Archive for the 'Protectionism' Category

Nov 10 2010

Yeah, we have a trade deficit, SO WHAT?!

The following is an excerpt from Chapter 22  – “Balance of Payments” of my soon to be published textbook “Pearson Baccalaureate Economics”

If the total spending by a nation’s residents on goods and services imported from the rest of the world exceeds the revenues earned by the nation’s producers from the sale of exports to the rest of the world, the nation is likely experiencing a current account deficit. The situation is not at all uncommon among many of the world’s trading nations. The map belowmap  represents nations by their cumulative current account balances over the years 1980-2008. The red countries all accumulated current account deficits over the three decades, with the largest by far being the United States with a cumulative deficit of $7.3 trillion. The green countries are ones which have had a cumulative surplus in their current accounts, the largest surplus belonging to Japan at $2.7 trillion, followed by China at $1.5 trillion.

source: http://en.wikipedia.org/wiki/File:Cumulative_Current_Account_Balance.png

The top ten current account deficit nations are represented below. It is obvious from this chart that the United States alone accounts for a larger current account deficit then the next nine countries combined. At $7.3 trillion dollars in deficits over 28 years, the US deficit surpasses Spain’s (at number 2) by 1,000 percent.

The consequences of a nation having a current account deficit are not immediately clear. It should be pointed out that it is debatable whether a trade deficit is necessarily a bad thing, in fact. Below we will examine some of the facts about current account deficits, and we will conclude by evaluating the pros and cons for countries that run deficits in the short-run and in the long-run.

Implications of persistent current account deficits: When a country like like those above experience deficits in the current account for year after year, there are some predictable consequences that may have adverse effects on the nation’s macroeconomy. These include currency depreciation, foreign ownership of domestic assets, higher interest rates and foreign indebtedness.

The effect of a current account deficit on the exchange rate: In the previous chapter you learned about the determinants of the exchange rate of a nation’s currency relative to another currency. One of the primary determinants of a currency’s exchange rate is the demand for the nation’s exports relative to the demand for imports from other countries. With this in mind, we can examine the likely effects of a current account deficit on a nation’s currency’s exchange rate. Additionally, we will see that under a floating exchange rate system, deficits in the current account should be automatically corrected due to adjustments in exchange rates.

When households and firms in one nation demand more of other countries’ output than the rest of the world demands of theirs, there is upward pressure on the value of trading partners’ currencies and downward pressure on the importing nation’s currency. In this way, a movement towards a current account deficit should cause the deficit country’s currency to weaken.

As an illustration, say that New Zealand’s imports from Japan begin to rise due to rising incomes in New Zealand and the corresponding increase in demand for imports. Assuming Japan’s demand for New Zealand’s output does not change, New Zealand will move towards a deficit in its current account and Japan towards a surplus. In the foreign exchange market, demand for Japanese yen will rise while the supply of NZ$ in Japan increases, as seen above, depreciating the NZ$.

The downward pressure on exchange rates resulting from an increase in a nation’s current account deficit should have a self-correcting effect on the trade imbalance. As the NZ$ weakens relative to its trading partners’ currencies, consumers in New Zealand will start to find imports more and more expensive, while consumers abroad will, over time, begin to find products from New Zealand cheaper. In this way, a flexible exchange rate system should, in the long-run, eliminate surpluses and deficits between nations in the current account. The persistence of global trade imbalances illustrated in the map above is evidence that in reality, the ability of flexible exchange rates to maintain balance in nations’ current accounts is quite limited.

Foreign ownership of domestic assets: By definition, the balance of payments must always equal zero. For this reason, a deficit in the current account must be offset by a surplus in the capital and financial accounts. If the money spent by a deficit country on goods from abroad ends up in the does not end up returning to the deficit country for the purchase of goods and services, it will be re-invested into the county through foreign acquisition of domestic real and financial assets, or held in reserve by surplus nations’ central banks.

