The Best Arguments for Trade Protection — and Why They Are Wrong

0:00My paper is about the best arguments for protection, and by protection I'm talking about protecting ourselves, protecting domestic industries from foreign competition with some type of trade restrictions. And there's an awful lot of arguments in favor of protection, and I don't want to have time to talk about all of them, but in the next few minutes I'd like to say that a useful way to think about these arguments is to put them into two categories. There are some naive arguments in favor of protection and then there are the best arguments in favor of protection. And then I'll have some comments about whether or not we should accept the best arguments. The case for free trade starts with the law of comparative advantage, but it doesn't end there.

0:49And I assume we're familiar with this law. Ricardo's law of comparative advantage says that if we specialize in producing the products where we have a comparative advantage and export those products and import the products where the other country has a comparative advantage, then this will increase social product. And this is an airtight argument, but it only holds under certain conditions. Within the conditions, it's an airtight argument. So the explicit premise of that argument is that capital is immobile across political borders. It's mobile within the political borders, but capital and other resources do not flow between countries. There are other sort of, they're not really premises to the law of comparative advantage, but they're sort of conditions.

1:38And Ricardo and everyone who has espoused this argument in the last two centuries recognize that they're not talking about situations where there's externalities or monopoly power, and that the law doesn't necessarily hold in those cases, and maybe in some other cases. So the naive arguments, which by the way are oftentimes the powerful arguments and they tend to hold the most weight in public opinion, the naive arguments are the ones that contradict the law of comparative advantage. So there are arguments out there that say we should protect ourselves from inexpensive imports, we should protect ourselves from trade with countries that have cheap foreign labor, We should protect ourselves from labor or we should protect ourselves from dumping.

2:27We should protect ourselves from allowing foreign firms selling their products, importing their products to us at prices that are relatively low in order to gain market share. There are also arguments about we should protect ourselves in order to increase jobs, increase production or increase employment. And there are arguments that say we should protect ourselves in order to foster infant industries. And all of these arguments by themselves are wrong because they contradict the law of comparative advantage. The proponents of these arguments see the benefits of the protection, but they don't see what Bastiat says. They don't see what is unseen. And we can dispose of these arguments relatively quickly, but there are popular arguments out there.

3:19Let me say one thing. Let me add one thing to that, though. A lot of the infant industries arguments, the infant industries arguments is that we need to protect industries so that they will mature and become competitive industries and the type of industries we want to have in the long run. Some of those infant industries arguments are mixed in with more complicated arguments that include conditions that don't hold under Ricardo's law of comparative advantage. So there are more sophisticated infant industries arguments out there. I don't have a lot of time to dispose of these naive arguments. I trust that you see that the proponents of these arguments are simply not seeing the whole picture here.

4:09Okay, what I'm calling the best arguments for protection are the arguments where the conditions under which the law of comparative advantage hold are no longer the case. So, there's a series of arguments out there in the trade literature about protecting ourselves or protecting industries that generate positive externalities, or maybe diminishing industries that have negative externalities. But generally they're talking about maybe we should protect industries that would generate positive externalities for the domestic country. And most of this This literature focuses on research and development. So the idea is if an industry is going to be good at research and development, we want it here, we should protect ourselves so that that industry generates positive externalities for the rest of the country. So even though that particular industry doesn't capture the gains, other industries in the country will capture those gains. One problem with that, I was going to go through this whole list, I was going to go through this whole list, but one problem with that is that these types

5:15of externalities tend to cross political borders. So in the neoclassical modeling of these arguments, they tend to say positive externalities stop at the political borders. But in today's world, you would think that if a firm in Asia developed a new technology, that firms in the US would be quick to embrace those new technologies. Regarding research and development, let me mention Gottfried Habler's. If you were going to read a book on international trade theory, I recommend Gottfried Hobbler's Theory of International Trade. It's a 1936 book, at least the first English edition is in 1936. But Hobbler argues that in cases of research and development, he talks about and Educative Effect. He argues that we should allow the country that has a comparative advantage in research and development to do that research and development and develop the new technologies and then we should have free trade and then free trade will generate a lot of competition here and that competition will force us to embrace the new technologies. So Hobbler turns

6:28In the case of research and development, the argument should be that we should adopt free trade instead of protection. Possibly better arguments for protection are the arguments where there's imperfect competition in markets, where there's monopoly rents. And so there's all of these models out there where they say it's a second best world, there are monopolies present, and then in a second best world you can develop a model that draws about any conclusion you want. So, for instance, some of the conclusions are that the optimal policy is what they call a negative tariff, so that you should subsidize other countries to send you stuff.

7:18You should take tax dollars in the face of imperfect competition and give it to other countries so that they'll send you products, which doesn't... But under the right modeling conditions, that's the right option. But regarding monopoly rents, many of the papers fall into two categories. Many of the arguments fall into two categories. And one is, if there's going to be a firm that generates monopoly rents, we should protect that firm so that it will locate in this country. And then the firm will sell products overseas, foreign consumers will pay the monopoly rents, and this country will capture the monopoly rents. The reverse argument is that if the foreign monopolist is going to be overseas and going to export into this country, we should enact a tariff so that our government captures the monopoly rents.

