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learning objectives

7-1 Identify the policy instruments used by governments to influence international trade flows.

7-2 Understand why governments sometimes intervene in international trade.

7-3 Summarize and explain the arguments against strategic trade policy.

7-4 Describe the development of the world trading system and the current trade issue.

7-5 Explain the implications for managers of developments in the world trading system.

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opening case

Back in the 1930s at the height of the Great Depression, the U.S. government stepped in to support the U.S. sugar industry with a combination of subsidies, price supports, import quotas, and tariffs. These actions were meant to be temporary, but as of 2014, they are still in place. Under policies approved in the 2008 farm bill, the government guarantees 85 percent of the market for U.S. producers, primarily farmers growing sugar beets and cane. The remaining 15 percent is allocated for imports from certain countries at a preferential tariff rate. The government also sets a floor price for sugar. If the price falls below the floor, the government steps in to purchase excess supply, driving the price back up again. The surplus is then sold at a loss to producers of ethanol. A significant U.S. sugar harvest in 2013 required the government to spend some $300 million to prop up U.S. sugar prices. As a result of these policies, be- tween 2010 and 2013, the U.S. sugar price has averaged between 64 percent and 92 percent higher than the world price of sugar.

American sugar producers say that the federal programs are necessary to keep big sugar producing countries like Brazil, India, and Thailand from flooding the U.S. market and driving them out of business. Opponents of the practice include numerous small candy producers. Many of them complain about the high U.S. price for sugar. Increasingly, they have responded by moving production offshore. For example, the Spangler Candy Company, the maker of Dum Dums, has moved 200 jobs from Ohio to Juarez, Mexico, where it makes candy canes that are then imported back into the United States. Similarly, Adams & Brooks, a California-based candy company, has shifted two-thirds of its production across the border to Mexico in response to higher U.S. sugar prices.

A recent academic study suggests that the U.S. sugar policies primarily benefit 4,700 sugar producers, while imposing costs of $2.9 billion to $3.5 billion per annum on U.S. consumers due to higher sugar prices. The same research predicts that removing the support programs would lead to the net creation of 17,000 to 20,000 new jobs in the United States, while dramatically reducing imports of products containing sugar.

Sugar Subsidies Drive Candy Makers Abroad

Government Policy and International Trade

–continued

196 Part Three The Global Trade and Investment Environment

Given the benefits of removing sugar support programs, and all the talk about deregulation and reducing the budget deficit in Congress, many observers thought that 2013 would be the year that the sugar programs were finally abandoned. The farm bill was up for renewal, and the sugar support programs were held up as an example of how wasteful government subsidies are. However, sugar producers spent some $20 million on political lobbying between 2011 and 2013. Partly due to their influence, the U.S. Senate voted 54 to 45 against any reform in the sugar programs. The majority included 20 out of 45 Republican senators, most of who publicly rail against this kind of government intervention. Apparently however, political expediency required that they support intervention in this case. • Sources: G. F. Will, “Congress Needs to Stop Subsidies to Sugar Farmers,” Washington Post, June 7, 2013; R. Nixon, “American Candy Makers, Pinched by Inflated Sugar Prices, Look Abroad,” New York Times, October 30, 2013; and J. B. A. Elobeid, “The Impact of the U.S. Sugar Program Redux,” Iowa State Working Paper 13-WP 538, May 2013, www.card.iastate.edu/publications/dbs/pdffiles/13wp538.pdf.

Introduction The review of the classical trade theories of Smith, Ricardo, and Heckscher-Ohlin in Chapter 6 showed that in a world without trade barriers, trade patterns are determined by the relative productivity of different factors of production in different countries. Coun- tries will specialize in products that they can make most efficiently, while importing prod- ucts that they can produce less efficiently. Chapter 6 also laid out the intellectual case for free trade. Remember, free trade refers to a situation in which a government does not attempt to restrict what its citizens can buy from or sell to another country. As we saw in Chapter 6, the theories of Smith, Ricardo, and Heckscher-Ohlin predict that the conse- quences of free trade include both static economic gains (because free trade supports a higher level of domestic consumption and more efficient utilization of resources) and dynamic economic gains (because free trade stimulates economic growth and the creation of wealth).

This chapter looks at the political reality of international trade. Although many na- tions are nominally committed to free trade, they tend to intervene in international trade to protect the interests of politically important groups or promote the interests of key domestic producers. The opening case illustrates one such situation. Even though suc- cessive U.S. administrations have often promoted free trade policies, the government still has a long history of intervening in markets to protect some domestic producers. U.S. sugar producers are a case in point. There is little doubt that policies put in place in the 1930s to support the U.S. sugar industry are now out of date. They lead to higher sugar prices in the United States, effectively imposing a tax on U.S. consumers, while creating an incentive for U.S. candy manufacturers to move production offshore where sugar prices are lower, which leads to job losses in the United States. However, due to effective political lobbying by sugar producers, the policies seem likely to continue in place for some time to come.

This chapter explores the political and economic reasons that governments have for intervening in international trade. When governments intervene, they often do so by re- stricting imports of goods and services into their nation, while adopting policies that pro- mote domestic production and exports. Normally, their motives are to protect domestic producers. In recent years, social issues have intruded into the decision-making calculus. In the United States, for example, a movement is growing to ban imports of goods from coun- tries that do not abide by the same labor, health, and environmental regulations as the United States.

This chapter starts by describing the range of policy instruments that governments use to intervene in international trade. A detailed review of governments’ various political and

Free Trade The absence of barriers to the free flow of goods and services between countries.

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economic motives for intervention follows. In the third section of this chapter, we consider how the case for free trade stands up in view of the various justifications given for govern- ment intervention in international trade. Then we look at the emergence of the modern international trading system, which is based on the General Agreement on Tariffs and Trade (GATT) and its successor, the WTO. The GATT and WTO are the creations of a series of multinational treaties. The final section of this chapter discusses the implications of this material for management practice.

Instruments of Trade Policy Trade policy uses seven main instruments: tariffs, subsidies, import quotas, voluntary export restraints, local content requirements, administrative policies, and antidumping duties. Tar- iffs are the oldest and simplest instrument of trade policy. As we shall see later in this chap- ter, they are also the instrument that the GATT and WTO have been most successful in limiting. A fall in tariff barriers in recent decades has been accompanied by a rise in nontar- iff barriers, such as subsidies, quotas, voluntary export restraints, and antidumping duties.

TARIFFS A tariff is a tax levied on imports (or exports). Tariffs fall into two categories. Specific tariffs are levied as a fixed charge for each unit of a good imported (e.g., $3 per barrel of oil). Ad valorem tariffs are levied as a proportion of the value of the imported good. In most cases, tariffs are placed on imports to protect domestic producers from for- eign competition by raising the price of imported goods. However, tariffs also produce rev- enue for the government. Until the income tax was introduced, for example, the U.S. government received most of its revenues from tariffs.

The important thing to understand about an import tariff is who suffers and who gains. The government gains, because the tariff increases government revenues. Domestic produc- ers gain, because the tariff affords them some protection against foreign competitors by in- creasing the cost of imported foreign goods. Consumers lose because they must pay more for certain imports. For example, in 2002 the U.S. government placed an ad valorem tariff of 8 to 30 percent on imports of foreign steel. The idea was to protect domestic steel pro- ducers from cheap imports of foreign steel. The effect, however, was to raise the price of steel products in the United States between 30 and 50 percent. A number of U.S. steel con- sumers, ranging from appliance makers to automobile companies, objected that the steel tariffs would raise their costs of production and make it more difficult for them to compete in the global marketplace. Whether the gains to the govern- ment and domestic producers exceed the loss to consumers depends on various factors, such as the amount of the tariff, the importance of the imported good to domestic consum- ers, the number of jobs saved in the protected industry, and so on. In the steel case, many argued that the losses to steel consumers apparently outweighed the gains to steel produc- ers. In November 2003, the World Trade Organization de- clared that the tariffs represented a violation of the WTO treaty, and the United States removed them in December of that year.

In general, two conclusions can be derived from eco- nomic analysis of the effect of import tariffs.1 First, tariffs are generally pro-producer and anticonsumer. While they protect producers from foreign competitors, this restric- tion of supply also raises domestic prices. For example, a study by Japanese economists calculated that tariffs on im- ports of foodstuffs, cosmetics, and chemicals into Japan cost the average Japanese consumer about $890 per year in the form of higher prices. Almost all studies find that im- port tariffs impose significant costs on domestic consumers in the form of higher prices. Second, import tariffs reduce

General Agreement on Tariffs and Trade (GATT) International treaty that committed signatories to lowering barriers to the free flow of goods across national borders and led to the WTO.

LO 7-1 Identify the policy instruments used by governments to influence international trade flows.

Tariff A tax levied on imports.

Specific Tariff Tariff levied as a fixed charge for each unit of good imported.

Ad Valorem Tariff A tariff levied as a proportion of the value of an imported good.

Which Country Is Really the Most Globally Competitive? The World Economic Forum is an independent international organization committed to improving the state of the world by engaging business, political, academic, and other leaders of society to shape global, regional, and industry agendas. The World Economic Forum also conducts global economic research and annually publishes country competitive rankings. Over the years, northern and western European countries have dominated the top 10 most globally competitive nations. The United States and Japan typically also hold strong positions. But is it really fair that the “global competitiveness” ranking indicates that rela- tively small Nordic countries such as Finland and Sweden are viewed as being as competitive as the United States and Japan? Should larger countries, with more people and a larger economy, be given preferential treatment in ranking such as when the topic is on “global competitiveness”?

Source: www.weforum.org.

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the overall efficiency of the world economy. They reduce efficiency because a protective tariff encourages domestic firms to produce products at home that, in theory, could be produced more efficiently abroad. The consequence is an inefficient utilization of resources.

Sometimes tariffs are levied on exports of a product from a country. Export tariffs are less common than import tariffs. In general, export tariffs have two objectives: first, to raise revenue for the government, and second, to reduce exports from a sector, often for political reasons. For example, in 2004 China imposed a tariff on textile exports. The primary objective was to moderate the growth in exports of textiles from China, thereby alleviating tensions with other trading partners.

SUBSIDIES A subsidy is a government payment to a domestic producer. Subsidies take many forms, including cash grants, low-interest loans, tax breaks, and government eq- uity participation in domestic firms. By lowering production costs, subsidies help domestic producers in two ways: (1) competing against foreign imports and (2) gaining export mar- kets. Agriculture tends to be one of the largest beneficiaries of subsidies in most countries. The European Union has been paying out about €44 billion annually ($55 billion) in farm subsidies. The farm bill that passed the U.S. Congress in 2007 contained subsidies of $289 billion for the next 10 years. The Japanese also have a long history of supporting inef- ficient domestic producers with farm subsidies. According to the World Trade Organization, in mid-2000 countries spent some $300 billion on subsidies, $250 billion of which was spent by 21 developed nations.2 In response to a severe sales slump following the global financial crisis, between mid-2008 and mid-2009, some developed nations gave $45 billion in subsi- dies to their automobile makers. While the purpose of the subsidies was to help them sur- vive a very difficult economic climate, one of the consequences was to give subsidized companies an unfair competitive advantage in the global auto industry. Somewhat ironically given the government bailouts of U.S. auto companies during the global financial crisis, in 2012 the Obama administration filed a complaint with the WTO arguing that the Chinese were illegally subsidizing exports of autos and auto parts. Details are given in the Country Focus feature.

Subsidy Government financial assistance to a domestic producer.

Are the Chinese Illegally Subsidizing Auto Exports?

In late 2012, during the presidential election campaign, the Obama ad- ministration filed a complaint against China with the World Trade Orga- nization. The complaint claims that China is providing export subsidies to its auto and auto parts industries. The subsidies include cash grants for exporting, grants for R&D, subsidies to pay interest on loans, and preferential tax treatment.

