Caves Trade Controls

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9TH EDITION

WORLD TRADE AND PAYMENTSAN INTRODUCTION

Richard E.CavesHarvard UniversityJeffrey A. FrankelHarvard UniversityRonald W. JonesUniversity of Rochester

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Editor-in-Chief: Denise ClintonAssociate Editor: Roxanne HochSenior Production Supervisor: Nancy H. FentonMarketing Manager: Adrienne D'AmbrosioDesign Manager: Regina HagenCover and Text Designer: Leslie HaimesSenior Manufacturing Buyer: Hugh CrawfordPublishing Services: Thompson Steele, Inc.World Trade and Payments: An Introduction, Ninth Edition

Copyright 2002 by Richard E. Caves, Jeffrey A. Frankel, and Ronald W. JonesAll rights reserved. No part of this publication may be reproduced, stored in a re-trieval system, or transmitted, in any form or by any means, electronic, mechanical,photocopying, recording, or otherwise, without the prior written permission of thepublisher. Printed in the United States.For information on obtaining permission for the use of material from this work,please submit a written request to Pearson Education, Inc., Rights and ContractsDepartment, 75 Arlington Street, Suite 300, Boston, MA 02116 or fax your requestto (617) 848-7047.Library of Congress Cataloging-in-Publication DataCaves, Richard E.World trade and payments: an introduction / Richard E. Caves,Jeffrey A. Frankel, Ronald W. Jones. - 9th ed.p. cm.Includes bibliographical references and index.ISBN 0-321-08904-91. International trade.I. Frankel, Jeffrey A. 2 Balance of payments. 3. Commercial policy.n. Jones, Ronald Winthrop III. Title.HF1379.C8 2001382-dc21 20010333326

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Hw prevalent are government restrictions on international trade? Howhave these restrictions evolved over time? Why do they change when theydo? In Chapter 11 we suggested that trade controls should be consideredan act of public choice. Here we explore the ups and downs of actual trade restric-tions in the United States. Actually, make that downs and ups. The United Statesand its major trading partners have undertaken a long, collaborative effort tolower the general level of restrictions. However, the very success of this processbred a reactive swing toward managed trade, in which lowered tariffs are replacedby other types of restrictions to shelter important (and politically powerful) indus-tries.TARIFFS: LEVELS AND TRENDSWithout doubt, tariffs and other governmental restraints on trade have curbed in-ternational specialization and reduced world economic welfare. It is known, forexample, that regions of the United States, trading freely with one another, are farmore specialized in production than independent industrial nations of comparablesize.' We consider the long-run pattern in the United States, then refer briefly tobroader patterns.Makers of public policy in the United States were little impressed with thevirtues of international trade until the last six decades. As Figure 13.1 shows, theAmerican tariff through much of the nineteenth century averaged 40 percent ormore on dutiable imports. It reached its high point in 1932 as a result of the Smoot-Hawley Act of 1930, then it began a substantial decline that was due in part toAmerican participation in the multinational tariff reductions. The average duty paidon total imports declined even more than did customs revenue on dutiable imports,as duty-free imports (often raw materials) became more important. The decreasedreliance on tariffs as a source of federal governmental revenue was striking. Customsrevenues, now less than 1 percent of the federal government's budget receipts, were89 percent in 1821 (when they were the only tax that was easy to collect).The history of tariff legislation is fascinating for its insights into the process ofpublic decision making. Early in the nineteenth century, America became a high-

IJohn McCallum, "National Borders Matter: Canada-U.S. Regional Trade Patterns," AmericanEconomic Review, 85 (June 1995): 615-623.

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Figure r 3. rLong-Run Trend in U.S.TariffsAverage duty collected on dutiable imports was high until the 1930s, then fellsharply. Average duty on total imports has fallen more, because a larger proportionof imports has become duty-free.

'--"I ,...I, ," ,~ , I', I'I I \, , \\ I'..I \, ,-,-- . . . . . .

. . . . ~ . . . . .,. . . . - - - . .

Tariff(percentage)70

60

50

40

30

20

10

___ Average duty ondutiable imports

---- Average duty ontotal imports

1821 1840 1860 1880 1900 1920 1940 1960 1980 200

tariff country mainly for two reasons. One was acceptance of the infant-industryargument that tariffs actually would raise real income by promoting economic development. The other reason was nationalism and a collective distaste for thingsBritish, notably imported British goods. Throughout the nineteenth centurychanges in the tariff reflected shifts in regional political strength-the manufactur-ing states in the Northeast benefited from tariffs while the primary-product exporters of the South suffered. The Civil War swung the power balance decisivelytoward the manufacturers and enshrined a high tariff for the rest of the centuryThe process that brought this drastic reduction of average tariffs for thUnited States has worked for other industrial countries as well. Industrial countries' average tariffs on manufactures are now typically around 5 percent. Theytend to be very low for differentiated goods and for the products of science-basedindustries, higher and more variable in mass production industries, and highest folabor-intensive products and some processed natural resources. This pattern iclose to the one seen in U.S. tariffs, which was analyzed in Chapter 11. Whateverthe political mechanism that has produced this sectoral pattern, it seems commonto most of the industrial countries.If many manufactures coast past the tariff collectors in industrial countriesagricultural produce is not so lucky. The following data show the size of the ad


