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Protectionism: Causes & Consequences

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Excerpt from: “Crystal Ball for Investing and Trading” Book.

Protectionism: Causes & Consequences

Meanwhile, the vicious circle of the currency war among countries to consistently devalue their currency against each other has found another vicious circle as a companion, the protectionism. Before defining it, let’s explain the notion of “trade balance.”

You have read earlier that technological innovations and their implementation in the systems of production of goods and services are one major cause of the increase in the rate of productivity. They also lead to specialization. The more companies or countries use technologies and become specialized, the more they become cost efficient and gain on competitive edge. As a result, they can produce goods and services with fewer resources, hence with ever-decreasing costs of production.

The countries’ trade balance measures the amount of imported and exported goods and services across the countries, generally in US dollars. A positive trade balance for a country, also called a surplus, means that the country exports more than it imports. In contrast, the opposite is called a trade deficit.

A country’s trade balance is influenced by the valuation of its national currency against other currencies, the country’s labor legislation, bureaucratic barriers such as imposed customs duties, and its rate of productivity. The more a country produces efficiently, the more it tends to export. Often the same products and services are produced in several competing countries at the same time. In the end, the countries with the lowest costs of production become the trade balance and the export champions. When this happens, inefficient companies of inefficient countries tend to close factories and dislocate jobs to produce in more competitive environment. As a result, inefficient national jobs of inefficient countries get progressively lost in favor of other nations.

As a rule, the free market system is most effective when there are no barriers to the free movement of (1) people (2) Products (3) services, and (4) capitals. This way, the competition can freely operate across the board, and most efficient countries become the trade balance champions. Therefore, this phenomenon exerts pressure on other nations to remove inefficiencies and become more competitive, too. The BRICS (Brazil, Russia, India, China, and South Africa) countries profited exactly from inefficiencies of the developed economies and became the world manufacturing factories after the 1980s. The emergence of new technological innovation since the 1980s led these countries to produce goods and services of the same quality at significantly lower costs, because of cheaper and flexible labor costs and conditions. This process is often referred to as “globalization.” Meanwhile, the intelligence and competence of qualified engineers of the developed countries have increasingly been emulated by robots. This process has led to a massive transfer of well-paid jobs from the developed countries toward the BRICS and other low-pay countries.

Under conditions of the free market, the volume of exchanged goods and services across borders grow because the increasingly lower price of goods and services attracts more consumers and generates more demand.

As a reader of this book, you may know by now that in times of economic prosperity and growth, major peace and trade treaties are signed. In contrast, you may also know that during economic depressions and crises, those treaties are frequently abandoned.

Coming back to the original topic of protectionism, it could be said that, starting in 2017, major trade partnerships and treaties are going to be torn off.

In short, protectionism is the result of populist governments’ policies to implement new trade barriers to protect the inefficient and non-competitive national companies and the associated inefficient jobs in the name of saving jobs.

Implementation of such measures is like keeping artificially a sick patient under permanent perfusion. At the same time, everyone knows that if the perfusion is stopped, the patient would die rapidly.

Protectionist measures are usually taken by powerful or less powerful rather inefficient conservative governments to give a false perception of job protection for their fragile national companies, jobs, and unemployed population. Such measures may have benefits temporarily, but in the long run, constitutes another vicious circle with major negative long-term impacts.

Implementation of protectionist measures by any country implies the implicit recognition of inefficiency and vulnerability of its national economy and financial system. Let’s analyze the issue in more details:

  1. Protectionist policies lead to ever-decreasing overall world trade volume. Decreased trade volume means a recession for production of goods and services in countries with a trade surplus. This may result in bankruptcy for many companies, and in job losses. The world economies nowadays are so connected that bankruptcy of any business in any country is immediately reflected in the financial indexes, worldwide.
  1. Such measures hurt the countries with a trade deficit too. Why? This is because, as an example, by imposing a 20% customs tax on imported goods, the price of associated goods increases proportionally for all citizens and consumers of the importing country. As a result, prices go up and generate artificial inflation. You may know by now that inflation is good for governments and central bankers, but not for citizens and consumers. The higher price of goods and services leads to lower levels of demand. Despite such taxes, companies continue to go bankrupt and lay off employees because the higher prices reduce the level of demand. The worse consequence of protectionism in countries with a trade deficit consists of the fact that, with the perceived new protections, inefficient companies become even more relaxed to address the inefficiencies built-up in the systems of production. Tax increases hurt the consumers’ wallet because it leads to a transfer of part of citizens wealth toward the governments. This effect, however, will be short-lived. Because the overall volume of purchased goods and services decreases drastically over time, the amount of collected taxes decreases proportionally as well.
  1. The exertion of any pressure generates a counter pressure of proportionally same level, more and less. This rule also applies to economics. The vicious circle of protectionism gets nourished with retaliation from other countries because affected nations will be forced to protect their national interests too. Levying an importation tax of e.g. 20 percent by the US government for the goods imported from Mexico could result in a retaliation levy of a 20 percent tax by the Mexican government for the imported goods from the US.
  2. Protectionism addresses only the symptoms and effects, not the cause. As a result, such measures will reveal inefficient in the long run. The cause is the presence of inefficiencies in the national system of production of goods and services, and the cure, removal of the built-in inefficiencies and improvement of economic competitiveness against other countries. To better explain, let’s take the example of a few metaphors. Protectionism is like wanting to measure the temperature with a thermometer and not liking the reading. However, instead of investigating why the temperature is not at the desired level, breaking or replacing the thermometer would not help. Other metaphors could be like having a hole in the house roof with the consequence of flooded floor each time it rains. Now, imagine someone telling you that the cure is to use a bucket on the floor to prevent the flooding (curing the symptom), instead of getting a carpenter to repair the roof (curing the cause). Another metaphor could be when saying, “a fish in an aquarium is sick because the aquarium water is toxic.” Now you go to a doctor who says, no problem. Just give these medicines to the fish, and it should recover. Likewise, this approach addresses the symptom, not the cause. The real cure would be a change of the toxic water (the cause), and potentially, prescription of some temporary medicine to support the fish for a more rapid recovery.

