Free Trade, 'Yes' - Mercantilism, 'No' - Why China Should be Shut Out

I have had several comments on the subject of free trade and protectionism, and thought the best way to answer this would be to dedicate a post to the subject. Much of the discussion revolved around some of the points that I made around the subject of China in the world trading system in recent posts, such as the notes at the end of my post on 'UK Bank Bailout - Round 2 Begins?'

The best way to start is to highlight my underlying principle, which is that free and fair trade is a good thing, and that such free and fair trade offers considerable benefits to all.

When I discuss fair trade, I would like to highlight that this is not the fair trade of 'fair trade coffee' and other such causes. I actually believe that such so called fair trade is grossly unfair and serves to create market distortion.

In the case of the coffee market, the reason for the fair trade movement was the collapse in coffee prices that was resultant from the decision by the government of Vietnam to expand the coffee business (yes another government distortion in the free market causing problems - see post here for an argument for free markets). The resultant glut in the coffee market caused considerable difficulties for other producers:

Apart from oversupply, there are two types of paradigm shifts underlying the current situation:

1. A structural change in the nature of supply, particularly increases in both the quantity and quality of Brazil and Vietnamese coffees.
2. Structural changes in demand, comprising increasing demand for high-end, differentiated products, new technology allowing greater flexibility in blending, and geographic-generational shifts in the appeal of different types of coffee products.

There are dramatic changes in the nature of this new supply. Of particular note is that global supply has become more concentrated. During the previous period of low prices in 1992, USDA data shows Colombia, Brazil, and Vietnam produced 44 percent of world production. In 2002-2003, 60 percent of world supply came from these three producers, and this figure is likely to increase unless production in other countries significantly reverses its decline. For some roasters, these three suppliers can provide almost everything they need, leaving them to buy only small amounts of coffee from other countries. (1)

The response to this shift in supply was to create the 'fair trade' coffee movement. At the heart of the movement were arguments about the immorality of the high prices charged for coffee in the West (Starbucks would often figure in these discussions), and the low prices achieved by farmers. This was apparently 'unfair'.

The result was that the fair trade movement instigated a system of guaranteed minimum wages for coffee farmers in particular regions, on a selective basis. In doing so, they offered prices for coffee that the market would not otherwise stand. This has created one central problem. If there is a glut in supply, and you guarantee prices, guarantee a living wage, you create a situation where a) you encourage otherwise inefficient producers to remain in the coffee market b) encourage new entrants into the market. In doing so, you are just prolonging the problem of oversupply in the market. Furthermore, on what basis do you award the guarantee to whom? Is it fair that farmer x gains a guarantee, even if he is an inefficient producer, but deny the same to farmer y, an efficient producer? What would be a fair basis to offer this guarantee? If farmer y is very hard working, very efficient, why would it be fair that he must compete in a market in which an artificial glut is maintained through price support for inefficient producers?

In this respect it is unfair trade. On the other hand, if we view it as a marketing tool, it is perfectly fair trade. If a company can persuade people to buy coffee on the basis of benefits to their sense of moral righteousness, then that is a good marketing ploy, and conveys a competitive advantage. They are no longer just selling coffee but a 'feel good', emotional benefit. However, that this is a genuinely moral activity is at the very least dubious. It is fair trade in the sense that a point of differentiation is created, but it is certainly not fair trade in the sense conveyed by the supporters of the fair trade movement.

The case of coffee illustrates my point of real fair trade perfectly. Real fair trade is about removing distortions from the market, but the coffee market has seen considerable distortions, including international agreements on quotas and all kinds of interventions (from the same report as above):

At the domestic level, state-managed governing bodies, such as the coffee boards, were often inefficient,and, under the ICO programs, their management of the export quotas gave them opportunities for rent seeking (Bohman and Jarvis 1999). When this rent seeking was combined with the inefficiencies, the marketing boards induced in their markets, it served to divert a significant share of the export value of these crops away from the producer toward either governments, the marketing boards themselves, or the export sector. even if they managed to smooth market signals and responses which most likely contributed to lower domestic volatility (Giovannucci, et al. 2002a). It was not surprising that, in many cases, the end of the ICO quota schemes led to both a dismantling of the coffee boards and a rise in the producers share of the export price.

