Guided Reading Activity 16 3 Foreign Exchange and Trade Deficits

This week we will look at all the different ways countries block trade. Some are more obvious than others, such as tariffs, quotas, and embargoes. However some ways, such as subsidies and standards, are more subtle. However they too block competition, allowing Americans companies to flourish without lowering prices or competing with foreign producers. Blocking trade is a tricky business, and governments use a variety of tactics to keep foreign goods out of their countries.

Different Types of Trade Restrictions

As David Ricardo taught us, w hen nations specialize and trade total world output is increased. Companies produce for foreign markets as well as domestic markets (markets in the home country). Exports are the goods and services sold in foreign markets. Imports are goods or services bought from foreign producers.

In spite of the benefits of international trade, many nations put limits on trade for various reasons. The main types of trade restrictions are tariffs, quotas, embargoes, licensing requirements, standards, and subsidies.

A tariff is a tax put on goods imported from abroad. The effect of a tariff is to raise the price of the imported product. It helps domestic producers of similar products to sell them at higher prices. The money received from the tariff is collected by the domestic government.

There are two types of tariffs: protective and revenue tariffs. Protective tariffs are put in place specifically to make foreign good more expensive to protect domestic industries from competition. Revenue tariffs are put in place to raise money for the government. It all depends on the intention of the government that implements the tariff. Oftentimes any tariff will end up accomplishing both goals at once (at the expense of the domestic consumer and the foreign business).

EXAMPLE: The Smoot-Hawley Tariff Act of June 1930 raised U.S. tariffs to the second highest levels in our nation's history (the highest was in 1828). The original intention of the tariff was to protect American farmers from foreign competition after WWI. When Europe began to recover after WWI and greatly expanded agricultural production, an oversupply of food caused declining farm prices in America. This tariff was meant to block trade with those foreign food producers. However when the Depression hit in 1929, the tariff was expanded to include most foreign imports. The new tariff imposed an effective tax rate of 60% on more than 3,200 products and materials imported into the United States. U.S. imports from Europe declined from a 1929 high of $1.3 billion to just $390 million in 1932, while U.S. exports to Europe fell from $2.3 billion in 1929 to $784 million in 1932. Overall, world trade declined by some 66% between 1929 and 1934. This amounted to less goods being bought or sold at a time when the world economy desperately needed money to flow freely. More generally, Smoot-Hawley also did nothing to foster trust and cooperation among nations in either the political or economic realm during a perilous era in international relations (the years leading up to WWII).

A quota is a limit on the amount of goods that can be imported. Putting a quota on a good creates a shortage, which causes the price of the good to rise and allows domestic producers to raise their prices and to expand their production. A quota on shoes, for example, might limit foreign-made shoes to 10,000,000 pairs a year. If Americans buy 200,000,000 pairs of shoes each year, this would leave most of the market to American producers.

An embargo stops exports or imports of a product or group of products to or from another country. Sometimes all trade with a country is stopped, usually for political reasons.

Some countries require import or export licenses. When domestic importers of foreign goods are required to get licenses, imports can be restricted by not issuing many licenses. Export licenses have been used to restrict trade with certain countries or to keep domestic prices on agricultural products from rising.

Standards are laws or regulations that nations use to restrict imports. Sometimes nations establish health and safety standards for imported goods that are higher than those for goods produced domestically. These have become a major form of trade restriction and are used in different amounts by many countries.

Subsidies can be thought of as tariffs in reverse. Instead of taxing the foreign import, the government gives grants of money to domestic producers to encourage exports. Those who receive such subsidies can use them to pay production costs and can charge less for their goods than foreign producers. A tariff is paid for by the buyers of the foreign goods and the buyers of domestic goods who pay higher prices. But subsidies are paid for by taxpayers who may or may not use the good.

Here is an article from The Economist criticizing our current subsidy system: http://www.economist.com/node/7887994

Agricultural subsidies also lead to the overproduction of corn, and therefore the widespread use of cheap corn syrup in most of the foods we eat. As Michael Pollan points out, this is not healthy: http://michaelpollan.com/articles-archive/you-are-what-you-grow/

So why do we block trade?
Well there are many reasons, namely:
1) To halt unemployment in America. American businesses must lay off workers if their goods can't compete with cheaper foreign goods.
2) To protect "crucial" domestic industries. Protectionists (people against free trade) argue that entire industries, such as oil, steel, cars, etc. are vital to the economy of the USA, and therefore must be protected from foreign competition.
3) To protect new "infant" industries in America. If these companies are shielded from competition for a while, they can grow strong enough to compete in the world market.

However, all three of these reasons are simply about giving America an advantage in industries where America should not have one. In other words, blocking free trade is the same as blocking the free market, and Adam Smith would not approve! Instead of improving lower-quality American goods, protectionists try to shield them from competition. Instead of allowing American consumers to purchase reasonably priced foreign cars, protectionists want to make them more expensive (so you'll buy American). Instead of drilling oil, mining precious metals, or building snowmobiles in countries that have a comparative advantage for doing all those things, protectionists want to keep all those industries in America, even if that means higher prices for American consumers. Here is an article that discusses what it would be like if America was embargoed by another country:
http://www.hoover.org/publications/hoover-digest/article/7311
Often times people blame our education system for why companies are moving their jobs overseas, however it has a lot more to do with wages and costs than it does with training. Just as David Ricardo explained two centuries ago, if a country can make a good cheaper than us, they will get the business and we won't. Here's an article that explains this concept in modern times:

http://www.salon.com/2012/01/30/the_education_crisis_myth/

However, there is a fourth reason to block free trade that has nothing to do with competition or prices:
4) To isolate and punish totalitarian governments and regimes that support terrorism, genocide, nuclear weapons programs, or (in some cases) Communism. America purposefully cuts off trade with certain nations (e.g. Cuba, Iran, North Korea) in an effort to force those nations' governments to change their ways. Here is a list of nations with whom America is currently restricting trade:
http://en.wikipedia.org/wiki/United_States_embargoes

However even this type of embargo rarely accomplishes the intended goal. Cuba is still Communist almost 50 years after we began blocking trade with them. North Korea and Iran ignore our embargoes and continue on with their nuclear weapons programs. In fact, trade embargoes generally hurt the exact people we are trying to help, by cutting off the citizens of these nations from much-needed food, medicine, and goods necessary for survival. Only free trade can help prevent starvation in North Korea; an embargo will only make things worse.

Speaking of North Korea, here is a mind-blowing look inside the real North Korea, created by undercover journalist Lisa Ling:
http://www.youtube.com/watch?v=mxLBywKrTf4

1) Do you believe North Korea is a 3rd world country? Why or why not?

2) What can we do to improve relations with North Korea?

(In-class assignment)
Free Trade Essay:
Please write a two-three paragraph essay - After analyzing the arguments for and against free trade, are you in favor of free trade, protectionism, or a mixture of both? Explain your answer.

Though we will continue to discuss trade this week in class, you will be reading about third world countries for homework (which we will discuss next week in detail).

1) What are all the different types of trade restrictions? How does each one work? Any examples?

Guided Reading Activity 16 3 Foreign Exchange and Trade Deficits

Source: https://www.sites.google.com/a/menloathertonhs.com/senigaglia/economics/15-nov-22-24