The United States estimates the value of the subsidies to be at least $1 billion between 2009 and 2011. The complaint also points out that in the years 2002 through 2011, the value of China’s exports of autos and auto parts increased more than ninefold from $7.4 billion to $69.1 billion. The United States was China’s largest market for exports of auto parts during this period. The United States is asserting that, to some degree, this growth may have been helped by subsidies. The complaint goes on to claim that these subsidies have hurt producers of automobiles and auto parts in the United States. This is a large industry in the United States, employing over 800,000 people and generating some $350 billion in sales.

While some in the labor movement applauded the move, the re- sponse from U.S. auto companies and auto parts producers was muted. One reason for this is that many U.S. producers do business in China and, in all probability, want to avoid retaliation from the Chinese gov- ernment. GM, for example, has a joint venture and two wholly owned subsidiaries in China and is doing very well there. In addition, some U.S. producers benefit by purchasing cheap Chinese auto parts, so any retaliatory tariffs imposed on those imports might actually raise their costs.

More cynical observers saw the move as nothing more than politi- cal theater. The week before the complaint was filed, the Republican presidential candidate, Mitt Romney, had accused the Obama admin- istration of “failing American workers” by not labeling China a cur- rency manipulator. So perhaps the complaint was in part simply another move on the presidential campaign chessboard. In any event, the WTO does not move and at the time of writing no ruling has yet been issued.

Sources: James Healey, “U.S. Alleges Unfair China Auto Subsidies in WTO Action,” USA Today, September 17, 2012; and M. A. Memoli, “Obama to Tell WTO That China Illegally Subsidizes Auto Imports,” Los Angeles Times, September 17, 2012.

country FOCUS

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The main gains from subsidies accrue to domestic producers, whose international com- petitiveness is increased as a result. Advocates of strategic trade policy (which, as you will recall from Chapter 6, is an outgrowth of the new trade theory) favor subsidies to help do- mestic firms achieve a dominant position in those industries in which economies of scale are important and the world market is not large enough to profitably support more than a few firms (aerospace and semiconductors are two such industries). According to this argument, subsidies can help a firm achieve a first-mover advantage in an emerging industry (just as U.S. government subsidies, in the form of substantial R&D grants, allegedly helped Boeing). If this is achieved, further gains to the domestic economy arise from the employment and tax revenues that a major global company can generate. However, government subsidies must be paid for, typically by taxing individuals and corporations.

Whether subsidies generate national benefits that exceed their national costs is debatable. In practice, many subsidies are not that successful at increasing the international competitive- ness of domestic producers. Rather, they tend to protect the inefficient and promote excess production. One study estimated that if advanced countries abandoned subsidies to farmers, global trade in agricultural products would be 50 percent higher and the world as a whole would be better off by $160 billion.3 Another study estimated that removing all barriers to trade in agriculture (both subsidies and tariffs) would raise world income by $182 billion.4 This increase in wealth arises from the more efficient use of agricultural land.

IMPORT QUOTAS AND VOLUNTARY EXPORT RESTRAINTS An import quota is a direct restriction on the quantity of some good that may be imported into a country. The restriction is usually enforced by issuing import licenses to a group of indi- viduals or firms. For example, the United States has a quota on cheese imports. The only firms allowed to import cheese are certain trading companies, each of which is allocated the right to import a maximum number of pounds of cheese each year. In some cases, the right to sell is given directly to the governments of exporting countries. Historically, this was the case for textile imports in the United States. However, the international agreement govern- ing the imposition of import quotas on textiles, the Multi-fiber Agreement, expired on Janu- ary 1, 2005.

A common hybrid of a quota and a tariff is known as a tariff rate quota. Under a tariff rate quota, a lower tariff rate is applied to imports within the quota than those over the quota. For example, as illustrated in Figure 7.1, an ad valorem tariff rate of 10 percent might be levied on 1 million tons of rice imports into South Korea, after which an out-of-quota

Import Quota A direct restriction on the quantity of a good that can be imported into a country.

Tariff Rate Quota Lower tariff rates applied to imports within the quota than those over the quota.

7.1 FIGURE Hypothetical Tariff Rate Quota

80%

10%

Tariff Rate % Quota Limit

In quota

Out of quota

2 million1 million Tons of Rice Imported0

200 Part Three The Global Trade and Investment Environment

rate of 80 percent might be applied. Thus, South Korea might import 2 million tons of rice, 1 million at a 10 percent tariff rate and another 1 million at an 80 percent tariff. Tariff rate quotas are common in agriculture, where their goal is to limit imports over quota.

A variant on the import quota is the voluntary export restraint. A voluntary export restraint (VER) is a quota on trade imposed by the exporting country, typically at the re- quest of the importing country’s government. One of the most famous historical examples is the limitation on auto exports to the United States enforced by Japanese automobile pro- ducers in 1981. A response to direct pressure from the U.S. government, this VER limited Japanese imports to no more than 1.68 million vehicles per year. The agreement was revised in 1984 to allow 1.85 million Japanese vehicles per year. The agreement was allowed to lapse in 1985, but the Japanese government indicated its intentions at that time to continue to restrict exports to the United States to 1.85 million vehicles per year.5 In 2012, Brazil im- posed what amounts to voluntary export restraints on shipments of vehicles from Mexico to Brazil. The two countries have a decade-old free trade agreement, but a surge in vehicles heading to Brazil from Mexico prompted Brazil to raise its protectionist walls. Mexico has agreed to quotas on Brazil-bound vehicle exports for the next three years.6 Foreign produc- ers agree to VERs because they fear more damaging punitive tariffs or import quotas might follow if they do not. Agreeing to a VER is seen as a way to make the best of a bad situation by appeasing protectionist pressures in a country.

As with tariffs and subsidies, both import quotas and VERs benefit domestic producers by limiting import competition. As with all restrictions on trade, quotas do not benefit con- sumers. An import quota or VER always raises the domestic price of an imported good. When imports are limited to a low percentage of the market by a quota or VER, the price is bid up for that limited foreign supply. The automobile industry VER mentioned earlier in- creased the price of the limited supply of Japanese imports. According to a study by the U.S. Federal Trade Commission, the automobile VER cost U.S. consumers about $1 billion per year between 1981 and 1985. That $1 billion per year went to Japanese producers in the form of higher prices.7 The extra profit that producers make when supply is artificially lim- ited by an import quota is referred to as a quota rent.

If a domestic industry lacks the capacity to meet demand, an import quota can raise prices for both the domestically produced and the imported good. This happened in the U.S. sugar

industry, in which a tariff rate quota system has long lim- ited the amount foreign producers can sell in the U.S. market. According to one study, import quotas have caused the price of sugar in the United States to be as much as 40 percent greater than the world price.8 These higher prices have translated into greater profits for U.S. sugar producers, which have lobbied politicians to keep the lucrative agreement. They argue U.S. jobs in the sugar industry will be lost to foreign producers if the quota system is scrapped.

LOCAL CONTENT REQUIREMENTS A local content requirement is a requirement that some specific fraction of a good be produced domestically. The requirement can be expressed either in physical terms (e.g., 75 percent of component parts for this product must be produced locally) or in value terms (e.g., 75 per- cent of the value of this product must be produced lo- cally). Local content regulations have been widely used by developing countries to shift their manufacturing base from the simple assembly of products whose parts are manufactured elsewhere into the local manufacture of component parts. They have also been used in developed countries to try to protect local jobs and industry from foreign competition. For example, a little-known law in

Voluntary Export Restraint (VER) A quota on trade imposed from the exporting country’s side, instead of the importer’s; usually imposed at the request of the importing country’s government.

Quota Rent Extra profit producers make when supply is artificially limited by an import quota.

Local Content Requirement A requirement that some specific fraction of a good be produced domestically.

Is Having a Local Content Requirement a Good Idea? Local content requirements refer to a specific fraction of a prod- uct that needs to be manufactured domestically. Basically, LCRs establish a minimum level of local content required under trade law when giving foreign companies the right to manufacture in a particular place. In the wake of the economic downturn in 2008, many economists feared that some governments would institute protectionist policies similar to the tariff escalations during the Great Depression of the 1930s. However, most public policy officials avoided traditional forms of protection (e.g., tariffs, quo- tas). This led some observers to underestimate the degree of protectionism. Instead, what had happened was that so-called nontariff barriers in the form of local content requirements (LCR) had become increasingly popular. As a (1) citizen of a specific country and (2) as a global customer, do you think local content requirements help you as a citizen of a country, as a global cus- tomer, as both, or as neither?

Source: G. C. Hufbauer and J. J. Scott, Local Content Requirements: A Global Problem Washington, DC; Peterson Institute for Global Economics, 2013.

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the United States, the Buy America Act, specifies that government agencies must give pref- erence to American products when putting contracts for equipment out to bid unless the foreign products have a significant price advantage. The law specifies a product as “Ameri- can” if 51 percent of the materials by value are produced domestically. This amounts to a local content requirement. If a foreign company, or an American one for that matter, wishes to win a contract from a U.S. government agency to provide some equipment, it must en- sure that at least 51 percent of the product by value is manufactured in the United States.

Local content regulations provide protection for a domestic producer of parts in the same way an import quota does: by limiting foreign competition. The aggregate economic effects are also the same; domestic producers benefit, but the restrictions on imports raise the prices of imported components. In turn, higher prices for imported components are passed on to consumers of the final product in the form of higher final prices. So as with all trade policies, local content regulations tend to benefit producers and not consumers.

ADMINISTRATIVE POLICIES In addition to the formal instruments of trade policy, governments of all types sometimes use informal or administrative policies to restrict imports and boost exports. Administrative trade policies are bureaucratic rules designed to make it difficult for imports to enter a country. It has been argued that the Japanese are the masters of this trade barrier. In recent decades, Japan’s formal tariff and nontariff barri- ers have been among the lowest in the world. However, critics charge that the country’s in- formal administrative barriers to imports more than compensate for this. For example, at one point the Netherlands exported tulip bulbs to almost every country in the world except Japan. In Japan, customs inspectors insisted on checking every tulip bulb by cutting it verti- cally down the middle, and even Japanese ingenuity could not put any back together. Fed- eral Express also initially had a tough time expanding its global express shipping services into Japan because Japanese customs inspectors insist on opening a large proportion of ex- press packages to check for pornography, a process that delayed an “express” package for days. As with all instruments of trade policy, administrative instruments benefit producers and hurt consumers, who are denied access to possibly superior foreign products.

ANTIDUMPING POLICIES In the context of international trade, dumping is variously defined as selling goods in a foreign market at below their costs of production or as selling goods in a foreign market at below their “fair” market value. There is a difference between these two definitions; the fair market value of a good is normally judged to be greater than the costs of producing that good because the former includes a “fair” profit margin. Dumping is viewed as a method by which firms unload excess production in foreign markets. Some dumping may be the result of predatory behavior, with producers using sub- stantial profits from their home markets to subsidize prices in a foreign market with a view to driving indigenous competitors out of that market. Once this has been achieved, so the argument goes, the predatory firm can raise prices and earn substantial profits.

An alleged example of dumping occurred in 1997, when two South Korean manufacturers of semiconductors, LG Semicon and Hyundai Electronics, were accused of selling dynamic random access memory (DRAM) chips in the U.S. market at below their costs of production. This action occurred in the middle of a worldwide glut of chip-making capacity. It was alleged that the firms were trying to unload their excess production in the United States.