Essentially, a country with a large current account deficit, since it cannot export enough goods and services to make up for its spending on imports, instead ends up “exporting ownership” of its financial and real assets. This could take the form of foreign direct investment in domestic firms, increased portfolio investment by foreigners in the domestic economy, and foreign ownership of domestic government debt, or the build up of foreign reserves of the deficit nation’s currency.

The effect on interest rates: A persistent deficit in the current account can have adverse effects on the interest rates and investment in the deficit country. As explained above, a current account deficit can put downward pressure on a nation’s exchange rate, which causes inflation in the deficit country as imported goods, services and raw materials become more expensive. In order to prevent massive currency depreciation, the country’s central bank may be forced to tighten the money supply and raise domestic interest rates to attract foreign investors and keep demand for the currency and the exchange rate stable. Additionally, since a current account deficit must be offset by a financial account surplus, the deficit country’s government may need to offer higher interest rates on government bonds to attract foreign investors. Higher borrowing rates for the government and the private sector can slow domestic investment and economic growth in the deficit nation.

Side note: While the interest rate effect of a large current account deficit should be negative (i.e. causing interest rates to rise in the deficit country), in recent years the country with the largest trade deficit, the United States, has actually experienced record low interest rates even while maintaining persistent current account deficits. This can be understood by examining by the macroeconomic conditions of the US and global economies, in which deflation posed a greater threat than inflation over the years 2008-2010. The fear of deflation combined with low confidence in the private sector among international investors has kept demand for US government bonds high even as the US trade deficit has grown, allowing the US government and central bank to keep interest rates low and continue to attract foreign investors.

Whereas under “normal” macroeconomic conditions a build up of US dollars among America’s trading partners would require the US to raise interest rates to create an incentive for foreign investors to re-invest that money into the US economy, in the environment of uncertainty and low confidence in the private sector that has prevailed over the last several years, America’s trading partners have been willing to finance its current account deficit at record low interest rates.

The effect on indebtedness: A large current account deficit is synonymous with a large financial account surplus. One source of credits in the financial account is foreign ownership of domestic government bonds (i.e. debt). When a central bank from another nation buys government bonds from a nation with which it has a large current account surplus, the deficit nation is essentially going into debt to the surplus nation. For instance, as of August 2010, the Chinese central bank held $868 billion of United States Treasury Securities (government bonds) on its balance sheet. In total, the amount of US debt owned by foreign nations in 2010 was $4.2 trillion, or around 50% of the country’s total national debt and 30% of its GDP.source: http://www.ustreas.gov/tic/mfh.txt

On the one hand, foreign lending to a deficit nation is beneficial because it keeps demand for government bonds high and interest rates low, which allows the deficit country’s government to finance its budget without raising taxes on domestic households and firms. On the other hand, every dollar borrowed from a foreigner has to be repaid with interest. Interest payments on the national debt cost US taxpayers over $400 billion in 2010, making up around 10% of the federal budget. Nearly half of this went to foreign holders of US debt, meaning almost $200 billion of US taxpayer money was handed over to foreign interests, without adding a single dollar to aggregate demand in the US.

The opportunity cost of foreign owned national debt is the public goods and services that could have been provided with the money that instead is owed in interest to foreign creditors. If the US current account were more balanced, foreign countries like China would not have the massive reserves of US dollars to invest in government debt in the first place, and the taxpayer money going to pay interest on this debt could instead be invested in the domestic economy to promote economic growth and development.

Discussion Questions:

  1. Why would a large current account deficit cause a nation’s currency to depreciate? How could a weaker currency automatically reduce a nation’s current account deficit?
  2. Why should governments be concerned about a large trade deficit? What is one policy a government could implement to reduce a deficit in the current account?
  3. Would a nation with a large trade deficit be better off without trade at all? Why or why not?
  4. Discuss the validity of the following claim: “Americans buy tons of Chinese imports, but the Chinese don’t buy anything from America, this is why the US has such a huge trade deficit with China”. To what extent is this claim true or false?

8 responses so far

Oct 04 2010

The high cost of tariffs

CBC News – Money – Shipping industry gets tariff break

A tariff is a tax on imported goods or services aimed at raising the price of foreign products to make domestically produced substitutes more attractive to consumers. A tariff is a form of protectionism, which we study in unit 4.1 of the IB Economics course.

