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April 15.

eCONOMIG
GOMMeNTORY
Federal Reserve Bank of Cleveland

On the Political Economy
of Trade Restraints
by Jerry L. Jordan

Xf you laid all the economists in the
world end to end. or so the story goes.
they would never reach a conclusion. On
one subject, at least, this maxim is inaccurate. Virtually all economists agree
that only a liberal world trading order can
make every nation better off. They understand, as did Adam Smith, that free
trade is truly the source and essence of
the wealth of nations. This ideal, however, has never been realized. Instead, history charts a continual ebb and flow of
protectionism. We can point to countries,
rich in human and natural resources, that
have withered behind trade barriers, and
others, lacking such endowments, that
have traded their way to world prominence.
Over the last 50 years, western nations
have largely held the corrosive effects
of these protectionist tides in check and
have even reclaimed some lost ground.
Recent events, however, suggest that
we may now have seen their low-water
mark, at least for a while. The Uruguay
Round of the General Agreement on
Tariffs and Trade (GATT). which has
been the primary vehicle for advancing
the ideal of free trade for the past 46
years, is now stalled. Trade relations
among the United States, Japan, and
the European Community (EC) seem
more strained than usual, and movements toward trading blocs in North
America and Europe, under some circumstances, could raise ominous possibilities for future conflicts.
Most disconcerting, however, is the
United States' recent departure from its

ISSN (M2K-1276

traditional role as a vigorous, unequivocal advocate of liberal trade. We now
seem more willing to embrace arguments
for industrial policies and selective
trade restraints based ultimately on the
proposition that private markets fail to
function perfectly.
Industrial societies have two broad
choices: They can allocate resources
through market mechanisms or through
political forums. The former ideally
produces a distribution of resources
perfectly consistent with economic efficiency, while the latter ideally furnishes
a distribution of resources perfectly compatible with broader, democratically de-*.
termined norms of social justice. In practice, both the market mechanism and the
political approach fall short of their philosophical goals.
The case for free trade, which I will
make here, rests not on the argument
that private markets function perfectly,
but on the proposition that the failures
resulting from the political approach
are far greater and pose a more serious
threat to both our personal freedom and
our economic performance than do the
failures of private markets.
• Markets
Economists have long recognized that
free, competitive markets foster the most
efficient use of real resources and that
expanding markets through international
trade magnifies these gains. Moreover—
and more important—economists recog-

Economists advocate free trade not because private markets function perfectly,
but because the alternative, allocating
resources through the political arena,
poses a far greater threat to individual
freedom and economic performance
than do market imperfections. Only free
trade has the potential to enhance the
welfare of all nations .simultaneously.

nize that all trading countries can share
in the benefits from trade.
The welfare gains from international
trade stem from both specialization in
production and exchange among nations. Each, however, can involve transitional difficulties. Specialization, for
example, requires a shift of economic
activity from the least efficient to the
most efficient producers. Such reorganizations are often slow, typically
create transitory unemployment, and
can permanently affect the distribution
of income within countries. Nevertheless, these shifts are necessary to foster
continuing improvements in living
standards, and they are often inevitable
even when trade is not their catalyst.
Nations cannot realize the gains from
specialization without also engaging in
exchange. As this implies, we measure
the benefits of trade in terms of greater
imports or, more specifically, by our
ability to acquire additional units of

imports at lower unit costs. Usually,
countries pay for their foreign purchases out of current exports, but sometimes they finance their imports with
claims on future resources. That is.
they run trade deficits. This does not
imply thai deficit countries do not
benefit from trade, nor does it indicate
that foreigners engage in unfair trading
practices. Rather, it ultimately reflects
a national preference for consumption
over saving.
The claim that free international trade enhances economic welfare rests on a number of assumptions that ensure complete,
competitive markets and guarantee a minimal role for government. These concern
the nature of goods, the number of buyers
and sellers, their access to information,
and the existence of property rights.
Economists refer to serious violations of
these underlying assumptions as market
failures, which can then justify government intervention.
Recently, some have theorized that
under specific types of market failure,
government involvement in international trade can improve a nation's welfare.
Sometimes, for example, the unit costs
of production decline when a firm increases the scale of its operations or
when the size of its entire industry expands. Scale economies often breed
markets dominated by a few large
firms. These firms can then eam economic rents, or profits in excess of what
a more competitive environment might
yield. Nevertheless, international trade
theory suggests that even with such
market imperfections, countries can
still benefit from international trade in
the sense of being able to consume
more goods at lower prices.
International trade is the vehicle through
which firms might achieve economies
of scale. In fact, economists believe
that economies of scale explain a substantial portion of world trade, particularly among large industrialized nations.
Unfortunately, international trade
theory tells us little about the pattern
of trade—that is. which countries will
export which goods—when economies