Antidumping policies are designed to punish foreign firms that engage in dumping. The ultimate objective is to protect domestic producers from unfair foreign competition. Although antidumping policies vary from country to country, the majority are similar to those used in the United States. If a domestic producer believes that a foreign firm is dump- ing production in the U.S. market, it can file a petition with two government agencies, the Commerce Department and the International Trade Commission (ITC). In the Korean DRAM case, Micron Technology, a U.S. manufacturer of DRAM chips, filed the petition. The government agencies then investigate the complaint. If a complaint has merit, the Commerce Department may impose an antidumping duty on the offending foreign imports (antidumping duties are often called countervailing duties). These duties, which represent a special tariff, can be fairly substantial and stay in place for up to five years. For example,

Administrative Trade Policies Administrative policies, typically adopted by government bureaucracies, that can be used to restrict imports or boost exports.

Dumping Selling goods in a foreign market for less than their cost of production or below their “fair” market value.

Antidumping Policies Designed to punish foreign firms that engage in dumping and thus protect domestic producers from unfair foreign competition.

Countervailing Duties Antidumping duties.

202 Part Three The Global Trade and Investment Environment

after reviewing Micron’s complaint, the Commerce Department imposed 9 percent and 4 percent countervailing duties on LG Semicon and Hyundai DRAM chips, respectively. The accompanying Management Focus discusses another example of how a firm, U.S. Magne- sium, used antidumping legislation to gain protection from unfair foreign competitors.

The Case for Government Intervention Now that we have reviewed the various instruments of trade policy that governments can use, it is time to look at the case for government intervention in international trade. Argu- ments for government intervention take two paths: political and economic. Political argu- ments for intervention are concerned with protecting the interests of certain groups within a nation (normally producers), often at the expense of other groups (normally consumers), or with achieving some political objective that lies outside the sphere of economic relation- ships, such as protecting the environment or human rights. Economic arguments for inter- vention are typically concerned with boosting the overall wealth of a nation (to the benefit of all, both producers and consumers).

LO 7-2 Understand why governments sometimes intervene in international trade.

Protecting U.S. Magnesium

In February 2004, U.S. Magnesium, the sole surviving U.S. producer of magnesium, a metal that is primarily used in the manufacture of cer- tain automobile parts and aluminum cans, filed a petition with the U.S. International Trade Commission contending that a surge in imports had caused material damage to the U.S. industry’s employment, sales, market share, and profitability. According to U.S. Magnesium, Russian and Chinese producers had been selling the metal at prices signifi- cantly below market value. During 2002 and 2003, imports of magne- sium into the United States rose 70 percent, while prices fell by 40 percent, and the market share accounted for by imports jumped to 50 percent from 25 percent.

“The United States used to be the largest producer of magnesium in the world,” a U.S. Magnesium spokesperson said at the time of the filing. “What’s really sad is that you can be state of the art and have modern technology, and if the Chinese, who pay people less than 90 cents an hour, want to run you out of business, they can do it. And that’s why we are seeking relief.”

During a yearlong investigation, the ITC solicited input from various sides in the dispute. Foreign producers and consumers of magnesium in the United States argued that falling prices for magnesium during 2002 and 2003 simply reflected an imbalance between supply and de- mand due to additional capacity coming on stream not from Russia or China but from a new Canadian plant that opened in 2001 and from a planned Australian plant. The Canadian plant shut down in 2003, the Australian plant never came on stream, and prices for magnesium rose again in 2004.

Magnesium consumers in the United States also argued to the ITC that imposing antidumping duties on foreign imports of magnesium would raise prices in the United States significantly above world lev- els. A spokesperson for Alcoa, which mixes magnesium with alumi- num to make alloys for cans, predicted that if antidumping duties were imposed, high magnesium prices in the United States would

force Alcoa to move some production out of the United States. Alcoa also noted that in 2003, U.S. Magnesium was unable to supply all of Alcoa’s needs, forcing the company to turn to imports. Consumers of magnesium in the automobile industry asserted that high prices in the United States would drive engineers to design magnesium out of automobiles, or force manufacturing elsewhere, which would ulti- mately hurt everyone.

The six members of the ITC were not convinced by these argu- ments. In March 2005, the ITC ruled that both China and Russia had been dumping magnesium in the United States. The government de- cided to impose duties ranging from 50 percent to more than 140 per- cent on imports of magnesium from China. Russian producers faced duties ranging from 19 percent to 22 percent. The duties were to be levied for five years, after which the ITC would revisit the situation. The ITC revoked the antidumping order on Russia in February 2011 but decided to continue placing them on Chinese producers, and as of 2014 they are still in place.

According to U.S. Magnesium, the favorable ruling would allow the company to reap the benefits of nearly $50 million in investments made in its manufacturing plant and enable the company to boost its capacity by 28 percent by the end of 2005. Commenting on the favor- able ruling, a U.S. Magnesium spokesperson noted, “Once unfair trade is removed from the marketplace we’ll be able to compete with any- one.” U.S. Magnesium’s customers and competitors, however, did not view the situation as one of unfair trade. While the imposition of anti- dumping duties no doubt will help to protect U.S. Magnesium and the 400 people it employs from foreign competition, magnesium consum- ers in the United States are left wondering if they will be the ultimate losers.

Sources: D. Anderton, “U.S. Magnesium Lands Ruling on Unfair Imports,” Desert News, October 1, 2004, p. D10; “U.S. Magnesium and Its Largest Consumers Debate before U.S. ITC,” Platt’s Metals Week, February 28, 2005, p. 2; and S. Oberbeck, “U.S. Magnesium Plans Big Utah Production Expansion,” Salt Lake Tribune, March 30, 2005; “US to keep anti-dumping duty on China pure magnesium,” Chinadaily.com, September 13th, 2012.

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Chapter Seven Government Policy and International Trade 203

POLITICAL ARGUMENTS FOR INTERVENTION Political arguments for government intervention cover a range of issues, including preserving jobs, protecting industries deemed important for national security, retaliating against unfair foreign compe- tition, protecting consumers from “dangerous” products, furthering the goals of foreign policy, and advancing the human rights of individuals in exporting countries.

Protecting Jobs and Industries Perhaps the most common political argument for government intervention is that it is necessary for protecting jobs and industries from unfair foreign competition. The tariffs placed on imports of foreign steel by President George W. Bush in 2002 were designed to do this (many steel producers were located in states that Bush needed to win reelection in 2004). A political motive also underlay establishment of the Common Agricultural Policy (CAP) by the European Union. The CAP was designed to protect the jobs of Europe’s politically powerful farmers by restricting imports and guaran- teeing prices. However, the higher prices that resulted from the CAP have cost Europe’s consumers dearly. This is true of many attempts to protect jobs and industries through gov- ernment intervention. For example, the imposition of steel tariffs in 2002 raised steel prices for American consumers, such as automobile companies, making them less competitive in the global marketplace.

National Security Countries sometimes argue that it is necessary to protect certain industries because they are important for national security. Defense-related industries often get this kind of attention (e.g., aerospace, advanced electronics, and semiconductors). Although not as common as it used to be, this argument is still made. Those in favor of protecting the U.S. semiconductor industry from foreign competition, for example, argue that semiconduc- tors are now such important components of defense products that it would be dangerous to rely primarily on foreign producers for them. In 1986, this argument helped persuade the federal government to support Sematech, a consortium of 14 U.S. semiconductor companies that accounted for 90 percent of the U.S. industry’s revenues. Sematech’s mission was to con- duct joint research into manufacturing techniques that could be parceled out to members. The government saw the venture as so critical that Sematech was specially protected from antitrust laws. Initially, the U.S. government provided Sematech with $100 million per year in subsidies. By the mid-1990s, however, the U.S. semiconductor industry had regained its leading market position, largely through the personal computer boom and demand for microprocessor chips made by Intel. In 1994, the consortium’s board voted to seek an end to federal funding, and since 1996 the consortium has been funded entirely by private money.9

Retaliation Some argue that governments should use the threat to intervene in trade policy as a bargaining tool to help open foreign markets and force trading partners to “play by the rules of the game.” The U.S. government has used the threat of punitive trade sanctions to

Trade Law

Government policy and international trade is the core focus of Chap- ter 7. This topic area has far-ranging implications, such as trade policy, free trade, and the world’s international trading system. Basically, we are talking about a lot of legalistic aspects starting at the government level and moving all the way to what organizations and even individu- als can and cannot do globally when trading. The globalEDGE section on “Trade Law” (globaledge.msu.edu/global-resources/trade-law) is a unique compilation of globalEDGE partner-designed “compendiums of trade laws,” country and region-specific trade law, free online learning

modules created for globalEDGE on various aspects of trade law, and much more. One fascinating resource related to trade law is the “A-CAPPP” program (Anti-Counterfeiting and Product Protection Program). A-CAPPP includes counterfeiting-related webinars, presen- tations, and research-related materials and working papers. Do you know what counterfeiting is? Take a look at the Trade Law section of globalEDGE and, especially, the A-CAPPP site to become more familiar with the topic. (Is China really as bad as many think in the international community?)

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try to get the Chinese government to enforce its intellectual property laws. Lax enforcement of these laws had given rise to massive copyright infringements in China that had been costing U.S. companies such as Microsoft hundreds of millions of dollars per year in lost sales reve- nues. After the United States threatened to impose 100 percent tariffs on a range of Chinese imports, and after harsh words between officials from the two countries, the Chinese agreed to tighter enforcement of intellectual property regulations.10

If it works, such a politically motivated rationale for government intervention may liber- alize trade and bring with it resulting economic gains. It is a risky strategy, however. A coun- try that is being pressured may not back down and instead may respond to the imposition of punitive tariffs by raising trade barriers of its own. This is exactly what the Chinese govern- ment threatened to do when pressured by the United States, although it ultimately did back down. If a government does not back down, the results could be higher trade barriers all around and an economic loss to all involved.

Protecting Consumers Many governments have long had regulations to protect con- sumers from unsafe products. The indirect effect of such regulations often is to limit or ban the importation of such products. For example, in 2003 several countries, including Japan and South Korea, decided to ban imports of American beef after a single case of mad cow disease was found in Washington State. The ban was motivated to protect consumers from what was

Trade in Hormone-Treated Beef

In the 1970s, scientists discovered how to synthesize certain hormones and use them to accelerate the growth rate of livestock animals, re- duce the fat content of meat, and increase milk production. Bovine so- matotropin (BST), a growth hormone produced by cattle, was first synthesized by the biotechnology firm Genentech. Injections of BST could be used to supplement an animal’s own hormone production and increase its growth rate. These hormones became popular among farmers, who found they could cut costs and help satisfy consumer demands for leaner meat. Although these hormones occurred naturally in animals, consumer groups in several countries soon raised concerns about the practice. They argued that the use of hormone supplements was unnatural and that the health consequences of consuming hor- mone-treated meat were unknown but might include hormonal irregu- larities and cancer.

The European Union responded to these concerns in 1989 by ban- ning the importation of hormone-treated meat and the use of growth- promoting hormones in the production of livestock. The ban was controversial because a reasonable consensus existed among scien- tists that the hormones posed no health risk. Although the EU banned hormone-treated meat, many other countries did not, including big meat-producing countries such as Australia, Canada, New Zealand, and the United States. The use of hormones soon became widespread in these countries. According to trade officials outside the EU, the Euro- pean ban constituted an unfair restraint on trade. As a result of this ban, exports of meat to the EU fell. For example, U.S. red meat exports to the EU declined from $231 million in 1988 to $98 million in 1994. The complaints of meat exporters were bolstered in 1995 when Codex Alimentarius, the international food standards body of the UN’s Food and Agriculture Organization and the World Health Organization, ap- proved the use of growth hormones. In making this decision, Codex reviewed the scientific literature and found no evidence of a link

between the consumption of hormone-treated meat and human health problems, such as cancer.

