Should we ignore the siren song of protectionism?

US-China tensions are increasing as their competition evolves. Drawing on academic works on international trade, Krishnan Ranganathan, Executive Director, Nomura, shares his take on the situation and its impact on financial services operations.

One of the great milestones of the past 50 years has been the stunning drop in global tariffs, from average import levies of >10% in the 1970s to 3% today. This fuelled a global commerce frenzy and a near-tripling in global GDP per capita. In May, Biden quadrupled tariffs on EVs from China to an eye-watering 100%. The Economist promptly dubbed Biden’s proposal “bad policy, worse leadership” and concluded “America is still leading global trade policy—but in the wrong direction.”

Well, the truth may be more complicated.

International trade through the lens of David Ricardo

The event brought back David Ricardo into the limelight, 200 years after his seminal work on international trade. Historians furiously debate what Ricardo “really meant”. Economists on both extremes of the political spectrum have argued that Ricardo’s writings justify their stances.

At age 27, having devoured the Wealth of Nations while on holiday, he found his calling in political economy. What followed, On the Principles of Political Economy and Taxation (1817), was the most influential text on economics published in the 75-year span between Smith's Wealth of Nations and John Stuart Mill’s Principles of Political Economy. But it isn’t a pleasure to read! Ricardo wrote in a dry style that lacks the flourish and colourful examples of Adam Smith.

Ricardo’s theory of comparative advantage states that each country should produce and trade what it is relatively least bad at.

Ricardo imagined that Portugal was better at producing both cloth and wine than England —it could produce both with less labour input than England.

His logic takes a step further. If it takes 75 Portuguese labourers to produce wine and 85 to produce cloth, it should export wine and import cloth since it’s more efficient at producing wine than cloth, i.e. Portugal would have to give up less cloth to make extra wine than England would.

This theory has been a standard item in basic economics textbooks and a prime justification for advocates of free trade. However, "free" trade is not "fair” trade.

When asked to identify one idea in the social sciences that was both true and non-trivial, Paul Samuelson replied: “Ricardo’s theory of comparative advantage”. But the truth in his reply “refers to the fact that Ricardo’s theory is mathematically correct, not that it is empirically valid”. Prof Charles Murdock of Loyola University, Chicago, goes a step further: Those who routinely parrot the notion that Ricardo's theory shows that foreign trade is beneficial to both countries have never read Ricardo and are unaware of the caveats he asserted. In summary, Ricardo’s theory doesn’t work in today’s globalised world.

What Ricardo didn’t consider (and we should)

Ricardo's proof of mutual benefit assumes that capital would be loyal to the country of origin and (akin to the gold standard) adjustments in the value of currencies would even out trade imbalances. This is no longer the case. We now have floating currencies that (supposedly) reflect the market demand for specific currencies. Since the US has a substantial trade deficit with China, there should be a good demand for yuan to enable US firms to buy Chinese goods, which should increase the value of the yuan v/s the USD. The cost of Chinese exports would rise and that of US exports fall, thus bringing the China/US trade into balance. But, if China cleverly “manipulates its currency” v/s the USD, there will be no self-regulating mechanism to restore the balance of trade between the two nations.

The movement of labour is scarcely mentioned by Ricardo. When capital is free to move around the world in search of the best return and when the conventional wisdom is that the purpose of a corporation is to maximise shareholder value, not worker well-being, international trade turns into labour arbitrage and jobs are shipped from the importing country to the exporting country. US has thus lost much of its manufacturing base.

Ricardo's example of cloth and wine didn’t involve dual-use technologies that have both industrial and military uses. One basis for comparative advantage that US enjoys is technological superiority, much of which is dual-use. However, some of its trading partners, like China, not only do not enforce the patent and copyright laws that protect this advantage, but also engage in piracy, as well as demand technological transfer as a pre-requisite to entering its markets. Thus, the merits of foreign trade are eroded by the misfeasance and malfeasance of foreign governments… activities that were beyond imagination during Ricardo’s time. This is a consistent pattern but not one that is consistent with free trade principles. The US considers the security risk of letting in Chinese cars as too great, since EVs are easily tracked and monitored. From a national security angle, can US rely upon either products that originate in, or supply chains that pass through, a potential adversary?

