Financial protectionism

inSight

19 Feb 2009

Financial protectionism

Financial protectionism is even more dangerous than trade protectionism.

I am sure readers are familiar with the economic theory of comparative advantage applied to production and trade, and how open markets can promote economic welfare. Indeed, free trade has done a lot of good to economies that have embraced it, by allowing much greater efficiency in the allocation of resources. Understandably, however, those in an importing country employed in an industry that is less efficient than the same industry in an exporting country will not like losing their jobs. They will want protectionist measures that limit (cheap) imports and promote (more expensive) domestic production. Although protectionist measures will, in theory at least, lower the overall welfare of the economy, governments often listen to the short-term interests of their people. So the threat of protectionism seriously limiting the application of international comparative advantage always exists.

In difficult times, protectionism is more likely to rear its head. Indeed, it is disturbing that this seems to be happening currently in the largest economy in the world. A significant part of the legislature is demanding the attachment of protectionist conditions to rescue packages and economic stimulus plans. It may spark retaliation from the country’s trading partners, which are also going through difficult times and under political pressure to look to the interest of their own people. Indeed, this was a feature, and I believe a significant reinforcing factor, of the Great Depression in the 1930s. I am glad to see world leaders in recent weeks issuing strong warnings against the danger of a revival of protectionism. A backward step from globalisation to protectionism would have serious consequences for the continued expansion of the global economy.

Financial protectionism is a new dimension to the problem, and I find it even more worrying. Globalisation of financial markets, made possible by financial liberalisation in individual economies, has been instrumental in the growth and development of the global economy, making the allocation and use of financial resources internationally more efficient. Developing economies that are competitive in the production of goods can have access to financial resources that would otherwise not be available if the domestic financial markets were closed to foreign capital, allowing the productive and economic growth potentials to be maximised to benefit the people of the country as well as the owners of foreign capital. Many developing economies are therefore dependent upon external finance that is often mobilised by financial institutions in the developed economies. If, for one reason or another, these financial institutions are prevented by law or government policies from lending overseas so that more funds can be made available for domestic borrowers, external finance for the developing economies may dry up. The results could be catastrophic.

Interestingly, many developed economies are also dependent upon external finance, but at a rather more macro level, because they run large current-account deficits. Ironically, the sources of capital inflow for these developed economies are principally the developing economies that have accumulated considerable foreign assets because they run current-account surpluses.

Unlike trade protectionism, financial protectionism can spread quickly, possibly leading to a sharp reversal of capital flows, with destabilising consequences for monetary and financial stability. Financial protectionism is something that all of us should work towards preventing.

Joseph Yam
19 February 2009

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