Chapter 17 International Trade and Finance 15 Thus the case for free trade is a subtle one. As always, special-interest group -- entrepreneurs, labor organizations, consumer groups -- will pursue their individual interests, competing for favors and benefits the same way they compete in the marketplace. Yet if all are to be treated equally by government, we must make the choice between free trade for all and protection for all. Economists generally choose free trade for all, because of its obvious benefits to the nation as a whole. There are some legitimate exceptions to that rule, such as the required domestic production of public goods, which are discussed below. Yet even trade restrictions necessary for the public good are abused by those who would secure protection for private purposes. FIGURE 17.5 Effects of Tariff Protection on Individual Industries: Case 2 In this more realistic case, the auto industry gains from tariff protection, even if both sectors are protected (cell IV). The textiles industry’s income falls from $20 (cell I) to $17 (cell IV), but the auto industry’s income rises from $30 (cell I) to $31 (cell IV). Thus the auto industry has no incentive to agree to the elimination of tariffs. Chapter 17 International Trade and Finance 16 The Case for Restricted Trade Proponents of tariffs rarely argue publicly that they will serve private interests, raise prices, and reduce the availability of goods. Instead, they typically advocate tariffs as the most efficient means to accomplishing some national objective. Any private benefits that would accrue to protected industries are generally portrayed as insignificant side effects. Although most arguments in favor of tariffs camouflage the underlying issues, one is partially valid. It has to do with the maintenance of national security. The Need for National Security Protariff arguments based on national or military security stress the need for a strong defense industry. If imports are completely unrestricted, certain industries needed in time of war or other national emergency could be undersold and run out of business by foreign competitors. In an emergency, the United States would then be dependent on possibly hostile foreign suppliers for essential defense equipment. (The nation could convert to production of war-related goods, but the conversion process might be prohibitively lengthy and complex.) Tariffs may create inefficiencies in the allocation of world resources, but that is one of the costs a nation must bear to maintain military self- sufficiency and hence a strong national defense. Given the unsteady popularity of U.S. foreign policy and the uncertain support of allies, this argument has some merit. Other nations, like Israel, have found that they cannot count on the support of all their allies in time of war. Because France disagreed with Israeli policy in the Middle East, it held up shipment of spare parts for planes it had sold to Israel earlier. The United States could conceivably find itself in a similar position if it relies on foreign firms for planes, firearms, and oil. Special-interest groups can easily abuse the national defense argument for tariffs. The textile industry, for example, promotes itself as a ready source of combat uniforms during wartime. Even candle manufacturers have petitioned Congress for increased tariff protection, on the grounds that candles are “a product required in the national defense.” 6 In years past, U.S. oil producers, contending that a healthy domestic oil industry is vital to the national defense, have lobbied for protection from foreign oil in wartime, the effects of a tariff are not entirely straightforward as might be thought. By making foreign oil more expensive, a tariff increases consumption of domestic oil. Since oil is a finite resource, a tariff can ultimately make the United States more dependent on foreign energy sources in time of emergency. Recent history illustrates the danger of dependence on foreign suppliers. In 1973, the OPEC oil cartel used U.S. dependence on its oil reserves as a bargaining tool in its efforts to reduce U.S. support for Israel. President Gerald Ford responded in 1974 by supporting a tariff on imported oil, to stimulate exploration for new domestic energy reserves. If the United States could become energy, independent by the end of the 1980s, Ford argued, it would reduce the threat of political blackmail from the Middle East. In 6 “Petition of the Candlemakers—1951,” in Readings in Economics, ed. Paul Samuelson (New York: McGraw-Hill, 1973), 7 th ed., p. 237. Chapter 17 International Trade and Finance 17 1983, for the same reason, the Reagan administration granted tariff protection to specialty steel products, which are used extensively in high-technology defense systems. Other Arguments Most of the other arguments in support of tariffs are weak from a practical as well as a theoretical perspective. In fact, while protectionism is a growth industry in recent years, the costs to society exceed the benefits. It is