Tariffs are appealing to policymakers as a tool for protecting domestic firms from foreign competition. Used wisely, a barrier to trade such as a tariff can promote the development of certain vital industries in the domestic economy that might otherwise not exist due to the existent of more efficient, lower cost foreign competition. Tariffs benefit domestic producers but harm domestic consumers, who must pay a higher price for the imported good than they would have to under purely free trade.

The Canadian government has, until recently, charged a 25% tariff on cargo ships, tankers and large ferries built in foreign countries. As of this month, however, this tariff is being removed.

Imported cargo ships, tankers and large ferries will no longer be subject to a 25 per cent tariff, Finance Minister Jim Flaherty announced Friday.

The measure is aimed at making it cheaper for Canadian shipowners to replace aging fleets with more modern and more efficient vessels.

Waiving the tariff will save the industry $25 million a year for the next 10 years, the government estimates.

“These were tariffs that don’t serve any purpose because … the ships to which they apply are not capable of being made competitively in Canada,” Flaherty told reporters…

The effects of a tariff in the Canadian ship market can be illustrated using a simple supply and demand diagram. The diagram below shows the Canadian ship market before the removal of the 25% tariff and after its removal.

The domestic supply and demand curves for ships in Canada are shown above. Notice that the domestic equilibrium price for ships in Canada without trade is very high. This is because Canadian ship builders have high costs of production and therefore would require a very high price in order to be able to build ships domestically.

So where do Canadian ship buyers get their ships from? The article mentions that one Canadian company bought ships from a Turkish ship builder. Besides Turkey, some of the other countries that specialize in ship production include Denmark, South Korea, China and Japan. The world supply of ships is represented by the blue line. In a purely free trade environment, the price of ships in Canada is determined by the intersection of domestic demand and world supply, at a price of Pw.

The world price of ships is completely unresponsive to changes in demand from Canadian ship buyers. This explains why world supply is horizontal. Since the Canadian market makes up such a small proportion of the total market for ships, an increase in demand in Canada will have no impact on the world price of ships. Therefore, the world supply curve as seen by Canada ship buyers is perfectly elastic. Canadian ship buyers can buy as few ships or as many ships as they like without affecting world price.

A tariff is a tax, and a tax is a determinant of supply. A tariff of 25% increases the costs of imported ships, and shifts the world supply curve upwards. This raises the price of imported ships, and decreases the quantity demanded of ships in Canada from Q3 to Q2 ships. Notice that at the higher world price of Pwt, there are a few domestic ship builders in Canada willing and able to produce and sell ships, so domestic quantity supplied increases from 0 to Q1.

The existence of a tariff reduces the number of imported ships in Canada from 0Q3 to Q1Q2. Domestic producers of ships, who without protection would not be able to compete and therefore produce zero ships, instead produce Q1 and enjoy producer surplus represented by the triangle X. The Canadian government collects taxes on the imported ships represented by the area Z, found by multiplying the number of imported ships (Q1Q2) by the amount of the tariff (Pwt-Pw).

The tariff on imported ships did little good for the Canadian ship market. Canadian ship builders were already uncompetitive and benefited little if at all. While the government did earn revenues from the tax, the net effect on the market was a loss of welfare represented by the triangles labelled Y in the graph above. These gray areas represent the net welfare loss (or dead weight loss) of the ship tariff.

The consumers of ships, which are in fact Canadian companies that produce other goods and services, such as the ferry companies that provide access to Canada’s several remote coastal and island communities, were clearly harmed by the 25% tariff, since the price of ships is a resource cost and the tariff translated into lower supply and higher prices for consumers of ferry services. The tariff’s effect on ship buyers in Canada is visible in the graph above. At a price of Pw, the total consumer surplus in the ship market is the area of VXYZ. With the higher price resulting from the tariff, however, consumer surplus is only the are V, while producer surplus increased only to the area X and government surplus (the tax revenue from the tariff) is area Z. The net effect, however, is a loss of total welfare of the triangles labelled Y.