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vantages over foreign producers conferred on domestic farmers by the UnitedStates, Japan, and most European countries (members of the European Union):Wheat Sugar Beef

United States 40.7% 68.4% 9.0%Japan 99.7 69.7 61.9European Union 31.0 32.8 43.5These figures encompass the combined effect of tariffs and other direct restrictionson imports, plus subsidies given to domestic farmers.?There is little doubt that world trade patterns and volumes are stronglyaffected by these and other governmental restrictions, despite the low tariffs onmanufactures in industrial countries. Markusen and Wigle used an empiricalgeneral-equilibrium model of the world economy to show the extensive distortionof trade between the industrial countries, which strongly protect their import-competing agricultural sectors, and the less-developed countries, which havestrongly protected their import-competing manufacturing sectors. They estimatedthat a change to worldwide free trade would at least double the volume of tradebetween these groups of countries, and trade among the less-developed countriesthemselves would increase by 246 percent! 3

13 .2 MULTILATERAL TARIFF REDUCTIONWhat accounts for the 90 percent drop in U.S. tariffs between the early 1930s andthe present day? The answer to this question lies in the policy change that ac-counted for half of the dec1ine-a program initiated by the United States, wherebynations join in simultaneous reductions of their tariffs.Evolution of the Trade Agreements ProgramIn the face of mountainous tariff rates imposed by the Smoot-Hawley Act of 1930,it was no wonder that the U.S. share of world trade dropped from 16 to 11 percentin the next five years. The world total also declined, as international trade shriv-eled in the face of the Great Depression of the 1930s. The combined effect on U.S.exports of the depression and of retaliatory increases in other countries' tariffsprompted a major shift in trade policy in 1934. Congress authorized the presidentto negotiate agreements with foreign trading partners to lower tariffs hamperingAmerican exports. In return, U.S. tariffs would be cut on selected goods exportedby the partner. The president could offer to cut the rates of duty set by the Smoot-Hawley Act up to 50 percent. By 1940 the United States had entered into bilateraltrade agreements with 20 partners, thereby establishing a ritual for these accords.

2U.S. Department of Agriculture estimates for 1982-1987. Summarized by Joachim Zietz andAlberto Valdes, "The Growth of Agricultural Protection," in Takatoshi Ito and Anne O. Krueger,eds., Trade and Protectionism (Chicago: University of Chicago Press, 1993), pp. 115-143.3James R. Markusen and Randall M. Wigle, "Explaining the Volume of North-South Trade,"Economic Journal, 100 (December 1990): 1206-1215.


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If the tariffs reduced by the agreement were not offsetting some specific failure of the market, their reductions should have increased world welfare. Did theyalso increase the welfare of each participating country? How were they consistentwith the setting of tariffs through a process of political choice? One possibleanswer comes from the role of tariffs in extracting monopoly profits from international trade (the optimal tariff). If the tariff-cutting importer is large enough tinfluence its terms of trade, or if it merely thinks it gives benefits to foreigners breducing its tariff, the reciprocal trade agreements make some sense. A tariff reduction now raises the world price of the imported good to the exporter's benefit. The size of this benefit depends on the initial volume of trade (as well as othe size of the tariff concession). This terms-of-trade gain to the exporter is a losto the importer unless its tariff was higher than optimal. The importer might nogain from cutting a single tariff (even though the world does), but the importer'sterms-of-trade loss on one product can be offset by its gain as an exporter whena reciprocal agreement is signed. In addition, these gains and losses are morelikely to cancel each other out if each party cuts tariffs on the same initial volume of trade."That all parties might gain through reciprocal tariff-cutting agreementsconsistent with the political economy of tariffs. Suppose that a country has higtariffs in place, the result of the political processes described in Chapter 11. Thgovernment knows that national economic welfare has been impaired; it wouldlike to reduce the tariffs and raise national welfare, but cannot get rid of tariffone at a time. Therefore, it proposes a broad tariff-cutting agreement with ittrading partners, which will benefit most of its export producers as well as consumers generally. Enough voters might perceive that they benefit significantlyfrom the package that a majority coalition forms in favor of it. Both this processof forming coalitions in favor of freer trade and the monopoly-tariff story proba-bly help explain the success of reciprocal trade agreements.The bilateral trade agreements program was running out of steam by the enof the 1930s. It was replaced in the postwar period by a process of multilateralbargaining in which countries increasingly bundled together their offers to reductariffs. Ultimately, the cuts took the form of consent on a common, across-the-board reduction in all tariffs. In the so-called Kennedy Round of multilateral tarifbargaining, completed in 1967, the chief industrial countries agreed on a target oa 50 percent across-the-board cut in all tariff rates. Each country could propose texcept some of its tariffs from the cut, presumably where unacceptable injury tdomestic industries would result. Bargaining proceeded over the size of the exceptions lists, rather than over the 50 percent cut itself. The participants agreed t

+Elemenrs of monopoly and product differentiation in individual product markets probably contribute to causing the prices of a country's imports net of tariff to rise when a tariff is reduced.study of U.S. tariff reductions in the 1950s found that nearly half of the price effects took thform of increased external prices, rather than reduced prices (including tariff) to domestic consumers. See M. E. Kreinin, "Effect of Tariff Changes on the Prices and Volume of Imports,"American Economic Review, 51 (June 1961): 310-324.