sometimes argued that because workers are paid less in foreign countries, U.S. industries cannot hope to compete with foreign imports—but trade depends on the relative costs of production, not absolute wage rates in various nations. U.S. wages may be quite high in either absolute or relative terms. If U.S. workers are more productive than others, however, the costs of production can be lower in the United States than elsewhere. The important point is what tariffs do to trade. In an earlier example of trade in textiles and beef, the United States was more efficient than Japan in the production of both products. That is, generally speaking, fewer resources were required to produce those goods in the United States than in Japan. Very possibly, the incomes of textiles and beef workers would be higher in the United States than in Japan, but because Japanese firms had a comparative cost advantage in textiles (measured in terms of the number of units of beef forgone for each textiles unit), they were able to undersell textiles firms in the United States. If the U.S. imposed tariffs or quotas on imported textiles because Japan had a comparative advantage in that product, it would destroy the basis for trade between the two nations. Reducing imports will tend to reduce exports, at least in the long run. A second questionable argument for tariffs is based on the faulty idea that the United States loses when money flows overseas in payment for imports. As Abraham Lincoln is reported to have said, “I don’t know much about the tariff, but this I do know. When we trade with other countries, we get the goods and they get the money. When we trade with ourselves, we get the goods and the money.” Lincoln was clearly right when he said he did not know much about the tariff. He failed to recognize the real income benefits of international trade, which are reduced by tariffs. He seems to have confused the nation’s welfare with its monetary holdings. It is true that if Americans buy goods from abroad, they get the goods and foreigners get the money. 7 What are foreigners going to do with the money they receive, however? If they never spend it, Americans will be better off, for they will have gotten some foreign goods in exchange for some paper bills, which are relatively cheap to print. At some point, however, foreign exporters will want to get something concrete in return for their labor and materials. They will use their dollars to buy goods from U.S. manufacturers. Again, trade is a give-and-take process, in which benefits flow to both sides. A third argument often made is that foreign nations impose tariffs on U.S. goods; unless we respond in kind, foreign producers will have the advantage in both markets. 7 Actually, the transaction may not involve the transfer of paper money. It is more likely—as explained in the next chapter—that payment will be made by transferring funds from one bank account to another. The importer’s bank balance will drop, and the exporter’s bank balance will increase. Chapter 17 International Trade and Finance 18 This argument has a significant flaw. By restricting their imports, foreign nations reduce their ability to sell to the United States and other nations. To buy Japanese goods, for instance, Americans need yen. They get yen by selling to Japan. If Japan reduces its imports from the United States, Americans will have fewer yen to buy Japanese goods. So the Japanese are restricting their own exports with their tariffs. They harm themselves as well as Americans. If Americans respond to their actions by imposing tariffs of their own, they will reduce trade even further. The harm is compounded, not negated. One sound reason for increasing tariffs is to strengthen our bargaining position in international trade conferences. By matching foreign restrictions, the United States may be able to force a multilateral reduction of tariffs. To the extent that all tariffs are reduced by such a strategy, world trade will be stimulated. According to the fourth argument, tariffs increase workers’ employment opportunities. If the government imposes tariffs on imported goods, the demand for American goods will rise. More workers will have jobs and can spend their income on goods and services produced by other Americans. It is true that in the short run, more workers are likely to be hired because of tariffs, but in the long run reduced imports will result in reduced exports. The market for U.S. goods will shrink, increasing unemployment in the export industries. Furthermore, if Americans reduce their demand for foreign goods to increase employment in the United States, their domestic recession will be transmitted to other nations. With fewer sales of foreign goods, fewer workers will be needed in foreign industries. Foreign governments may retaliate by imposing tariffs of their own. Tariffs will temporarily increase their employment levels and can be used as a bargaining tool in trade negotiations as well. The end result will be a reduction in total worldwide