Fortified by such decisions, in 1995 the United States pressed the EU to drop the import ban on hormone-treated beef. The EU refused, citing “consumer concerns about food safety.” In response, Canada and the United States filed formal complaints with the World Trade Or- ganization. They were soon joined by a number of other countries, in- cluding Australia and New Zealand. The WTO created a trade panel of three independent experts. After reviewing evidence and hearing from a range of experts and representatives of both parties, the panel in May 1997 ruled that the EU ban on hormone-treated beef was illegal be- cause it had no scientific justification.

This ruling left the EU in a difficult position. Legally, the EU had to lift the ban or face punitive sanctions, but the ban had wide public support in Europe. The EU feared that lifting the ban could produce a consumer backlash. Instead the EU did nothing. In February 1999 the United States asked the WTO for permission to impose punitive sanctions on the EU. The WTO responded by allowing the United States to impose punitive tariffs valued at $125 million on EU exports to the United States. The EU decided to accept these tariffs rather than lift the ban on hormone-treated beef. In 2012, the EU struck a deal with the United States that allowed it to keep the ban in place, in return for increasing its import quota of high-quality non-hormone-treated beef from the United States. In response, the U.S. lifted its punitive tariffs on EU food exports, thereby ending one of the longest running trade disputes in history.

Sources: C. Southey, “Hormones Fuel a Meaty EU Row,” Financial Times, September 7, 1995, p. 2; E. L. Andrews, “In Victory for U.S., European Ban on Treated Beef Is Ruled Illegal,” The New York Times, May 9, 1997, p. A1; R. Baily, “Food and Trade: EU Fear Mongers’ Lethal Harvest,” Los Angeles Times, August 18, 2002, p. M3; Scott Miller, “EU Trade Sanctions Have Dual Edge,” The Wall Street Journal, February 26, 2004, p. A3; and G. Reilhac, “Lawmakers Approve Rise in Imports of Hormone Free Beef,” Reuters, March 14, 2012.

country FOCUS

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seen to be an unsafe product. Together, Japan and South Korea accounted for about $2 billion of U.S. beef sales, so the ban had a significant impact on U.S. beef producers. After two years, both countries lifted the ban, although they placed stringent requirements on U.S. beef im- ports to reduce the risk of importing beef that might be tainted by mad cow disease (e.g., Japan required that all beef must come from cattle under 21 months of age). The accompanying Country Focus describes how the European Union banned the sale and importation of hor- mone-treated beef. The ban was motivated by a desire to protect European consumers from the possible health consequences of eating meat from animals treated with growth hormones.

Furthering Foreign Policy Objectives Governments sometimes use trade pol- icy to support their foreign policy objectives.11 A government may grant preferential trade terms to a country with which it wants to build strong relations. Trade policy has also been used several times to pressure or punish “rogue states” that do not abide by international law or norms. Iraq labored under extensive trade sanctions after the UN coalition defeated the country in the 1991 Gulf War until the 2003 invasion of Iraq by U.S.-led forces. The theory is that such pressure might persuade the rogue state to mend its ways, or it might hasten a change of government. In the case of Iraq, the sanctions were seen as a way of forcing that country to comply with several UN resolutions. The United States has main- tained long-running trade sanctions against Cuba. Their principal function is to impover- ish Cuba in the hope that the resulting economic hardship will lead to the downfall of Cuba’s Communist government and its replacement with a more democratically inclined (and pro-U.S.) regime. The United States has also had trade sanctions in place against Libya and Iran, both of which were accused of supporting terrorist action against U.S. in- terests and building weapons of mass destruction. In late 2003, the sanctions against Libya seemed to yield some returns when that country announced it would terminate a program to build nuclear weapons. The U.S. government responded by relaxing those sanctions. Similarly, the U.S. government used trade sanctions to pressure the Iranian government to halt its alleged nuclear weapons program, with limited success as of 2013.

Other countries can undermine unilateral trade sanctions. The U.S. sanctions against Cuba, for example, have not stopped other Western countries from trading with Cuba. The U.S. sanctions have done little more than help create a vacuum into which other trading na- tions, such as Canada and Germany, have stepped.

Protecting Human Rights Protecting and promoting human rights in other coun- tries is an important element of foreign policy for many democracies. Governments some- times use trade policy to try to improve the human rights policies of trading partners. For example, as discussed in Chapter 5, the U.S. government long had trade sanctions in place against the nation of Myanmar, in no small part due to the poor human rights practices in that nation. In late 2012 the U.S. said that it would ease trade sanctions against Myanmar in response to democratic reforms in that country. Similarly, in the 1980s and 1990s, Western governments used trade sanctions against South Africa as a way of pressuring that nation to drop its apartheid policies, which were seen as a violation of basic human rights.

ECONOMIC ARGUMENTS FOR INTERVENTION With the develop- ment of the new trade theory and strategic trade policy (see Chapter 6), the economic argu- ments for government intervention have undergone a renaissance in recent years. Until the early 1980s, most economists saw little benefit in government intervention and strongly advocated a free trade policy. This position has changed at the margins with the develop- ment of strategic trade policy, although as we will see in the next section, there are still strong economic arguments for sticking to a free trade stance.

The Infant Industry Argument The infant industry argument is by far the oldest economic argument for government intervention. Alexander Hamilton proposed it in 1792. According to this argument, many developing countries have a potential comparative advan- tage in manufacturing, but new manufacturing industries cannot initially compete with estab- lished industries in developed countries. To allow manufacturing to get a toehold, the

Infant Industry Argument New industries in developing countries must be temporarily protected from international competition to help them reach a position where they can compete in world markets with the firms of developed nations.

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argument is that governments should temporarily support new industries (with tariffs, import quotas, and subsidies) until they have grown strong enough to meet international competition.

This argument has had substantial appeal for the governments of developing nations during the past 50 years, and the GATT has recognized the infant industry argument as a legitimate reason for protectionism. Nevertheless, many economists remain critical of this argument for two main reasons. First, protection of manufacturing from foreign competi- tion does no good unless the protection helps make the industry efficient. In case after case, however, protection seems to have done little more than foster the development of ineffi- cient industries that have little hope of ever competing in the world market. Brazil, for ex- ample, built the world’s tenth-largest auto industry behind tariff barriers and quotas. Once those barriers were removed in the late 1980s, however, foreign imports soared, and the in- dustry was forced to face up to the fact that after 30 years of protection, the Brazilian auto industry was one of the world’s most inefficient.12

Second, the infant industry argument relies on an assumption that firms are unable to make efficient long-term investments by borrowing money from the domestic or interna- tional capital market. Consequently, governments have been required to subsidize long- term investments. Given the development of global capital markets over the past 20 years, this assumption no longer looks as valid as it once did. Today, if a developing country has a potential comparative advantage in a manufacturing industry, firms in that country should be able to borrow money from the capital markets to finance the required investments. Given financial support, firms based in countries with a potential comparative advantage have an incentive to endure the necessary initial losses in order to make long-run gains without requiring government protection. Many Taiwanese and South Korean firms did this in industries such as textiles, semiconductors, machine tools, steel, and shipping. Thus, given efficient global capital markets, the only industries that would require government protec- tion would be those that are not worthwhile.

Strategic Trade Policy Some new trade theorists have proposed the strategic trade policy argument.13 We reviewed the basic argument in Chapter 6 when we considered the new trade theory. The new trade theory argues that in industries in which the existence of

Even though the United States holds trade sanctions with Cuba, other Western countries continue to trade with the island nation.

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substantial economies of scale implies that the world market will profitably support only a few firms, countries may predominate in the export of certain products simply because they have firms that were able to capture first-mover advantages. The long-term dominance of Boeing in the commercial aircraft industry has been attributed to such factors.

The strategic trade policy argument has two components. First, it is argued that by appropriate actions, a government can help raise national income if it can somehow ensure that the firm or firms that gain first-mover advantages in an industry are domestic rather than foreign enterprises. Thus, according to the strategic trade policy argument, a govern- ment should use subsidies to support promising firms that are active in newly emerging in- dustries. Advocates of this argument point out that the substantial R&D grants that the U.S. government gave Boeing in the 1950s and 1960s probably helped tilt the field of competi- tion in the newly emerging market for passenger jets in Boeing’s favor. (Boeing’s first com- mercial jet airliner, the 707, was derived from a military plane.) Similar arguments have been made with regard to Japan’s dominance in the production of liquid crystal display screens (used in computers). Although these screens were invented in the United States, the Japanese government, in cooperation with major electronics companies, targeted this industry for research support in the late 1970s and early 1980s. The result was that Japanese firms, not U.S. firms, subsequently captured first-mover advantages in this market.

The second component of the strategic trade policy argument is that it might pay a govern- ment to intervene in an industry by helping domestic firms overcome the barriers to entry cre- ated by foreign firms that have already reaped first-mover advantages. This argument underlies government support of Airbus, Boeing’s major competitor. Formed in 1966 as a consortium of four companies from Great Britain, France, Germany, and Spain, Airbus had less than 5 percent of the world commercial aircraft market when it began production in the mid-1970s. By 2012, it had increased its share to 45 percent, threatening Boeing’s long-term dominance of the mar- ket. How did Airbus achieve this? According to the U.S. government, the answer is a $15 billion subsidy from the governments of Great Britain, France, Germany, and Spain.14 Without this subsidy, Airbus would never have been able to break into the world market.

If these arguments are correct, they support a rationale for government intervention in international trade. Governments should target technologies that may be important in the future and use subsidies to support development work aimed at commercializing those tech- nologies. Furthermore, government should provide export subsidies until the domestic firms have established first-mover advantages in the world market. Government support may also be justified if it can help domestic firms overcome the first-mover advantages en- joyed by foreign competitors and emerge as viable competitors in the world market (as in the Airbus and semiconductor examples). In this case, a combination of home-market pro- tection and export-promoting subsidies may be needed.

The Revised Case for Free Trade The strategic trade policy arguments of the new trade theorists suggest an economic justifi- cation for government intervention in international trade. This justification challenges the rationale for unrestricted free trade found in the work of classic trade theorists such as Adam Smith and David Ricardo. In response to this challenge to economic orthodoxy, a number of economists—including some of those responsible for the development of the new trade theory, such as Paul Krugman—point out that although strategic trade policy looks appeal- ing in theory, in practice it may be unworkable. This response to the strategic trade policy argument constitutes the revised case for free trade.15

RETALIATION AND TRADE WAR Krugman argues that a strategic trade policy aimed at establishing domestic firms in a dominant position in a global industry is a beggar-thy-neighbor policy that boosts national income at the expense of other countries. A country that attempts to use such policies will probably provoke retaliation. In many cases, the resulting trade war between two or more interventionist governments will leave all countries involved worse off than if a hands-off approach had been adopted in the first place. If the U.S. government were to respond to the Airbus subsidy by increasing its own subsidies

Strategic Trade Policy Government policy aimed at improving the competitive position of a domestic industry and/or domestic firm in the world market.

LO 7-3 Summarize and explain the arguments against strategic trade policy.

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208 Part Three The Global Trade and Investment Environment

to Boeing, for example, the result might be that the subsidies would cancel each other out. In the process, both European and U.S. taxpayers would end up supporting an expensive and pointless trade war, and both Europe and the United States would be worse off.

Krugman may be right about the danger of a strategic trade policy leading to a trade war. The problem, however, is how to respond when one’s competitors are already being sup- ported by government subsidies; that is, how should Boeing and the United States respond to the subsidization of Airbus? According to Krugman, the answer is probably not to engage in retaliatory action but to help establish rules of the game that minimize the use of trade- distorting subsidies. This is what the World Trade Organization seeks to do.