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weighted-average tariff cuts of around 35 percent, making the Kennedy Round themost sweeping tariff reduction since these rounds began.The Tokyo Round (1973-1979) continued the procedure of the KennedyRound but also tackled the thorny problem of nontariff barriers to trade. In thetariff-cutting part of the agreement the industrial countries agreed to reduce theirtariffs, on average, by another third over an eight-year period. Most of the majorcountries lowered individual tariffs by a formula that shaves more off those tariffsthat were higher initially.Uruguay Round and the World Trade OrganizationThe latest event in this series of trade agreements was the Uruguay Round, begunin 1986 but completed only in 1993. It appeared to accomplish far more than itspredecessors, although its implementation remains a question.

1. A 40 percent general reduction in tariffs, in the manner of previous rounds of bar-gaining, but also an agreement among the industrialized nations to eliminatetariffs among themselves on products of ten important industries, including con-struction equipment, farm machinery, furniture, medical equipment, paper, phar-maceuticals, and steel.2. Uniform national laws protecting intellectual property-patents, copyrights, andtrademarks. These property rights avert an important market failure: If the phar-maceutical firm's new wonder drug or the writer's literary creation can be freelycopied by others, their incentive to invest in developing these products is greatlyreduced. The agreement of all countries to recognize intellectual property rights isa major gain for the United States and other industrial countries that are major

producers of inventions, books, recordings, and other goods easily imitated. Othercountries have previously served their own national interests by letting their citi-zens freely copy foreigners' intellectual properties.3. A start was made on the mutual reduction of the heavy protection given in formsother than tariffs to agriculture, textiles and apparel, and certain other sectors.These are to be converted to tariffs-which makes the severity of the restrictionsplain to hapless consumers-and are then supposed to undergo reduction at tar-geted rates.4. The World Trade Organization (WTO) was created to replace the GeneralAgreement on Tariffs and Trade (GATT), a patchwork apparatus that had been in

place since 1947-1948 to monitor promised tariff reductions.Most observers agree that the WTO is a modest but useful advance on its pre-decessor. Neither organization was empowered to make rules, only to resolve dis-putes over agreements reached in the tariff-bargaining rounds. Under GATT acountry charged with violating its own commitment could readily stalemate theproceeding against it. WTO largely removes that option. The accused still has dis-cretion about conforming to the finding of a dispute-settlement panel. When oneof its trade policies is found in violation, it can retain that policy and sacrifice


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others as compensation to the plaintiff. Or it can tough out the adverse finding anendure the retaliation that the WTO then may authorize.> The United States habeen a fairly active plaintiff before the WTO, and sometimes a defendant as welIn 2000 the United States was charged by the European Union (EU) with maintaining an illegal export-subsidy arrangement in the form of a tax exemption for icome from export sales booked through an organization called a Foreign SalCorporation (FSC). With the United States facing WTO-authorized sanctions o$4 billion of U.S. exports, Congress passed a bill ending the FSC arrangement-but recasting the tax benefit in another form. The EU agreed to withhold retaliation until 2001, when the WTO was expected to rule on this new arrangementThe United States in 1999 had assailed EU policies that favored bananas importefrom the Caribbean over imports from U.S.-owned plantations in CentraAmerica. The United States imposed 100-percent tariffs on $300 million a yearEuropean products (mostly luxury goods) until the dispute was resolved (2001

Gains from Trade LiberalizationTrade liberalization is always controversial. With the progressive reduction of tarifby the industrial countries, some observers have begun to wonder whether the rewelfare gains warrant the political effort involved. To discuss this and other problemof quantifying the welfare effects of trade controls, economists commonly rely on thpartial-equilibrium analysis that was displayed in Figure 10.1. A number of economists have estimated the deadweight losses that are expected to be recovered from thUruguay Round.s The estimated increases in world gross domestic product rangfrom 0.7 to 1.3 percent; these are permanent gains expected to be realized by the timthe changes are fully phased in. Although not every country necessarily gain(there can be terms-of-trade losses from reducing tariffs for countries that exploitemonopoly power), no losers are identified, although the gains range from 0.6 percenfor the least developed countries to 2.1 percent for some European countries whicare not yet members of the European Union. As we expect from Figure 10.1, the proportional increase in trade (5 to 20 percent expected) is larger than the expecteincrease in welfare.

13.3 THE TREND TOWARD "MANAGED" TRADEThe undeniable success of multinational tariff reduction has occurred againstcounterpoint of the replacement of tariffs by other forms of trade restrictionsalong with some reimposition of tariffs that had been negotiated downward

5Anne O. Krueger, ed., The WTO as an International Organization (Chicago: UniversityChicago Press, 1998); Jeffrey J. Schott, WTO 2000: Setting the Course for World Tra(Washington, D.C.: Institute for International Economics, 1996).6Summarized by Alan V. Deardorff, "Economic Effects of Quota and Tariff Reductions,"Susan M. Collins and Barry P. Bosworth, eds., The New GATT: Implications for the UnitStates (Washington: Brookings Institution, 1994), pp. 7-27.