The tariff’s removal, on the other hand, increases the welfare of ship consumers back to VXYZ, eliminating the dead weight loss and increasing total welfare and efficiency in the ship market. This also benefits the customers of the companies that buy ships, including ferry passengers, as evidenced in the article

“The duty remission to BC Ferries will allow it to implement a two per cent rate reduction for its users later this month, the Finance Department said.”

A tariff on imports is a protectionist measure aimed at increasing domestic producer surplus in a market in which domestic firms face competition from lower cost foreign producers. However, it should be observed that a tariff generally creates a net loss of welfare for society as a whole, as the consumers of the taxed good face a higher price and demand a lower quantity of output. While a tariff reduces imports may increase domestic production, the benefit to producers comes at the cost of lost consumer surplus and a net loss of welfare in the market as a whole. The tariff also leads to allocative inefficiency in a market, as domestic resources are over-allocated towards the production of a good on which imports are subject to tariffs.

Removing tariffs on ships increases the benefit to ship buyers, who in turn pass that benefit on to their own customers, lowering the prices of important services such as shipping and ferry service to Canadian consumers. In addition, foreign producers of ships increase their sales in Canada and experience greater demand, benefiting foreign producers and workers. The increase in foreign income may mean more demand for Canada’s exports in turn, increasing employment in other sectors of the Canadian economy in which they do have a comparative advantage over their trading partners. Overall the elimination of tariffs increases total welfare, eliminates dead weight loss, and leads to a more efficient allocation of a nation’s resources towards the goods it is able to competitively produce in the global economy.

Discussion Questions:

  1. What was the intended purpose of the 25% tariff on imported ships? Was this a valid reason to tax foreign built ships?
  2. Who are the various “stakeholders” affected by a tariff on imported ships. Try to identify five different stakeholders who are affected by the tariff and its removal.
  3. Why does the removal of a tariff improve allocative efficiency in a country? Does it also improve productive efficiency?

15 responses so far

Sep 30 2010

Free Trade Debate: to what extent has globalization based on free trade contributed to global economic growth and development?

Today in class, my IB year 2 students undertook a debate on the extent to which free trade has contributed to or hurt the well-being of the world’s people. In preparation for this debate, students were asked to research and bookmark to our class’s Diigo group one article offering evidence in support of their argument.

The debate was framed around a quote from Paul Krugman from chapter 11 of the excellent book, Naked Economics.

“You could say that globalization, driven not by human goodness but by the profit motive, has done far more good for more people than all the foreign aid and soft loans provided by well-intentioned governments and aid agencies.”
I was very impressed with their well thought out viewpoints, considering we have only just started our Unit 4: International Trade section of the IB course. Below are the summaries of my student’s arguments for and against free trade. Next to their names are links to the articles they found to support their argument.
Anti-trade arguments
Ika:
  • 80% of the toys sold in America are made in China.
  • Foreign companies make toys in factories operated and owned by Chinese.
  • Working conditions in China are horrible with a minimum wages that is far too low.
  • In addition to low wages, standards of worker safety are lower than the United States, leading to exploitation of labor to produce cheap toys for Americans.
  • To make matters worse, the prices of a certain toy may vary greatly from rich country to rich country. For example, a doll that sells for $29 in the USA sells for $64 in Holland. How is this fair?
  • The cost of labor makes up less than 5% of the price of the toy.
  • Free trade only increases the profits of the capitalists, but does not help the workers in the poor countries where products are manufactured.
Koen: The Negative Impact of Free Trade | eHow.com
  • Due to free trade, demand for labor in more developed countries decreases since production occurs in other countries where it’s cheaper to produce.
  • This means jobs lost in rich countries, so less economic growth, less consumption, lower incomes.
  • Growth in some countries comes at the expense of growth in other countries. There are winners and LOSERS in free trade.
Sarah: Doha trade deal ‘will hurt Africa’ | Environment | The Guardian
  • Under free trade as we call it today, subsidies to farmers in Europe make it difficult for African farmers to compete.
  • Africa accounts for less of the total trade in the world today than it did in 1990, mostly because of its inability to export produce due to subsidies to farmers in Europe.
  • With less access to advanced capital and the lack of government  subsidies, African farmers find it difficult to compete on the global produce market.
  • Free trade hurts poor countries’ farmers and therefore increases the gap between rich and poor.
Silvia:
  • Trade liberalization creates some losers as it increases the gap between those with skills to work in the global market and those who don’t have those skills.
  • Trade leads to an increase in inequality and more relative poverty.
  • Trade creates severe tensions between big and small firms and workers who succeed and those who lag behind.
  • Export growth can exacerbate the exploitation of natural resources. Without environmental protection, trade may make us richer but at the price of future development.
Pro-trade arguments
Duy Anh: allAfrica.com: Africa: Free Trade Area for East, Southern Africa Making Progress
  • Africa is establishing Free Trade Areas to improve the flow of goods and services across country. If trade were not beneficial, then why would so many countries be clamoring to enter a free trade area?
  • When workers can move freely in a region it can lead to better, more efficient resource allocation. The same is true of capital, goods and services. Larger markets lead to more efficiency and greater opportunities for employment and for business operators.
  • Reducing tariffs, quotas and other barriers to trade increases efficiency and allows for more opportunities for all those who live within a free trade areal.

