By RGE Monitor

As governments around the world fight rising unemployment, falling exports and bank credit crunch, and several central banks are facing liquidity traps, many are turning to restrictions that privilege national producers. These populist measures attempt to minimize growth impact, social unrest and pain from the credit crunch that poses a risk to several ruling governments, especially those facing elections soon. Furthermore, some officials hope that such restrictions will reduce the leakage of the scarce funds used in bank bailouts and fiscal stimulus to other countries.

But as history shows, the impacts of trade protectionism on exports and job creation if any are small in the short-term and instead may lead to global retaliation, and in the long-term result in inefficient allocation of labor and capital and trade distortions, affecting potential output and employment. But given the increased capital flows and labor migration in recent years and dependence on external capital in developed and developing countries to drive domestic demand, asset markets and growth, rising financial and labor protectionism pose an even greater risk of exacerbating the current global recession as trade protectionism did in the recession of 1930s. Increased global integration since the 1930s also indicates the consequences of protectionism will also be larger.

The US and EU’s stance will provide clues to other countries policy towards globalization. So it might be somewhat alarming that US anti-recession policies propose protectionist elements, and Western Europe has rejected a bailout package for Eastern Europe while implementing policies that pose risk to EMU’s ongoing trade, capital and labor integration.

However, there are at least some signs of global policy co-operation to suggest that a return to the Smoot-Hawley era might be less probable. Countries around the world have been coordinating since the crisis began to cut interest rates, inject liquidity into the banking system and contain rising spreads in the money markets. Other instances include countries implementing fiscal stimulus packages, the Fed extending swap lines to South Korea, Singapore, Mexico and Brazil; surplus Asian countries increasing their contribution to the pool of regional swaps; Japan filling IMF’s coffin to help increase assistance to crisis-hit countries in spite of its dire economic situation; and Western European countries willing to offer a case-by-case bailout to some of the Eastern European countries.

Trade protectionism
Plunging global manufacturing activity and consumer demand along with the trade finance crunch, commodity correction and exchange rate fluctuations are already bound to cause a contraction in global trade in 2009. Increasing instances of imposition of trade barriers by countries to restrict imports and promote exports will only exacerbate and prolong the decline in global trade and make export-dependent economies worse-off. Furthermore they may do little to help the imposing countries. However, sharp devaluations in some countries, especially emerging markets may increase import substitution.

Trade barriers such as tariffs are the most common element of protectionism that countries use in difficult times as witnessed during the food shortages in 2008. Countries like Indonesia, India, Vietnam, Ukraine, Russia, Argentina, Ecuador and Turkey have raised import tariffs, duties or laid restrictions on import licenses or quotas.

In their fiscal stimulus packages, several countries are also offering distortionary subsidies, and credit and other incentives for exporting firms to sustain trade flows, especially countries with high export dependence and low domestic demand. But trying to promote exports amid global demand and industrial activity slump might only add to the global excess capacity and deflation pressures.

One of China’s first steps was to reinstate and then increase export rebates which create disincentives to sell goods at home, a move that might only increase the domestic imbalances, as might the government’s efforts to buy grain and metals to support prices.

As WTO bound rates, especially for developing countries, have fallen significantly in recent years, governments have ample room to raise tariffs closer to the bound rate levels without violating WTO rules. And with policymakers preoccupied with domestic economic challenges, Doha trade talks might not be revived in the near-term despite the exhortations of the G7, G20 and other groupings.

Plunging sales and tightened access to domestic and foreign credit have also led many auto companies to seek bailouts from their home governments. Amidst scarce resources and to promote domestic firms over competitors, governments are offering financial assistance to just the domestic auto firms over the foreign-owned ones despite the relative inefficiencies of several of these national champions compared to other global players.

After the US government’s bailout of domestic automakers, GM and Chrysler, several countries including UK, China, Brazil, and Canada and in EU such as Sweden, France, Germany, Italy and Spain have followed suit to help their own auto companies. Western European auto sector support, a move that may hurt Eastern European countries, is seen as a challenge to EU’s single-market ideology even if they have passed EU competition rules. In China’s case, government policy aims to finally consolidate the industry.

But restricting assistance to some firms via loans or loan guarantees, tax incentives to firms and households buying autos, subsidies to undertake R&D and invest in renewable energy is highly distortionary and undermines domestic as well as trade efficiency, particularly if the beneficiaries do not make the difficult cuts required as part of the funding.

There have been growing calls for a global fiscal stimulus policy partly to support global trade, as coordinated action will have a better chance of boosting aggregate demand especially for smaller, open economies. Given that the global supply chain is highly integrated today, import demand by one country will boost exports for other countries and therefore their incomes and import demand, which in turn will boost the source county’s exports. However, to prevent import leakages and promote production and jobs at local firms, fiscal stimulus in countries like US, Spain and France encourage spending on domestically produced goods at the expense of foreign-owned firms and nationals working at those firms.

The US fiscal stimulus package limits sourcing infrastructure spending related goods from WTO signatories like EU, NAFTA and Japan while excluding non-signatories like China, Brazil, India, Russia, Ukraine, Turkey and many other developing countries. Since close to 55% of the infrastructure spending will take place after 2009-10, the impact of this measure on jobs and growth will be limited in the short-term. But this has nevertheless led other countries implementing fiscal stimulus and infrastructure spending to retaliate with similar measures to protect their own jobs and firms. As a result, this will impact jobs at importing firms and also the demand for US exports and jobs, sometimes affecting output and jobs in the same industries and sectors that the policymakers were aiming to protect. As it is, Obama and the Democratic Congress’ stance to renegotiate trade deals to incorporate non-tariff barriers like labor and environmental standards, and promote influence of labor unions has already cautioned the world on the US trade policy going forward even if Obama emphasized the importance of trade on his recent visit to Canada.

Moreover as exports are slowing, several developing countries such as in Asia and Latin America are increasingly favoring an undervalued currency. The initial currency plunge may have been due to deleveraging but given the export collapse, few countries are likely to allow much appreciation. And this is leading other countries to follow suit with the risks being particularly high in Asia, as these export oriented economies might favor competitive devaluations. Some Japanese officials have argued for intervention to weaken the yen, which only recently slipped from the heights where they intervened in the early part of this decade.

The Chinese yuan, which rose about 6% against the US dollar early in 2008, and appreciated more in real terms, returned to its de facto peg at mid-year and even depreciated somewhat. Treasury Secretary Timothy Geithner’s confirmation testimony re-ignited US China currency tensions by noting that President Obama views China as a currency manipulator, a tag that would allow trade retaliation. China has similarly publicly expressed concerns about the value of its large stock of US debt (over $700 billion) acquired in the process of managing its currency. Given the collapse in China’s exports, it is unlikely to allow a stronger currency which might give it little choice but to keep buying US assets, albeit likely at a slower pace than in early 2008.

However, the probability of these measures becoming significant enough to lead to a trade war like the 1930s might be low given that counties understand that retaliation effects will counter-productive for domestic growth and jobs. Moreover, the WTO surveillance mechanism, absent during the 1930s, will help countries go to the WTO court if they face import barriers and thus prevent trade wars.