Question

Questions:

c) An emergency tariff on a wide range of imports would be effective in addressing U.S deficits and forcing other nations to purchase more U.S. exports;

d) One reason the U.S. does not export more is lagging investment in domestic industries.

Why Protectionism Cannot Cure the Trade Deficit

The causal link between investment flows, exchange rates, and the balance of trade explains why protectionism cannot cure a trade deficit. In his 1997 book, One World, Ready or Not, Washington journalist William Greider proposes an “emergency tariff” of 10 or 15 percent to reduce the U.S. trade deficit. If Congress were to implement that awful idea, American imports would probably decline as intended. But fewer imports would mean fewer dollars flowing into the international currency markets, raising the value of the dollar relative to other currencies. The stronger dollar would make U.S. exports more expensive for foreign consumers and imports more attractive to Americans. Exports would fall and imports would rise until the trade balance matched the savings and investment balance.

Without a change in aggregate levels of savings and investment, the trade deficit would remain largely unaffected. All the new tariff barriers would accomplish would be to reduce the volume of both imports and exports, leaving Americans poorer by depriving them of additional gains from the specialization that accompanies expanding international trade. Government export subsidies would be equally ineffective in reducing the trade deficit. Partly in response to the Asian financial crisis, President Clinton proposed in his 1999 federal budget an increase in subsidies to U.S. exporters through the Export-Import Bank. By allowing certain exporters to lower their prices on sales abroad, the subsidies would stimulate foreign demand, but the greater demand for dollars needed to buy U.S. goods would bid up the dollar’s value in foreign exchange markets. The stronger dollar, in turn, would raise the effective price of U.S. exports generally,

offsetting any price advantage gained by the subsidies. Total exports, and hence the trade deficit, would remain unchanged. Subsidies only divert exports from less favored to more favored sectors.
In theory, trade policy can indirectly affect the trade deficit by influencing a nation’s level of savings and investment. For example, a higher tariff would presumably raise government revenue through additional customs duties, thus reducing the budget deficit (or increasing the surplus) and reducing the need to borrow from abroad - resulting in a smaller trade deficit. But a tariff can also stimulate investment in the protected industry, increasing demand for foreign capital and leading to a larger trade deficit.

Understanding the Trade Deficit

The most important economic truth to grasp about the U.S. trade deficit is that it has virtually nothing to do with trade policy. A nation’s trade deficit is determined by the flow of investment funds into or out of the country. And those flows are determined by how much the people of a nation save and invest - two variables that are only marginally affected by trade policy. An understanding of the trade deficit begins with the balance of payments, the broadest accounting of a nation’s international transactions. By definition, the balance of payments always equals zero - that is, what a country buys or gives away in the global market must equal what it sells or receives - because of the exchange nature of trade. People, whether trading across a street or across an ocean, will generally not give up something without receiving something of comparable value in return. The double-

entry nature of international bookkeeping means that, for a nation as a whole, the value of what it gives to the rest of the world will be matched by the value of what it receives.
The balance of payments accounts capture two sides of an equation: the current account and the capital account. The current account side of the ledger covers the flow of goods, services, investment income, and uncompensated transfers such as foreign aid and remittances across borders by private citizens. Within the current account, the trade balance includes goods and services only, and the merchandise trade balance reflects goods only. On the other side, the capital account includes the buying and selling of investment assets such as real estate, stocks, bonds, and government securities.

If a country runs a capital account surplus of $100 billion, it will run a current account deficit of $100 billion to balance its payments. As economist Douglas Irwin explains, “If a country is buying more goods and services from the rest of the world than it is selling, the country must also be selling more assets to the rest of the world than it is buying.”

The necessary balance between the current account and the capital account implies a direct connection between the trade balance on the one hand and the savings and investment balance on the other. That relationship is captured in the simple formula:

Savings - Investment = Exports - Imports

Thus, a nation that saves more than it invests, such as Japan, will export its excess savings in the form of net foreign investment. In other words, it must run a capital account deficit. The money sent abroad as investment will return to the country as payments for its exports, which will be in excess of what the country imports, creating a corresponding trade surplus. A nation that invests more than it saves - the United States, for example -

must import capital from abroad. In other words, it must run a capital account surplus. The imported capital allows the nation’s citizens to consume more goods and services than they produce, importing the difference through a trade deficit.

The transmission belt that links the capital and current accounts is the exchange rate. As more net investment flows into the United States, demand rises for the dollars needed to buy U.S. assets. As the dollar grows stronger relative to other currencies, U.S. goods and services become more expensive to foreign consumers, reducing demand, while imports become more affordable to Americans. Falling exports and rising imports adjust the trade balance until it matches the net inflow of capital. In effect, foreign investors will outbid foreign consumers for limited U.S. dollars until the investors satisfy their demand for U.S. assets. Of course, most day-to-day currency transactions are not directly related to trade, but demand for U.S. goods, services, and assets affects demand for the dollars needed to buy them, thus influencing the value of the dollar in global currency markets. Germany in the early 1990s offers a case study of how this mechanism works. West Germans routinely ran large current account (and trade) surpluses in the 1980s, but between 1990 and 1991 Germany’s current account flipped from a surplus of 3.2 percent of gross domestic product to a deficit of 1.0 percent. The reason for the reversal was not that German manufacturers suddenly lost their legendary efficiency, or that Germany’s trading partners imposed new and unfair trade barriers on the night of December 31, 1990. What caused the switch was the huge increase in domestic investment needed to rebuild formerly communist eastern Germany. An increase in domestic investment repatriated a huge amount of German savings that had been flowing abroad, thus reducing the amount of German marks in the foreign currency markets and raising their

value relative to other currencies. The stronger mark, in turn, raised the price of German exports and lowered the price of imports, evaporating Germany’s trade surplus.

Answer 1

Protectionism means the shielding of the countries domestic market by the implication of the tariffs on the imports of the country so that the outflow of the money can be reduced and the domestic industries can be made self reliant.

Trade deficit means that the inflow of the capital in the country is less than the outflow and the BOP of the country is showing the negative balance.

The policy of protectionism cannot be used to cure the trade deficit because just by restricting the imports of the country the deficit cannot be covered rather this will make the economy poorer. The deficit would remain unaffected without the change in the level of aggregate savings and investment. The increase in the rate of the import tariffs will have adverse effects on the currency going out in the foreign market. The exports will become more expensive and the value of dollar will start rising gradually. With the decrease in the value of exports the economy will have to suffer more losses.The imports will become more attractive and will be against the desire of the economy. The amount of investment will decrease because with the increase in the value of dollar people would like to keep the money with themselves rather than investing it outside.

Hence the policy of the protectionism will not be helpful in curing the trade deficit rather it may pose more problems for the economy.