Losing the barriers
India is on course to being the third largest economy in the world. But fulfilling this promise will require sustained reform and a commitment to openness.
In his all-time classic, Protection or Free Trade, published in 1886, American political economist Henry George provides one of the wittiest and most persuasive defences of free trade. At the time he wrote, the world was in the midst of the First Globalisation. Liberal trade policies had swept across the globe. Yet, his own country remained staunchly protectionist. Unsurprisingly, his axe fell on every conceivable argument protectionists of his day offered.
In the book, George observes that protection implies prevention and defence. In this vein, protective tariffs prevent foreign goods from flowing into our country. Unlike a flood, earthquake or tornado, which are acts of nature, flow of goods is the result of human action. He asks, who are the people whose actions lead to this flow of goods?
Foreign sellers may well be the answer. George reasons, however, that this is erroneous because those sellers could not sell their products to our people unless our people wanted to buy them. Therefore, it is our own people whose actions cause the flow of these goods into our country. Protection thus prevents the protected from what they want to do; it defends them, not against foreigners, but themselves.
At the time George wrote, free trade prevailed in most of the colonies as well. This was not a choice that the colonies themselves had made; indeed, it had been thrust upon them by self-interested colonial powers. Paradoxically, during the inter-war period, as the colonies acquired the ability to choose their own trade policies, they chose protection. Later, as they won their political freedom in the wake of the Second World War, they uniformly went for yet higher protection.
India followed this general pattern. Textiles and the iron and steel industries had sought and got high protection during the inter-war years. Endemic shortages during the Second World War led to the introduction of far more stringent import controls via import licensing. After independence, when a balance of payments crisis broke out in 1958, the country adopted foreign exchange budgeting. This change paved the way for the emergence of a near-autarchic trade policy regime. Those old enough to remember life during the 1960s through the 1980s would testify to the hardships this regime brought to daily lives. No consumer goods could be imported under any circumstances and even raw materials and machinery imports required producers to jump numerous bureaucratic hoops.
Indian producers partially won their freedom in 1991 when the government decided to remove import licensing on raw material and machinery. But they experienced fuller freedom only after the government significantly lowered tariffs. The Indian consumer had to wait even longer. For, import licensing on consumer goods ended only in 2001, after the World Trade Organization ruled against it. Our commerce ministry lost the case in Geneva but our consumer smelled freedom.
With trade thus liberalised alongside other reforms, India saw its per capita income rise by more during the first 17 years of the 21st century than during the entire 20th century. With gross domestic product (GDP) at $2.6 trillion in 2017-18, India is now the sixth largest economy worldwide. In less than 10 years, we will be the third largest economy, behind only the United States and China. Pre-British glory days when India and China together accounted for more than half of the global economy are within our grasp.
Fulfilling this promise will of course require sustained reforms and commitment to openness. Today, with imports having expanded to more than one-fifth of the GDP, bureaucratic temptation to return India to import substitution through higher protection is high. But the wisdom that George imparted to late 19th century United States remains valid for today's India.
Demands for protection are frequently made on infant industry grounds. George urged the America of his time to stand firm against these demands. He reasoned, All experience shows that the policy of encouragement, once begun, leads to a scramble in which it is the strong, not the weak; the unscrupulous, not the deserving, that succeed. What are really infant industries have no more chance in the struggle for governmental encouragement than infant pigs have with full-grown swine about a meal-tub.
George argued that when offered, infant industry protection goes, not to industries capable of eventually surviving without protection but to industries that can survive only in this way. He noted that the struggle for existence which drives out unprofitable industries is the best determinant of which industries are needed under prevailing circumstances and which are not. For rare industries that genuinely deserve support, his prescription was a subsidy conditional upon success.
George went on to remind his countrymen how infants protected in the early days of the American republic still remained protected and continued to claim infancy. The infant boys and girls of that time [when protection was originally granted] have grown to maturity, become old men and women, and with rare exceptions have passed away. But the infant industries, for which a little temporary protection was then timidly asked, are still infants in their desire for encouragement. Though they have grown mightily, they claim the benefits of the Baby Act all the more lustily... Georges words aptly describe our own auto industry, which has been fully shielded from foreign competition since independence on infant industry grounds and continues to enjoy prohibitive tariffs till today.
Separately, today, India also faces the question whether it should retaliate against recent tariffs on steel and aluminum by the United States. Predictably, George advised against an eye for an eye approach to trade policy. Coincidentally, he made his argument by recourse to long-standing US tariffs on none other industry than iron. He reasoned that these tariffs inflicted far greater injury on the United States than on any individual trading partner such as Great Britain. The latter was able to compensate for the loss of exports to the United States due to high US tariffs by diverting its exports of iron to other countries. But the United States did not have the option to soften the blow to itself from its own tariffs. For the effect of duties on iron and iron ore and of the system of which they are part, has been so to increase the cost of American productions as to give to Great Britain the greater part of the carrying trade of the world, for which we were her principal competitor, and to hand over to her the trade of South America and of other countries, of which, but for this, we should have had the largest share.
And in the same way, he concluded, for any nation to restrict the freedom of its own citizens to trade, because other nations so restrict the freedom of their citizens, is a policy of the biting off one's nose to spite one's face order. Other nations may injure us by the imposition of taxes which tend to impoverish their own citizens... But no other nation can thus injure us so much as we shall injure ourselves if we impose similar taxes upon our own citizens by way of retaliation. Decades later, Cambridge economist Joan Robinson stated the point more dramatically, quipping that just because others throw rocks into their harbour, that is no reason to throw rocks into our own.
I can think of only one circumstance under which retaliatory tariffs by India could advance its national interest: they persuade the United States to withdraw its tariffs in a reasonably short period of time. If retaliation ends up being just that, we would have piled a bigger injury to ourselves on top of the initial smaller injury inflicted by the US.
A necessary but not sufficient condition for retaliation to persuade the United States to withdraw its tariffs is that all major exporters of steel and aluminum retaliate against it. But with the European Union and the United States in conciliatory talks, prospects for serious joint retaliation are dim. The inescapable conclusion, therefore, is that our interest will be best served by bargaining away retaliation for more valuable concessions from the United States in areas in which it can offer them at low cost to itself.
(Arvind Panagariya is Professor of Economics at Columbia University. His latest book, Free Trade and Prosperity: How Openness Helped the Developing Countries Grow Richer and Combat Poverty, is to be published shortly by the Oxford University Press)