• Arguments for Protection
• Methods of Protection
• Arguments for Free Trade
• Measures of Trade
• Statistics Can Have Different Interpretations

All governments regulate foreign trade. The extent to which they do so is a matter of great controversy and debate. The news is full of reports of various groups protesting about:

• New trade agreements
• Adverse effects of trade on domestic industry, and
• Dilution of the environmental and labor standards, especially in the developing economies

Free trade proponents stand for an open trading system with few limitations and little government involvement. Advocates of protectionism believe that governments must take action to regulate trade and subsidize industries to protect their domestic economy.

Although the amount of government involvement in trade varies from country to country and product to product, overall barriers to trade have been lowered since World War II. All governments practice protectionism to some extent. The debate is over how many, or how few, such measures should be used to reach the country’s long-term macroeconomic goals.

Completely free trade would:

• Deliver the most goods and services at the lowest possible cost;
• Provide consumers the freedom to buy from whomever produces the goods and services most efficiently; and
• Result in competition for domestic industries which may lead to unemployment and slower growth at the least efficient companies

If cars can be produced more efficiently in another country and consumers are free to buy them from anywhere, the domestic auto industry will lose business and may ask for government protection by limiting imports of lower-cost cars.

• Cheap labor: Less developed countries have a natural cost advantage as labor costs in those economies are low. They can produce goods less expensively than developed economies and their goods are more competitive in international markets.

• Infant industries: Protectionists argue that infant, or new, industries must be protected to give them time to grow and become strong enough to compete internationally, especially industries that may provide a firm foundation for future growth, e.g. computers and telecommunications. However, critics point out that some of these infant industries never "grow up."

• National security concerns: Any industry crucial to national security, such as producers of military hardware, should be protected. That way the nation will not have to depend on outside suppliers during political or military crises.

• Diversification of the economy: If a country channels all its resources into a few industries, no matter how internationally competitive those industries are, it runs the risk of becoming too dependent on them. Keeping weaker industries competitive through protection may help in diversifying the nation’s economy.

• Lowering environmental standards: In the rush to meet the world demand for their exports, some countries may compromise on critical environmental standards. This is particularly true for less developed countries that do not have well defined environmental protection laws in place.

• Tariffs: Tariffs are taxes on imports. Tariffs make the item more expensive for consumers, thereby reducing the demand.

• Import Quotas: Governments sometimes restrict the sale of foreign goods by imposing import quotas. These limit the quantity of foreign goods that can be imported and help domestic producers by limiting the share of the market that can be taken by foreigners.

• Voluntary restraints: Sometimes governments negotiate agreements whereby a country agrees to voluntarily limit its export of a certain product. Japan voluntarily limited its export of cars to the United States in 1992 to 1.65 million cars per year.

With tariffs, it is the importing country that stands to gain through increases in the tax revenue. However, in case of quantitative restraints, the exporting country gains as the price of the imported good rises.

Both import quotas and voluntary restraints thwart the functioning of the free market. The quantity of goods remains constant while the price changes, instead of demand and supply determining both quantity and price.

• Subsidies: Another way to achieve the goals of protectionism is to make the domestic industry more competitive. Subsidies, which are grants by the government to an industry, can accomplish this. Subsidies can be:
  • Direct—outright payments
  • Indirect—special tax breaks or incentives, buying of surplus goods, providing low-interest loans or guaranteeing private loans

For example, the United States subsidizes the sugar and dairy industries, among others.

• Trade ban: Sometimes governments ban trade with certain countries for political reasons—during times of war or political crises. Governments also ban import of certain products to protect domestic industries. For instance, Japan bans importation of rice to protect its domestic rice industry.

• Imposing standards: Health, environmental and safety standards often vary from country to country. These may act as a barrier to free trade and a tool of protectionism. For example, the European Union has very stringent health and safety standards that goods have to meet in order to be imported.

• Others: Apart from the legal restrictions there may be other less formal obstacles that impede trade. Cultural factors are one such obstacle.

• Free trade and the resulting foreign competition forces US companies to keep prices low
• Consumers have a larger variety of goods and services to choose from in open markets
• Domestic companies have to modernize plants, production techniques and technologies to keep themselves competitive
• Any kind of protectionist measures, like tariffs, often bring about retaliatory actions from foreign governments, which may restrict the sale of US goods in their markets. This may result in inflation and unemployment in the US as the export industries suffer and prices of imports rise
• An open trading system creates a better climate for investment and entrepreneurship than one in which there is fear of governments cutting off access to certain markets.
• The cost of protection often outweighs the benefits. Learn more

Balance of trade is the difference between a nation’s exports and imports of both goods and services. Balance of payments gives a complete summary of all economic transactions that involve money flowing into or from a country.

Exports are the value of goods and services sold abroad over any specific period of time. Imports are the value of goods and services purchased from foreign countries over a specific period of time.