DOMESTIC POLICIES Governments do not always act in the national interest when they intervene in the economy; politically important interest groups often influence them. The European Union’s support for the Common Agricultural Policy (CAP), which arose because of the political power of French and German farmers, is an example. The CAP benefits inefficient farmers and the politicians who rely on the farm vote, but not consumers in the EU, who end up paying more for their foodstuffs. Thus, a further reason for not embracing strategic trade policy, according to Krugman, is that such a policy is almost certain to be captured by special-interest groups within the economy, which will distort it to their own ends. Krugman concludes that in the United States,

To ask the Commerce Department to ignore special-interest politics while formulat- ing detailed policy for many industries is not realistic; to establish a blanket policy of free trade, with exceptions granted only under extreme pressure, may not be the opti- mal policy according to the theory but may be the best policy that the country is likely to get.16

Development of the World Trading System Strong economic arguments support unrestricted free trade. While many governments have recognized the value of these arguments, they have been unwilling to unilaterally lower their trade barriers for fear that other nations might not follow suit. Consider the problem that two neighboring countries, say, Brazil and Argentina, face when deciding whether to lower trade barriers between them. In principle, the government of Brazil might favor lowering trade barriers, but it might be unwilling to do so for fear that Argentina will not do the same. Instead, the government might fear that the Argentineans will take advantage of Brazil’s low barriers to enter the Brazilian market while continuing to shut Brazilian products out of their market through high trade barriers. The Argentinean government might believe that it faces

the same dilemma. The essence of the problem is a lack of trust. Both governments recognize that their respective nations will benefit from lower trade barriers between them, but neither government is willing to lower barriers for fear that the other might not follow.17

Such a deadlock can be resolved if both countries nego- tiate a set of rules to govern cross-border trade and lower trade barriers. But who is to monitor the governments to make sure they are playing by the trade rules? And who is to impose sanctions on a government that cheats? Both governments could set up an independent body to act as a referee. This referee could monitor trade between the countries, make sure that no side cheats, and impose sanc- tions on a country if it does cheat in the trade game.

While it might sound unlikely that any government would compromise its national sovereignty by submitting to such an arrangement, since World War II an interna- tional trading framework has evolved that has exactly these features. For its first 50 years, this framework was

LO 7-4 Describe the development of the world trading system and the current trade issue.

Do You Believe in Free Trade Agreements? The benefits of free trade agreements are often hard to see. At the same time, the benefits of protecting certain industries and/ or companies from foreign competition are often very visible. Given these scenarios, many people often argue that free trade agreements are bad for their country. Perhaps as a result, many governments impose many tariffs, quotas, and other nontariff barriers to trade. For example, the common perception is that by establishing trade barriers, a country keeps the jobs at home instead of jobs being shipped overseas. But is this really true?

Source: D. J. Boudreaux, “The Benefi ts of Free Trade: Addressing the Myths” Washington, DC; Mercatus Center, George Mason University, 2013.

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Chapter Seven Government Policy and International Trade 209

known as the General Agreement on Tariffs and Trade (GATT). Since 1995, it has been known as the World Trade Organization. Here, we look at the evolution and workings of the GATT and WTO.

FROM SMITH TO THE GREAT DEPRESSION As noted in Chapter 5, the theoretical case for free trade dates to the late eighteenth century and the work of Adam Smith and David Ricardo. Free trade as a government policy was first officially embraced by Great Britain in 1846, when the British Parliament repealed the Corn Laws. The Corn Laws placed a high tariff on imports of foreign corn. The objectives of the Corn Laws tariff were to raise government revenues and to protect British corn producers. There had been annual motions in Parliament in favor of free trade since the 1820s when David Ricardo was a member. However, agricultural protection was withdrawn only as a result of a protracted debate when the effects of a harvest failure in Great Britain were compounded by the imminent threat of famine in Ireland. Faced with considerable hardship and suffering among the populace, Parliament narrowly reversed its long-held position.

During the next 80 years or so, Great Britain, as one of the world’s dominant trading powers, pushed the case for trade liberalization, but the British government was a voice in the wilderness. Its major trading partners did not reciprocate the British policy of unilateral free trade. The only reason Britain kept this policy for so long was that as the world’s largest exporting nation, it had far more to lose from a trade war than did any other country.

By the 1930s, the British attempt to stimulate free trade was buried under the economic rubble of the Great Depression. Economic problems were compounded in 1930 when the U.S. Congress passed the Smoot-Hawley tariff. Aimed at avoiding rising unemployment by protecting domestic industries and diverting consumer demand away from foreign products, the Smoot-Hawley Act erected an enormous wall of tariff barriers. Almost every industry was rewarded with its “made-to-order” tariff. The Smoot-Hawley Act had a damaging effect on employment abroad. Other countries reacted by raising their own tariff barriers. U.S. exports tumbled in response, and the world slid further into the Great Depression.18

1947–1979: GATT, TRADE LIBERALIZATION, AND ECONOMIC GROWTH Economic damage caused by the beggar-thy-neighbor trade policies that the Smoot-Hawley Act ushered in exerted a profound influence on the economic institu- tions and ideology of the post–World War II world. The United States emerged from the war both victorious and economically dominant. After the debacle of the Great Depression, opinion in the U.S. Congress had swung strongly in favor of free trade. Under U.S. leader- ship, the GATT was established in 1947.

The GATT was a multilateral agreement whose objective was to liberalize trade by elim- inating tariffs, subsidies, import quotas, and the like. From its foundation in 1947 until it was superseded by the WTO, the GATT’s membership grew from 19 to more than 120 nations. The GATT did not attempt to liberalize trade restrictions in one fell swoop; that would have been impossible. Rather, tariff reduction was spread over eight rounds.

In its early years, the GATT was by most measures very successful. For example, the av- erage tariff declined by nearly 92 percent in the United States between the Geneva Round of 1947 and the Tokyo Round of 1973–1979. Consistent with the theoretical arguments first advanced by Ricardo and reviewed in Chapter 5, the move toward free trade under the GATT appeared to stimulate economic growth.

1980–1993: PROTECTIONIST TRENDS During the 1980s and early 1990s, the trading system erected by the GATT came under strain as pressures for greater protec- tionism increased around the world. There were three reasons for the rise in such pressures during the 1980s. First, the economic success of Japan during that time strained the world trading system (much as the success of China has created strains today). Japan was in ruins when the GATT was created. By the early 1980s, however, it had become the world’s sec- ond-largest economy and its largest exporter. Japan’s success in such industries as automo- biles and semiconductors might have been enough to strain the world trading system. Things were made worse by the widespread perception in the West that despite low tariff

Smoot-Hawley Act Enacted in 1930 by the U.S. Congress, this act erected a wall of tariff barriers against imports into the United States.

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rates and subsidies, Japanese markets were closed to imports and foreign investment by ad- ministrative trade barriers.

Second, the world trading system was strained by the persistent trade deficit in the world’s largest economy, the United States. The consequences of the U.S. deficit included painful adjustments in industries such as automobiles, machine tools, semiconductors, steel, and textiles, where domestic producers steadily lost market share to foreign competitors. The resulting unemployment gave rise to renewed demands in the U.S. Congress for pro- tection against imports.

A third reason for the trend toward greater protectionism was that many countries found ways to get around GATT regulations. Bilateral voluntary export restraints (VERs) circum- vent GATT agreements, because neither the importing country nor the exporting country complains to the GATT bureaucracy in Geneva—and without a complaint, the GATT bureaucracy can do nothing. Exporting countries agreed to VERs to avoid more damaging punitive tariffs. One of the best-known examples is the automobile VER between Japan and the United States, under which Japanese producers promised to limit their auto imports into the United States as a way of defusing growing trade tensions. According to a World Bank study, 16 percent of the imports of industrialized countries in 1986 were subjected to nontariff trade barriers such as VERs.19

THE URUGUAY ROUND AND THE WORLD TRADE ORGANIZA- TION Against the background of rising pressures for protectionism, in 1986 GATT members embarked on their eighth round of negotiations to reduce tariffs, the Uruguay Round (so named because it occurred in Uruguay). This was the most ambitious round of negotiations yet. Until then, GATT rules had applied only to trade in manufactured goods and commodities. In the Uruguay Round, member countries sought to extend GATT rules to cover trade in services. They also sought to write rules governing the protection of intel- lectual property, to reduce agricultural subsidies, and to strengthen the GATT’s monitoring and enforcement mechanisms.

The Uruguay Round dragged on for seven years before an agreement was reached on December 15, 1993. It went into effect July 1, 1995. The Uruguay Round contained the fol- lowing provisions:

1. Tariffs on industrial goods were to be reduced by more than one-third, and tariffs were to be scrapped on more than 40 percent of manufactured goods.

2. Average tariff rates imposed by developed nations on manufactured goods were to be reduced to less than 4 percent of value, the lowest level in modern history.

3. Agricultural subsidies were to be substantially reduced. 4. GATT fair trade and market access rules were to be extended to cover a wide range of

services. 5. GATT rules also were to be extended to provide enhanced protection for patents,

copyrights, and trademarks (intellectual property). 6. Barriers on trade in textiles were to be significantly reduced over 10 years. 7. The World Trade Organization was to be created to implement the GATT agreement.

The World Trade Organization The WTO acts as an umbrella organization that encompasses the GATT along with two new sister bodies, one on services and the other on intellectual property. The WTO’s General Agreement on Trade in Services (GATS) has taken the lead to extending free trade agreements to services. The WTO’s Agreement on Trade-Related Aspects of Intellectual Property Rights (TRIPS) is an attempt to narrow the gaps in the way intellectual property rights are protected around the world and to bring them under common international rules. WTO has taken over responsibility for arbitrating trade disputes and monitoring the trade policies of member countries. While the WTO operates on the basis of consensus as the GATT did, in the area of dispute settlement, mem- ber countries are no longer able to block adoption of arbitration reports. Arbitration panel reports on trade disputes between member countries are automatically adopted by the WTO unless there is a consensus to reject them. Countries that have been found by the

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arbitration panel to violate GATT rules may appeal to a permanent appellate body, but its verdict is binding. If offenders fail to comply with the recommendations of the arbitration panel, trading partners have the right to compensation or, in the last resort, to impose (com- mensurate) trade sanctions. Every stage of the procedure is subject to strict time limits. Thus, the WTO has something that the GATT never had—teeth.20

WTO: EXPERIENCE TO DATE By 2014, the WTO had 159 members, including China, which joined at the end of 2001, and Russia, which joined in 2012. WTO members collectively account for 98 percent of world trade. Since its formation, the WTO has remained at the forefront of efforts to promote global free trade. Its creators expressed the belief that the enforcement mechanisms granted to the WTO would make it more effective at policing global trade rules than the GATT had been. The great hope was that the WTO might emerge as an effective advocate and facilitator of future trade deals, particularly in areas such as ser- vices. The experience so far has been encouraging, although the collapse of WTO talks in Seattle in late 1999, slow progress with the next round of trade talks (the Doha Round), and a shift back toward some limited protectionism following the global financial crisis of 2008– 2009 have raised a number of questions about the future direction of the WTO.

WTO as Global Police The first two decades in the life of the WTO suggests that its policing and enforcement mechanisms are having a positive effect.21 Between 1995 and 2013, more than 400 trade disputes between member countries were brought to the WTO.22 This record compares with a total of 196 cases handled by the GATT over almost half a century. Of the cases brought to the WTO, three-fourths have been resolved by informal consulta- tions between the disputing countries. Resolving the remainder has involved more formal procedures, but these have been largely successful. In general, countries involved have adopted the WTO’s recommendations. The fact that countries are using the WTO repre- sents an important vote of confidence in the organization’s dispute resolution procedures.

Expanding Trade Agreements As explained earlier, the Uruguay Round of GATT negotiations extended global trading rules to cover trade in services. The WTO was given the role of brokering future agreements to open up global trade in services. The WTO was also encouraged to extend its reach to encompass regulations governing foreign direct investment, something the GATT had never done. Two of the first industries targeted for reform were the global telecommunication and financial services industries.

