Protectionism Threatens Global Economic Recovery

When G20 leaders met last November in Washington, trade was a side issue; urgent efforts focused on stabilizing financial systems and kick-starting economies. When they meet at the April 2009 London Summit, trade must move to center stage. Trade is experiencing a sudden, severe and globally synchronized collapse (see Figure 1).

Protectionist forces have already emerged and will strengthen as the recession gets worse. But this is not 1930s-style protection that relies on transparent tariff barriers. Governments’ crisis-fighting measures have spawned new, murkier forms of protection which discriminate against foreign firms, workers and investors – often in subtle ways. A World Bank database finds 47 trade-restricting measures enacted by G20 members despite their pledge at the Washington summit to eschew such measures. The use of WTO legal protection, such as antidumping measures, is also up sharply.

The book we published on VoxEU.org concludes that protection is not yet a cause of trade’s plunge. It would, however, be irresponsible not to recognize that the mercantilist specter is knocking at everybody’s door and that the recession emboldens protectionist forces inside every G20 member. As Yale professor and former Mexican President Ernesto Zedillo has noted, a perverse feedback between recession and protectionism is no longer an historical reminiscence of the 1930s, but a possible scenario now – hopefully still with a low probability. It is also a scenario that the G20 leaders could rule out with prompt and forceful action at the London Summit.

A protection-recession spiral is one of the few things that have not yet gone wrong in this crisis. The G20 should try to get out in front of the crisis and take concrete steps to ensure the spiral never begins.

In our book, trade experts from around the world provide a list of such steps. The boldest proposal, by Zedillo, is to keep the “peace” by preparing for war. He suggests that countries pledge to use whatever legal means they have at their disposal to retaliate against others for protectionist actions that harm their exports. “All you need,” he writes, “is one major trade partner to commit to retaliation for others to follow suit…We need tough love, not sweet words in our present circumstances.”

Other proposals in the book are more traditional and include a commitment to a more specific and broader standstill on new protection backed up by a real-time surveillance mechanism, a pre-commitment to negotiating the removal of all crisis-linked measures in three years time and a leaders-level negotiation that would get the Doha talks back on track.

The facts are not all in, but two leading explanations of the sharp contraction in trade are the widespread use of international supply chains and the drying up of short-term trade credit. Of these two, the supply chain could be key.

Manufactured exports are no longer made in one nation and sold in another. Today, goods are made via complex, international networks; effectively, nations are nodes in international supply chains, as Yale professor Peter Schott points out in a 2007 column on VoxEU.org. ¹ How does this explain the trade freefall?

Lower US spending on, say, laptops assembled in China, not only lowers Chinese exports: As the laptop parts and components are sourced globally, exports across the entire supply chain fall. The decline in trade is a multiple of the recession-linked decline in US final-good import demand. The point is that trade is measured as the total value of the goods, so the same value-added product crosses borders many times as parts become components, components become intermediate goods and intermediate goods become final goods. This is how international supply chains amplify the trade effects of national downturns in demand.

Supply chains also explain the unusually sudden and synchronized collapse. The supply-chain nodes continuously communicate to keep the parts-and-components flow in line with final goods demand. When the message comes that one less laptop will be assembled in China, the whole chain scales back immediately.

Most international trade involves one company ordering products from another. The exporter faces payments uncertainty, and the buyer faces counterparty risk until the exported good is actually delivered to the foreign port and payment is made. To bridge this uncertainty, the buyer’s and seller’s banks typically issue paired credits, with a letter of credit being a prime example.

The crisis has affected trade finance in two ways: The first is that traders who have always used such trade financing are finding it harder to obtain. Banks no longer trust each other, and so the issuing of paired credit is breaking down, even though trade credit is viewed as a particularly safe credit risk. Trade credits – like all forms of credit – are affected by the generalized credit crunch. The second is that widespread fear of the unknown has led many traders to insist on letters of credit from partners with whom they previously traded on the basis of trust.

It is an iron law of politics that major increases in government intervention in the economy are always accompanied by measures that favor domestic goods, companies, workers and investors. Today’s massive bailouts and fiscal stimulus packages are no exception. Yet this is not Economics 101 protection. This is “murky protectionism” – measures that abuse legitimate discretion allowed by various international trade agreements. Examples include abuses of health and safety regulations and clauses in stimulus packages that confine spending to domestic producers.

So far, developed nations tend to rely on subsidies and regulation, while developing nations deploy all forms of protection, but especially tariffs and other border measures. For example, Russia raised tariffs on used automobiles, and Ecuador raised tariffs on more than 900 items. India banned Chinese toys as supposedly unsafe, and a clause in the recent US stimulus legislation subsidizes the manufacturing of advanced batteries and components, but only for manufacturers located in the US.

Retaliation against foreign measures has not yet been an important motivation, except in the banking and auto sectors. The automotive sector bailouts announced or discussed prove a deliberate pattern of retaliation/reaction. After the US started talks on a massive bailout of US automakers, Britain, Canada, France, Germany, Italy, Russia, Sweden and China are all considering or have implemented auto-industry bailout measures. The real fear is that this sort of retaliation spiral could get going in other sectors, if the G20 fails to act forcefully at their April meeting.

A protectionist spiral in the next nine months would be a tragedy – aborting any hope that the stimulus packages will work and killing any hopes that cooperation on the economic crisis will set the stage for tackling other global commons problems. This simple truth seems to have escaped the attention it deserves – perhaps because the G20 process is guided by finance ministries and central banks.

1 Peter Schott (2007). "How does China compete with developed countries?" VoxEU.org, 10 October. http://voxeu.org/index.php?q=node/599.