Protection racket lingers on

Those arguing for strategic trade theory are -- like all protectionists simply seeking to avoid competition, writes Richard Wood.

BILL WEEKES was correct when he wrote in The Age on Monday that "the protection debate is not over".  But the reason that protectionist pressures will continue derives not from any new trade theory but from the inescapable fact that there will always be some who seek to avoid competition rather than to meet it.

Fortunately for the consumer and for employment, in Australia most old protectionists are now acknowledging the bipartisan acceptance that protection is not the way to go.  This was vividly illustrated when the new president of the Textile, Clothing and Footwear Council made it clear on Sunday that the future of the industry now lies in the development of exports.

The new trade theory -- the so-called strategic trade theory -- is based on the notion that government intervention in the operation of markets may produce benefits for the community which would more than outweigh the costs of such intervention, both to industries that are not assisted and to consumers.  Its basis is that some industries can earn higher than normal returns because economies of scale exist when they increase production.  In such circumstances, if government were to assist such industries to increase their output, the country could benefit through the establishment of a monopolistic position in the market for the industries' products.

There is, however, nothing particularly novel about trying to establish a monopoly position where economies of scale exist.  The problem is that there are severe limits to the application of the theory on a country basis.  Australia is a relatively small player in international trade and it would be a very risky undertaking to try to expand manufacturing, to the point of trying to establish a dominant position in international markets, in the sort of industries usually nominated for government assistance.  We would be competing against the same industries in other countries that would also have the benefit of economies of scale.

The main populariser of strategic trade theory, Dr Paul Krugman, has readily acknowledged the practical problems with it.  In a 1987 article he stated:  "It is possible, then, both to believe that comparative advantage is an incomplete model of trade and to believe that free trade is nevertheless the right policy.  In fact this is the position taken by most of the new trade theorists themselves."

Contrary to the suggestion by Mr Weekes, there is no contradiction between obtaining increasing returns to scale and the "law" of diminishing returns.  In fact, the two principles deal with fundamentally different issues.  Thus, the law of diminishing returns simply states that, if you increase the quantity of one input of production but hold all other input quantities constant, the quantity of additional output will progressively diminish.  The principle of economies of scale, on the other hand, refers to the situation where all inputs are increased simultaneously by the same percentage but the quantity of output increases by more.

Finally, it is, of course, erroneous to suggest that the major reason for high unemployment is "the erosion of our domestic industrial base by imports, reflecting government policies over the past 20 years".

The reduction in protection has been more than offset by the depreciation in the (real) exchange rate.  As a result, the capacity of manufacturers to compete has actually been increasing.  The decline in manufacturing employment reflects structural changes in consumer spending and in the efficiency of manufacturing industry.  In developed economies the main source of jobs growth now comes from the service industries, not from manufacturing.

The old protectionists will need to do a lot better if they are to reverse the tide which is now running fast against them in Australia.

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