In February 1997, the WTO brokered a deal to get coun- tries to agree to open their telecommunication markets to competition, allowing foreign operators to purchase owner- ship stakes in domestic telecommunication providers and establishing a set of common rules for fair competition. Most of the world’s biggest markets—including the United States, European Union, and Japan—were fully liberalized by January 1, 1998, when the pact went into effect. All forms of basic telecommunication service are covered, including voice telephone, data, and satellite and radio communica- tions. Many telecommunication companies responded posi- tively to the deal, pointing out that it would give them a much greater ability to offer their business customers one- stop shopping—a global, seamless service for all their corpo- rate needs and a single bill.

This was followed in December 1997 with an agreement to liberalize cross-border trade in financial services. The deal covered more than 95 percent of the world’s financial services market. Under the agreement, which took effect at the beginning of March 1999, 102 countries pledged to

Should a Standard Process Be in Place for Import Licenses? Import licenses are permits granted before a product is imported. The administrative procedures for obtaining the licenses should be simple, neutral, equitable, and transparent. Where possible, they should be given automatically and quickly, and even if they are nonautomatic, they should not obstruct trade unnecessarily. Australia, Turkey, the European Union, Norway, Thailand, the United States, New Zealand, Costa Rica, Colombia, Peru, Chinese Taipei, Japan, the Republic of Korea, Switzerland, and Canada said their producers and traders reported that exports to Argentina have declined or been delayed by Argentina’s licens- ing processes and requirements, which some described as “pro- tectionist.” Should there be a standardized process and timeline for processing import licenses in member countries of the World Trade Organization?

Source: “Members Continue to Criticize Argentina’s Import Licensing,” 2012, www.wto.org/english/news_e/news12_e/impl_27apr12_e.htm.

212 Part Three The Global Trade and Investment Environment

open (to varying degrees) their banking, securities, and insurance sectors to foreign compe- tition. In common with the telecommunication deal, the accord covers not just cross-border trade but also foreign direct investment. Seventy countries agreed to dramatically lower or eradicate barriers to foreign direct investment in their financial services sector. The United States and the European Union (with minor exceptions) are fully open to inward investment by foreign banks, insurance, and securities companies. As part of the deal, many Asian coun- tries made important concessions that allow significant foreign participation in their finan- cial services sectors for the first time.

THE FUTURE OF THE WTO: UNRESOLVED ISSUES AND THE DOHA ROUND Since the successes of the 1990s, the World Trade Organization has struggled to make progress on the international trade front. Confronted by a slower grow- ing world economy after 2001, many national governments have been reluctant to agree to a fresh round of policies designed to reduce trade barriers. Political opposition to the WTO has been growing in many nations. As the public face of globalization, some politicians and nongovernmental organizations blame the WTO for a variety of ills, including high unem- ployment, environmental degradation, poor working conditions in developing nations, fall- ing real wage rates among the lower paid in developed nations, and rising income inequality. The rapid rise of China as a dominant trading nation has also played a role here. Like senti- ments regarding Japan 20 years ago, many perceive China as failing to play by the interna- tional trading rules, even as it embraces the WTO.

Against this difficult political backdrop, much remains to be done on the international trade front. Four issues at the forefront of the current agenda of the WTO are antidumping policies, the high level of protectionism in agriculture, the lack of strong protection for in- tellectual property rights in many nations, and continued high tariff rates on nonagricultural goods and services in many nations. We shall look at each in turn before discussing the latest round of talks between WTO members aimed at reducing trade barriers, the Doha Round, which began in 2001 and is still ongoing.

Antidumping Actions Antidumping actions proliferated during the 1990s. WTO rules allow countries to impose antidumping duties on foreign goods that are being sold cheaper than at home, or below their cost of production, when domestic producers can show that they are being harmed. Unfortunately, the rather vague definition of what consti- tutes “dumping” has proved to be a loophole that many countries are exploiting to pursue protectionism.

Between 1995 and 2012, WTO members had reported implementation of some 4,230 antidumping actions to the WTO. India initiated the largest number of antidumping actions, some 667; the EU initiated 451 over the same period, and the United States, 469. China accounted for 916 complaints, South Korea for 306, the United States for 244, Taiwan for 234, and Japan for 171. Antidumping actions seem to be concentrated in certain sectors of the economy, such as basic metal industries (e.g., aluminum and steel), chemicals, plastics, and machinery and electrical equipment.23 These sectors account for approximately 70 per- cent of all antidumping actions reported to the WTO. Since 1995, these four sectors have been characterized by periods of intense competition and excess productive capacity, which have led to low prices and profits (or losses) for firms in those industries. It is not unreason- able, therefore, to hypothesize that the high level of antidumping actions in these industries represents an attempt by beleaguered manufacturers to use the political process in their na- tions to seek protection from foreign competitors, which they claim are engaging in unfair competition. While some of these claims may have merit, the process can become very po- liticized as representatives of businesses and their employees lobby government officials to “protect domestic jobs from unfair foreign competition,” and government officials, mindful of the need to get votes in future elections, oblige by pushing for antidumping actions. The WTO is clearly worried by the use of antidumping policies, suggesting that it reflects per- sistent protectionist tendencies and pushing members to strengthen the regulations govern- ing the imposition of antidumping duties.

Chapter Seven Government Policy and International Trade 213

Protectionism in Agriculture Another focus of the WTO has been the high level of tariffs and subsidies in the agricultural sector of many economies. Tariff rates on agricul- tural products are generally much higher than tariff rates on manufactured products or services. For example, the average tariff rates on nonagricultural products among developed nations are around 4 percent. On agricultural products, however, the average tariff rates are 21.2 percent for Canada, 15.9 percent for the European Union, 18.6 percent for Japan, and 10.3 percent for the United States.24 The implication is that consumers in these countries are paying significantly higher prices than necessary for agricultural products imported from abroad, which leaves them with less money to spend on other goods and services.

The historically high tariff rates on agricultural products reflect a desire to protect do- mestic agriculture and traditional farming communities from foreign competition. In addi- tion to high tariffs, agricultural producers also benefit from substantial subsidies. According to estimates from the Organization for Economic Cooperation and Development (OECD), government subsidies on average account for about 17 percent of the cost of agricultural production in Canada, 21 percent in the United States, 35 percent in the European Union, and 59 percent in Japan.25 OECD countries spend more than $300 billion a year in agricul- tural subsidies.

Not surprisingly, the combination of high tariff barriers and subsidies introduces signifi- cant distortions into the production of agricultural products and international trade of those products. The net effect is to raise prices to consumers, reduce the volume of agricultural trade, and encourage the overproduction of products that are heavily subsidized (with the government typically buying the surplus). Because global trade in agriculture currently amounts to 10.5 percent of total merchandized trade, the WTO argues that removing tariff barriers and subsidies could significantly boost the overall level of trade, lower prices to consumers, and raise global economic growth by freeing consumption and investment re- sources for more productive uses. According to estimates from the International Monetary Fund, removal of tariffs and subsidies on agricultural products would raise global economic welfare by $128 billion annually.26 Others suggest gains as high as $182 billion.27

The biggest defenders of the existing system have been the advanced nations of the world, which want to protect their agricultural sectors from competition by low-cost pro- ducers in developing nations. In contrast, developing nations have been pushing hard for

Removing barriers to trade and subsidies in agricultural products should benefit consumers.

214 Part Three The Global Trade and Investment Environment

reforms that would allow their producers greater access to the protected markets of the de- veloped nations. Estimates suggest that removing all subsidies on agricultural production alone in OECD countries could return to the developing nations of the world three times more than all the foreign aid they currently receive from the OECD nations.28 In other words, free trade in agriculture could help jump-start economic growth among the world’s poorer nations and alleviate global poverty.

Protecting Intellectual Property Another issue that has become increasingly im- portant to the WTO has been protecting intellectual property. The 1995 Uruguay agree- ment that established the WTO also contained an agreement to protect intellectual property (the Trade-Related Aspects of Intellectual Property Rights, or TRIPS, agreement). The TRIPS regulations oblige WTO members to grant and enforce patents lasting at least 20 years and copyrights lasting 50 years. Rich countries had to comply with the rules within a year. Poor countries, in which such protection was generally much weaker, had 5 years’ grace, and the very poorest had 10 years. The basis for this agreement was a strong belief among signatory nations that the protection of intellectual property through patents, trade- marks, and copyrights must be an essential element of the international trading system. In- adequate protections for intellectual property reduce the incentive for innovation. Because innovation is a central engine of economic growth and rising living standards, the argument has been that a multilateral agreement is needed to protect intellectual property.

Without such an agreement it is feared that producers in a country—let’s say, India— might market imitations of patented innovations pioneered in a different country—say, the United States. This can affect international trade in two ways. First, it reduces the export opportunities in India for the original innovator in the United States. Second, to the extent that the Indian producer is able to export its pirated imitation to additional countries, it also reduces the export opportunities in those countries for the U.S. inventor. Also, one can ar- gue that because the size of the total world market for the innovator is reduced, its incentive to pursue risky and expensive innovations is also reduced. The net effect would be less in- novation in the world economy and less economic growth.

Market Access for Nonagricultural Goods and Services Although the WTO and the GATT have made big strides in reducing the tariff rates on nonagricultural products, much work remains. Although most developed nations have brought their tariff rates on industrial products down to an average of 3.8 percent of value, exceptions still remain. In particular, while average tariffs are low, high tariff rates persist on certain imports into de- veloped nations, which limit market access and economic growth. For example, Australia and South Korea, both OECD countries, still have bound tariff rates of 15.1 percent and 24.6 percent, respectively, on imports of transportation equipment (bound tariff rates are the highest rate that can be charged, which is often, but not always, the rate that is charged). In contrast, the bound tariff rates on imports of transportation equipment into the United States, EU, and Japan are 2.7 percent, 4.8 percent, and 0 percent, respectively. A particular area for concern is high tariff rates on imports of selected goods from developing nations into developed nations.

In addition, tariffs on services remain higher than on industrial goods. The average tariff on business and financial services imported into the United States, for example, is 8.2 percent, into the EU it is 8.5 percent, and into Japan it is 19.7 percent.29 Given the rising value of cross- border trade in services, reducing these figures can be expected to yield substantial gains.

The WTO would like to bring down tariff rates still further and reduce the scope for the selective use of high tariff rates. The ultimate aim is to reduce tariff rates to zero. Although this might sound ambitious, 40 nations have already moved to zero tariffs on information technology goods, so a precedent exists. Empirical work suggests that further reductions in average tariff rates toward zero would yield substantial gains. One estimate by economists at the World Bank suggests that a broad global trade agreement coming out of the current Doha negotiations could increase world income by $263 billion annually, of which $109 bil- lion would go to poor countries.30 Another estimate from the OECD suggests a figure closer to $300 billion annually.31 See the accompanying Country Focus for estimates of the benefits to the American economy from free trade.

Chapter Seven Government Policy and International Trade 215

Looking further out, the WTO would like to bring down tariff rates on imports of non- agricultural goods into developing nations. Many of these nations use the infant industry argument to justify the continued imposition of high tariff rates; however, ultimately these rates need to come down for these nations to reap the full benefits of international trade. For example, the bound tariff rates of 53.9 percent on imports of transportation equipment into India and 33.6 percent on imports into Brazil, by raising domestic prices, help protect inefficient domestic producers and limit economic growth by reducing the real income of consumers who must pay more for transportation equipment and related services.

A New Round of Talks: Doha In 2001, the WTO launched a new round of talks between member-states aimed at further liberalizing the global trade and investment framework. For this meeting, it picked the remote location of Doha in the Persian Gulf state of Qatar. The talks were originally scheduled to last three years, although they have already gone on for 12 years and are currently stalled.

