Chapter 5 Outline

The Case for Government Intervention

Now that we have reviewed the various instruments of trade policy, it is time to take a more detailed look at the case for government intervention in international trade. In general, there are two types of argument for government intervention, political and economic. Political arguments for intervention are concerned with protecting the interests of certain groups within a nation (normally producers), often at the expense of other groups (normally consumers). Economic arguments for intervention are typically concerned with boosting the overall wealth of a nation (to the benefit of all, both producers and consumers).

Political Arguments for Intervention

Political arguments for government intervention cover a range of issues including protecting jobs, protecting industries deemed important for national security, retaliating to unfair foreign competition, protecting consumers from "dangerous" products, furthering the goals of foreign policy, and protecting the human rights of individuals in exporting countries.

Protecting Jobs and Industries

Perhaps the most common political argument for government intervention is that it is necessary for protecting jobs and industries from foreign competition. Antidumping policies are frequently justified on such grounds. The voluntary export restraints that offered some protection to the US automobile, machine tool, and steel industries during the 1980s were motivated by such considerations. Similarly, Japan's quotas on rice imports are aimed at protecting jobs in that country's agricultural sector. The same motive underlay the establishment of the Common Agricultural Policy (CAP) by the European Union. The CAP was designed to protect the jobs of Europe's politically powerful farmers by restricting imports and guaranteeing prices. However, the higher prices that resulted from the CAP have cost Europe's consumers dearly. This is true of most attempts to protect jobs and industries through government intervention. As we saw earlier in the chapter, all that the VER in the automobile industry did was raise the price of Japanese imports, at a cost of $1 billion per year to US consumers.

In addition to trade controls hurting consumers, evidence also indicates they may sometimes hurt the producers they are intended to protect. In Chapter 4, for example, we noted how the VER agreement in the US machine tool industry has been self-defeating. By limiting Japanese and Taiwanese machine tool imports, the VER raised the prices of machine tools purchased by US manufacturers to levels above those prevailing in the world market. In turn, this raised the capital costs of the US manufacturing industry, thereby decreasing its international competitiveness.

National Security

Countries sometimes argue that it is necessary to protect certain industries because they are important for national security. Defense-related industries often get this kind of attention (e.g., aerospace, advanced electronics, semiconductors, and so on). Although not as common as it used to be, this argument is still made. Those in favor of protecting the US semiconductor industry from foreign competition, for example, argue that semiconductors are now such important components of defense products that it would be dangerous to rely primarily on foreign producers for them. In 1986, this argument helped convince the federal government to support Sematech, a consortium of 14 US semiconductor companies that accounts for 90 percent of the US industry's revenues. Sematech's mission is to conduct joint research into manufacturing techniques that can be parceled out to members. The government saw the venture as so critical that Sematech was specially protected from antitrust laws. Initially, the US government provided Sematech with $100 million per year subsidies. By the mid-1990s, however, the US semiconductor industry had regained its leading market position, largely through the personal computer boom and demand for microprocessor chips made by Intel. In 1994, the consortium's board voted to seek an end to federal funding, and since 1996 the consortium has been funded entirely by private money.⁹

Retaliation

Some argue that governments should use the threat to intervene in trade policy as a bargaining tool to help open foreign markets and force trading partners to "play by the rules of the game." Successive US governments have been among those that adopted this get-tough approach. The US government has used the threat of punitive trade sanctions to get the Chinese government to enforce its intellectual property laws. As you will recall from Chapter 2, lax enforcement of these laws had given rise to massive copyright infringements in China that have been costing US companies such as Microsoft hundreds of millions of dollars per year in lost sales revenues. After the United States threatened to impose 100 percent tariffs on a range of Chinese imports, and after harsh words between officials from the two countries, the Chinese backed down and agreed to tighter enforcement of intellectual property regulations.¹⁰

If it works, such a politically motivated rationale for government intervention may liberalize trade and bring with it resulting economic gains. It is a risky strategy, however, because a country that is being pressured might not back down and instead may respond to the punitive tariffs by raising trade barriers of its own. This is exactly what the Chinese government threatened to do when pressured by the United States, although the Chinese ultimately did back down. If a government does not back down, however, the results could be higher trade barriers all around and an economic loss to all involved.