Trade theories vs realities today

Often nations shape their comparative advantage to influence what they specialise in, say, with governmental policies that promote certain sectors. This extension of Ricardo’s model has been developed by Paul Krugman (“new trade theory”) who won the Nobel Prize for the dynamic theory of trade. Although economists welcome cheap imports, politicians can fight back if they worry that an influx would hurt specific industries and towns. The recent EV tariffs are targeted at voters who are economically tied to the US auto industry in the swing states of Michigan, Wisconsin, Ohio, and Georgia. A virtual ban on Chinese EVs builds on Biden’s promises to support the US auto industry.

Ricardo’s notion of comparative advantage didn’t envisage an export-oriented government that would eliminate other countries’ competitive advantage by subsidising exports at the expense of its own citizens via ultra-lax worker health and safety measures far below global norms.

US Senator Marco Rubio’s Made in China 2025 report recognised that markets cannot function without rules and so the government should ensure that the rules provide for “strong families and decent wages for average people.” The report asserted that the drive to maximise shareholder value, rather than for all American workers, can lead to catastrophic results.

Can US blindly ignore the realities of the situation and rely abstractly on the notion that the market solves all problems? While comparative advantage is a compelling theory, it doesn’t clearly explain the real world as the "assured mutual benefits of global trade" seem illusory. The underpinnings upon which Ricardo based his theory do not exist today.

For Ricardo, facts are for wimps. It almost didn’t matter if facts appeared to disprove his theories; if the theories had progressed logically from first principles then they were necessarily true. Today’s economists call this the “Ricardian vice”. Ricardo’s writings are deeply theoretical and abstract — so much so that decades later Alfred Marshall would spend many happy hours converting Ricardo’s arguments into mathematical equations.

In summary, isn’t the US justified to adopt an industrial policy that will safeguard its national security and rebuild manufacturing prowess, especially in strategic industries?

What then are the prospects for the US in using the protection of tariffs to develop a competitive EV industry? Perhaps, mixed.

Protectionism: A historical review and future visions

In the past, nations have successfully resorted to protectionism in the auto sector to give their “infant industries” time to grow before being exposed to global competition. Post WWII, Japan protected its own fledgling auto market when it placed high tariffs on imported passenger vehicles and engines. South Korea also used protections to give its Hyundai, Daewoo, and Kia a chance to catch up before exporting to US.

Biden faces the twin challenges of China and inflation. The solution he has chosen to face off China (tariffs) may hurt him when it comes to inflation. By definition, tariffs stifle competition, limit consumer choice and raise prices. So while a tough trade policy towards China might help Biden politically in industrial swing states, he may pay a high price (no pun intended!) on the issue of inflation that is frequently raised by voters as their biggest financial headache.

And for China?

Huawei has shown that firms can find workarounds. Chinese EV firms may ramp up production in Mexico. As reported, trade bosses are already eyeing that loophole, potentially turning this into a game of Whac-a-Mole. Moreover, the auto industry is global. Swedish sedans (Volvo S60s) owned by a Chinese firm making cars in Ridgeville, South Carolina is par for the course.

Two centuries ago, Napoleon warned, “Let China sleep; when she wakes, she will shake the world." Today China has awakened, and the world is beginning to shake.

Higher tariffs may not be the last word on the US/China auto war yet.

Krishnan Ranganathan is an Executive Director with Nomura and is responsible for the execution of global regulatory and transformation projects across Risk, Finance and Operations in Nomura India. He is an alumnus of Harvard Business School and is a member of the Young Scholars Initiative at the Institute for New Economic Thinking. Views are personal.