The decision of the American government to impose trade tariffs on goods from Canada, Mexico, and the European Union has caused an uproar and ignited plans of retaliation right away. The world has entered a trade world. Even more so like real wars, a trade war knows only losers. Economic nationalism has put the world into the Great Depression in the 1930s, when the United States imposed the infamous Smoot-Hawley Tariff on thousands of goods. The leaders of the world had learnt about this catastrophe and after World War II, the United States had acted as the leader in order to promote free trade around the globe.
The costs of protectionism are paid by the consumer. Protectionism means that goods become more expensive and that the quality falls. The apparent advantage of protecting the home industry vanishes because protectionism by one nation invites retaliation from the other nations. In the end, all are worse off.
When the United States complains about its trade deficit, it must notice the paradox that the U.S. economy has the highest degrees of international competitiveness. In many sectors, the United States operates at the forefront of technological progress. American companies are known world-wide and enjoy the highest valuations. Thus, what lies behind the new protectionism.
American industry has been at the top of industrial development and surpassed all other countries since the turn of the century. After World War I and World War II, the United States has taken gigantic leaps forward in establishing its leadership. This position has held until today. It is, therefore, somewhat a conundrum when the United States resorts to protectionism which is usually reserved to countries that are economically weak and suffer from a low degree of international competitiveness.
In order to understand what is going on, one must look at the world monetary order. With the inception of the Bretton Woods System, the U.S. dollar has become the international reserve currency. The demand for U.S. dollars outstrips by far the need to have dollars to buy American products. While there is quasi an unlimited demand for dollars because the American currency serves as a global means of payment, this constellation also means that the United States is the only country, which has almost no constraint on its trade deficit and consequently no barriers against accumulating excessive foreign debt.
Imbalances in foreign trade lead to structural changes in a country’s economy. In the case of the United States this means that the persistent current account deficits that have been in place since the early 1980s have led to crowding-out of a part of the U.S. manufacturing sector. This trend has also brought about a deterioration of the income distribution in the United States.
Global trade and the international monetary order
The American dilemma
While the high-tech sector has been flourishing, and consumer demand is booming, the U.S. manufacturing sector has been suffering and with that has also come a profound rise of income inequality. With the well-paid manufacturing jobs vanishing, the demand for top-qualified persons rose in the high-tech sector while at the same time employment has grown in the low-end service sector.
Few people recognize that the election victory of Donald Trump is the result of the effects of international trade on income distribution. The incumbent American President came to power with the promise of making America great again by way of revitalizing the lost manufacturing sector. Since being in power, Donald Trump keeps up to his promise.
In this perspective, the irritating actions of the President - such as getting out of the Paris Accord and cancelling the environmental restrictions on coal mining - make sense. It is the same with the recent imposition of tariffs on steel.
The dollar’s curse
Why does the United Sates have trade deficits when its economy is one of the most, maybe even the most competitive in the world? The answer is that the U.S. dollar is overvalued against almost any other currency. This overvaluation of the American currency is the immediate result of the use of the dollar as a global means of payments and consequently as an international reserve currency.
The monetary equivalent of the resource curse that afflicts some commodity exporters is the dollar curse that afflicts the United States. Both lead to an overvalued currency. In the case of the United States this leads to the situation that on the one hand, the United States suffers from persistently high trade deficits, while, on the other hand, it need not worry about its international payments capability because the country’s foreign debt is denominated in the home currency, i.e. in US-dollars.
Need of a new monetary order
Most economists agree that protectionism is not the solution to the dilemma. On the contrary, protectionism makes matters worse. What needs to be done is abandon the role of the U.S. dollar as the international reserve currency. For this to happen, one must establish a new kind of monetary order.
Different from the expectation, the new European currency could not play a role equivalent to the U.S. dollar. The share of the euro in the composition of international reserves has remained relatively low. Even less so does the Chinese yuan qualify as a substitute for the U.S. dollar. Constructing a new international monetary order remains the big challenge of our time.
Stuck in the middle-income trap
The so-called middle-income trap has come back to haunt the emerging economies. A country finds itself in the middle-income when it falls into prolonged stagnation after its high-growth phase of the take-off and reaches the middle-income bracket, which currently is the range from more than 1,006 $ and under 3,955 $ of a per-capita income for the lower middle-income countries, and a range for more than 3,956 $ and under 12,235 $ for the upper middle-income countries. World bank studies found that only 13 countries out of 101 middle-income economies in 1960 became high income by 2008.
Brazil represents a case where entering the middle-income trap has resulted in a series of inadequate policies that have worsened the situation. The next big test case is how China will fare in the face of slower growth in the future.
Remaining stuck in the middle-income trap means that the country has not succeeded in changing its growth strategy from a cumulative and imitative model to a model of a competitive, entrepreneurial and innovative economy. Simple imitation of the advanced economies generates high returns only when the distance between the emerging economy and the advanced countries is large. When the distance to the leading economies narrows, imitation becomes less viable. As the certainty of imitation vanishes, the new trajectory requires trial and error, which implies much more sophisticated skills than the mere imitation of a mature technology under state control would necessitate.
When the take-off had come along with an expansion of state activity, the presumption often prevails that more state control instead of less would be the answer to respond to the slowdown. Yet the consequence of this policy is not economic growth but clientelism, corruption, and the misallocation of resources.
An unfavorable business climate discourages private business to wage riskier investment project that yield high returns. Because of the unfavorable business climate, mainly in standard production will be invested and consequently, productivity remains low.
It is so hard to get out of the middle-income trap because one must bring about a fundamental transformation in its economy. The country must change from a cumulative and imitative economy to an innovative economy. Instead of a top-down transformation, the economy needs to blossom from below. Such a transformation requires the liberalization of the regulatory and bureaucratic obstacles that gag entrepreneurial activity. Reducing the tax burden and eliminating the bureaucratic nightmare are essential. The state sector must abandon its ad hoc interventionism, which creates uncertainties, in favor of a policy that is limited to offer legal and institutional security, and that facilitates entrepreneurship.
Expansionary fiscal and monetary policies to get out of the middle-income trap only worsen the situation. These policies lead to imbalances between savings, investments, spending, and the exchange rate. Even worse gets the case when the government accrues budget deficits, which generate a reduction of the national rate of savings. With less savings available for private investment, such policies hamper the productivity gains and thus to obtain economic progress.To achieve higher levels of productivity, governments must abandon state capitalism, which was chosen as the method for take-off. To get out of the middle-income trap, the emerging country must open its economy to the entrepreneurial capitalism of creative destruction.