The US trade balance measures the level of its economic competitiveness and efficiency. On February 1, 2017, its trade deficit amounted to over $737 billion, with a deficit of $344 billion to China alone. Any protectionist measure to reduce the deficit e.g. against China would substantially hurt both, the Chinese and the US economies directly.

Above being said, the US economy has meanwhile become quite inefficient. The main reasons are (1) the US controlling of the world global finances (the World Bank and IMF, the SWIFT system, and the US dollar), (2) the US dollar is the world reserve currency (3) undoing of dollar backing by gold, and finally (4) the petrodollar. These are very efficient and powerful tools that have consistently been used by the US successive governments to preserve, protect, and expand its national interests quite easily.

Other countries must produce efficiently and export goods and services to the US to obtain the needed dollars to purchase e.g. the crude oil from Saudi Arabia. The US, however, has no need to be efficient and export goods and services to other countries to get the needed US dollars. It easily and simply prints them. Meanwhile, the European Union and Japan central banks are replicating the money printing policy too.

Why does the US tend to move in 2017 toward protectionism? Since WWII, the US has taken advantage and profited from its status as the world economic, financial, and military power. After 2009, it has completed three rounds of QE programs and tapering, with an interest rate of virtually 0% for over six years until the end of 2015. The purpose of the QE programs was to manipulate and weaken the valuation of the US dollar against other currencies artificially, to support the US exporting industries and to improve its trade balance.

Meanwhile, the European Central Bank (ECB) started its QE program in January 2015 too and decided to introduce negative interest rates to support its trade balance. These actions led to a euro depreciation of over 25% against the US dollar.

Japan has also decided a negative interest rate policy. Meanwhile, one solution for the US to propel its trade balance consists of depreciating its currency through new rounds of QE program. However, any depreciation of US dollars potentially could support the US trade balance with the European Union and Japan. What concerns its trade deficit with China, a resumption of QE programs would have marginal effects because the Chinese yuan is pegged to the US dollar.

Furthermore, the effects of the world previous and ongoing QE programs have generated a relatively significant level of inflation in the world economies. Consequently, the rate of interest should rather go higher.

Finally, the decision of two rate hikes of 25 basis point each in December of 2015 and 2016, and the anticipation of the ones to come in 2017, have already led to substantial appreciations of the US dollar. The rate hikes cause the interest rate to rise. As you may know, rising interest rates are damaging for the bond market, which had already suffered substantial losses. So, the only alternative would be a return to the Zero Interest Rate Policy (ZIRP) with its own consequences.

In brief, the world and the US policies of previous decades have meanwhile led its own and the world economy close to a cliff. On the one hand, it can no longer raise the interest rates without risking the collapse of the bond market, increase the burden of servicing the government debt of some 20 trillion, increase the risk of defaulting on its debt, import further deflation with the additional danger of losing jobs, and deteriorate the trade balance. On the other hand, it can lower the interest rate by resuming a QE program.

This may partially improve its trade balance with the European Union and Japan but not with China. It could also raise the risk of being unable to attract enough external loans for its bond at practically zero interest rate while, in addition, the government budget deficit may easily grow to over a trillion dollars per year starting in 2018.

Who would wish to lend money at 0% to any government with an inflation rate of around 1.5%? Only the Fed could do. However, each newly printed $100 note would then diminish a fraction of trust in the US dollar and generates inflation. Such decision would have adverse consequences for the Treasury Bonds.

The foreign governments could be forced to dump their reserves in dollars, hence exacerbating losses in the bond market which in turn, could lead to higher rates of interest. Regardless, the process of QE programs will finally result in the collapse of the fiat monetary system, loss of trust in the US dollar, and generation of hyperinflation. The history has taught us that all paper currencies will eventually end where they should end, at the intrinsic value of the printed paper.

To justify the protectionism, the leaders become creative and often use allegations of unfair trade agreements, border protection against immigrants, wasting of social benefits by minorities and so on. Such arguments are an easy way of distracting the citizens’ opinion from the real cause of trade deficits, which is the built-up of inefficiencies in the world economic, financial, political, and social systems since 1789.

Political leaders who do not take responsibility for their national miseries and accuse others to justify protectionism are simply refusing to recognize the real deficiencies in their homes. How can someone lead other countries when at the same time refuses to do his own homework first? This is particularly true for some of the European Union and Eurozone countries in 2017.

The impending crash is the human fate and destiny regardless of who are the head of states and central banks. The crash cannot indefinitely be delayed either. It is inevitable and needed to prepare the solid foundation on top of which the next wave of growth and prosperity can safely develop.

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