The recent financial crisis and prospects of a prolonged downturn in global economic activity have once again invigorated the critiques of global financial integration and free trade.
Indeed, as incomes and jobs have come under increasing threat in recent months, a number of countries have already raised import tariffs to protect domestic industries, according to the latest data from the International Trade Centre. Of course, there is nothing new in this response. The last major financial crisis that we witnessed - the Asian Crisis in 1997 - also saw a wave of protectionism.
A recent empirical study by Goldberg et al (2008) provides a timely reminder on why a backlash against trade liberalisation would be futile for growth and job prospects.* This paper focuses on the impact of trade reforms on imports of intermediate inputs and the role of these inputs on manufacturing growth in India.
It argues that one quarter of India's manufacturing output growth during the 1990s stemmed from products that were not manufactured prior to the reforms. Moreover, this expansion of new products was driven in large part by access of Indian firms to previously unavailable imported inputs.
Prior to the 1990s, while imports of certain intermediate goods were banned under the import substitution strategy, imports of other intermediates were restricted via import licences or via exorbitant tariff rates. India's average tariff rate on intermediate goods in 1985 was nearly 150 per cent. Subsequently, average tariff rates on inputs were gradually brought down from 90 per cent in 1991 to 30 per cent by 1997.
The paper notes that as trade barriers were reduced, the imports of intermediate goods more than doubled. Furthermore, two-thirds of this growth came from products which were not imported by India previously, either because imports of these goods were outlawed or simply because it was too costly to import them. Access to these new intermediate inputs since the early 1990s which included different varieties of mechanical appliances, machinery, computers and computer-related products played an important role in the overall growth of the Indian economy.
The tariff reductions not only lowered prices and increased volumes of existing imports but also enabled firms to gain access to new types of intermediate products. The lower price of intermediate imports helped domestic firms to cut manufacturing costs. Such cost savings were in turn used by firms to cover the fixed costs of entering new product lines, such as purchasing new equipments.
Moreover, the access to cheaper and higher quality intermediate inputs and capital equipments helped boost firms' productivity. This is popularly dubbed the "variety in, variety out" model of economic growth. Thus, the Indian economy benefited immensely from trade reforms not only via cheaper imports of existing intermediate inputs, but also by having access to new intermediate inputs.
An important policy implication emanating from this study is that imports and access to new imported intermediates may be crucial for spurring domestic production and for exporting. Given the current crisis, policy makers may be inclined to build a wall of tariff barriers to combat the downturn in domestic activity. Once put in place, tariffs are difficult to remove as popular and political pressure often takes hold. Protectionism can also lead to trade wars among countries as they compete to raise barriers against each other. The results in the Goldberg paper suggest that protectionism would ultimately be self-defeating as it would reduce our access to imports and in turn have an adverse impact on our growth. It is higher growth that ultimately creates jobs and generates much needed revenues for the government.
It is true that trade liberlisation on its own cannot lead to long-term sustained growth when other obstacles such as poor infrastructure remain in place. Also, the ability of trade to accelerate growth may be undermined by factors such as poor governance often witnessed in India. Nonetheless, an additional gain from trade that would be cut off by increased protectionism is what is highlighted by this paper. In sum, trade protectionism is certainly not the way to fight an economic crisis.
* Imported Intermediate Inputs and Domestic Product Growth: Evidence from India, Goldberg, PK, A Khandelwal, N Pavcnik and P Topalova, NBER Working Paper No. 14416, October 2008.
The author is Senior Economist, CRISIL.Global meltdown: Complete coverage