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While GATT sought to install a stable regime of trade policy subject to simple andpredictable rules, governments have chosen to intervene more and more closely inmany important international markets, using non tariff controls and tariffs tailor-made to the perceived needs of protected domestic industries. One study? esti-mated that the proportion of countries' trade subject to nontariff barriers had risenas follows: 1966 1986

(%) (%)United States 36 45 (12)European Union 21 54 (19)Japan 31 43 (14)All developed countries 25 48 (16)

Although the increase shown here is evident on any reckoning, the levels mayprompt an over-pessimistic interpretation. Nontariff barriers are defined to includeboth nontariff measures specifically intended to restrict trade and various domesticpolicies (technical or health and safety standards, border tax adjustments, etc.)that incidentally impose extra costs on foreign suppliers. If only the former restric-tions are considered, the figures shown in parentheses for 1986 apply. These arestill high, however, and they have increased greatly. The Uruguay Round marks aserious international effort to stop this process, but its success is not assured.The following section reviews some theories of nontariff barriers to trade, thenturns to important real-life forms of these barriers.Theory of Quantitative RestrictionsA quantitative restriction (QR) has basically the same effect as a tariff, yet its inci-dental differences are important. The similarity is shown when we turn back toFigure 10.1. Given domestic demand and supply and the world price P u a tariff ofP, imposed by the government will shrink the volume of imports from KL to MN.This outcome could equally well be obtained by the government's allowing onlyMN imports to enter the market. With the market purely competitive, this volumeof imports will allow the market to clear only at the price P t. The Uruguay Roundobligated countries to perform this calculation and reveal to consumers the tariff-equivalents of the highly restrictive quotas in use for agricultural products. EUquotas have the effect of tariffs of 178 percent on dairy products, 152 percent onsugar. United States tariff-equivalents for these products are 93 and 92 percent, re-spectively. Japan imposes a tariff-equivalent of 326 percent on dairy products and152 percent on wheat.Given this basic equivalence, tariffs and quotas can have important differencesin practice. Some of these depend on what happens to the revenue representing the

7Sam Laird and Alexander Yeats, "Trends in Nontariff Barriers of Developed Countries,1966-1986," Weltwirtschaftliches Archiv, 126,2 (1990): 299-326.


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gap between the foreign and the domestic price. The tariff generates governmenrevenue equal to area 3 in Figure 10.1. When imports are limited by quota, ordnarily no tariff is collected, yet the privilege of buying abroad at Pwand selling dmestically at P, is obviously valuable. The government might auction off licensesimport to the highest bidder. Competitive bidding by would-be importers woulwipe out this potential profit and hand the government the same revenue as iflevied the tariff equivalent. On the other hand, the government might give awaimport licenses to the domestic importers, in which case they capture the proceedIf the government awards the licenses to foreign exporters, their country gains thscarcity rent. Note that the world welfare cost of the restriction is the same in eaccase. The method of administering a quota only redistributes income."A special type of quantitative restriction now in widespread use is the so-callevoluntary export restraint (VER), whereby the importing nation induces the eporting countries to curtail their shipments. This device simply hands over areato the exporters, who are expected to charge the price that clears the market fthe restricted volume of sales. A VER obviously maximizes the cost to the imporing country's real income of restricting imports. We will speculate on why thchoice of VERs has been so popular among importing-country governments.Another difference between tariffs and quotas arises if the domestic industrynot perfectly competitive, because a tariff and quota that let in the same volumeimports have different effects on the domestic price. We consider the case of a sigle, monopolistic domestic seller, shown in Figure 13.2. The world price is Pw ' tmonopoly's marginal cost is MC, and domestic demand is D. A quota of Z causthe monopoly to select its most profitable output by ceding this much of the maket and maximizing its profit on the residual demand of D - Z. MR is marginrevenue corresponding to this residual demand. The monopoly selects a quantitof output Qz that equates marginal revenue to marginal cost and commandsprice of Pz. Now we must find the tariff that makes Z the equilibrium volumeimports. The country (and the monopoly) are price-takers on the world market,that a tariff raises the world price inside the country but still leaves the monopolfacing an exogenous price. If that price were P t, the monopoly would select outpuQt, which equates MC to the constant marginal revenue indicated by the tarifridden world price Pt. Qt and Z satisfy domestic demand at P t, which is therefoan equilibrium price. P, considerably exceeds Pt. The intuition behind this diffeence is that the quota caps the amount of imports and leaves the monopoly facina (net) domestic demand that is imperfectly elastic. The tariff, however, allows tquantity of imports to expand when the monopoly raises its price.Management through VERsThe United States seldom imposed quotas unilaterally on imports of manufactureproducts, but it has used VERs extensively to regulate the quantities of goods thexporters ship to the United States. The VERs began with an informal agreeme

SAtone time the Japanese government was financing its entire international commercial integence network (JETRO) from its cut of the profits of importers licensed to bring quota-restrictbananas into Japan.