Protecting Consumers

The opening case describes how the European Union banned the sale and importation of hormone-treated beef. The ban was motivated by a desire to protect European consumers from the possible health consequences of meat treated with growth hormones. It was motivated by concerns for the safety and health of consumers, as opposed to economic considerations. Many governments have long had regulations to protect consumers from "unsafe" products. Often, the indirect effect of such regulations is to limit or ban the importation of such products. Another example concerns the 1998 decision by the Clinton administration to permanently ban imports into the United States of 58 types of military-style assault weapons (the United States already prohibits the sale of such weapons by US-based firms). The ban was motivated by a desire to increase public safety. It followed a rash of random and deadly shootings by deranged individuals using such weapons, including one in the president's home state of Arkansas that left four children and a schoolteacher dead.¹¹

The conflict over the importation of hormone-treated beef into the European Union may prove to be a taste of things to come. In addition to the use of hormones to promote animal growth and meat production, biotechnology has made it possible to genetically alter many crops so that they are resistant to common herbicides, produce proteins that are natural insecticides, have dramatically improved yields, or can withstand inclement weather. One example is a new breed of genetically modified tomatoes that have an antifreeze gene inserted into their genome and can be grown in colder climates than hitherto possible. Another example is a genetically engineered cotton seed produced by Monsanto. The seed has been engineered to express a protein that provides protection against three common insect pests--the cotton bollworm, tobacco budworm, and pink bollworm. Use of this seed reduces or eliminates the need for traditional pesticide applications for these pests. As enticing as such innovations sound, they have met with intense resistance from consumer groups, particularly in Europe. The fear is that the widespread use of genetically altered seed corn could have unanticipated and harmful effects on human health and may result in "genetic pollution." (An example of genetic pollution would be when the widespread use of crops that produce "natural pesticides" stimulates the evolution of "super-bugs" that are resistant to those pesticides.) Such concerns have led Austria and Luxembourg to outlaw the importation, sale, or use of genetically altered organisms. Strong sentiment against genetically altered organisms also exists in several other European countries, most notably Germany and Switzerland. It seems increasingly likely, therefore, that the World Trade Organization will be drawn into the conflict between those that want to expand the global market for genetically altered organisms, such as Monsanto, and those that want to limit it, such as Austria and Luxembourg.¹²

Furthering Foreign Policy Objectives

Governments will use trade policy to support their foreign policy objectives.¹³ A government may grant preferential trade terms to a country with which it wants to build strong relations. Trade policy has also been used several times as an instrument for pressuring or punishing "rogue states" that do not abide by international law or norms. The most obvious recent example is Iraq, which has labored under extensive trade sanctions ever since the UN coalition defeated the country in the 1991 Gulf War. The theory is that such pressure might persuade the rogue state to mend its ways, or perhaps hasten a change of government. In the case of Iraq, the sanctions are seen as a way of forcing that country to comply with several UN resolutions. In another example, the United States has maintained long-running trade sanctions against Cuba. Their principal function is to impoverish Cuba in the hope that the resulting economic hardship will ultimately lead to the downfall of Cuba's Communist government and its replacement with a more democratically inclined (and pro-US) regime. The United States also has long-running trade sanctions in place against Libya and Iran, both of which it accuses of supporting terrorist action against US interests.