production and real income. Finally, tariff advocates sometimes claim that new industries deserve protection because they are too small to compete with established foreign firms. If protected by tariffs, these new industries can expand their scale of production, lower their production costs, and eventually compete with foreign producers. It is very difficult, however, for a government to determine which new industries may eventually be able to compete with foreign rivals. Over the long period of time that an industry needs to mature, conditions, including the technology of production, may change significantly. For a so-called infant industry to become truly competitive, furthermore, it must develop a comparative cost advantage, not just economies of scale. Moreover, the mere likelihood that a firm will eventually be able to compete with its foreign rivals does not in itself warrant protection. Not until firms have become established will consumers receive the benefit of lower prices. In the interim, tariff protection hurts consumers by raising the prices they must pay. Proponents of protection must be able to show that the time-discounted future benefits to be gained by establishing an industry exceed the current costs of protecting it. Finally, if a firm can expand, cover all its costs of production, and eventually compete with it foreign rivals, private entrepreneurs are not likely to miss the opportunity to invest in it. Through the stock and bond markets, firms with growth potential will be Chapter 17 International Trade and Finance 19 able to secure the funds they need for expansion. If a firm cannot raise capital from private sources, it may be because the return on the investment is too low in relation to the risk. Why should the government accept risks that the private market will not accept? INTERNATIONAL FINANCE People rarely use barter in trade. Exchanging one toy for two pens or three pots for the rear end of a steer simply is not practical. Because the bartering seller must also be a buyer, buyers and sellers may have to incur very substantial costs to find one another, even in the domestic market. When people are hundreds or thousands of miles apart and separated by national boundaries and foreign cultures and languages, as they are in international trade, barter would be all the more complicated. We rarely see exporters acting as importers, exchanging specific exports for specific imports. In the domestic economy, money reduces the cost of making exchanges. The seller of pots needs only to find a buyer willing to pay with bills, coins, or a check. He does not have to accept goods that may be difficult to store, use, and trade. In the international economy too, money facilitates trade, but well over a hundred different national currencies are in use. The French have the franc; the Japanese, the yen; the Americans, the dollar. To deal with this complication, a system of international exchanges emerged in which importers pay for the goods they buy in their currency. Before international trade can take place, it is usually necessary for the country buying to convert to the currency of the trading partner. Importers demand foreign currency and exporters supply it. How the international monetary system works, and the problems inherent in it, are the subjects of this section. The Process of International Monetary Exchange Imagine you own a small gourmet shop that carries special cheeses. You may buy your cheese either domestically—cheddar from New York, Monterey Jack from California— or abroad. If you buy from a domestic firm, it is easy to negotiate the deal and make payment. Because the price of cheese is quoted in dollars and the domestic firm expects payment in dollars, you can pay the same way you pay other bills—by writing a personal check. Only one national currency is involved. Purchasing cheese from a French cheesemaker is a little more complicated, for two reasons. First, the price of the cheese will be quoted in francs. Second, you will want to pay in dollars, but the French cheesemaker must be paid in francs. Either you must exchange your dollars for francs, or the cheesemaker must convert them for you. At some point, currencies must be exchanged at some recognized exchange rate. Foreign exchange is the monetary means or instruments used to make monetary payments and transfers from one currency to another. The funds available as foreign exchange include foreign coin and currency, deposits in foreign banks, and other short-term, liquid financial claims payable in foreign currencies. Chapter 17 International Trade and Finance 20 International Exchange Rates Before you buy, you will want to compare the prices of French and domestic cheeses. You must convert the franc price of cheese into its dollar equivalent. To do that, you need to know the international exchange rate between dollars and francs. The international exchange rate is the price of one national currency (like the franc) stated in terms of another national currency (like the