of scale are involved. Some patterns
may simply reflect historical accidents.
(Swiss watches are a noted example.)
This creates the possibility that, through
the instruments of industrial policy,
governments can modify the international pattern of trade to their national
advantage. By offering a subsidy, for
example, a government might enable a
domestic firm to capture a bigger share
of the world market and. hopefully,
economic rents that exceed the cost of
the initial subsidy." One nation then
gains at the expense of another. Judging from its recent choice of jargon, including "'managed trade," "aggressive
unilateralism." and "comparable access," the Clinton administration seems
inclined to view trade as a zero-sum
game and is entertaining such policies.
These arguments are not new. They
have closely related antecedents that attained academic respectability with
John Stuart Mills' 1848 edition of the
Principles of Political Economy: Although economists since Mills have
acknowledged these arguments as
theoretically insightful/most do not accept them as prescriptions for national
policy. These theories have never
shaken our profession's belief in the
viability of markets and the importance
of free trade.
Economists have challenged the policy
prescriptions of the new, strategic-trade
models on many points, but the greatest
shortcoming of these theories arises
from their idyllic view of governments
and the political process. They portray
the government as a referee that acts to
maximize a nation's collective welfare
in the face of specific and identifiable
market failures. The government then
imposes taxes, tariffs, and subsidies
that address the particular failure, without creating distortions elsewhere in
the economy. Political officials next apportion the financial rewards resulting
from their actions evenly across all segments of society. Finally, the policy
recommendations typically assume that
foreign governments will sit passively
by while all this occurs.

As one can see. the model makes a number of rather stringent assumption* about
the nature of democratic processes. Economists refer to serious violations of these
assumptions as government failures. Will
substituting government failures for market failures make us better off?
• Politics
Economic policies inevitably redistribute
income. Consequently, these concerns,
rather than arguments about economic
efficiency, often dominate policy debates
in countries with democratically elected
governments. Trade restraints exist because they confer substantial financial
benefits on certain segments of society.
Limitations on the importation of foreign
steel, for example, reward domestic steel
producers by enabling them to sell more
at home at higher prices. Trade regulations obviously impose economic burdens
on others. In the steel example, users of
domestic steel must pay more. Restraints,
then, benefit some at the expense of
others, with a net loss to all because of the
economic inefficiencies that ensue.
Both the gainers and losers have incentives to organize: one to seek trade restraints, the other to avoid them. The
benefits of trade restraints, however,
usually accrue to a relatively small,
'concentrated, and easily identifiable
group, while the costs are borne by a
much wider portion of society. Who
in fact knows how much the latest
tariffs on steel imports will cost him or
her personally? You can be sure that
the steel producers have calculated
their gains. Firms that use steel also
know their cost increases, but this
group is so diverse that the expense of
organizing and lobbying strenuously
against the restraints undoubtedly exceeds the expense of passing the costs on
to consumers.
Now extrapolate this problem across all
goods and services subject to various
types of trade restrictions. The typical
voter has little ability or incentive to
discern the costs of trade restraints on
his income and thus can offer only marginal resistance to the proliferation of
such policies.

With the benefits of trade restraints so
highly skewed, it is little wonder that
Congress is amenable to protectionist
pressures. Those expecting to profit from
national industrial policies have strong incentives to lobby and to exhaust real economic resources to secure such market
privileges.6 The president and many of
our current freshmen congressmen were
elected in part because they promised to
either amend or oppose the North American Free Trade Agreement (NAFTA), and
interest groups now expect to collect on
their election bets.
When we demonstrate a willingness to
allocate resources through the political
arena instead of through the market, we
encourage individuals to reduce their
investments in private economic activities and to increase their investments
in political speculation. Through this
unfortunate arbitrage, we are all eventually made poorer.
• Checks and Balances
Although democratically elected governments seem predisposed to interventionist, beggar-thy-neighbor policies—
particularly when such policies have
some intellectual credence—two important factors seem to check this inclination, albeit tenuously at times.

these changes. Perhaps the most important of such developments is the business cycle. When economic activityslows and unemployment rises, protectionist sentiments grow. When the
economy once again approaches full
potential, such sentiments abate.
Other, more structural events can be
equally disruptive. Changes in energy
prices, reductions in the demand for
military goods, and the introduction of
computers and robots to production
processes create winners and losers and
possible repercussions for national
trade policies.
Other constraints on protectionism are
external. After a devastating trade war
in the early 1930s contributed to the
Great Depression, most industrialized
countries came to accept that free trade
offers the only positive-sum game. That
is, it is the sole feasible trading arrangement with the potential to enhance all
nations' economic well-being simultaneously. At any given point, an individual country might temporarily improve
its economic lot through trade restraints,
but if many more countries follow suit,
each will be made much worse off than if
all had maintained free trade.

The first factor is internal. Trade restraints
place costs on society that, although diffused and difficult to measure, do add up
as restrictive legislation proliferates. Even
the most ardent seventeenth century mercantilists realized that a nation cannot export if it does not import. A substantial
portion of our industries either sell foreign
goods or use them in their production
processes, and virtually every American
household benefits from some foreign
products. The costs of additional trade restraints build until, at some point, they
outweigh the benefits, and elected governments will not increase them further.