Christopher: Foreign Trade, Not Foreign Aid « John Stossel

  • If we help developing countries improve and increase their trade with each other and the rest of the world, it will create jobs, allow entrepreneurs to start companies and therefore reduce unemployment.
  • Greater opportunities and less unemployment leads to more social stability, reduction in poverty, and less likelihood that the poor people of the world will become “extremists” or result to violence and terrorism to express their dissatisfaction with the world.
  • More trade and international relationships reduces likelihood of conflict between and within poor countries.
  • We should expect to see social and political stability arising from increased economic opportunity.
  • Free trade WILL increase economic opportunities in poor countries.
General comments from the class after both sides have presented their arguments
  • Unlike aid, free trade cannot be “used up”. Aid is a one-off, when it’s gone it’s over, but trade can be self-perpetuating.
  • On the other hand, Sarah says,  “but it all depends on the kind of aid and how it is used!”
  • Aid can be invested responsibly, but often times it is not.
  • So maybe there is room for BOTH aid AND trade.
  • Lara says,  “In extreme circumstances, aid is necessary. In other, trade is better as a long-run means of achieving growth and development”

The exercise of debating the pros and cons of free trade for rich and poor countries was rewarding and provided an interesting and engaging way to introduce Unit 4 of the IB Economics course. The final two units, on International Trade and Economic Development, are closely tied, as one of the main strategies for achieving improvements in people’s standards of living is to improve the unfettered access to resource, good and service markets across national boundaries. We will be revisiting the debate on the effectiveness of trade versus aid at promoting the objectives of economic development repeatedly throughout the rest of the second year of IB economics.

For now, some questions went unresolved in today’s debate, and I will ask my student and any other interested reader to respond to those questions in the comments below.

Discussion questions:

  1. Is it possible that free trade has increased not only the relative poverty in the world, but also the number of people living in absolute poverty? In other words, trade makes the rich get richer, but does it make the poor get poorer? Or do the poor just feel poorer due to increased wealth and income of the rich?
  2. In 1970, the economies of China and Africa were roughly the same size, and the average income of a Chinese person was around the same as an African’s. Today, China’s economy is more than three time’s the size of Africa’s. What has China done differently than Africa to lead to such a huge income gap between the two regions?
  3. Why should people in Europe, America and other high income regions of the world care about the economic development of the world’s poorest countries? Does improving the lives of Africans require that we in Europe and the rich West make sacrifices in our own standards of living?
  4. African countries want Europe to stop subsidizing its farmers to make it easier for African farmers to compete. But doing so would mean the loss of an important part of European history and culture. Why would less subsidies to farmers in Europe help Africa, and should Europe listen to Africa on this issue or not?

11 responses so far

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