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If you ever wondered how trade wars start, pay attention. We are in the early stages of saber-rattling on trade and if some adult supervision does not come along, it could get much worse. Here’s how.

Politicians try to curry favor with unions or the steel industry or the auto industry and they insert a “Buy American” clause into legislation. In this case, it was the American Recovery & Reinvestment Act of 2009, otherwise known as President Obama’s economic stimulus plan. Then, politicians in other countries get the same ‘bright’ idea and they insert protectionist trade policies into legislation over there as China is now doing. Rinse, repeat and escalate and before long you have a serious problem.

By the way, I believe the Great Depression itself should have been just a recession, but that government actions including higher income taxes (Presidents Hoover & Roosevelt), trade restrictions (Smoot Hawley Tariff Act of 1930) and a significant contraction in the money supply (Federal Reserve) all combined to drag the economy down much more than otherwise would have happened (see How to Squelch an Economic Recovery for much more detail on this issue).

Just as we had in the 1930s, we now have real movement towards trade protectionism, which is an enormous policy mistake. The ‘Buy American’ provision has already stirred complaints from our trading partners. Also, Mexico announced that it is putting up tariffs on American goods over another dispute. Though these are relatively minor events, protectionism is hard to stop once it gets going.

Though many believe the Buy American policy was withdrawn, that is incorrect. Canada, Mexico and Brazil have complained about this policy and they are doing so with good reason. This piece from Reuters illustrates Brazil’s issue [emphasis added]:

Brazil may challenge the legality of a “Buy American” clause in the recently approved U.S. economic stimulus package at the World Trade Organization, Brazilian Foreign Minister Celso Amorim said on Monday.

…The U.S. Congress approved a $787 billion plan to jump-start the world’s biggest economy on Friday, stipulating that public works and building projects funded by the stimulus use only U.S.-made goods, including iron and steel.

Major commodities exporter Brazil has been a key player in the Doha round of global trade negotiations, and had hoped the G20 group of leading economies would honor a November pledge in Washington to avoid protectionism.

Amorim said the U.S. move was counterproductive, likening it to a pain-killer that heals the symptoms of disease but not its cause. He said the Doha round was not dead but would be hard to revive.

“It’s a bad sign. … It’s not positive at a moment when the world economy is trying to revive,” Amorim said.

Chinese official media also blasted the Buy American provisions over the weekend, saying they were “poison” to the world economy.

U.S. business groups last week criticized Congress and warned the clause would dilute the bill’s impact and invite other countries to keep American goods out of their stimulus programs…

I believe the quotations from the spokesman for Brazil are accurate. Protectionism is a dangerous proposition and the consequences are likely to be negative. There seems to be a real failure by many of our politicians to understand that protectionist policies in our country will just spur similar policies in other countries.

Now, we are seeing protectionist trade policies in China. This Associated Press piece spells out China’s protectionist retaliation [emphasis added]:

China has imposed a requirement for its stimulus projects to use domestically made goods — a move that could strain ties with trading partners after Beijing criticized Washington’s “Buy American” stimulus provisions.

Projects must obtain official permission to use imported goods, said an order issued by China’s main planning agency and eight other government bodies.

Even before the order, business groups worried that foreign companies might be excluded from construction and other projects financed by Beijing’s 4 trillion yuan ($586 billion) stimulus. Foreign makers of wind turbines complain they have been shut out of bidding on a $5 billion stimulus-financed power project.

“Government investment projects should buy domestically made products unless products or services cannot be obtained in reasonable commercial conditions in China,” says the order, dated June 1 and reported this week by state media. “Projects that really need to buy imports should be approved by the relevant government departments before purchasing activity starts.”…

The wording on this is similar to various “Buy American” proposals and it must make sense to politicians, even though it makes no economic sense to me. First, the requirements for bureaucratic approval are a sham. The bureaucracies can easily make it next to impossible to get approval on any reasonable basis. Second, it just concentrates even more authority in a given bureaucracy and requires companies to curry favor with the bureaucrats. Third, the local suppliers typically charge more than the products would cost if there was competitive bidding with foreign suppliers. And, fourth, by slowing everything down, it ramps up costs.

This Bloomberg piece aptly illustrates the problems inherent in large scale projects and “Buy American” policies [emphasis added]:

Cisco, Alcatel Chafe at ‘Buy American’ Mandate in Stimulus Plan (Bloomberg, June 10, 2009, Todd Shields and Mark Drajem)

Cisco Systems Inc. and Alcatel- Lucent want “Buy American” provisions waived for a $7.2 billion U.S. program to expand high-speed Internet access, saying the rules are difficult to meet and undermine the economic stimulus program.

Requiring U.S.-made parts would be “grossly inefficient” and a “radical departure” from normal markets, said Cisco, the largest maker of networking equipment. The comments were filed with the U.S. agency running the broadband initiative, part of the $787 billion stimulus package.

The rules may slow projects the stimulus was meant to spur because telecommunications networks contain parts from around the globe, the two equipment makers say. Congress, seeking to boost U.S. jobs, said funds provided under the law passed in February generally can’t be used for iron, steel and factory goods that aren’t U.S.-produced.

“We’re talking about technologies that are no longer made in the United States,” John Marinho, vice president of public affairs for Paris-based Alcatel-Lucent, said in an interview. The company operates in 130 countries, and “you need a global scale,” he said.

One obvious problem to this ‘Buy American ‘ proviso is how do you define U.S. produced? Even cars made in America by domestic car companies have significant foreign-sourced components of between 20% and 30%.

cd-domestic-car-content-cars.png

Source: Carpe Diem / Chicago Federal Reserve

This data is compiled by the Chicago Federal Reserve based on 2006 information. So, under the “Buy American” provisions could you buy a GM (GMGMQ.PK) car or truck? What about Toyota (NYSE:TM)?

As another example, consider a complex broadband computer network that would require thousands of parts, each of which is made up of even more parts. Who is going to track the provenance of all these items? What will that cost? And, what happens when a given part is no longer made here? Do you need a pass from the regulators?

For years, we tried quotas and high tariffs to protect our domestic auto industries and those policies have not helped those companies one bit. In fact, GM and Chrysler are in Washington right now asking for additional billions in government bailouts. Those tariffs and quotas did not help domestic industries, but they did hurt consumers by raising prices.

Source: China Counterattacks With a 'Buy China' Policy