Or:

Stabilization funds suffer from a number of structural weaknesses. As discussed above, the tendency of commodity prices to have short spikes and long troughs means that stabilization funds have a tendency to run out of money before a recovery can occur. In the case of Papua New Guinea, this led to the fund having to borrow from the government—loans that later had to be forgiven. There is also an assumption that the stabilization fund managers can better invest the levies received during periods of high prices than can individuals, and producer support for stabilization funds may, therefore, be indicative of a problem of lack of access to financial services.

I can not reproduce the entire paper here, but what you see is not a market of free and fair trade, but a market in which there are endless interventions both internationally and at national government level. If we just take the example of Papua New Guinea, the intervention meant that their coffee producers were given an unfair advantage in the market of a subsidy. Someone, somewhere, will lose from this subsidy because they will be faced with less efficient producers than themselves who are still in the market place due to subsidy. It is a classic case of 'beggar-thy-neighbour' policy. The end result of such policies is that everyone tries to manipulate the market, the gluts continue, and the problem of excess supply never goes away.

The end result of such distortions is that there is a lot of land devoted to producing a commodity that nobody really wants, and that means that potentially productive resource is actually not producing anything of value. At the local level, it is easy to make a case for intervention, but each intervention ripples through the market eventually hurting someone else.

As such, if you want true fair trade, then you need to make the markets as free and as fair as possible, which means that the most efficient producers survive, and the inefficient get out of the business. The problem with such a solution is that it meets with resistance in each of the countries that are unable to compete.

The coffee market is world trade writ large as, for some reason, farmers appear to have greater emotive appeal than, for example, a worker in a widget factory. For some reason a farmer going bust has greater emotive appeal than a widget factory worker being made redundant. In both cases they might be thrown into poverty, but for some reason the farmer's poverty counts for more. As such the distorting effects of intervention are particularly more apparent in markets such as coffee.

It is at this point it is worthwhile opening up the discussion of free trade to a broader frame of reference. No doubt, all of the readers will be aware of the bailout of the US automotive industry, and that similar bailouts are being proposed elsewhere (e.g. the UK). Even before the contraction of the world economy that we are now seeing, there has long been a glut in the supply capacity of cars, and the current contraction should have seen the end of the US automotive industry (or at least the end of one of the big three, possible two). Just as with the coffee market, we have a situation in which a government subsidy will create the same beggar-thy-neighbour effect as the intervention of Papua New Gunea in the coffee market. Someone else somewhere will pay the price of this intervention.

In the meantime, there is another problem. In intervening to prop up inefficient industry, it may appear that this is a good thing for the intervening country, but in some respects it will only cause them long term harm. In this case, the money for the car industry is being provided by central government, and that (one way or another) will be paid for elsewhere in the economy. There are several ways that this might cause hurt.

One is that, if it is funded out of borrowing, that money will need to be repaid, and that means that the efficient parts of the economy will have to pay for the inefficient parts of the economy, thereby removing capital from those efficient parts, and therefore constraining their growth potential. If the bailout is paid for by printing money, then it is paid for by a general tax on the economy as a whole, as the value of the existing money is transferred onto the printed money (the tax), and then transferred to the inefficient industry. In both cases, the efficient parts of the economy will be taxed to pay for the inefficient.

From this perspective, all seems very clear. Subsidy, it appears, hurts yourself. However, I have emphasised that it also has a beggar-thy-neighbour impact. The point here is that, if you subsidise an industry sufficiently, you have the potential to destroy the same industry in your neighbour. Having destroyed that industry, you remove the glut, and your inefficiently run industry can then achieve a position of profitability and market domination.