dollar). In other words, the international exchange rate is the dollar price you must pay for each franc you buy. Once you know the current exchange rate, conversion of currencies is not difficult. Assume that you want to buy F5,000 (read “5,000 francs”) worth of cheese, and that the international exchange rate between dollars and francs is $0.10 (that is, $1 sells for F10). F5,000 at $0.10 apiece will cost you $500. For the rest of this chapter we will assume that the dollar price of the franc is $0.10 to make our arithmetic examples easier to follow. The international exchange rate determines the dollar price of the foreign goods you want to buy. A different exchange rate would have changed the dollar price of cheese. For instance, suppose the exchange rate rose from $0.10 = F1 to $0.20 = F1. In the jargon of international finance, such a change represents a depreciation (a devaluation involves a depreciation relative to the monetary standard and not necessarily relative to other monies) of the dollar. A depreciation of the dollar (or any other national currency) is a reduction in the exchange value or purchasing power, brought about by market forces, in relation to other national currencies. The dollar is now cheaper in terms of francs: It takes fewer francs (F5) to buy a dollar than previously (F10). The same change represents an appreciation of the franc. An appreciation of the dollar (or any other national currency) is an increase in the exchange value or purchasing power, brought about by market forces, in relation to other national currencies. Each franc will now buy a large fraction of a dollar—0.20 as opposed to $0.10. From the perspective of the gourmet shop, the important point is that at the higher exchange rate, the dollar price of the cheese purchase is $1,000 ($0.20 times 5,000). If the exchange rate fell from $0.10 = F1 to $0.05 = F1, the price of the French cheese would decline to $250. As you can see, your willingness to buy French cheese depends -- much on the franc price of cheese and the exchange rate. If the franc price of cheese increases or decreases, your dollar price increases or decreases. TABLE 17.7 The Likely Long-Run Effects of Depreciation and Appreciation of the Dollar on U.S. Exports and Imports Depreciation Appreciation Of Dollar of Dollar Price of exports Decrease Increase Total dollar value of exports Increase Decrease Price of imports Increase Decrease Total dollar value of imports Decrease Increase Chapter 17 International Trade and Finance 21 Changes in the dollar price of francs have a similar effect. If the dollar depreciates (that is, if the price of francs in dollars rises), the dollar price of French cheese rises. It is very likely you will be inclined to import less, since at the higher price your customers will buy less. If the dollar appreciates (that is, if the price of francs falls), the dollar price of French cheese falls. Very likely, you will import more because you can lower your own price and sell more. In general, a depreciation of the dollar discourages imports; an appreciation of the dollar encourages imports. The likely long- run results of changes in the international rate of exchange are summarized in Table 17.8 In contrast, in the short run a depreciation can worsen a country’s balance of trade according to the J-curve phenomenon because elasticities are smaller. Although the initial impact of depreciation is often an increase in nominal spending on imports because higher prices cause a deterioration in the normal spending on imports, over time depreciation will tend to improve both nominal and real net exports. 8 Thus, although a depreciation in the exchange rate will eventually achieve a balance-of-trade equilibrium as shown in Table 17.8, it may take some time. In general, long-run price elasticities are greater—often considerably greater—than short-run price elasticities. As a rule, economic agents respond reasonably quickly and significantly to changes in economic stimuli. 8 Rudiger Dornbush and Paul Krugman, “Flexible Exchange Rates in the Short Run” Brookings Papers on Economic Activity (March 1976), pp. 537-575. The Exchange of National Currencies Assume you have figured the dollar price of cheese using the exchange rate and find it satisfactory. Since your American customers pay for their groceries in dollars, that is the only currency you have to make the payment. Yet cheesemakers in France need francs to pay for their groceries. Therefore the French cheese exporter must ultimately be paid in francs. How can you make payment in dollars while the French exporter is paid in francs? A bank will exchange your dollars for you. Banks deal in national currencies for the same reason that business people trade in commodities: to make money. An automobile dealer buys cars at a low price with the hope of selling them at a higher price. Banks do the same thing, except that their commodities are national currencies. They buy dollars and pay for them in francs or yen, with the idea of selling them at a