This article was first published in the Economic Times on October 27, 2017; Co-author: Jaya Dixit
Former US President George W Bush spoke about democracy and free trade at the ‘Spirit of Liberty: At Home, In the World’, event in New York on October 19 (goo.gl/or7NLi). He spoke of the values that made the US great and said, “conflict, instability, and poverty follow in the wake of protectionism”. On Monday, the US Citizenship and Immigration Services released a memo that ordered its officers to apply the same level of scrutiny to an H-1B extension request as they had to the initial application, consistent with policies “that protect the interests of US workers”.
Amid these stricter H-1B visa norms and US President Donald Trump’s protectionist agenda, there is an ongoing debate if the Indian government should also put some form of restrictions on US companies. This leads to a broader question — when our trading partner engages in protectionism, then is eye for an eye a good idea?
Protectionism refers to restrictions on foreign goods and capital, including human capital, to reduce or eliminate their access to domestic markets. Countries throughout history have utilised this as a tool under the misguided belief that prosperity comes from helping domestic firms against competition from foreign markets. While protectionism protects domestic firms from outside competition, it results in inefficient allocation of resources, higher cost for consumers and possible non-fulfillment of demand. On the contrary, free trade allows for goods and capital to flow into businesses where the firms have a comparative advantage.
Competition frees up capital that is tied up with firms that are not good at what they do, either in terms of quality or efficient use of resources. Foster Competition Hence, competitive forces, be it international or domestic, lead firms to become more efficient through consolidation or development of technology and skills.
This, in the longterm, is beneficial to the firm, the customers and the country. So should protectionism be answered by protectionism? Proponents claim that subsidies by international governments are unfair and, hence, we must do something to protect our businesses. However, eye for an eye strategy in this case leads to a worse deal for domestic consumers who could have enjoyed cheaper products leading to greater discretionary income that can be re-invested into the economy. In addition, subsidies, tax breaks etc. to some, and not to others, exist even within domestic markets.
Furthermore, in the extreme case where an entire industry is displaced, the freed-up capital would be put to its highest valued uses. Any unemployment caused will only be temporary in nature. While painful in the interim, it would lead to better outcomes in the medium to long term.
In the early 1990s, there was a lot of opposition to economic reforms from the informal group of Indian industrialists known as the ‘Bombay Club’. Perhaps they thought, similar to several countries implementing protectionist measures nowadays, that opening up of borders would harm their bottom-line, expose them to competition from companies with better technologies that came from countries that had enjoyed advantages of free market much longer than they had. Avoid A Counteroffensive Their resistance was unfounded. Indian businesses did very well and contributed significantly to the growth of India ‘even after’ liberalisation.
In fact, after markets were opened to foreign capital and goods in the 1990s, founding of new businesses — both by business groups and stand-alone firms — increased tremendously as shown in a research paper by Murali Chari and Jaya Dixit (‘Business Groups and Entrepreneurship in Developing Countries After Reforms’, Journal of Business Research, 2015, goo.gl/FZDx3V).
When free markets are allowed to function they increase the size of the pie that can be shared leading to benefits for domestic businesses, consumers and the nation. Even if a country erects trade barriers, responding in kind would not be beneficial. For example, in the current case of H-1B visa restrictions, it would not be in India’s benefit to respond with trade and capital restrictions on US companies. One likely scenario due to the H1B restrictions and other US protectionist measures is that US companies may feel pressured to disaggregate their value chains leading to setting up of more offices, R&D centres, manufacturing facilities abroad.
In such a scenario, countries that provide the most pro-business environment will be benefitted. This is only one scenario. But there could be other scenarios where US protectionism is beneficial for other countries, but not if they respond with protectionism. So then is the protectionist rhetoric a good idea to dissuade other countries from adopting protectionist policies? For example, is it a good strategy politically to have a rhetoric of tit-for-tat with respect to protectionism, in order to put pressure on US policymakers while having no intention of putting these restrictions in place?
This is a slippery slope, as any policy rhetoric is also a negative signal to US companies that may be trying to find new home for themselves and searching for new markets. Two wrongs do not make a right and neither does answering protectionism by protectionism. The costs of protectionism are far greater, even if not obvious, than the transitory costs of moving to a free market. Free trade works regardless of whether any other country engages in it.