It is for this reason that governments intervene to support their industries. It is very rarely ever discussed in these terms, but the central idea behind subsidy is that of supporting an industry until it is the 'last man standing'. I do not mean this in the literal sense, as it is unlikely in most cases that it will be the last man standing, but rather if there are not many men left standing, then the industry can achieve profitability. I recently read an essay in a book (2) in which they discussed the 'rule of threes'. This is the idea that, over time, industries will whittle down to three major players, and that in an increasingly globalised system this is starting to apply internationally. Whilst not agreeing with their entire argument, the principle is roughly right. In such circumstances, whilst having some negative effects on your own economy, subsidy can pay.

From this starting point, we now come on to China. I have consistently argued that there are two fundamental problems with the rise of China. In particular the theft of intellectual property, and aggressive trading practices such as currency manipulation. I had the following to say in an earlier post on China (it is a little clearer in the original context, but the central point is clear enough);

I have suggested in a previous post that the world trading system needs to get tough with China. I did not have the time to dig up the articles that I had read, which caused me so much concern, so have previously not outlined this point of view. However, on reading the latest attempt by the Chinese government to manipulate trade, it seemed a good point in time to outline this problem. I am at heart a free trade advocate, but I also believe that trade should be free and use reciprocal rules should be binding and enforced. It is very clear that China intends to rise economically by any means, fair or foul. The crazy part is that the foul is unnecessary, and one then becomes very suspicious of the underlying motives for such methods.

In another post I concluded the following:

China poses a real and ongoing threat to the world economic order, and will continue to grow at the expense of the West, unless the West responds by restructuring of their economies through (real) improvements in education, lowering their cost base, and taking an aggressive approach to intellectual property and fair trade (for why, see here).

And in yet another post:

One of the key elements in the rise of the Chinese economy has been their very lax attitude to Intellectual Property, which is stolen at a rate that is truly astounding. For example, it is nearly impossible in most Chinese cities to buy genuine computer software for individuals, excepting that which is preloaded on new computers. If we just took the example of Microsoft Windows, we can take a reasonable guess that, at least, 100 million computers are running on the software, and the majority of these are illegal copies. At something like $100 retail per unit for Windows, it is not difficult to grasp the scale of the theft. This is just one example. Multiply this across all of the software, and the numbers start to look truly shocking.

I later go on to say the following:

Another problem has been the exchange rate in China. It has been fixed, then moved to a basket with a partial floating rate. In a free trade situation, this is unacceptable. However, the West congratulated China on holding firm on its exchange rate during the Asian financial crisis, thereby hobbling the ability to complain about the problem of the exchange rate later. Had the exchange rate been free, the RMB would have strengthened, making Chinese exports more expensive, and thereby avoided the degree of imbalance that has occurred.

What I am therefore saying is that there was always going to be some pain for the Western economies, but the foolishness/weakness of Western leaders contributed to the scale of the current problems. China always had the potential to grow, but the rise was boosted by two practices which might be described as 'unfair' trade practices. These have accelerated the growth and have contributed mightily to the degree of imbalance that we now see.

As you will note, my stance on free trade has been pretty consistent, and in particular with regards to China. My argument has always been that China has enough advantage without any subsidy, whether that is through the export subsidy and protectionism implicit in exchange rates or through the theft of intellectual property. I believe that, as a result of the implicit subsidy in the exchange rate, in conjunction with intellectual property theft, China has been in a position where it has been effectively been allowed to destroy industries in its competitors. The worst part of this is that China has always had the potential for strong growth without such measures. I have always believed that China deserves its place in the sun, but only on free and fair trade terms.

I should qualify this slightly, as I think that all countries indulge in some unfair practices to some degree or another. This is not to condone any such practices, but at least they should be minimal. The difference with China is that it has practiced two policies which have such a massive impact on the trading position of the country.

The real question in all of this is why the world trading system has not responded, and this is a difficult question. One part of the equation was detailed in one of the posts I have already cited as follows:

On a related subject, in an article a while ago the Telegraph, it was reported that senior Chinese officials were willing to use dollar sales as a way of exerting power over the US. In short, the Chinese have the power to destroy the $US by selling the currency, and therefore have huge economic power over the US. The Chinese government later denied the policy, but those familiar with Chinese culture will know that using such methods of presenting a threat is not unusual.