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and the goods' sale value at the destination. He found tariff equivalents of 27 pecent for the United States and 14 percent for the European Union; added to thconventional tariffs that continue to apply to these imports, the combined tradbarriers are 56 percent for the United States, 33 percent for the Union."VERs have been very popular with the United States and other developedcountry governments. Besides the thicket surrounding the Multifiber Arrangementby 1986 at least 99 additional VERs covered other exports (steel, electronicsfootwear, transportation equipment). Why their popularity? The answer probablylies in the bargaining power possessed by foreign exporters. When a large customesuch as the United States raises its trade barriers, it certainly inflicts short-runlosses on foreign exporters and may permanently worsen their terms of tradeExporting countries often have ways of retaliating, such as restricting imports fromthe United States. In addition, the United States may appear to be less protectiveforeigners "voluntarily" restrain their exports than if U.S. quotas are imposed.Management by Special Protection: DelayingAdjustmentImportant U.S. industries have obtained special protection through channels othethan VERs, usually, but not always, following a bout of stiffened import competition. They have advanced their interests through the following legal or politicachannels:

1. Escape-clause relief (currently under Section 201 of the Trade Act of 1974) foindustries that can blame their suffering on GATT-round tariff reductions.2. Relief under various other statutory provisions, including national security, countervailing duties, antidumping rules, and special regulations covering agriculture3. Special protection (including VERs) obtained by going around these standard ecape routes and appealing directly to the president and Congress.4. Preservation of longstanding high rates of statutory protection from reductionthe GATT rounds.

Many, though not all, of these devices have been used for relatively short-runinterventions to manage international trade on behalf of industries that havshown reduced profits or employment due (or allegedly due) to increased impocompetition. The one objective that most commonly leads to the managementtrade is delaying or retarding a domestic industry's contraction. Industries thseek special protection usually flaunt scars that can be blamed on import compettion, and policymakers often rationalize special protection to assist an industryadjustment to increased import competition. Therefore, it is necessary to observhow the patterns of special protection relate to adjustments by import-competingindustries.If special protection aims only to smooth the process of adjustment, it shoulbe reasonably short-lived. Industries that received escape-clause relief durin1950-1983 indeed had shelter for a median duration of only four years, althoug"Carl Hamilton, "An Assessment of Voluntary Restraints on Hong Kong Exports to Europe athe USA," Economica, 53 (August 1986): 339-350.


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industries protected under other prOVISIOnshave enjoyed prolonged assistance.The textile and apparel sectors have been protected since 1957. However, protec-tion has clearly not served to smooth the orderly exit of factors of production fromthis industry, in that one-third of all U.S. textile and apparel firms were less thansix years old in 1982.How much adjustment actually takes place during these periods of special pro-tection? Hufbauer and Rosen's study of 31 troubled industries that received specialprotection found that the median industry lost employment at a rate of 2.2 percentannually, while the market share held by imports continued to grow a bit (0.8percent annually) despite the restrictions. Because any industry experiences a sig-nificant amount of natural turnover in its work force (retirement, job change), thisrate of decline of employment means that in the typical case few workers actuallylost their jobs. Therefore, the effect of special protection was really to slow thegrowth of competing imports and thus the contraction of these industries, and tolimit involuntary losses of jobs. Policy makers awarding protection routinely urge

the favored industry not to contract but to increase its efficiency and to stand up tothe cheaper imports. Such recoveries rarely happen, for the good reason that anyavailable efficiency raising investments would be undertaken by profit-seekingfirms without the spur of import competition, and the arrival of an external com-petitive threat if anything reduces their expected payout. The industries that havesuccessfully adjusted to imports either moved to lower-cost locations in the UnitedStates, thus costing the original workers their jobs anyway (bicycles), or werebailed out by demand shifts (motorcycles).How costly has special protection been? Hufbauer and Rosen calculated thatin 1984 special protection for 31 industries cost consumers $53 billion, and thatsociety as a whole lost $8 billion. A more meaningful figure is the annual cost toconsumers of each job preserved by special protection. The cost is usually morethan the average worker's annual earnings-between $20,000 and $100,000 an-nually for most of Hufbauer and Rosen's industries, but in four cases exceeding$500,000,10

Even if special protection holds some value for offsetting inefficiencies in theadjustment process, it is probably not the best remedy. Economists argue foraddressing such market failures by the most direct route possible (see Section11.2)-in this case by directly assisting the factors of production under pressure toadjust. In general, adjustment-assistance policies in the United States have notworked well in practice.Management by Special Protection: Raising Rivals' PricesSpecial protection to preserve declining industries, like protection of low-skill,labor-intensive industries, is a widespread practice consistent with the politicaleconomy of the conservative social welfare function, discussed in Section 11.3. AlOSee Gary Clyde Hufbauer and Howard F . Rosen, Trade Policy for Troubled Industries(Washington: Institute for International Economics, 1986); and Robert Z. Lawrence and RobertE. Litan, Saving Free Trade: A Pragmatic Approach (Washington: Brookings Institution, 1986).


