Why US protectionism can not be the answer

The other day, I received a three-page email from Klaus Bockstaller, who runs the Baring Emerging Europe Trust. I have to say that while I get at least 100 emails a day, the issues that Klaus raised, his thoughts, and the resulting questions were some of the most interesting and challenging that I have ever encountered. They have driven me along an illuminating path of reflection, and given rise to some interesting conclusions.

In essence, Klaus has the following theory. When, in the future, Western political leaders realize that the Bernanke-type monetary policies don't really work (or are doomed to fail, as I would put it), but lead to inflation and a depreciation of the dollar, they will increasingly pursue a policy of protectionism, which will buy the developed countries of the West some time and keep jobs from migrating to low-cost service providers, such as India, and more competitive manufacturing centers, such as we find in China, Vietnam, and Eastern European countries, among many others.

A sharply depreciating dollar and import duties will lift the price level in the US, but the disadvantage of higher domestic inflation could be partially offset if production and tradable services shifted back to the US.

The only remaining problem in this scenario (of depreciating dollars) would be oil. But, according to Klaus Bockstaller, the US has wisely taken steps to ensure that it will have sufficient supplies at reasonable prices in the future, vis-à-vis occupying Iraq.

Klaus concludes that while he agrees with me that the US is headed towards 'ein böses Ende' (disastrous eventual outcome), he nevertheless feels that a country like the US, whose money is 'the' reserve currency of the world, can, as Bernanke suggested not long ago, print money at practically zero cost.

If this policy does not work, however, Klaus suggests that the US can simply implement protectionist policies in order to postpone for quite some time the 'ultimate debacle'. If the US succeeds in putting off its problems for quite some time, then the equity markets could perform very well for a period.

While I fully agree with Klaus Bockstaller's basic presuppositions, I believe that the lease of life of economic policies that are designed to postpone problems, rather than to solve them - and to hurt competitors through competitive devaluations and protectionist measures - is far shorter than generally accepted. As Mao Tse Tung wrote during the struggle to 'liberate' China, 'a single spark can start a prairie fire.' Let me explain the reasons for my somewhat less sanguine views.

More than two years after the Fed began to ease aggressively, it is now becoming more obvious that the policy of aggressively driving down short-term rates has failed to produce any meaningful recovery. Consider, for instance, the booming housing industry. Given the red-hot conditions in this sector (don't forget that it is excessive credit growth that drives residential house inflation), one would assume that the furniture manufacturing industry would also be thriving.

But, not so! Industrial production for furniture and related products has been declining since 2000, while employment in this sector has totally collapsed. Why? Easy money has led to new capacities in the furniture industry - not in the US, but in Vietnam and in China, two countries from which the importing of furniture imports into the US are soaring.

So, it should already be obvious to US economic policymakers that in an environment of free trade and free capital flows, monetary policies can stimulate borrowings and spending in a high-cost country, but not capital spending and production, which, given a highly competitive situation, will naturally shift to the lowest-cost producers and lead to the ongoing wealth transfer to Asia via the US current account deficit.

But what about protective duties, quotas, and regulatory measures that would prevent service jobs from migrating overseas? It is on this point that I disagree with Klaus Bockstaller. Import duties and quotas will make matters worse and not just in the long term but also immediately. Let me explain.

First of all, import tariffs and quotas on a large scale would increase prices for manufactured goods in the US and, combined with the ongoing inflation for services, would lead to higher inflation rates across the board and, therefore, depress bond prices further. In turn, rising interest rates would bring the refinancing boom, which has kept consumption up, to an abrupt end. In addition, selective tariffs, such as were imposed on steel imports, will not create jobs.

Because of the steel tariffs, US steel prices are now far above steel prices in Asia, Russia, and Brazil. So, what is the result? Manufacturers of goods with a heavy steel content (such as car-part manufacturers) are shifting production overseas, where not only labor but also now steel prices are lower. And if across-the-board import duties were levied, such duties would not only hurt foreign manufacturers, but also US companies, which in the last few years have set up production capacities overseas and import their products back to the US (I understand that about 50% of US imports originate from US companies overseas).

In fact, under careful analysis, it should be obvious that the lack of competitiveness of US companies has led to the shift overseas of goods production and the provision of services. Import duties or restrictions will 'protect' unproductive and uncompetitive industries and make them even less competitive, since duties will now diminish the competitive pressures.
For the US economy, rising protectionism would also mean far higher inflation rates, as well as a huge competitive disadvantage on the global markets for US corporations.

Sure, the lowest-cost providers of services and producers of goods would temporarily be hurt, but the world's economic geography is now mutating rapidly. Already, the Asian markets combined are far larger than the US economy in a number of sectors. Consequently, American protectionism would merely redirect trade flows, but not eliminate them. (As an example, Thailand's exports were up in May year-on-year by 13.5%, but exports to China soared by 82%.) I might add that the threat of protectionism will actually make exporters in Asia and India stronger, because they would then direct their efforts to lowering their dependence on the US market by looking for customers elsewhere.

Lastly, rising protectionism in the US, which is already evident in a number of industries where foreign firms are accused of dumping, would probably mean the end of the WTO and lead to retaliatory measures by foreign governments. This is hardly a picture that would be very beneficial for economic growth and financial markets, not to mention the negative geopolitical consequences for the US!

In sum, I suppose that American protectionism would be bad for everyone, but especially so for the US, as it would not cure the cause of job losses and the trade deficit problem but, rather, would address only the symptoms of these problems.