8:09That foreign monopolist pays the rents in the form of tariff revenue to our government. So we extract, they call it extracting the rents from the foreign monopolist. Let me mention one more argument and then I'll say why I think all of these best arguments are why we should be suspicious of these arguments. The third best argument, it's not the third best, the third argument in this category is the argument where capital is flowing across political borders, capital is mobile. And I think this is the main argument today. I think this is the argument we hear if you listen closely. I think this is the argument, a few years ago at the Austrian Scholars Conference, Paul Crete Roberts gave a talk, and I think this was his point, is that capital flows out of the country under certain conditions. I think this is the point, I read one of Lew Dobbs' book, you kind of have to tease this out of the book, but I think that's his point,

9:17is that capital flows out of the country. And I think that's the, some people are making this outsourcing argument that we need to protect ourselves so we're not outsourcing. I think that's at least some of the more sophisticated arguments about outsourcing. I think that's their point. So I think this is the important argument. So the idea here is maybe we could construct protectionist policies that generate capital inflows. And then we would have a country that has more capital The idea is, if we had the capital inflows, we would have the benefits of the increased capital, there would be less trade, so we would give up some of the efficiencies of trade, but maybe there is a net benefit overall. So you can think of a world where, the idea is, would you rather have a country with lots of capital and not much trade, or not much capital and free trade.

10:02So maybe it would be better, as far as the amount of goods and services we have, maybe it would be better to have more capital, at least that is the argument. One of the problems here is that almost everybody who talks about this, they see the increased capital flows, but they only think of it as, they only see a partial equilibrium in the economy, they only see the protected industries and the capital inflows there, but they don't see that if we're going to import less, then we tend to export less. So they don't see the diminished exporting industries and they tend to not see the capital outflows in those industries. So they tend to not see the whole picture. That's not really a crushing argument against it, but they tend to not see the whole picture.

10:53A lot of these arguments, a lot of these papers were written in the last 30 years. But Hobbler in the 1930s spends a lot of time on this issue, and he starts this section about capital flows by saying, can protection generate these net increased benefits due to increased capital inflows? And he says, this is an exact quote, he says, definitely not. And then he spends several pages explaining it, and he ends up concluding that tariffs are unlikely to increase the income of the home population by attracting factors from abroad. So he seems to admit it's possible. And the two quotes are just six pages apart.

11:46So why are these arguments wrong here? Am I out of time, Tom? Do I have that much time?

11:59Then, let me say one more thing here. A second book, if you were going to read two books on international trade theory, I would recommend Gottfried Haveler's book. And then the second book is by Leland Yeager and David Turk. And it's a 1976 book called Foreign Trade and and U.S. Policy, The Case for Free International Trade. This book was, Jaeger and Turk was published in 1976, and starting in the 1980s, there was a whole series of papers written on optimal protectionist policies. And every time I read And I think I'll bet Jaeger and Turk rebutted it before any of these papers were written.

12:51And I can always go back to the 1976 book and say, well, there's the answer why the 1987 paper was wrong. So it's rather an amazing, I think if you're interested in this issue, I think it's a must read. But Jaeger and Turk argued that if you want capital inflows, that free trade is the right policy because free trade is, countries that have free trade generally are not interventionists in general, and those are the kind of countries investors want to invest in. So they argue, they turn the argument around and say capital inflows are good, but protectionist policies tend to be a sign of intervention in general, and investors tend to flee those countries. So they argue that capital flows are due to mainly other issues other than tariffs.

13:42The best arguments for protection are the ones that cannot be dealt with using the law of comparative advantage, or at least that's my phrase for them. The reason they're wrong, or the reason I think they're wrong, is that a lot of these... Well, first of all, the models overlook the real world complications. So most of these arguments are just neoclassical model building and they start with a series of assumptions and then they're able to derive anything. So they tend to assume away the negative aspects of the protection and emphasize them.

14:32You can emphasize the positive aspects by saying there are certain conditions about about factor prices, or about price elasticities of demand for imports and exports, or you can claim that you know that a particular firm is a Stackelberg leader, or that the Cournot condition holds, or sometimes they assume that the foreign nations will never retaliate against your policies. Sometimes they assume they will retaliate, but it's in a predictable manner. So you know what to do about it, because you know how they're going to react. And a lot of times they'll assume there's just one monopolist. There is a monopolist, but there is only one. Because if there is more than one, then that throws the model off. So they are able to build models doing this, but the models tend to assume away the real-world complexities of the situation. However you could imagine a world without the modeling, you could imagine a world where the protectionism increases Social Product You can imagine it.

15:35You could think about a world where there's a tariff that attracts a large amount of capital inflows for industries that generate positive externalities and gain a large amount of monopoly rents. But it diminishes other industries, but those industries result in a small amount of capital outflows and those industries generate negative externalities, which you want them diminished anyway, and there's no loss of monopoly rents. You can at least imagine that world. So in that world, why can't we, why is free trade the right policy? Well, I think there's, largely speaking, there's two reasons. One is that in order to have an optimal tarot policy, the policy makers need to be be trying to implement an optimal tariff policy. And we should be suspicious of this. We should suspect that policy makers will tend to protect industries based on political considerations, not welfare issues. But to me, the main argument against it is that the policy makers in the real world are not able to gain the knowledge and do the calculation necessary to implement

16:53these policies. And a lot of these papers recognize this. A lot of these protectionist papers, they build a model and then they say, the conclusion of the model is that the tariff is the right policy under certain conditions and then they say, but you can't apply this model in the real world. Time after time these papers say, we just simply don't have enough knowledge to do it. Paul Krugman says it, and he's the leading writer, he was the leading This is an obvious point. None of them cite Mises or Hayek. They don't cite Mises' calculation paper or Hayek's work on knowledge, but implicitly that's sort of the argument they're making. But it's impossible to implement these policies in the real world, because policymakers simply, even if they were angelic beings trying to do the right thing, they simply don't have the knowledge, nor are they able to do the calculations necessary to devise an optimal tariff.

17:52So, Mises and Hayek's work, I think, rebut the best arguments for protection.