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study of nontariff barriers in 41 countries found them higher where real wages peworker were low and declining, import competition was extensive, and tariffs weralready high but capped by commitments under GATT.1l Burgeoning special protection also has other roots, however, revealed in the regulation of "unfair trade.Economic analysis supports fairness in the marketplace in the sense that awould-be sellers (and buyers) should have equally free access to most marketsIt does not support fairness in the sense that the less efficient or higher comarket participant should be protected from competition from a stronger rivaUnfortunately, demands for fair trade usually take the latter form: Producerclaim that their rivals charge unfairly low prices. United States legislation givdomestic producers several grounds for crying unfair treatment: Foreign rivaare subsidized by their governments; foreign firms "dump" when they chargless for the goods they sell in the United States than those they sell to their homcustomers; foreign firms charge prices that are unfairly below their costDomestic producers increasingly invoke the unfair-trade provisions of U.S. lawDuring the 1980s they accounted for 95 percent of U.S. trade regulation caseeven if we exclude the blizzard of actions brought by the steel industry.l-These perceived unfair prices generally do not correspond to economic ineficiency, and restricting imports to achieve fairness typically extracts an economicost. We saw in Section 12.3 that dumping and subsidized exports generally benfit the importing country, although the exporter might be worse off. The negativwelfare evaluation for U.S. policy becomes even clearer when we note thatpermits domestic producers to bring a charge of dumping not because foreigproducers set higher prices elsewhere but because their price is low relativetheir alleged costs. It thus becomes a device for a domestic oligopolist to forceforeign rival to raise its price, especially when the government errs on the geneous side (as it usually does) in estimating the foreign rival's full costs. In a tellinillustration of antidumping policy's role in suppressing competition, in early 199Canada and the United States each issued antidumping rulings against the othecountry's steel producers. A study of U.S. antidumping proceedings found thduring the proceeding itself (that is, regardless of the final decision) imports dcline and the complaining domestic producers' outputs increase. In an industrwith few sellers worldwide such an outcome clearly harms welfare.UOne cannot be entirely certain about the effect on welfare of policies that raithe prices charged by foreign rivals, for the reason developed in Section 12.3: Itbetter for national welfare to have profits captured by an entrenched domestthan an entrenched foreign oligopolist. However, fair-trade policies in practice aiat preserving oligopoly profits and staving off competition, a policy harmfulnational welfare.I1Jong-Wha Lee and Phillip Swagel, "Trade Barriers and Trade Flows across Countries aIndustries," Review of Economics and Statistics, 79 (August 1997): 372-382.12Data from Table 2-2 in Pietro S. Nivola, Regulating Unfair Trade (Washington: BrookinInstitution, 1993), a good general source on this subject.13Robert W. Staiger and Frank A. Wolak, "Measuring Industry-Specific Protection: Antidumpinin the United States," Brookings Papers on Economic Activity: Microeconomics 1994, p51-103.


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How Special Protection Works: The Steel IndustryThe major integrated steel producers of the United States have been importantbeneficiaries of protection since 1969, and the steel industry teaches several lessonsconcerning the political economy of protection. Import competition became signif-icant in the 1960s, with imports' share rising to 17 percent of domestic steel con-sumption in 1968. The industry was losing its comparative advantage because theprime sources of ore and energy inputs, once abundant in interior North America,shifted overseas. Also, recent technical improvements in steelmaking are not easily in-corporated into old facilities, and new steel mills (mainly in Japan and the developingcountries) are much lower-cost simply because they embody the latest technologyfrom the ground up. Furthermore, the U.S. steel industry's prices had been high.Formerly, it had earned some monopoly profits. More importantly, substantial rentswere captured by its unionized work force: In 1982 a steelworker's compensation wasdouble the average for production workers in U.S. manufacturing. Through the 1980sand 1990s steel received varying forms and amounts of protection. After the Asian fi-nancial crisis deeply depressed the world prices of steel and other primary commodi-ties, the United States developed a program of loan guarantees for the weakerAmerican producers. The loans kept these firms open-their outputs depressing theprofits of other, more viable u.s. producers. The government will almost surely haveto make good on the loans to these bankruptcy-bound firrns.!"The first significant lesson from steel's experience concerns the form of theprotection it has received. Steel is a large industry with considerable political clout.Repeatedly, steel threatened to use the statutory machinery for special protectionat times when a victory would prove embarrassing to U.S. diplomatic relationswith major, foreign steel-producing countries (Western Europe and Japan). Thegovernment responded with a series of special deals that would never have beenavailable to a small industry. These included several rounds of voluntary export re-straints, which helped to restrain imports' share of the U.S. market.The second lesson pertains to the adjustment process in an industry that is los-ing its comparative advantage. Outsiders typically urge such industries to hangtough and raise their productivity levels. However, investments to raise productiv-ity can pay only if the industry has access to new technology that will not onlylower the industry's costs, but lower them more than it lowers overseas competi-tors' costs. The U.S. steelmakers had no such magic bullets. Therefore, the efficientchoice was to run existing facilities until they could no longer cover their variablecosts, then close them down.

The third lesson concerns the source of the major steel producers' difficulties.Public policy offers special protection against import competition, but usually notagainst the many adverse disturbances of domestic origin that can strike an indus-try. Therefore, an industry has an incentive to blame its troubles on imports even

14Robert Guy Matthews, "Steelrnaker-Aid Plan Draws Industry Flak As Market Softens," WallStreet Journal, January 9, 2001, pp. AI, AS.


