This paper deals with trade policy issues of particular interest to the Fund. It is motivated both by the revival of protectionist attitudes in the industrial countries and the prevalence of liberalization proposals for developing countries. In view of Fund concerns with the functioning of the international monetary system and with individual countries’ macroeconomic policies, the paper focuses on the areas where macroeconomic policy, and especially exchange rate issues, relate to protection. Thus its discussion of the more standard microeconomic effects of protection is rather brief. The paper begins with a discussion of the relationship between protection and the current account, an issue that is particularly relevant currently for the United States.

The analysis supplements an earlier Fund publication, Trade Policy Issues and Developments (Occasional Paper No. 38, July 1985), which contains a comprehensive survey of developments in the field up to early 1985. The present paper does not go over the earlier ground and is primarily concerned with policy-relevant analytical issues, with a heavy emphasis on macroeconomic aspects.

The Fund’s position is to favor an open trading system, in general to oppose the use of trade restrictions for balance of payments and other purposes, and to support trade liberalization. Some Fund programs specifically include trade liberalization as an objective. Governments have also committed themselves to embark on negotiations for further liberalization in the recent Punta del Este Declaration of the Contracting Parties of the General Agreement on Tariffs and Trade (GATT). Furthermore, there is a wide consensus among professional economists about the benefits of free or freer trade. Nevertheless, protectionist beliefs are widely held and many arguments for protection persist, even though a vast theoretical literature has pointed out their weaknesses. Arguably, it is these beliefs as well as the influence of pressure groups, rather than complexities of trade negotiations, that underlie the persistence of protection and the difficulties in bringing about liberalization.

The purpose of this paper is to analyze various protectionist arguments so that either they can be more effectively refuted or any kernel of truth in them can be better understood and taken into account in policy proposals.

Protection in this paper refers to all devices that restrict or distort trade, notably tariffs, import quotas and other nontariff barriers, such as voluntary export restraints, preferential procurement arrangements, and export taxes. At various points reference will also be made to protection of industries by subsidization.

The paper is inevitably limited in its coverage. Specifically it does not deal, other than peripherally, with issues of trade discrimination, with measurement problems (concerned with the satisfactory measurement of the costs or benefits of various protective devices), and it does not deal with details of proposed trade negotiations and the various negotiating proposals that are being put forward. These are all large subjects of their own.

There are some fundamental and well-known principles justifying the case for an open trading system and explaining the benefits from free trade—the same arguments that explain why there are gains from free trade and interchange within the borders of a country. Essentially these rest on the principle of comparative advantage as well as the benefits of exploiting economies of large scale and specialization. These basic arguments are not restated here, being so well known; the focus is rather on various possible qualifications to the basic free trade approach. In this context, the arguments for protection that are analyzed in this paper should be seen as no more than suggested modifications of the very general and simple—but nevertheless vitally important— case for free and undistorted international trade. Even when a protectionist argument has some validity it may only provide a marginal qualification, applying in some special cases. This has to be stressed at the beginning of this paper since the arguments for protection that are discussed here may appear to overwhelm the simple but powerful case for free trade.

It has to be accepted that in particular cases, if certain assumptions are actually believed to be applicable, some protectionist arguments can be justified. The theory of second best has been widely applied in this field and has helped to define more precisely the assumptions required to support certain arguments. The theme of this theory is that—in the presence of market failure or of various policies of governments that distort or override the market but that cannot be changed—there are some offsetting policies that address the source of the distortion and will maximize national income. These are “first-best” solutions, essentially because they tackle the consequences of the market failure in the most direct way possible. For instance, if externalities in a given activity cause private costs to be lower than social costs and result in higher output than would otherwise occur, the first-best solution would be for the authorities to tax that activity. Other policies have less favorable consequences because they are not as direct and hence have some adverse “by-product” effects, but would still bring about an improvement. These are “second-best” policies: pursuing the same example, a tariff on imports of the good produced under domestic distortions would be a second-best approach. Others are still less direct, possibly have more by-product effects, and are third best, and so on. The distinction between first best, second best, and so on runs right through this paper.¹ But actual policies are not necessarily determined by sound first- or second-best logic from a national interest point of view. As will be noted below, sectoral pressure groups play a role, often a very important one, and in addition there may be a lack of understanding of the costs of protection and the economic arguments for liberal trade.

Section II of the paper presents a very brief overview of recent protectionist trends and what the facts show. The main discussion begins with Section III, which deals with protection and macroeconomics, especially exchange rate issues, focusing on topics that have been discussed primarily with respect to industrial countries. Can protection improve the current account in a floating rate system, does exchange rate instability justify protection, is there a case for protection when unemployment is caused by real wages being too high, and so on?

Section IV assesses various popular arguments for protection in both industrial and developing countries and also discusses the use of trade taxes for fiscal purposes, bearing in mind that such taxes may have protective effects as by-products. Section V looks at some broader issues, namely the “rent-seeking” effects of protection, how protection is likely to affect the rate of growth as distinct from the level of real income, and the distributional problem in assessing intervention policies.

Section VI is concerned with macroeconomic policy in developing countries. What is the role of protection in a short-term policy package designed to improve the current account? What are the main issues involved in trade liberalization, and how do they relate to capital market liberalization? Finally, a particularly important question is discussed: does protection by industrial countries justify protection by developing countries?