A serious problem with using trade as an instrument of foreign policy is that other countries can undermine any unilateral trade sanctions. The US sanctions against Cuba, for example, have not stopped other Western countries from trading with Cuba. The US sanctions have done little more than create a vacuum into which other trading nations, such as Canada and Germany, can and have stepped. In an attempt to halt this and further tighten the screws on Cuba, in 1996 Congress passed the Helms-Burton Act. This act allows Americans to sue foreign firms that use Cuban property confiscated from them after the 1959 revolution. A similar act, the D'Amato Act, aimed at Libya and Iran was also passed that year. The passage of Helms-Burton elicited howls of protest from America's trading partners--including the European Union, Canada, and Mexico--all of whom claim that the law violates their sovereignty and is illegal under World Trade Organization rules. For example, Canadian companies that have been doing business in Cuba for years see no reason why they should suddenly be sued in US courts when Canada has not and does not restrict trade with Cuba. They are not violating Canadian law and they are not US companies, so why should they be subject to US law? Despite such protests, the law is still on the books in the United States, although the Clinton administration has been less than enthusiastic about enforcing it--probably because it is unenforceable. The fuss over Helms-Burton illustrates that trade policy is a rather blunt and sometimes counterproductive instrument of foreign policy.

Protecting Human Rights

Protecting and promoting human rights in other countries is an important element of foreign policy for many democracies. Governments sometimes use trade policy to try to improve the human rights policies of trading partners. In recent years, the most obvious example of this has been the annual debate in the United States over whether to grant most favored nation (MFN) status to China. MFN status allows countries to exports goods to the United States under favorable terms. Under MFN rules, the average tariff on Chinese goods imported into the United States is 8 percent. If China's MFN status were rescinded, tariffs would probably rise to around 40 percent. Trading partners who are signatories of the World Trade Organization--as most are--automatically receive MFN status. However, China is not yet a member of the WTO. The decision of whether to grant MFN status to China is made more difficult by the perception that China has a poor human rights record. Critics of China often point to the 1989 Tiananmen Square massacre, China's continuing subjugation of Tibet (which China occupied in the 1950s), and the quashing of political dissent in China (there are an estimated 1,700 political prisoners in China).¹⁴ These critics argue that the United States should withhold MFN status until China shows measurable improvement in its human rights record. They argue that trade policy should be used as a political weapon to force China to change its internal policies toward human rights.

On the other hand, some argue that limiting trade with countries such as China where human rights abuses are widespread makes matters worse, not better. The best way to change the internal human rights stance of a country is to engage it in international trade, they argue. At its core, the argument is simple: Growing bilateral trade raises the income levels of both countries, and as a state becomes richer, so its people begin to demand--and generally receive--better treatment with regard to their human rights. This is a variant of the argument touched on in Chapter 2 that economic progress begets political progress (if political progress is measured by the adoption of a democratic government that respects human rights). This argument has currently won the day in the United States. In 1997, President Clinton announced he would grant MFN status to China and in doing so argued that trade and human rights issues should be de-coupled. The United States is not alone in taking such a position. Europe is close behind. For example, in March 1996, France, eager for China to sign a $1.5 billion contract for Airbus planes, argued within the European Union against a resolution in the UN Commission on Human Rights urging improvement of Chinese human rights practices.

Economic Arguments for Intervention

With the development of the new trade theory and strategic trade policy (see Chapter 4), the economic arguments for government intervention have undergone something of a renaissance in recent years. Until the early 1980s, most economists saw little benefit in government intervention and strongly advocated a free trade policy. This position has changed somewhat with the development of strategic trade policy, although as we will see in the next section, there are still strong economic arguments for sticking to a free trade stance.

The Infant Industry Argument

The infant industry argument is by far the oldest economic argument for government intervention. It was proposed by Alexander Hamilton in 1792. According to this argument, many developing countries have a potential comparative advantage in manufacturing, but new manufacturing industries there cannot initially compete with well-established industries in developed countries. To allow manufacturing to get a toehold, the argument is that governments should temporarily support new industries (with tariffs, import quotas, and subsidies) until they have grown strong enough to meet international competition.

