18.0 Trade Policy

“Open economy macro” – viewing macro analysis from a global rather than national perspective There are many governments, but they can not impose their rules beyond their borders However, other nations can respond to one nation’s policies

Nations have several tools they can use in order to influence their position in global trade We will examine them and also look at the problems with using these tools

A nation can out-compete its rivals by lowering its cost of production and offering a better price on goods This can be done by increasing efficiency and/or lowering factor costs Under the nice assumptions, this advantage would not be maintained, as others enter and profits get driven to zero

In the global economy, as in the domestic one, advantages can be sustained if competitors play by a different set of rules

Nations can create market power for themselves by shaping policies regarding production standards Ex. Have no child labor laws, no limits on work hours, no safety rules, and no environmental rules This gives a real advantage to those nations compared to nations which place those restrictions on themselves

A nation could also become more competitive in the global economy by making products suitable with tastes of the time (ex. Volkswagen –1960s) or developing a reputation for quality and dependability (ex. Toyota, Honda s and 80s)

An imbalance in trade can not be sustained without an offsetting capital flow Increased Japanese car imports were also a result of the U.S. high budget deficits causing higher interest rates, and a stronger dollar Each Japanese car was “on sale” because of exchange rate changes

Nations can make it difficult to have others sell in their country through red tape – bureaucratic hassles for importers U.S. claimed Japan was a master at this Some see these same rules as a reasonable regulation Ex. Biologically engineered food

People who lose jobs and market share to other nations often call for their politicians to have a response These responses can be subtle, or more “in your face”

A nation can weaken its own currency This will encourage more exports and less imports It can be done in two ways

First, governments can buy and sell currencies on the open market Many governments not only have access to their own currencies, but also have stocks of other currencies as well To weaken our dollar, the U.S. could buy yen on the open market and supply more dollars, shifting supply of dollars out

Second, Monetary policy choices can weaken a currency A lower domestic interest rate means capital flows out, weakening the dollar

Manipulating exchange rates carries risk Weaker currencies and lower rates may provide stimulus, but as foreign competitor’s goods become more expensive, it might be easier for domestic producers to raise prices Stimulus plus protection may cause inflation

More direct response to a trade problem – Quotas – set limit on number of units to be imported Ex. Only so many cars allowed to be sold Can invite retaliation as other restrict their market to your goods

Most direct, “in your face” response – tariffs Tariffs are taxes on imports Can stop all imports with high enough tariffs Almost invariably invites retaliation Tariff wars can result Some economists argue that the Great Depression was so severe because of high tariffs that nations imposed In the U.S., this was called the Smoot-Hawley tariff

Trade policy – Historical Background Global economy emerges in the 1400s and 1500s with the rise of nation states Dutch do extremely well with little homeland to develop Their wealth was based on success at trade Many thinkers thought success at trade would determine a nation’s wealth

The dominant view at this time was trade was a zero sum game- more for me means less of the pie for you With winners and losers, nations tried to figure out how to be the winner – Mercantilism – 1700s and 1800s Restrict imports, have strong navies to control trade, get colonies for raw materials Nations tried to sustain these advantages

1776 – Adam Smith writes Wealth of Nations Smith imagines a liberal society where opportunities are not skewed by power, competition exists and justice prevails He sees a positive sum game where constructive competition is good for individuals and nations Debunks mercantilism

Promise of free and open global economy – Pareto optimality Problems – justice of the distribution of initial endowments and distortions of market power and market failure Plus, instead of one government, there are many Interventionist hope for good government intervention and Non-interventionist hope for no intrusion seem more remote

Mercantilist thinking still abounds Protectionism is very popular politically because job losses to imports do hurt people Trade wars have no winners, however Keynes wrote prior to to WWII that if nations could just provide full employment through their domestic policies, there was no need to interfere with free international markets

Developing nations face challenges in a global economy Little financial capital Some compete with cheap labor costs, but with what many consider to be violations of human rights

Financial capital is really important to compete With so little capital at home, these countries must attract capital from the outside Capital is mobile and fickle The International Monetary Fund (IMF) is the lender of last resort to make sure panics don’t occur

Some institutions have been established to set global rules for international trade Early effort – Global Agreement on Tariffs and Trade (GATT) Tried to encourage free and open global markets Replaced by the WTO – World Trade Organization

Some regional agreements have been made NAFTA – North American Free Trade Agreement – U.S., Canada, Mexico functioning as a free trade zone Europe’s use of the common currency of the Euro makes it a “United States of Europe” from a trade perspective Monetary policy is now in the hands of the European Central Bank

Both NAFTA and the WTO suffer from the fact that the participants are sovereign nations which can interpret differently and even ignore certain provisions with regard to workers’ right and environmental protections

Anyone who says it’s simple is either simple minded, or thinks you are