profit. Chapter 17 International Trade and Finance 22 If you pay for your French cheese in dollars, you write a check against your checking account and send it to the French firm. 9 The French cheesemaker will accept the check knowing that your dollars can be traded for francs (that is, sold to a French bank) at the current rate of exchange. If the exchange rate is $0.10 = F1, and you have sent the cheesemaker a check for $500, the exporter will receive F5,000 for your check from the French bank. Remember that banks, even foreign ones, have accounts with other banks, just as individuals do. The French bank will deposit your check with its U.S. banker. Your bank balance will fall, and the French bank’s balance at the U.S. institution will rise. Then the French bank will sell (or trade) the dollars it has on account for francs. In the process of buying and selling dollars, the French bank may make a profit. Suppose, for example, that the French bank buys dollars from the French cheesemaker at a rate of $0.10 = F1 (or $1 = F10), paying F500, a net gain of F555. This hypothetical purchase of French cheese leads to an important observation. Any U.S. import, be it cheese or watches, will increase the dollar holdings of foreign banks. So will American expenditures abroad whether for tours or for foreign stocks and bonds. Americans must have francs for such transactions; therefore, they must offer American dollars in exchange. In most instances, foreign banks end up holding the dollars that Americans have sold. In the same way, U.S. exports reduce the dollar holdings of foreign banks. Exports are typically paid for out of the dollar accounts of foreign banks. Foreign expenditures on trips to the United States or on the stocks and bonds of U.S. corporations have the same effect. They reduce the dollar holdings of foreign banks and increase the foreign currency holdings of U.S. banks. If American expenditures abroad exceed foreign expenditures here, the dollar holdings of foreign banks will rise—and vice versa. If American expenditures abroad exceed foreign expenditures here for a long time, foreign banks will eventually accumulate all the dollars they can reasonably expect to use. Foreign banks then have several options. First, they may sell their dollar holdings to other foreign commercial banks to their government—or, more properly, to their government’s central bank (for example, the Bank of France). The market may already be saturated with dollars, however. No one including the central bank, may want to buy dollars at the going price, $0.10 – F1 in our illustration. In that case, foreign banks can induce people to buy dollars by lowering their price. For instance, they can alter the exchange rate from $0.10 = F1 to $0.15 = F1. In so doing they increase the price of francs and decrease (depreciate) the price of dollars. A depreciation of the U.S. dollar in the exchange rate will have several effects, all tending to reduce the number of dollars coming onto the international money market. As explained earlier, the exchange will make French goods more expensive for Americans to buy. Thus it will tend to reduce U.S. imports, and accordingly the number of dollars that must be exchanged for foreign currencies. Depreciation will also tend to reduce the price of American goods to foreigners. For instance, at an exchange rate of $0.10 = F1, the franc price of a $1 million American computer is F10 million. At an exchange rate of 9 Instruments of exchange other than checks are often used in international transactions. The process, however, is the same. Chapter 17 International Trade and Finance 23 $0.15 = F1, the franc price of the same computer is F6.66 million—a substantial reduction in price. To buy American goods at the new lower franc price, the French will increase their demand for dollars. Again, the quantity of dollars being offered on the money market will fall, and the growth in foreign dollar holdings will be checked. Determination of the Exchange Rate Like the price of anything else, exchange rates are determined by the forces of demand and supply, although government may interfere to alter the rate from what market forces along would have produced. When there is no official or government interference, the rates are free or floating. When government intervenes, by buying or selling currency in the foreign exchange rates by a central bank or other some official government agency, the exchange rates are fixed or pegged. From 1945 to 1971 exchange rates were basically fixed. Since 1971, however, rates have been set flexibly with some government intervention in a “dirty,” or managed, floating exchange rate system, in which the prices of currencies are partly determined by competitive market forces and partly determined by official government intervention. National currencies have a market value—that is, a price—because individuals, firms, and governments use them to buy foreign goods, services, and securities. There is a market demand for a national currency like the