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Wednesday, June 5, 2002

Debunking free-market dogmatism


Washington's propensity to say one thing and then do something quite different wins few friends. But U.S. determination to protect its domestic steel industry with high antidumping tariffs may not be quite as wicked as most assume. The move flies in the face of claimed U.S. devotion to free-trade principles. But those principles were never quite as fine as they are made out to be.

Free-trade theory says that if a nation tries to protect an industry in which it is noncompetitive, it not only harms nations that can produce the same good more efficiently. It will also harm itself and -- not just because goods produced by the industry will be that much more expensive. By using up resources needed by other and more efficient industries, costs rise throughout the economy. (Free-trade theory owes much to the quaint 19th-century assumptions about decreasing rather than increasing returns to scale.)

But in that case how come Japan made such good progress back in the days when it sought ruthlessly to protect a whole range of noncompetitive domestic industries? Japan showed us how rapidly costs in an industry can fall as production increases behind tariff barriers (increasing rather than decreasing returns to scale). It also showed how the entire industrial base of an economy improves as various industries develop in unison (more increasing returns to scale).

By protecting its steel industry from foreign competition, Japan not only eventually became the world's most efficient steelmaker. In the process, it gained skills and other economies that lowered production costs in other industries. Others following the same route include pre-World War Germany and the U.S., much of East and Southeast Asia, and now China.

Free-trade dogmatists manage to ignore all this. Indeed, thanks to the slogan of globalization, they are getting even more aggressive. In the 1980s, Malaysia developed an efficient car industry through clever protectionist policies. But Tokyo complained bitterly when Indonesia tried to do the same 10 years later.

Obviously there are times when free trade is desirable. But there are also times when protectionism is needed. Free-trade dogmatists don't seem able to get their minds around this kind of subtlety. Like all dogmatists, they want to insist that the principles they have embraced are good for all times and all situations.

The problem of fluctuating exchange rates is a good example. Most currency fluctuations are due to speculators or policy shifts rather than changes in economic fundamentals. This means that rises and falls can have highly protectionist or antiprotectionist results.

For example, if the yen falls by say 10 percent, this is exactly the same as 10-percent tariff protection for all Japanese industries competing with imports, and a 10-percent subsidy for all exporters. The main reason Japanese carmakers today are reporting record profits is the weakening of the yen in recent years.

Yet the free-traders who are so opposed to any hint of tariffs or subsidies in trade matters, accept currency protectionism without even a murmur since currency fluctuations are caused by "free markets." That word "free" really seems to grab them.

Sometimes the dogmatism goes completely overboard. The late '80s saw Australian free-traders launch a furious attack on tariff protection for the domestic car industry. As a result tariffs were reduced by around 20 percent.

Normally this would have meant the loss of an industry crucial to preserving Australia's industrial base. But because earlier tariff cuts had destroyed so many other industries, soaring imports caused a currency collapse of around 50 percent, which meant the car industry gained a net 30 percent protection -- enough to allow it to survive and recoup efficiency. The free traders then boasted how the increased efficiency was due to the drop in tariffs forcing carmakers to be more competitive!

Which brings me back to U.S. willingness to protect its noncompetitive steel industry. To the extent the industry has been hurt by recent over-valuation of the dollar, it is automatically entitled to some protection. To the extent the industry is salvageable and crucial to preserving the U.S. industrial base it is entitled to more protection. Failure to protect that base from the ravages of currency overvaluation in the past is the main reason for the current U.S. trade imbalance. If and when that imbalance causes a collapse of the U.S. dollar comparable to that of the Australian dollar, even the free traders -- the Japanese variety especially -- will have something to worry about.

They should have done their worrying much earlier. In the early '80s when U.S. industries were being badly hit by the then grossly undervalued yen, Washington briefly had the sense to ignore free-trade dogma and threaten an across-the-board duty on all imports from Japan. Sitting on a Japanese Finance Ministry trade-policy committee at the time, one of Japan's better economists, Takashi Hosomi, and myself suggested Japan solve the problem by imposing its own duty on exports to the U.S.

The funds gained would go to Japan rather than the U.S., we argued. Prior action by Japan would also ease trade frictions.

We got nowhere. The free traders were appalled. But as we saw in the recent Shenyang consulate affair, the main problem was the inability of the phenomenalistic Japanese mind to handle the logical abstractions involved.

Currently Japan and other trading nations suffer from China's undervalued currency. Beijing realizes this and is already making plans arbitrarily to force up the prices of some exports. The Chinese mind seems better able to handle trade logic.

Gregory Clark is a former Australian diplomat and honorary president of Tama University. He was also a member of former Foreign Minister Makiko Tanaka's private discussion group on foreign policy matters.


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