The Doha agenda includes cutting tariffs on industrial goods and services, phasing out subsidies to agricultural producers, reducing barriers to cross-border investment, and limiting the use of antidumping laws. The talks are currently ongoing. They have been characterized by halting progress punctuated by significant setbacks and missed deadlines. A September 2003 meeting in Cancún, Mexico, broke down, primarily because there was no agreement on how to proceed with reducing agricultural subsidies and tariffs; the EU, United States, and India, among others, proved less than willing to reduce tariffs and subsidies to their politically important farmers, while countries such as Brazil and certain West African nations wanted free trade as quickly as possible. In 2004, both the United States and the EU made a determined push to start the talks again. Since then, however, little progress has been made, and the talks are in deadlock, primarily because of disagreements over how deep the cuts in subsidies to agricultural producers should be. As of early 2013, the goal was to reduce tariffs for manufac- tured and agricultural goods by 60 to 70 percent and to cut subsidies to half of their current level—but getting nations to agree to these goals was proving exceedingly difficult. In re- sponse the apparent failure of the Doha Round negotiations to progress, many nations have pushed forward with bilateral free trade agreements. These include the United States and the EU, which in 2013 launched bilateral talks aimed at reducing trade barriers between them.

Estimating the Gains from Trade for America

A study published by the Institute for International Economics tried to estimate the gains to the American economy from free trade. According to the study, due to reductions in tariff barriers under the GATT and WTO since 1947, by 2003 the gross domestic product (GDP) of the United States was 7.3 percent higher than would otherwise be the case. The benefits of that amounted to roughly $1 trillion a year, or $9,000 extra income for each American household per year.

The same study tried to estimate what would happen if America concluded free trade deals with all its trading partners, reducing tariff barriers on all goods and services to zero. Using several methods to estimate the impact, the study concluded that additional annual gains of between $450 billion and $1.3 trillion could be realized. This final march to free trade, according to the authors of the study, could safely be expected to raise incomes of the average American household by an additional $4,500 per year.

The authors also tried to estimate the scale and cost of employ- ment disruption that would be caused by a move to universal free

trade. Jobs would be lost in certain sectors and gained in others if the country abolished all tariff barriers. Using historical data as a guide, they estimated that 226,000 jobs would be lost every year due to ex- panded trade, although some two-thirds of those losing jobs would find reemployment after a year. Reemployment, however, would be at a wage that was 13 to 14 percent lower. The study concluded that the disruption costs would total some $54 billion annually, primarily in the form of lower lifetime wages to those whose jobs were disrupted as a result of free trade. Offset against this, however, must be the higher economic growth resulting from free trade, which creates many new jobs and raises household incomes, creating another $450 billion to $1.3 trillion annually in net gains to the economy. In other words, the estimated annual gains from trade are far greater than the estimated annual costs associated with job disruption, and more people benefit than lose as a result of a shift to a universal free trade regime.

Sources: S. C. Bradford, P. L. E. Grieco, and G. C. Hufbauer, “The Payoff to America from Global Integration,” in The United States and the World Economy: Foreign Policy for the Next Decade, C. F. Bergsten, ed. (Washington, DC: Institute for International Economics, 2005).

country FOCUS

test PREP Use LearnSmart to help retain what you have learned. Access your instructor’s Connect course to check out LearnSmart or go to learnsmartadvantage.com for help.

FOCUS ON MANAGERIAL IMPLICATIONS

TRADE BARRIERS, POLICY ISSUES, AND FIRM STRATEGY What are the implications of all this for business practice? Why should the international manager care about the political economy of free trade or about the relative merits of argu- ments for free trade and protectionism? There are two answers to this question. The first concerns the impact of trade barriers on a firm’s strategy. The second concerns the role that business firms can play in promoting free trade or trade barriers.

TRADE BARRIERS AND FIRM STRATEGY To understand how trade barriers affect a firm’s strategy, consider first the material in Chap- ter 6. Drawing on the theories of international trade, we discussed how it makes sense for the firm to disperse its various production activities to those countries around the globe where they can be performed most efficiently. Thus, it may make sense for a firm to design and engineer its product in one country, to manufacture components in another, to perform final assembly operations in yet another country, and then export the finished product to the rest of the world.

Clearly, trade barriers constrain a firm’s ability to disperse its productive activities in such a manner. First and most obvious, tariff barriers raise the costs of exporting products to a country (or of exporting partly finished products between countries). This may put the firm at a competitive disadvantage to indigenous competitors in that country. In response, the firm may then find it economical to locate production facilities in that country so that it can compete on an even footing. Second, quotas may limit a firm’s ability to serve a country from locations outside of that country. Again, the response by the firm might be to set up production facilities in that country—even though it may result in higher production costs. Such reasoning was one of the factors behind the rapid expansion of Japanese automaking capacity in the United States during the 1980s and 1990s. This followed the establishment of a VER agreement between the United States and Japan that limited U.S. imports of Japa- nese automobiles.

Third, to conform to local content regulations, a firm may have to locate more pro- duction activities in a given market than it would otherwise. Again, from the firm’s per- spective, the consequence might be to raise costs above the level that could be achieved if each production activity was dispersed to the optimal location for that activity. And finally, even when trade barriers do not exist, the firm may still want to locate some pro- duction activities in a given country to reduce the threat of trade barriers being imposed in the future.

All these effects are likely to raise the firm’s costs above the level that could be achieved in a world without trade barriers. The higher costs that result need not translate into a sig- nificant competitive disadvantage relative to other foreign firms, however, if the countries imposing trade barriers do so to the imported products of all foreign firms, irrespective of their national origin. But when trade barriers are targeted at exports from a particular na- tion, firms based in that nation are at a competitive disadvantage to firms of other nations. The firm may deal with such targeted trade barriers by moving production into the country imposing barriers. Another strategy may be to move production to countries whose exports are not targeted by the specific trade barrier.

Finally, the threat of antidumping action limits the ability of a firm to use aggressive pricing to gain market share in a country. Firms in a country also can make strategic use of antidumping measures to limit aggressive competition from low-cost foreign produc- ers. For example, the U.S. steel industry has been very aggressive in bringing antidumping actions against foreign steelmakers, particularly in times of weak global demand for steel and excess capacity. In 1998 and 1999, the United States faced a surge in low-cost steel imports as a severe recession in Asia left producers there with excess capacity. The U.S. producers filed several complaints with the International Trade Commission. One argued

LO 7-5 Explain the implications for managers of developments in the world trading system.

216 Part Three The Global Trade and Investment Environment

Chapter Seven Government Policy and International Trade 217

that Japanese producers of hot rolled steel were selling it at below cost in the United States. The ITC agreed and levied tariffs ranging from 18 percent to 67 percent on im- ports of certain steel products from Japan (these tariffs are separate from the steel tariffs discussed earlier).32

POLICY IMPLICATIONS As noted in Chapter 6, business firms are major players on the international trade scene. Because of their pivotal role in international trade, firms can and do exert a strong influence on government policy toward trade. This influence can encourage protectionism, or it can encourage the government to support the WTO and push for open markets and freer trade among all nations. Government policies with regard to international trade can have a direct impact on business.

Consistent with strategic trade policy, examples can be found of government interven- tion in the form of tariffs, quotas, antidumping actions, and subsidies helping firms and industries establish a competitive advantage in the world economy. In general, however, the arguments contained in this chapter and in Chapter 6 suggest that government interven- tion has three drawbacks. Intervention can be self-defeating because it tends to protect the inefficient rather than help firms become efficient global competitors. Intervention is dan- gerous; it may invite retaliation and trigger a trade war. Finally, intervention is unlikely to be well executed, given the opportunity for such a policy to be captured by special-interest groups. Does this mean that business should simply encourage government to adopt a laissez-faire free trade policy?

Most economists would probably argue that the best interests of international busi- ness are served by a free trade stance, but not a laissez-faire stance. It is probably in the best long-run interests of the business community to encourage the government to aggressively promote greater free trade by, for example, strengthening the WTO. Busi- ness probably has much more to gain from government efforts to open protected markets to imports and foreign direct investment than from government efforts to support cer- tain domestic industries in a manner consistent with the recommendations of strategic trade policy.

This conclusion is reinforced by a phenomenon we touched on in Chapter 1—the in- creasing integration of the world economy and internationalization of production that has occurred over the past two decades. We live in a world where many firms of all national origins increasingly depend for their competitive advantage on globally dispersed produc- tion systems. Such systems are the result of freer trade. Freer trade has brought great ad- vantages to firms that have exploited it and to consumers who benefit from the resulting lower prices. Given the danger of retaliatory action, business firms that lobby their gov- ernments to engage in protectionism must realize that by doing so they may be denying themselves the opportunity to build a competitive advantage by constructing a globally dispersed production system. By encouraging their governments to engage in protection- ism, their own activities and sales overseas may be jeopardized if other governments re- taliate. This does not mean a firm should never seek protection in the form of antidumping actions and the like, but it should review its options carefully and think through the larger consequences.

free trade, p. 196 General Agreement on Tariffs and Trade (GATT), p. 197 tariff, p. 197 specific tariff, p. 197 ad valorem tariff, p. 197 subsidy, p. 198

import quota, p. 199 tariff rate quota, p. 199 voluntary export restraint (VER), p. 200 quota rent, p. 200 local content requirement, p. 200 administrative trade policies, p. 201

dumping, p. 201 antidumping policies, p. 201 countervailing duties, p. 201 infant industry argument, p. 205 strategic trade policy, p. 207 Smoot-Hawley Act, p. 209

Key Terms

218 Part Three The Global Trade and Investment Environment

Critical Thinking and Discussion Questions

1. Do you think governments should consider human rights when granting preferential trading rights to countries? What are the arguments for and against taking such a position?

2. Whose interests should be the paramount concern of government trade policy—the interests of producers (businesses and their employees) or those of consumers?

Summary

This chapter described how the reality of international trade deviates from the theoretical ideal of unrestricted free trade reviewed in Chapter 6. In this chapter, we re- ported the various instruments of trade policy, reviewed the political and economic arguments for government in- tervention in international trade, reexamined the economic case for free trade in light of the strategic trade policy argument, and looked at the evolution of the world trading framework. While a policy of free trade may not always be the theoretically optimal policy (given the arguments of the new trade theorists), in practice it is probably the best policy for a government to pursue. In particular, the long- run interests of business and consumers may be best served by strengthening international institutions such as the WTO. Given the danger that isolated protectionism might escalate into a trade war, business probably has far more to gain from government efforts to open protected markets to imports and foreign direct investment (through the WTO) than from government efforts to protect domestic industries from foreign competition. The chapter made the following points:

1. Trade policies such as tariffs, subsidies, antidumping regulations, and local content requirements tend to be pro-producer and anticonsumer. Gains accrue to producers (who are protected from foreign competitors), but consumers lose because they must pay more for imports.

2. There are two types of arguments for government intervention in international trade: political and economic. Political arguments for intervention are concerned with protecting the interests of certain groups, often at the expense of other groups, or with promoting goals with regard to foreign policy, human rights, consumer protection, and the like. Economic arguments for intervention are about boosting the overall wealth of a nation.

3. A common political argument for intervention is that it is necessary to protect jobs. However, political intervention often hurts consumers, and it can be self- defeating. Countries sometimes argue that it is important to protect certain industries for reasons of national security. Some argue that government should

use the threat to intervene in trade policy as a bargaining tool to open foreign markets. This can be a risky policy; if it fails, the result can be higher trade barriers.

4. The infant industry argument for government intervention contends that to let manufacturing get a toehold, governments should temporarily support new industries. In practice, however, governments often end up protecting the inefficient.