Because of this "prisoners' dilemma"
aspect of trade policy, it is imperative that
each country repeatedly signal its commitment to liberal markets and its willingness to solve trade disputes within a multilateral framework.7 Since 1947. GATT
has provided just such a forum through
its ongoing negotiations and its twin principles of reciprocity and most-favorednation status. Within a continuing commitment to GATT. the world can more
readily tolerate the inevitable, temporary
deviations from the ideal of liberal trade,
knowing that a transgressor has not abandoned the ideal and having a mechanism
by which to judge and sanction the offending nation's actions collectively.

But this "equilibrium" point changes.
In due course, the evolution of any
dynamic economy will precipitate
resource reallocation that leaves some
segments of society better off and
others worse off. Often, a surge of protectionist pressures is a repercussion of

Unfortunately, many trade specialists
now believe that GATT is in trouble for
reasons that go beyond the immediate
problems of the Uruguay Round. The
proliferation of non-tariff barriers and
"voluntary" export restraints, often not

explicitly prohibited in the agreement,
is one important reason. The relative
decline in U.S. economic leadership
may be another. Moreover, the threat of
communism, which was an effective
catalyst to western cohesion and which
may have encouraged multilateral trade
negotiations, has faded. Whatever the
causes, multilateral trade agreements
seem increasingly difficult to achieve.
In part because of the problems of working within GATT. interest in preferential
trading agreements like NAFTA and the
EC is growing. These two trade blocs so
far include countries with close, longestablished economic interdependencies.
By removing trade barriers and enhancing
the benefits of specialization and exchange, they promise to strengthen existing economic ties among their members.
Moreover, both trading blocs are poised
to grow eventually—NAFTA through
Central and possibly South America, and
the EC through Scandinavia and Eastern
Europe—thereby furthering the gains
from liberalized trade.
Preferential trading arrangements can be
a two-edged sword, however. While enhancing trade among participating
countries, they can also reduce economic
well-being by diverting trade away from
efficient producers outside the bloc.
Moreover, many fear that by increasing
the collective economic power of member countries, such accords could encourage the strategic use of trade policies. Ironically, then, the long-term
effects of trading blocs like NAFTA and
the EC may depend on the existence of a
multilateral agreement like GATT that
can prevent preferential agreements
from becoming vehicles for trade wars.
• Conclusion
The United States is the most prosperous
nation on earth. We have maintained that
status not because we have more natural
resources, not because we have a more
powerful army, and not because our children are brighter or our executives more
clever than those elsewhere in the world.
We have done so because, more than any
other country in history, we have relied
on market mechanisms, despite their

imperfections, rather than on political
decisions to allocate our resources.
Many contend that Germany and Japan
—our current rivals for economic preeminence—have managed to close the
economic gap through national industrial policies and managed trade, a
course we should now imitate. While
both of these countries have made advances, arguably with more government
involvement than in the United States.
I question the now-fashionable conclusion that industrial policy and managed
trade are the sources of their success. No
one seriously believes that we should
follow an industrial policy like those of
Great Britain and Sweden, or like the
managed trade policies of the former
Soviet bloc. 1 suggest, therefore, that the
postwar advances in both Germany and
Japan have more to do with the willingness of their citizens to embrace economic liberalism and to compete vigorously on a global scale than with their
governments" involvement in markets.

• Footnotes
1. See Paul R. Krugman, "Is Free Trade
Passe?" Journal of Economic Perspectives.
vol. 1. no. 2 (Fall 1987). pp. 131-44.
2. Two seminal studies on strategic trade are
James A. Brander and Barbara J. Spencer.
"International R&D Rivalry and Industry
Strategy," Review of Economic Studies, vol.
50. no. 4 (1983), pp. 707-22: and "Export Subsidies and International Market Share Rivalry."
Journal of International Economics, vol. 16,
no. 1/2 (February 1985), pp. 83-100.
3. For a historical perspective, see Douglas
A. lrwin, "Free Trade at Risk: A Historical
Perspective." Board of Governors of the
Federal Reserve System. International
Finance Discussion Paper No. 391. December 1990.
4. This argument is based on George J.
Stigler. "The Economics of Information,"
Journal of Political Economy, vol. 69. no. 3
(June 1961). pp. 213-25.

7. Prisoners' dilemma refers 10 a strategicsituation where the policy choice promising
the best outcome for an individual is optimal
only if others do not respond in kind. When
all adopt the same self-focused policy, this
outcome becomes the worst course of action.
An alternative policy choice that considers
the response of the group, rather than of the
isolated individual, then becomes the best.
See David M. Kreps. A Course in Microeconomic Theory Princeton. N.J.: Princeton
University Press. 1990.

Jfrn 1 L. Jordan is president of the Federal
Reserve Bank of Cleveland. Tins Economic
Commentary is adapted from a speech lie
presented to the 1993 Annual Miles International Conference on Trade Issues.
Cleveland, on April 22. 1993.

5. This view of voters stems from Anthony
Downs. An Economic Analysis of Democracy. New York: Harper & Row. 1957.
6. See Gordon Tullock. "The Welfare Costs
of Tariffs. Monopolies, and Theft." Western
Economic Journal, vol. 5 (June 1967).
pp. 224-32.

Markets, like political systems, do not
function perfectly, but they offer the
only game in which all nations can be
made better oft. This is not a theoretical point, but an observation on history.

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