This argument has appealed to the governments of developing nations during the past 40 years. Also, the infant industry argument has been recognized as a legitimate reason for protectionism by the WTO. Nevertheless, many economists remain very critical of this argument. They make two main points. First, protection from foreign competition does no good unless the protection helps make the industry efficient. In case after case, however, protection seems to have done little more than foster the development of inefficient industries that have little hope of ever competing in the world market. Brazil, for example, built up the world's 10th largest auto industry behind tariff barriers and quotas. Once those barriers were removed in the late 1980s, foreign imports soared and the industry was forced to face up to the fact that after 30 years of protection, the Brazilian industry was one of the world's most inefficient.¹⁵

A second point is that the infant industry argument relies on an assumption that firms are unable to make efficient long-term investments by borrowing money from the domestic or international capital market. Consequently, governments have been required to subsidize long-term investments. Given the development of global capital markets over the past 20 years, this assumption no longer looks as valid as it once did (see Chapter 11 for details). Today, if a developing country has a potential comparative advantage in a manufacturing industry, firms in that country should be able to borrow money from the capital markets to finance the required investments. Given financial support, firms based in countries with a potential comparative advantage have an incentive to go through the initial losses in order to make long-run gains without requiring government protection. This is what many Taiwanese and South Korean firms did in industries such as textiles, semiconductors, machine tools, steel, and shipping. Thus, given efficient global capital markets, the only industries that would require government protection would be those that are not worthwhile.

Strategic Trade Policy

The strategic trade policy argument has been proposed by the new trade theorists.¹⁶ We reviewed the basic argument in Chapter 4 when we considered the new trade theory, which argues that countries may predominate in the export of certain products simply because they had firms that were able to capture first-mover advantages in industries that would support only a few firms because of substantial economies of scale. The dominance of Boeing in the commercial aircraft industry is attributed to such factors.

There are two components to the strategic trade policy argument. First, a government can help raise national income if it can somehow ensure that the firm or firms to gain first-mover advantages in such an industry are domestic rather than foreign enterprises. Thus, according to the strategic trade policy argument, a government should use subsidies to support promising firms in emerging industries. Advocates of this argument point out that the substantial R&D grants the US government gave Boeing in the 1950s and 60s probably helped tilt the field of competition in the newly emerging market for jet passenger planes in Boeing's favor. (Boeing's 707 jet airliner was derived from a military plane.) Similar arguments are now made with regard to Japan's dominance in the production of liquid crystal display screens (used in laptop computers). Although these screens were invented in the United States, the Japanese government, in cooperation with major electronics companies, targeted this industry for research support in the late 1970s and early 80s. The result was that Japanese firms, not US firms, captured the first-mover advantages in this market.

The second component of the strategic trade policy argument is that it might pay government to intervene in an industry if it helps domestic firms overcome the barriers to entry created by foreign firms that have already reaped first-mover advantages. This argument underlies government support of Airbus Industrie, Boeing's major competitor. Airbus, a consortium of four companies from Great Britain, France, Germany, and Spain, was formed in 1966. When it began production in the mid-1970s, it had less than 5 percent of the world commercial aircraft market. By the late 1990s, it had increased its share to around 40 percent and was threatening Boeing's dominance. How has Airbus achieved this? According to the US government, the answer is a $13.5 billion subsidy from the governments of Great Britain, France, Germany, and Spain.¹⁷ Without this subsidy, Airbus would have never been able to break into the world market. In another example, the rise to dominance of the Japanese semiconductor industry, despite the first-mover advantages enjoyed by US firms, is attributed to intervention by the Japanese government. In this case, the government did not subsidize the costs of domestic manufacturers. Rather, it protected the Japanese home market while pursuing policies that ensured Japanese companies got access to the necessary manufacturing and product know-how.

If these arguments are correct, they clearly suggest a rationale for government intervention in international trade. Specifically, governments should target technologies that may be important in the future and use subsidies to support development work aimed at commercializing those technologies. Furthermore, government should provide export subsidies until the domestic firms have established first-mover advantages in the world market. Government support may also be justified if it can help domestic firms overcome the first-mover advantages enjoyed by foreign competitors and emerge as viable competitors in the world market (as in the Airbus and semiconductor examples). In this case, a combination of home-market protection and export-promoting subsidies may be called for.