5. Strategic trade policy suggests that with subsidies, government can help domestic firms gain first-mover advantages in global industries where economies of scale are important. Government subsidies may also help domestic firms overcome barriers to entry into such industries.

6. The problems with strategic trade policy are twofold: (a) Such a policy may invite retaliation, in which case all will lose, and (b) strategic trade policy may be captured by special-interest groups, which will distort it to their own ends.

7. The GATT was a product of the postwar free trade movement. The GATT was successful in lowering trade barriers on manufactured goods and commodities. The move toward greater free trade under the GATT appeared to stimulate economic growth.

8. The completion of the Uruguay Round of GATT talks and the establishment of the World Trade Organization have strengthened the world trading system by extending GATT rules to services, increasing protection for intellectual property, reducing agricultural subsidies, and enhancing monitoring and enforcement mechanisms.

9. Trade barriers act as a constraint on a firm’s ability to disperse its various production activities to optimal locations around the globe. One response to trade barriers is to establish more production activities in the protected country.

10. Business may have more to gain from government efforts to open protected markets to imports and foreign direct investment than from government efforts to protect domestic industries from foreign competition.

Use the globalEDGE website (globaledge.msu.edu) to complete the following exercises:

1. You work for a pharmaceuticals company that hopes to provide products and services in New Zealand. Yet management’s current knowledge of this country’s trade policies and barriers is limited. After searching a resource that summarizes the import and export regulation, outline the most important foreign trade barriers your firm’s managers must keep in mind while developing a strategy for entry into New Zealand’s pharmaceutical market.

2. The number of member nations of the World Trade Organization has increased considerably in recent years. In addition, some nonmember countries have observer status in the WTO. Such status requires accession negotiations to begin within five years of attaining this preliminary position. Visit WTO’s website to identify a list of current members and observers. Identify the last five countries that joined the WTO as members. Also, examine the list of current observer countries. Do you notice anything in particular about the countries that have recently joined or have observer status?

Research Task http://globalEDGE.msu.edu

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Rare earth metals are a set of 17 chemical elements in the periodic table and include scandium, yttrium, cerium, and lanthanum. Small concentra- tions of these metals are a crucial ingredient in the manufacture of a wide range of high-technology products, including wind turbines, iPhones, in- dustrial magnets, and the batteries used in hybrid cars. Extracting rare earth metals can be a dirty process due to the toxic acids that are used during the refining process. As a consequence, strict environmental regu- lations have made it extremely expensive to extract and refine rare earth metals in many countries.

Environmental restrictions in countries such as Australia, Canada, and the United States have opened the way for China to become the world’s leading producer and exporter of rare earth metals. In 1990, China ac- counted for 27 percent of global rare earth production. By 2010, this figure had surged to 97 percent. In 2010, China sent shock waves through the high-tech manufacturing community when it imposed tight quotas on the exports of rare earths. In 2009, it exported around 50,000 tons of rare earths. The 2010 quota limited exports to 30,000 tons. The quota remained in effect for 2011 and was increased marginally to around 31,000 tons in 2012 and 2013.

The reason offered by China for imposing the export quota is that sev- eral of its own mining companies didn’t meet environmental standards and had to be shut down. The effect, however, was to dramatically increase prices for rare earth metals outside of China, putting foreign manufacturers at a cost disadvantage. Many observers quickly concluded that the imposi- tion of export quotas was an attempt by China to give its domestic manu- facturers a cost advantage and to encourage foreign manufacturers to move more production to China so that they could get access to lower-cost supplies of rare earths. As news magazine The Economist concluded, “Slashing their exports of rare earth metals has little to do with dwindling supplies or environmental concerns. It’s all about moving Chinese manu- facturers up the supply chain, so they can sell valuable finished goods to the world rather than lowly raw materials.” In other words, China may have been using trade policy to support its industrial policy.

Developed countries cried foul, claiming that the export quotas violate China’s obligations under World Trade Organization rules. In July 2012, the WTO responded by launching its own investigation. Commenting on the investigation, a U.S. administration official said that the export quotas were part of a “deeply rooted industrial policy aimed at providing substantial

China Limits Exports of Rare Earth Materials

3. Given the arguments relating to the new trade theory and strategic trade policy, what kind of trade policy should business be pressuring government to adopt?

4. You are an employee of a U.S. firm that produces personal computers in Thailand and then exports them to the United States and other countries for sale. The personal computers were originally produced in Thailand to take advantage of relatively low labor costs and a skilled workforce. Other possible locations considered at the time were Malaysia and Hong Kong. The U.S. government decides to impose punitive

100 percent ad valorem tariffs on imports of computers from Thailand to punish the country for administrative trade barriers that restrict U.S. exports to Thailand. How should your firm respond? What does this tell you about the use of targeted trade barriers?

5. Reread the Management Focus, “Protecting U.S. Magnesium.” Who gains most from the antidumping duties levied by the United States on imports of magnesium from China and Russia? Who are the losers? Are these duties in the best national interests of the United States?

Chapter Seven Government Policy and International Trade 219

220 Part Three The Global Trade and Investment Environment

competitive advantages for Chinese manufacturers at the expense of non- Chinese manufacturers.”

In the meantime, the world is not sitting still. In response to the high prices for rare earth metals, many companies have been redesigning their products to use substitute materials. Toyota, Renault, and Tesla, for example—all major automotive consumers of rare earth products—have stated that they plan to stop using parts that have rare earth elements in their cars. Governments have also tried to encourage private mining com- panies to expand their production of rare earth metals. By 2012, there were some 350 rare earth mine projects under development outside of China and India. An example, Molycorp, a U.S. mining company, is quickly boosting its rare earth production at a California mine. As a consequence of such actions, by early 2014, China’s share of rare earth output had slipped to 80 percent. This did not stop China from announcing quota limits in 2014 that seemed to be in line with those of 2013.

Sources: Chuin-Wei Yap, “China Revamps Rare-Earth Exports,” The Wall Street Journal, December 28, 2011, p. C3; “The Difference Engine: More Precious than Gold,” The Economist, September 17, 2010; “Of Metals and Market Forces,” The Economist, February 4, 2012; and J. T. Areddy and C. W. Yap, “China Raises Rare- Earth Export Quota,” The Wall Street Journal, August 22, 2012.

CASE DISCUSSION QUESTIONS 1. Which groups benefitted the most from China imposing an export

quota on rare earth metals? Did it give the Chinese domestic manufacturers a significant cost advantage? Did it result in dramatically increased quality and environmental standards?

2. Given that 97 percent of rare earth metal production is now done in China, an increase from 27 percent to 97 percent between 1990 and 2010, do you think countries such as Australia, Canada, and the United States should reconsider their environmental restrictions on product of such metals?

3. The restrictions imposed by China on rare earth metals has resulted in some companies (e.g., Toyota, Renault, Tesla) starting to look for alternatives. They plan to use parts that do not include rare earth metals. Is this a good solution?

Endnotes

1. For a detailed welfare analysis of the effect of a tariff, see P. R. Krugman and M. Obstfeld, International Economics: Theory and Policy (New York: HarperCollins, 2000), Ch. 8.

2. World Trade Organization, World Trade Report 2006 (Geneva: WTO, 2006).

3. The study was undertaken by Kym Anderson of the Univer- sity of Adelaide. See “A Not So Perfect Market,” The Econo- mist; Survey of Agriculture and Technology, March 25, 2000, pp. 8–10.

4. K. Anderson, W. Martin, and D. van der Mensbrugghe, “Dis- tortions to World Trade: Impact on Agricultural Markets and Farm Incomes,” Review of Agricultural Economics 28 (Summer 2006), pp. 168–94.

5. R. W. Crandall, Regulating the Automobile (Washington, DC: Brookings Institution, 1986).

6. J. B. Teece, “Voluntary Export Restraints Are Back; They Didn’t Work the Last Time,” Automotive News, April 23, 2012.

7. Krugman and Obstfeld, International Economics.

8. G. Hufbauer and Z. A. Elliott, Measuring the Costs of Protec- tionism in the United States (Washington, DC: Institute for International Economics, 1993).

9. Alan Goldstein, “Sematech Members Facing Dues Increase; 30% Jump to Make Up for Loss of Federal Funding,” Dallas Morning News, July 27, 1996, p. 2F.

10. N. Dunne and R. Waters, “U.S. Waves a Big Stick at Chinese Pirates,” Financial Times, January 6, 1995, p. 4.

11. Peter S. Jordan, “Country Sanctions and the International Business Community,” American Society of International Law Proceedings of the Annual Meeting 20, no. 9 (1997), pp. 333–42.

A worker in China dries products containing rare earth elements.

Chapter Seven Government Policy and International Trade 221

12. “Brazil’s Auto Industry Struggles to Boost Global Competi- tiveness,” Journal of Commerce, October 10, 1991, p. 6A.

13. For reviews, see J. A. Brander, “Rationales for Strategic Trade and Industrial Policy,” in Strategic Trade Policy and the New International Economics, P. R. Krugman, ed. (Cambridge, MA: MIT Press, 1986); P. R. Krugman, “Is Free Trade Passé?” Journal of Economic Perspectives 1 (1987), pp. 131–44; and P. R. Krugman, “Does the New Trade Theory Require a New Trade Policy?” World Economy 15, no. 4 (1992), pp. 423–41.

14. “Airbus and Boeing: The Jumbo War,” The Economist, June 15, 1991, pp. 65–66.

15. For details see Krugman, “Is Free Trade Passé?”; and Brander, “Rationales for Strategic Trade and Industrial Policy.”

16. Krugman, “Is Free Trade Passé?” 17. This dilemma is a variant of the famous prisoner’s dilemma,

which has become a classic metaphor for the difficulty of achieving cooperation between self-interested and mutually suspicious entities. For a good general introduction, see A. Dixit and B. Nalebuff, Thinking Strategically: The Competitive Edge in Business, Politics, and Everyday Life (New York: W. W. Norton & Co., 1991).

18. Note that the Smoot-Hawley Act did not cause the Great Depression. However, the beggar-thy-neighbor trade policies that it ushered in certainly made things worse. See J. Bhag- wati, Protectionism (Cambridge, MA: MIT Press, 1988).

19. World Bank, World Development Report (New York: Oxford University Press, 1987).

20. Frances Williams, “WTO—New Name Heralds New Powers,” Financial Times, December 16, 1993, p. 5; and Frances

Williams, “GATT’s Successor to Be Given Real Clout,” Financial Times, April 4, 1994, p. 6.

21. W. J. Davey, “The WTO Dispute Settlement System: The First Ten Years,” Journal of International Economic Law, March 2005, pp. 17–28.

22. Information provided on WTO website, www.wto.org/english/ tratop_e/dispu_e/dispu_status_e.htm.

23. Data at www.wto.org/english/tratop_e/adp_e/adp_e.htm.

24. Annual Report by the Director General 2003 (Geneva: World Trade Organization, 2003).

25. Ibid.

26. Ibid.

27. Anderson, Martin, and van der Mensbrugghe, “Distortions to World Trade.”

28. World Trade Organization, Annual Report 2002 (Geneva: WTO, 2002).

29. S. C. Bradford, P. L. E. Grieco, and G. C. Hufbauer, “The Payoff to America from Global Integration,” in The United States and the World Economy: Foreign Policy for the Next Decade, C. F. Bergsten, ed. (Washington, DC: Institute for Interna- tional Economics, 2005).

30. World Bank, Global Economic Prospects 2005 (Washington, DC: World Bank, 2005).

31. “Doha Development Agenda,” OECD Observer, September 2006, pp. 64–67.

32. “Punitive Tariffs Are Approved on Imports of Japanese Steel,” The New York Times, June 12, 1999, p. A3.