franc. Furthermore, the demand for the franc (or any other currency) slopes downward, like curve D in Figure 17.6. To see why, look at the market for francs from the point of view of a U.S. resident. As the dollar price of the franc falls, the price of French goods to Americans also falls. As a result, Americans will want to buy more French goods. They will require a larger quantity of francs to complete their transactions. The supply of francs coming into the market reflects the French people’s demand for American goods, services, and securities. To get American goods, the French need dollars. They must pay for those dollars with francs, and in doing so they supply francs to the international money market. As the dollar price of the franc rises, the price of American goods to the French falls. To buy a larger quantity of American goods at the lower franc price, the French need more dollars; they must offer more francs to get them. Therefore, the quantity of francs supplied on the market rises. Thus the supply curve for francs slopes upward to the right, like curve S in Figure 17.6. The buyers and sellers of francs make up what is loosely called the international money market in francs. Banks are very much involved in such markets. They buy francs from the sellers (suppliers) and sell to the buyers (demanders). As in other markets, the interaction of suppliers and demanders determines the market price. That is, given the supply and demand curves in Figure 17.6, in a competitive market the dollar price of the franc will move toward the equilibrium point at E involving the intersection of the supply and demand curves. The equilibrium price, or exchange rate, will be ER 2 , the price at which the quantity of francs supplied exactly equals the quantity of francs demanded. Chapter 17 International Trade and Finance 24 _________________________________________ FIGURE 17.6 Supply and Demand for Francs on the International Currency Market The international exchange rate between the dollar and the franc is determined by the forces of supply and demand with the equilibrium at E. If the exchange rate is below equilibrium, say at ER 1 , the quantity of francs demanded, shown by the demand curve, will exceed the quantity supplied, shown by the supply curve. Competitive pressure will push the exchange rate up. If the exchange rate is above equilibrium, say at ER 3 , the quantity supplied will exceed the quantity demanded, and competitive pressure will push the exchange rate down. Thus the price of a foreign currency is determined in much the say way as the price of any other commodity. At the market equilibrium point there is no build-up of dollars or francs in the accounts of foreign banks. French and U.S. banks have no reason to modify the exchange rate to encourage or discourage the purchase or sale of either currency. To use a financial expression, the net balance of payments coming into and going out of each nation is zero. If the exchange rate is below equilibrium level -- say ER 1 -- the quantity of francs demanded will exceed the quantity supplied. An imbalance in the balance of payments will develop. In the jargon of international finance, the United States will develop a balance of payments deficit—a shortfall in the quantity of a foreign currency supplied. (This is a conceptual definition. When it comes to defining the balance of payments deficit in a way that can be measured by the Department of Commerce, economists are in considerable disagreement.) As in other markets, this imbalance will eventually right itself. Because of the excess demand for francs, French banks will accumulate excess dollar balances. French banks will have more dollars than they can sell and fewer francs than they need. Competitive pressure will then push the exchange rate back up to ER 2 . People who cannot buy francs at ER 1 will offer a higher price. As the price of francs rises, French goods will become less attractive to Americans, and the quantity of francs demanded will fall. Conversely, American goods will become more attractive to the French, and the quantity of francs supplied will rise. Similarly, at an exchange rate higher than ER 2 -- say ER 3 –the quantity of francs supplied will exceed the quantity demanded (see Figure 17.6). A balance of payments surplus—an excess quantity of a foreign currency supplied—will develop. The surplus will not last forever, however. Eventually the exchange rate will fall back toward ER 2 , causing an increase in the quantity of francs demanded and a decrease in the quantity supplied. In short, in a free foreign currency market, the price of a currency is determined in the same say the prices of other commodities are determined. . holdings of foreign banks. So will American expenditures abroad whether for tours or for foreign stocks and bonds. Americans must have francs for such transactions;. efforts to reduce U.S. support for Israel. President Gerald Ford responded in 1974 by supporting a tariff on imported oil, to stimulate exploration for