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Dear Dr. Dollar:

Supposedly, countries should produce what they are best at. If the United States makes computers and China produces rice, then the theory of free trade says China should trade its rice for computers. But if China puts tariffs on U.S.-made computers and builds up its own computer industry, then it will become best at making them and can buy rice from Vietnam. Isn't it advantageous for poor countries to practice protectionism and become industrial powers themselves, rather than simply producing mono-crop commodities? I'm asking because local alternative currencies like Ithaca Hours benefit local businesses, though they restrict consumers to local goods that may be more expensive than goods from further away.
—Matt Cary, Hollywood, Fla

This article is from the July/August 2004 issue of Dollars and Sense: The Magazine of Economic Justice available at http://www.dollarsandsense.org/archives/2004/0704dollar.html

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This article is from the July/August 2004 issue of Dollars & Sense magazine.

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The modern theory of free trade argues that countries are “endowed” with certain quantities of labor, capital, and natural resources. A country with lots of labor but little capital should specialize in the production of labor-intensive goods, like hand-woven rugs, hand-sewn garments, or hand-picked fruit. By ramping up production of these goods, a developing country can trade on world markets, earning the foreign exchange to purchase capital-intensive products like computers and cars. Free trade thus permits poor countries (or, to be more precise, their most well-off citizens) to consume high-tech goods that they lack the ability to produce and so obtain higher living standards. “Capital-rich” countries like the United States benefit from relatively cheap fruit and garments, freeing up their workforce to focus on high-tech goods. Free trade, according to this story, is a win-win game for everyone.

The flaw in this tale, which you have hit upon exactly, is that being “capital-rich” or “capital-poor” is not a natural phenomenon like having lots of oil. Capital is created—typically with plenty of government assistance and protection.

Developing countries can create industrial capacity and train their citizens to manufacture high-tech goods. But doing so takes time. Building up the capacity to manufacture computers, for example, at prices that are competitive with firms in developed countries may take several years. To buy this time, a government needs to keep foreign-made computers from flooding its market and undercutting less-established local producers. It also needs to limit inflows of foreign capital. Studies show that when foreign firms set up production facilities in developing countries, they are unlikely to share their latest techniques, so such foreign investment does not typically build local expertise or benefit local entrepreneurs.

The United States and other rich countries employed these protectionist strategies. In the 1800s, American entrepreneurs traveled to England and France to learn the latest manufacturing techniques and freely appropriated designs for cutting-edge industrial equipment. The U.S. government protected its nascent industries with high tariff walls until they could compete with European manufacturers.

After World War II, Japan effectively froze out foreign goods while building up world-class auto, computer, and electronics industries. Korea later followed Japan’s strategy; in recent years, so has China. There, “infant industries” are heavily protected by tariffs, quotas, and other trade barriers. Foreign producers are welcome only if they establish high-tech facilities in which Chinese engineers and production workers can garner the most modern skills.

Development economists like Alice Amsden and Dani Rodrik are increasingly reaching the conclusion that carefully designed industrial policies, combined with protections for infant industries, are most effective in promoting internal development in poor countries. “Free-trade” policies, on the other hand, seem to lock poor countries into producing low-tech goods like garments and agricultural commodities, whose prices tend to decline on world markets due to intense competition with other poor countries.

In the contemporary global economy, however, there are three difficulties with implementing a local development strategy. First, some countries have bargained away their right to protect local firms by entering into free-trade agreements. Second, protectionism means that local consumers are denied the benefits of cheap manufactured goods from abroad, at least in the short run.

Finally, in many parts of the world the floodgates of foreign-made goods have already been opened and, with the middle and upper classes enjoying their computers and cell phones, it may be impossible to build the political consensus to close them. This last concern bears on the prospects for local alternative currencies. Since it is impossible to “close off” the local economy, the success of local currencies in bolstering hometown businesses depends on the willingness of local residents to deny themselves the benefits of cheaper nonlocal goods. Like national protectionist polices, local currencies restrict consumer choice. Ultimately, the success or failure of such ventures rests on the degree of public support for local business. With local currencies, participation is voluntary and attitudes toward local producers often favorable. National protectionist polices, however, entail coerced public participation and generally fail when governments are corrupt and unable to command public support.

Ellen Frank, a member of the D&S collective, is senior economic analyst at the Poverty Institute at Rhode Island College and author of The Raw Deal: How Myths and Misinformation about the Deficit, Inflation, and Wealth Impoverish America (Beacon Press, 2004).

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