makes the country and its industries less competitive in international trade.

Four Protectionist Policies

The most common protectionist strategy is to enact tariffs that tax imports. That immediately raises the price of imported goods. They become less competitive when compared to local goods. This method works best for countries with a lot of imports, such as the United States.

The chart below shows the share of tariffs collected on U.S. imports since 1790. Tariffs hit a record 57.3% in 1830 due to the Tariff of Abominations. They hit a record low in 2008 at 1.2%.

Protectionism fell out of favor after the Smoot-Hawley Tariff of 1930. It was designed to protect farmers from agricultural imports from Europe. U.S. farmers were already suffering from the Dust Bowl. European farmers were ramping up production after the destruction of World War I. But Congress added many other tariffs. Other countries retaliated. The resultant trade war restricted global trade. It was one reason for the extended severity of the Great Depression.

The Use of Subsidizes

Governments also frequently subsidize local industries to help them compete in the global market. Subsidies come in the form of tax credits or direct payments. The most commonly used are farm subsidies. That allows producers to lower the price of local goods and services. This support makes the products cheaper, even when shipped overseas. Subsidies work even better than tariffs. This method works best for countries that rely mainly on exports.

But sometimes subsidies can have the opposite effect. The Agricultural Adjustment Act of 1933 allowed the government to pay farmers not to grow crops or livestock. The government wanted to control supply and increase prices. Farmers could also let their fields rest and regain nutrients due to overproduction. It helped the agriculture industry but raised food costs during the Depression.

Using Import Quotas and Currency Manipulation

A third method is to impose quotas on imported goods. This method is more effective than the first two. No matter how low a foreign country sets the price through subsidies, it can’t ship more goods.

Most textbooks omit the fourth type of trade protectionism because it is subtle. It is a deliberate attempt by a country to lower its currency value. This currency manipulation would make its exports cheaper and more competitive. This method can result in retaliation and start a currency war. One way countries can lower their currency's value through a fixed exchange rate, like China's yuan. Another way is by creating so much national debt that it has the same effect. Some countries criticize the U.S. government for doing that, creating a U.S. dollar decline.

Advantages 

If a country is trying to grow strong in a new industry, tariffs will protect it from foreign competitors. That gives the new industry’s companies time to develop their competitive advantages.

Protectionism also temporarily creates jobs for domestic workers. The protection of tariffs, quotas, or subsidies allows domestic companies to hire locally. This benefit ends once other countries retaliate by erecting protectionism.

Disadvantages 

In the long term, trade protectionism weakens the industry. Without competition, companies within the industry do not need to innovate. Eventually, the domestic product will decline in quality and be more expensive than what foreign competitors produce.

Job outsourcing is a result of declining U.S. competitiveness. Competition has declined from decades of the United States not investing in education. This failure is particularly true for high-tech, engineering, and science. Increased trade opens new markets for businesses to sell their products. The Peterson Institute for International Economics estimates that ending all trade barriers would increase U.S. income by $500 billion.

Increasing U.S. protectionism will further slow economic growth. It would cause more layoffs, not fewer. If the United States closes its borders, other countries will do the same. These actions could cause layoffs among the 12 million U.S. workers who owe their jobs to exports.

Anti-Protectionism

Since the Smoot-Hawley Act, most countries have been anti-protectionist. They realize protectionism lowers international trade for everyone. One of the strongest tools in anti-protectionism is the free trade agreement (FTA). It reduces or eliminates tariffs and quotas between trading partners.

The largest agreement is the North American Free Trade Agreement. It is between the United States, Canada, and Mexico. The Trans-Pacific Partnership would have been larger. But President Trump withdrew the United States from that agreement. As a result, the other involved countries have formed their own accord. If China decides to join them, it will replace NAFTA as the world's largest trade pact.

Also, in the running for the world's largest trade agreement would have been the Transatlantic Trade and Investment Partnership. It was between the European Union and the United States. But the Trump administration has not pursued it.  Another large multilateral trade pact is the Central American-Dominican Republic Free Trade Agreement (CAFTA-DR), between the United States and Central America.

There are also bilateral agreements with Chile, Colombia, Panama, Peru, and Uruguay. The United States also has agreements with the Middle Eastern countries of Israel, Jordan, Morocco, Bahrain, and Oman.

But FTAs don't eliminate protectionist measures like subsidies or currency wars. One of the disadvantages of NAFTA was that subsidized U.S. farm products put Mexican farmers out of business. However, despite their disadvantages, for some countries and industries, free trade agreements have more pros than cons. 

The Bottom Line

In a global economy, protectionism is damaging to everyone. Trump’s “America First” economic policy could hurt the U.S. economy in the long run. Tariff imposition on imports from China, Canada, EU, Mexico, and India have triggered retaliatory tariffs. A trade war with these large economies leads to serious consequences for U.S. exporters and the labor force.

But the immediate losers will be the global consumers. They will be forced to pay inflated prices. High costs could create inflation around the world. 

Free trade agreements could advance the world economy. Although unfavorable to uncompetitive domestic industries, these boost local industries that can produce at better economies of scale than those of other nations.