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if they are a minor source, simply because public policy will respond. The U.integrated steel producers indeed lost markets to imports, but they lost nearlymuch business to domestic mini-mills, companies utilizing electric furnacecharged with steel scrap. The mini-mills operate efficiently at much smaller scalthan traditional integrated facilities and at much lower costs. The U.S. integrateproducers could not hope to persuade the government to hobble the minis,their rent-seeking (or rent-preserving) efforts were devoted instead to beating othe imports.l-Managed Trade: The ProspectsThis section will conclude by considering the prospects for managed trade. Wthe management of international trade continue to proliferate, or will nations suceed in restoring the regime of progressive liberalization and stable rules fostereunder GATT and now the WTO? These questions pertain not just to the UniteStates but to the major industrial countries in general, and they bring us backthe political economy of trade policy introduced in Chapter 11.From that perspective, the Uruguay Round and its predecessors representcontinuing effort of national policy makers to pursue efficient and unrestricteinternational trade. The United States long played a major leadership role in thcampaign, which from the days of the Cold War linked U.S. security intereststhe economic unity and welfare of the nations outside the Communist bloc-especially the industrial nations that were the main supporters of GATT. A libertrade regime could be sustained and promoted because it was placed on the higground of defense and international cooperation with allies. Also, with all coutries cutting tariffs at the same time, expected benefits could lead export producerto mobilize and oppose the interests of import-competing producers.The Uruguay Round nearly foundered, and its successful completion mustcounted as good fortune for efficient national policies toward trade. The UniteStates' hegemonic position has suffered a long-term decline (other countries' morapid economic growth is a sufficient explanation) that reduced the momentumtrade liberalization, and the evaporation of the Communist bloc as a unified mitary threat undermined the tactic of bundling a liberal trading regime with defenand security considerations. Probably the Uruguay Round's success is owed toimportant new factor: The increasing conviction of many developing countries,well as the Eastern European "economies in transition," that competitive markeare, in general, the best way to organize economic activity.However, the very success in lowering conventional tariffs to modest levels icreased the demand for special protection and the pressure on political leadersaccommodate it. Several other forces contributed to swelling the demandindustrial countries to manage international trade. New countries moving up

15See Robert W. Crandall, "Steel Imports: Dumping or Competition?" Regulation, 4 (Ap1982): 17-24; Michael O. Moore, "The Rise and Fall of Big Steel's Influence on U.S. TraPolicy," in Anne O. Krueger, ed., The Political Economy of Trade Protection (ChicagUniversity of Chicago Press, 1996), Chapter 2.


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13.3 "', THE TREND TOWARD "MANAGED" TRADE 249

the scale of economic development came to be successful producers and exportersof many manufactured goods, starting with textiles and apparel and moving intomore sophisticated assembled products (consumer electronics) and industrial ma-terials (steel). As each established industry in the industrial countries came to facemore than its accustomed level of international competition, it could seize oneither adjustment costs or fairness as a banner under which to seek special protec-tion. The newly industrialized countries of Asia have been disproportionate targetsof special protection. Another factor is the widespread perception that the success-ful expansion of industrial exports to the United States results from conspiratorialindustrial policies and associated subsidies in other countries (especially Japan). Aswe saw in Chapter 12, the ratio of rhetorical smoke to economic fire has been veryhigh when it comes to any positive role of public policy in promoting economicwelfare through manipulating exports. Nonetheless, the public perception is easilyfostered that American producers could never lose a fair fight to foreign exporters;thus if our side lost, the fight must have been unfair.The reaction of U.S. policy makers to these demands for protection has notbeen to embrace an overall policy of offering protection. Rather, the effort hasbeen to defuse the issue by means of general policies that run in other directions.One was bringing the Uruguay Round to completion. The other is to co-opt the is-sue of fair trade by demanding changes in selected policies of other countries thatcould be portrayed as unfair to U.S. exports. In the Omnibus Trade andCompetitiveness Act of 1988, Congress pressed the executive branch to "gettough" with exporting countries perceived to employ unfair trading practices.Unfairness could rest not just on violations of GATT or commitments under bilat-eral treaties but on any policy perceived by U.S. producers as competing unfairly:"export targeting," denial of workers' rights, or even the toleration of perceivedanticompetitive practices among the foreign country's producers. Under the 1988Act's mandate the administration indeed brought broad charges of unfair tradepractices against Japan, India, and Brazil, but that particular authority expired in1991, leaving in place a lower-voltage version enacted in 1974. Paradoxically,many of these "aggressively unilateral" actions by the United States probably ben-efited the target nation by pressing it to alter a policy not in its own national inter-est. The United States was more often successful in this dubious "reform" cam-paign when it had the leverage of large imports from the target country and whena trade control was at issue, rather than some deeper and more general policy.wIn terms of the political economy of trade policy, U.S. political leaders appar-

ently decided to offer the electorate the policy of fair trade sought by protectionistinterests, but to turn it into a demand for access by U.S. exporters to foreign mar-kets rather than a demand for protection of U.S. importers. Such a maneuver isconsistent, as Destler argued, with the assumption that U.S. political leaders be-lieve in the substantive merit of unrestricted trade, but do not believe it can be16Kimberly Ann Elliott and J. David Richardson, "Determinants and Effectiveness of'Aggressively Unilateral' U.S. Trade Actions," in Robert C. Feenstra, ed., The Effects of u.s .Trade Protection and Promotion Policies (Chicago: University of Chicago Press, 1997), pp.215-243.


