By Eric Vandenbroeck and co-workers

How Tariffs Erode Democracy

Global growth is expected to decline, and downside risks to intensify as major policy shifts unfold. Hence, as we have seen, great power competition has returned.

Protectionism has met with plenty of criticism over the last several months, but the magnitude of the danger it poses is not yet fully appreciated. Much of the discussion surrounding the tariffs proposed by U.S. President Donald Trump has focused on their short-term consequences, stock market disruption, rising inflation, retaliation, and a potential recession. But as bad as these outcomes are, a worse possibility looms. Protectionism, if allowed to linger, could lead to a complete disfiguration of U.S. capitalism and democracy as they are known today.

Latin America experienced such a devolution in the mid-twentieth century. Driven by a logic similar to that which the Trump administration seems to be following today, leaders implemented protectionist tariffs and trade restrictions as part of an effort to encourage domestic manufacturing and rebalance trade relationships that they perceived to be unfair.

The result, however, was not an economic renaissance but financial unrest and undemocratic governance. As long as Washington follows a similar playbook, it risks a similar fate.

 

An Industrial Trap

After the Great Depression took hold in the 1930s, several of Latin America’s strongman leaders, such as Getúlio Vargas in Brazil, Lázaro Cárdenas in Mexico, and, later, Juan Perón in Argentina, concluded that the answer to the region’s many problems was industrialization. Since the colonial era, Latin America has been an extractive enclave, producing and exporting mostly agricultural products while importing most industrial goods. In the 1930s, many politicians and intellectuals deemed this an unfair trade structure because it kept the region under-industrialized and thus underdeveloped.

 

U.S. President Donald Trump is trashing the world trade system over a basic economic fallacy.

Businesses in Germany and Britain produced less this month amid worries about President Donald Trump’s near-universal tariffs, in another sign that the global damage from his import levies is adding up.

Closely watched surveys of purchasing managers showed Wednesday that private sector output contracted in Germany, Europe’s biggest economy, and the United Kingdom.

“Tariff concerns and uncertainty weighed on business confidence and demand,” S&P Global and Hamburg Commercial Bank, which publish the survey of German companies, said in a news release.

Likewise, in the UK, “survey respondents widely commented on the negative impact of US tariffs and a subsequent slump in confidence among clients,” S&P Global said.

The first reading of Germany’s Purchasing Managers’ Index, which tracks activity in the manufacturing and service sectors, came in at 49.7, from 51.3 in March. A reading below 50 indicates a contraction.

The downturn is probably the result of multiple forces, said economists at Berenberg, a bank.

“Beyond international headwinds such as the tariff-related uncertainty, this likely also reflects the broad-based domestic economic weakness,” they wrote in a note.

Early data already points to a slump in global trade in the face of Trump’s import taxes. South Korea’s Customs Service reported that exports for the first 20 days of April declined 5.2% compared with the same period last year. That singular data point is a “key bellwether” for where trade is heading, Min Joo Kang, a senior economist at ING, said in a note Monday.

Leaders thus set out to rebalance their countries’ trade relationships. If Latin America went heavy on protectionism and blocked imports from industrial trading partners, they believed, local manufacturing would proliferate. Governments enacted policies that came to be known as import substitution industrialization, or ISI: increased tariffs, enormous barriers to foreign investment, and high spending on newly created state-owned enterprises, especially utilities and infrastructure.

These policies did lead to manufacturing growth. But they also made Latin American industry one of the least competitive in the world and fueled corruption. By the 1960s, the damage was palpable. Countries that had embraced this strategy developed huge macro- and microeconomic problems. Inflation soared, reaching annual rates that were often three times higher than the world average (except in oil states, Mexico, and Venezuela). Government budget deficits ballooned as states found it increasingly necessary to provide subsidies to local manufacturers. And the manufacturing base that emerged was uncompetitive: locally produced industrial goods were often more expensive and of lower quality than those that had previously been imported, which made them completely unmarketable abroad.

The cause of these problems was simple: when states shield firms from competition, for example, through trade barriers, they take away their incentives to innovate, maximize efficiency, introduce cutting-edge technologies, and keep costs low. As the political scientist Gustavo Flores-Macías recently put it, “ISI created complacency.” The region entered a trap: manufacturing expanded, but exports of manufactured goods declined, depriving local economies of sources of foreign exchange.

Even at the height of ISI, it was impossible for the region’s protected manufacturing to survive without imports. Factories still needed to import machinery and parts, but firms could not gather the capital to buy them because they lacked export revenue. The state had to step in with more and more subsidies. This increase in government spending sent states into a chronic fiscal crisis. Thus, not only did protectionism lead to runaway inflation in the short term by eliminating cheap imports, but it also created the conditions for inflation to persist: insulating local firms from competition incentivized price gouging and led to expanding fiscal deficits, which states could support only by printing money. Wages lost purchasing power rapidly. Although workers could find jobs in the local industry, they struggled to afford locally produced consumer goods.