Another factor which is somewhat harder to summarise has been a divide and conquer, carrot and stick approach, in which the two major trading partners of China, the US and Europe, have been played off, one against the other. It has appeared to me that the Chinese government have long played this game, but it is hard to support such an allegation. The carrot has always been the access for each country's companies to the lucrative engineering and infrastructure projects, ease of access to the Chinese market and so forth. The stick is getting unfavourable treatment within the Chinese market. All the time there will be pressure from business on governments to keep China 'sweet', in order to secure the access.

In other words, what has been lacking is a unified stand against the unfair trade practices of China. I believe that, as the severity of the impact of the speed of growth of China's impact on US manufacturing gathered pace, the US would have acted, were it not for threat that China could destroy the $US. By the time the US woke up to the impact of China, it was too late to act, as they had already ceded economic power to China by allowing the massive accumulation of $US reserves.

My argument has always been that it is better to take the risk of economic damage now (the damage to the $US), rather than later. The longer it is left, the greater the accumulation of $US reserves by China, the greater the numbers of industries permanently destroyed, and the greater the long term pain. In other words, the longer that the confrontation with China is delayed, the less able the rest of the world will be to withstand the consequences. When I first wrote about this, the full impact of the economic crisis was just in my imagination, was just a prediction. Now that it is here, the weakness of the economies of West is such that the leverage of China is that much greater. I have long predicted the collapse of the $US, and mainstream thinking such as Willem Buiter, are coming around to the idea. In the situation of an already vulnerable currency......

At the end of this post, I can only conclude that it is time to face up to the mercantilism of China, and finally address the problems that are being caused by such practices. I do not, and will not agree with protectionism, but I do believe that, where a country is systemically mercantalist, then action should be taken, including raising trade barriers and tariffs. I would even countenance a complete embargo on trade.

The trouble is that, as I pointed out in a previous post, China has now placed itself in a position where too large a proportion of the economy is geared towards export. It is destroying the very customers that are supporting its economic growth. If the West were now to act to discipline China, it is a very dangerous proposition. In particular it will wreak even greater damage on the Chinese economy, which is already suffering from the contraction of its major markets. Regardless of the rights and wrongs of the situation, China will cry 'foul', and will proceed to stir up nationalist fervour within China. This will see attacks and boycotts on Western and foreign owned businesses. It will see even greater unrest in China, which is already seeing unrest as a result of world economic contraction, and the situation will potentially become explosive. In letting the nationalist genie out of the bottle, with legitimacy of the Chinese government founded on economic growth and nationalism, we have the makings of a heady cocktail. Where such a heady cocktail might lead can only be a matter of supposition, but it will certainly not be a good direction.

The real answer is that the question of the rise of China should have been dealt with long ago. However, the situation as it stands does need to be confronted. Saying that it should have been dealt with long ago is not very helpful. The trouble is that, because it was not dealt with, a situation has arisen in which the costs of dealing with China have exploded. One commentator mentioned that it seemed that the world trading system appears to be fragile, if China's rise can have so much impact. It is only fragile because the impact was not addressed earlier, at a time when the impact of China could have been the emergence of a strong economy in a (in very loose terms) free trade world.

In short, we have a very, very serious problem at the heart of the world trade system. Not only that, but it is a problem whose resolution can only be painful. However, the problem must be resolved, one way or another.


(1) Lewin, Bryan, Giovannucci, Daniele and Varangis, Panos,Coffee Markets: New Paradigms in Global Supply and Demand(March 2004). World Bank Agriculture and Rural Development Discussion Paper No. 3 .

(2) Sheth, Uslay C, and Sisodia, R, (2008) The Globalisation of Markets and the Rule of Three, in Marketing Metaphors and Metamorphosis, ed Kitchen, P