What Is Protectionism?

Protectionism and Its Impact on Global Investments

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"If there were an Economist's Creed, it would surely contain the affirmations 'I understand the Principle of Comparative Advantage' and 'I advocate Free Trade'." - Paul Krugman, Economist

Protectionism is a word that's commonly used in the financial media, but it's a concept that is widely misunderstood by the general public. While most people agree the term has a negative connotation, the same people will argue for the need to protect local domestic manufacturing jobs from cheaper foreign products entering the market from China or Japan.

Defining Protectionism

Protectionism consists of economic policies that restrict trade between countries to promote fair competition. For instance, the United States may feel that China is undervaluing its currency to make exports cheaper and impose a tariff on certain goods imported from the country. Tariffs are only one form of protectionism.

Most of the time, protectionism stems from a desire to help improve domestic manufacturers by making them more competitive with imported goods. And often times, these desires result from a weak job market that could be improved with more domestic manufacturing jobs. Unfortunately, economists believe that many of these efforts may be misguided.

In other cases, a government may only be seeking to protect a single strategic industry. For example, many countries imposed tariffs on Chinese photo voltaic solar panels after the country began dumping them into the global market to handle an oversupply due to a slowdown in demand. The goal was to protect their own domestic solar operations and ensure energy security in the future.

Types of Protectionism

Protectionism has a broad definition that encompasses a number of different economic policies designed to restrict trade and boost domestic manufacturing. From new taxes to import restrictions, these policies are implemented by both emerging markets and developed economies alike, and can have a negative impact on global free trade.

Some of the most popular protectionist policies include:

  • Import tariffs–Taxing imported goods increases the cost to importers and raises the price of the imported goods in local markets.
  • Import quotas–Limiting the number of goods that can be produced abroad and sold domestically limits foreign competition in domestic markets.
  • Domestic subsidiesSubsidizing costs or providing cheap loans to domestic companies can increase their competitiveness against foreign imports.
  • Exchange rates–Intervening in the foreign exchange (forex) market to lower a currency's valuation can raise the cost of imports and lower the cost of exports.
  • Administrative barriers–Excessive government regulations can place huge burdens on foreign imports, making it difficult to sell them in domestic markets.

Costs of Protectionism

There's little question among economists that protectionism is harmful, with costs that far outweigh benefits over the long run. Comparative advantage provides much of the rationale for this argument, saying that two countries can benefit from free trade, even if one is more efficient in the production of all goods than the other.

For instance, suppose that China can produce 10 toys and 10 appliances per hour, while the United States can produce only 3 appliances or 6 toys per hour. The United States has a comparative advantage in toys and can trade them with China for appliances. Without trade, the opportunity cost per appliance was 2 toys, but that cost can be reduced to 1 toy by trading with China.

These concepts can seem counter-intuitive to non-economists, but are extremely important to understand for politicians and international investors considering the ramifications of protectionist policies on a country's long-term economic growth.

Arguments for Protectionism

Despite the beliefs held by many mainstream economists, there are many economists who argue for protectionism. Many of these economists insist that the mobility of capital around the world undercuts comparative advantage, as capital can move to wherever costs are lowest to pursue an absolute advantage, thereby eliminating the key premise.

Proponents for protectionism further argue that nearly all developed countries have successfully implemented protectionist programs. For example, the U.S. auto industry has been a consistent beneficiary of protectionism and has flourished for the most part over the past several decades, despite cheaper competition from Japan and Germany.

These arguments seem to hold true in specific situations, but it's difficult to determine cause and effect when looking at why a specific industry has succeeded. For example, the U.S. auto industry may have succeeded despite protectionism due to higher quality or better marketing.

Key Points

Protectionism consists of a number of economic policies designed to restrict free trade and boost domestic manufacturing and the products they produce. Many economists argue that protectionism has a net negative effect on economic growth, but there are arguments on both sides. Many developed countries actively implement protectionist policies, while, in many cases, emerging markets tend to support free trade.