A "favorable" balance of trade, or trade surplus, occurs when exports exceed imports. A "negative" balance, or trade deficit, occurs when the imports surpass exports.

From the mid-1970s through 2001, the United States ran persistent trade deficits. Economists disagree as to what effect these deficits had on the economy, but they allowed:

• Foreigners to accumulate US dollars from US import payments; and
• Facilitated the purchase of US goods, services and assets, such as real estate and companies, by foreigners

The balance of trade alone does not give the whole picture. The detailed record of all economic transactions between a country and the rest of the world is called the balance of payments. This includes trade in:

• Goods and services; and
• Financial and non-financial assets

The balance of payments is separated into two main accounts:

• Current account—records transactions that involve the export or import of goods and services and interest payments. The entire merchandise trade balance is contained in this account
• Capital account—records transactions that involve the purchase or sale of assets or investments, like companies, stocks, bonds, bank accounts, real estate and factories

If you buy an automobile made by a factory in Germany, the transaction will be recorded in the current account. However, if you buy the automobile factory or stock in the automobile factory, the transaction will be a part of the capital account.

Every international transaction automatically enters the balance of payments twice, once as a credit and once as a debit, resulting in two equal and opposite entries. A transaction that involves money flowing into the country is recorded as a balance of payment credit and anything that draws money out of the country is a balance of payment debit.

For example, if you buy a camera from a Japanese company, XYZ Inc., and pay by check, your purchase results in the following two entries in the balance of payments statements:

Your payment to buy a good (the camera) from a foreign company is recorded as a debit in the UScurrent account. Let’s say XYZ Inc. deposits the check in their account at ABC Bank in New York. This means, XYZ Inc. has purchased, and ABC Bank has sold, a US asset (a bank deposit) worth $1,000—and the transaction will appear as a credit in the UScapital account.

This system of double-entry bookkeeping tries to ensure that the current and capital accounts are balanced. However, due to accounting conventions and differences in the recorded values of transactions, this does not always happen. Accounting for these differences, called statistical discrepancies, makes possible the following fundamental identity of the balance of payment accounts:

Current Account

The current account consists of four sub accounts:

• Merchandise trade consists of all raw materials and manufactured goods bought, sold, or given away. Since early 1990s, the merchandise trade account has been combined with services to determine the "balance of trade."

• Services include tourism, transportation, engineering, and business services, such as law, management consulting, and accounting. Fees from patents and copyrights on new technology, software, books, and movies also are recorded in the service category.

• Income receipts record investment incomes made up of interest and dividend payments and earnings of domestic owned firms operating abroad.

• Unilateral transfers are payments that do not correspond to the purchase of any good, service or asset. These usually take the form of international aid, gifts, or worker remittances from abroad.

Capital Account

The capital account measures the difference between sales of assets to foreigners and purchases of assets located abroad.

• U.S.-owned assets abroad are divided into official reserve assets, government assets, and private assets. These assets include gold, foreign currencies, foreign securities, reserve position in the International Monetary Fund, US credits and other long-term assets, direct foreign investment, and US claims reported by US banks
• Foreign-owned assets in the United States are divided into foreign official assets and other foreign assets in the United States. These assets include US government, agency, and corporate securities; direct investment; US currency, and US liabilities reported by US banks

Balance of Payments Deficit and Surplus

In theory, the current account should balance with the capital account. The sum of the balance of payments statements should be zero. Therefore, when a country buys more goods and services than it sells (a current account deficit), it must finance the difference by borrowing, or by selling more capital assets than it buys (a capital account surplus). A persistent current account deficit amounts to exchanging capital assets for goods and services. Large trade deficits mean that a country is borrowing from abroad and it appears as an inflow of foreign capital in the balance of payments.

The accounts do not exactly offset each other, due to statistical discrepancies, accounting conventions, and exchange rate movements that change the recorded value of transactions.

2001 US Balance of Payments

In 2001, the US imported goods and services worth $1,352 billion, while its exports were only $1,004 billion. And with net unilateral transfers of $50.5 billion, the deficit on the current account amounted to $417 billion. To cover this deficit, the United States required a capital inflow of the same amount. That means net borrowings or net sales of assets to foreigners of the same magnitude.

In the same period, the capital account registered an increase of $439 billion in US assets located abroad and a $895 billion increase in foreign assets held in the US giving us a surplus balance of $456 billion.

The difference, of approximately $39 billion, was attributed to statistical discrepancy, leaving a zero balance in the balance of payment statement.

More information on the US foreign trade statistics may be accessed on the Department of Commerce, Bureau of Economic Analysis web site.

Balance of Payments and Interest Rates

The balance of payments is influenced by many factors, including the financial and economic climate of other countries. If the US banks are offering higher interest rates for deposits than banks abroad, foreign funds will flow into the United States. Conversely, if interest rates are higher abroad, US investors will choose to invest their money abroad.