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250 CHAPTER 13 TRADE CONTROLS IN PRACTICE

offered to the electorate as a broad issue. The electorate, he suggested, is somewhat opposed to international competition but not deeply concerned with the isue; it broadly favors fairness in trade, however, and that leaves the fairness issuopen for capture.I?13.4 SUMMARY

Over the last 50 years tariffs imposed on manufactured goods by the United Stateand other industrial countries have been reduced greatly, but governmental restrictions still substantially restrict world trade (for example, the exchange of primarproducts for manufactures between the industrial and less-developed countries)Little of the remaining protection has any obvious justification in terms of ecnomic models of national welfare.The industrial countries' success in reducing tariffs carne through a serieof reciprocal reductions initiated by the United States in the 1930s. These reductions were broadened into multilateral and increasingly across-the-board reductions. The most recent (Uruguay) round went far, not only in lowering tariffs bualso in protecting intellectual property rights, seeking to curb special protectionand improving the governance of international trading relations. Two interpretations are offered of how multilateral tariff reductions were able to raise world ecnomic welfare. The reductions might have effected a truce in nations' mutually dstructive efforts to improve their terms of trade. Or the multilateral reductionmight have aided domestic political alliances able to defeat protectionist interestsimport-competing industries.Running counter to the multilateral reduction of tariffs has been the increasetendency for countries to "manage" international trade in pursuit of objectives rlated to particular problem industries. Management often involves the use of quotas or voluntary export restraints. These are comparable to tariffs but generallimpose on the importing nation higher welfare costs than do tariffs having equincidence. Quotas give domestic monopolies rich opportunities to distort outpulevels. One use of special protection is to delay adjustment in troubled industriethat face increasing competition from imports. If such delays have a welfare justifcation, it must rest on the imperfection of short-run adjustment processes in thfactor markets (better tackled by improving the adjustment process). Another uof special protection (under the banner of fair trade) is to force foreign rivalsraise their prices, in order to stop dumping or simply reduce the competitivenessan international market. The U.S. steel industry illustrates how a declining sectouses public policy to its advantage.

171. M. Destler, American Trade Politics, 3rd ed. (Washington: Institute for InternationaEconomics, 1995).


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SU GG ESTION S FO R FUR THER R EAD IN G 251

CHAPTER PROBLEMS1. You are asked to estimate the welfare cost of a tariff imposed in a market like thatdepicted in Figure 10.1. You are told that imports were $100 million before thetariff and $50 million (valued at world prices) after it was imposed; the tariff rate

is 20 percent. Can you estimate the approximate loss in national welfare due to thetariff?2. Suppose the trade restriction described in the preceding problem were due not to atariff but to a voluntary export restraint. Then what would the welfare loss be?3. Exporting countries sometimes administer export restraints by creating transfer-able rights to export to the restricted market, which domestic manufacturers cantrade among themselves. Suppose you learn that Hong Kong shirtmakers pay $20for the privilege of exporting a dozen shirts to the United States, and that the shirtshave a world market value of $60. What conclusions can you draw about the tariffequivalent of the export restraint?4. You are a domestic manufacturer persuading the government to protect your in-dustry. You can secure either a 20 percent tariff or a fixed quota that is equivalentto it. You expect the market to grow in real terms. Will that fact affect whetheryou choose the tariff and the quota?5. Governments in some European countries are believed to make substantial use ofindustrial subsidies to avert the contraction of some industrial sectors. What dif-ference does it make for national welfare whether the subsidy applies to domesticsales, export sales, or both? Governments do not find it easy to raise tax revenuesto finance such subsidies. Does that fact help explain why such governmentswould rather subsidize an industry's export sales than its sales in the domesticmarket?6. In 1986 the United States and Japan reached an agreement setting minimum priceson Japanese semiconductor chips sold by Japanese manufacturers not just directlyto the United States but also to all other export markets. At the time, producers inboth countries had considerable excess capacity because demand was unexpect-edly low. Explain why chip prices in Japan plummeted and why third-country chipbuyers started to obtain their supplies from intermediaries and brokers in Japan.7. Producer groups sometimes urge that fair trade requires that Japan's tariff ongoods that they export be no higher than the tariff protecting their home (U.S.)market. What should be the consequences of this policy for the home industry'squantity and profits if (a) markets are purely competitive and both countries aresmall, (b) markets are competitive but both are large, and (c) markets are notpurely competitive (oligopoly, product differentiation)?

SUGGESTIONS FOR FURTHER READINGBaldwin, Robert E. The Political Economy of u.s . Import Policy (Cambridge,MA: M.LT. Press, 1985). Detailed study of political mechanism of importrestriction.


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252 CHAPTER 13 'i , TRADE CONTROLS IN PRACTICE

Bhagwati, Jagdish, and Hugh T. Patrick, eds. Aggressive Unilateralism (AArbor: University of Michigan Press, 1990). Papers on the U.S. campaignforce other countries to reduce trade barriers in the name of fairness.Feenstra, Robert c., ed. The Effects of u.s . Trade Protection and PromotioPolicies (Chicago: University of Chicago Press, 1997). Sophisticated studiesvarious specific sectors and issues involved in U.S. trade policy.Krueger, Anne O. Economic Policies at Cross-Purposes: The United States andDeveloping Countries (Washington: Brookings Institution, 1993). Reviewsthe many ways in which U.S. trade and aid policies affect the LDCs.___ . The Political Economy of American Trade Policy (Chicago: UniversityChicago Press, 1996). Extensive studies of protection in eight U.S. industrie___ , ed. The WTO as an International Organization (Chicago: UniversityChicago Press, 1998). Essays on policy issues related to WTO.Ostry, Sylvia. The Post-Cold War Trading System (Chicago: UniversityChicago Press, 1997). Long view of policy development in the internationtrading system.Schott, Jeffrey J . WTO 2000: Setting the Course for World Trade (WashingtoInstitute for International Economics, 1996). Early evaluation of WTO's pformance.

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