The Dangers of Protectionism

Competition means that there are winners and losers. But losers can benefit through creative destruction as failure forces them to innovate.

Even the perceived downside risk of free trade — running a trade deficit — may not be so bad. That’s because:

Countries that have more money, like the US, consume more goods than other countries. If the US runs a trade deficit, that helps other economies grow — so they can ultimately purchase more of our goods.

Running a trade deficit with the US gives other countries more money to invest back in the US, such as through Treasury purchases, but protectionism reduces foreign direct investment (FDI). For example, Canadian investment comprised 10% of the total FDI in 2016. However, according to the Bank of Canada’s January 2018 Monetary Policy Report, “Trade policy uncertainty is expected to reduce the level of investment by about 2% by the end of 2019.”

Bank of Canada Governor Stephen Poloz summarized the risks of protectionism in a March 2017 speech: “Protectionism does not promote growth, and its costs are steep.” In fact, most economists agree that protectionism exacerbated the Great Depression:

“The Great Depression of the 1930s was marked by a severe outbreak of protectionist trade policies. Governments around the world imposed tariffs, import quotas and exchange controls to restrict spending on foreign goods. These trade barriers contributed to a sharp contraction in world trade in the early 1930s beyond the economic collapse itself, and to a lackluster rebound in trade later in the decade, despite the worldwide economic recovery.”1

In addition, trading partners such as China and Japan could retaliate by not buying or even selling US Treasuries. As I warned in a Jan. 29 blog, “Countries can retaliate in other ways as well, given how interconnected we are.

One powerful retaliatory tool — which many seem to be overlooking — is that they could choose to curtail purchases of US Treasuries or, even worse, also sell some of the Treasuries they hold, which could, all else being equal, drive up US borrowing costs.”

Now, that does not mean that free trade is free from risk. Free trade means that some industries in some countries will lose jobs — and that is always a very high price to pay. We can only hope that governments spearhead effective job retraining programs, so that employees are able to learn new skills for the jobs of the future that free trade will help create.

This also does not mean that free trade is truly fair, as Lee Iacocca referred to in his book. That may be where “soft” protectionist tools can be employed (such as lower-interest rate loans or subsidies for certain industries) which aren’t quite as blunt an instrument as tariffs. And, where appropriate, countries can utilize the World Trade Organization to correct unfair trade practices on the part of other countries.

Key takeaway

In short, I have warned for a while that one of the key risks to global economic growth, in my view, is protectionism. Tariffs rarely occur in a vacuum. They can multiply, as we saw in the 1930s.

Today, markets appear to be appropriately fearful of them because of the impact they can have on global economic growth; not only did stocks sell off on news of the steel and aluminum tariffs, but we saw the yield on the 10-year US Treasury back down as well, which I believe is an indication of how seriously markets took this threat.

While developments as of March 5 suggest that this tariff announcement is really just a bargaining chip in North American Free Trade Agreement negotiations, we will want to follow the current situation closely given the continued potential for trade wars to erupt.