 

Competition Among Cronies

The political fallout of import substitution industrialization was even worse. Protectionist policies invariably required new bureaucracies to enact them, determining which products from which countries would be subject to which tariffs or import licenses. Many of these decisions were arbitrary—or at least, were not bound to strict rules or standards. The details of licenses, rates, and tariffed products were regularly arranged in backroom deals between bureaucrats and private actors with vested interests in how and when those protectionist measures were applied. Private companies directed their energies to lobbying the state for more protection, such as higher tariffs on their competitors, or for special import licenses if they needed foreign inputs to produce their finished goods. In return, they offered favors such as bribes, campaign contributions, or political endorsements. Protectionism, in short, led to corruption on a massive scale.

It also impeded the rise of modern capitalism. Economies in twentieth-century Latin America transitioned from oligarchic extractivism to state-led cronyism, or what became known as rent seeking. Although the private sector was more or less profitable under ISI, those profits depended mostly on state favors, not on market gains. Firms devoted resources not to innovation but to lobbying; competition between firms took place not in the markets but in backroom negotiations.

As Latin America’s political economies became reliant on deals hidden from public view, democratic processes weakened, and in some cases, the system collapsed altogether. Ever-rising inflation led to labor unrest; ever-rising rent-seeking led to spiraling demands on the state for more favors. The system could not deliver. In 1973, the Argentine sociologist Guillermo O’Donnell became famous for recognizing that this crisis of mounting labor and business pressures, which he called the “exhaustion stage” of ISI, was producing an inevitable outcome: the military stepping in to try to end the madness. In the 1960s and 1970s, military coups in Argentina, Brazil, Chile, Peru, and Uruguay paved the way for years of autocracy.

Even under new military leadership, ISI continued everywhere except Chile, and governments continued to accumulate bureaucracy, debt, and deficits. To describe these military juntas of the 1960s and 1970s, O’Donnell coined the term “bureaucratic authoritarianism.” Local industry became only more inefficient and dependent on state favors. Corruption and inflation flourished into the early 1980s. Poverty remained unabated. Business insiders, shielded by their political sponsors, posted profits while everyone else suffered the corrosive effects of inflation. Inequality grew.

In countries where democracy survived along with protectionism, such as Venezuela in the 1970s and 1980s, public discontent with the corrupt system led to widespread support for radical movements. Those attitudes gave rise to the left-wing authoritarian government of Hugo Chávez, who ruled Venezuela from 1999 to 2013. Chávez also relied on protectionism to gain favors from business elites.

Eventually, under protectionism, something has to give. When the United States raised interest rates in the late 1970s, Latin America’s system of import substitution industrialization imploded. Higher interest rates meant governments could no longer service their debts, and private banks could not step in to subsidize the economy to the same extent that state bureaucracies had. Credit tumbled. A depression set in. Private banks collapsed or faced huge stresses such as bank runs. Governments couldn’t borrow money at home or abroad to save the banks or to meet their debt obligations, much less to spend their way out of the recession. The result was the 1982 debt crisis, which would plague Latin America for a decade and, in the case of some countries, two.

 

Protecting Insiders

Protectionism is not the solution that its advocates often proclaim. It led to industrialization in Latin America only because the region had none before. Its more salient byproduct was the destruction of market forces, with the rise of noncompetitive firms; macroeconomic distortions in the form of inflation and debt; and the entrenchment of a chronically arbitrary state.

In the United States today, the decline of manufacturing is not the result of trade imbalances but mostly of secular trends such as supply chain manufacturing. Most modern manufacturing today involves assembling products that require various intermediate parts. Many of these components can be purchased, at competitive prices, from small vendors located in manufacturing hubs around the world. These international hubs did not exist before the 1990s, when most manufacturing was concentrated in a handful of countries. Further contributing to deindustrialization in the United States are technological changes in production, educational deficiencies, and tax structures that preclude states from generating revenue to retrain workers. None of these problems can be resolved through protectionism.

Instead, protectionism disfigures capitalism and undermines democracy. It makes consumers angry about inflation and a lack of choice. It makes private companies less competitive and more corrupt. Lobbying the state for trade favors becomes the dominant game. This already started to happen in the United States during the first Trump administration, with firms filing over 100,000 exclusion requests for tariffs on steel and aluminum imports. Now that tariffs have increased, these requests will certainly multiply, giving the second Trump administration even more opportunities to negotiate special deals with private actors.

In short, protectionism grants states too much arbitrary power to intervene in the market and thus spawns more platforms for the exchange of political favors. This is not the path toward business regeneration but one toward the demise of capitalism and transparent governance.

 

 

For updates click hompage here