Arvind Panagariya and Shruti Rajagopalan Talking Trade

Episode 3: Arguments for Protection: Beyond Infant Industry (Part II)

SHRUTI RAJAGOPALAN: Welcome to the discussion series on free trade and liberalization as part of the 1991 Project at the Mercatus Center. I’m Shruti Rajagopalan, and in this conversation series I will be talking trade with Professor Arvind Panagariya, who is the director of the Deepak and Neera Raj Center on Indian Economic Policies, and the Jagdish Bhagwati Professor of Indian Political Economy at Columbia University.

In the past, he has served as the first vice chairman of the NITI Aayog in the Government of India, and as chief economist of the Asian Development Bank. He is the author of a number of books, but for today’s conversation, in particular, we will focus on his recent book, “Free Trade and Prosperity.” Welcome, Arvind.

ARVIND PANAGARIYA: Hi, Shruti. Very pleased to be back with you.

SHRUTI RAJAGOPALAN: Thank you for joining us, and talking trade and reforms. I wanted to talk today about a few aspects of protectionism as a continuation of our conversation last time. In the last episode, you detailed some of the common arguments against free trade and for protectionism, especially in developing countries.

Bias Against Imports

Now, I want to come to one of the most—to me, it’s one of the most annoying arguments in favor of protectionism and against free trade. I am yet to see the economic logic of it, even though I’ve thought about it for a long time.

There seems to be this implicit bias against imports, and there is a bias toward exports. Everyone wants that we should import nothing, and we should keep exporting. That’s the idea. This is driven by some basic misunderstanding of trade deficits, this idea that trade deficits are this terrible thing in any economy. It’s going to tank the economy, we need to keep trade deficits lower and always be in surplus.

That’s one part of the argument. This keeps coming back. A very large part of this Make in India movement, which is going on right now—I mean, with 30 years post liberalization, and these arguments come back with a vengeance. This just doesn’t go away. I don’t understand the economic logic that supports it or the fascination with it. What exactly is this argument and what is the merit, if any? Why isn’t this case closed once and for all?

PANAGARIYA: This is absolutely right. When you say what is the argument, there is no argument, so that answer is difficult to give. One can try to explain why there is not an argument, but we can also come back to why, partly, it keeps coming is that somehow you think that when imports come in, they displace my products. That whatever is imported, I would be producing.

This is also the fallacy, the same fallacy runs through the import substitution argument as well to which we can come in at the end. That’s the thing going on here. To see how fallacious, how wrong that argument is, just think about two options. One is that the country can import whatever it needs without having to export anything at all. We can all go on vacation, let somebody else do the production and we can all be at leisure.

RAJAGOPALAN: That could be amazing.

PANAGARIYA: It is fantastic. That’s one option. You’ve got a second option where the country sends out exports and receives nothing in return as imports. You can even think, because you think that exports are good, imports are bad, so you have said, “All right. I don’t want any imports, but I want to export.” Well, put your goods on the ship. Let them go half way into the ocean. Dump all the goods there, let them come back.

On your books, these have been exported, so your exports would look very, very good. You didn’t want any imports in return anyway, so what does it matter if the goods got dumped into the ocean? You can see how foolish that would be, and no country would actually do that. That’s the point. This whole idea somehow that exports are good and imports are bad is totally cockeyed because, in the end, you want to export so that you can import.

The whole idea ultimately is to be able to export so that you can import. It’s the imports that you are seeking. In trade, we say that if you get a higher price for your exports, which will mean that for any given amount of exports, you get more imports, that’s better. That’s an improvement in your terms of trade.

It’s like, I work for Columbia, and if Columbia raises my salary, that’s a good thing for me, it’s not a bad thing. I want more, then I can spend more. It’s the same thing that if we can get a higher price for our exports, then we will be able to import more for that money, for those dollars that we get in return. Milton Friedman once famously said in—I don’t know if he wrote it out, but in a speech he made in a video that exists somewhere, and I remember watching it—he said that, “Exports, once sent are gone, and we can’t eat, but imports we can eat. We can’t eat exports because they’re gone, but we can eat imports.” Once gone, they can neither be consumed nor used to produce any other products, but imports allow you to produce other products, or can be directly consumed. Somehow, this notion of exports are good and imports are not is totally wrong.

RAJAGOPALAN: Is this because we used to have terrible capital controls? The foreign exchange problem was really bad, which means the only way you could import anything was if you earned foreign exchange. They tried to reduce the number of people who were spending foreign exchange, and therefore, encouraging people who were earning foreign exchange.

In the Indian context, that seems to be the only recent logic I can trace. It’s very illogical, it’s a bad autarkic system of a closed economy. That’s the only place I can even understand why someone would suggest something like this. On every other margin, I simply don’t get it. I have a few more specific questions here. The first is you gave this wonderful example of yourself. You are in a perpetual trade surplus with Columbia, right?

PANAGARIYA: Yes.

RAJAGOPALAN: You sell them your services, you buy very few services from Columbia. You are in a perpetual trade deficit with Westside Market, or Fairway, which is the grocery store in your neighborhood, because you are constantly buying things from there every single day. Now, this is not a problem for you at all. In fact, the larger your trade deficits with restaurants and grocery stores, in a way, the happier you are because you are able to buy more.

Why does this seem so logical at the individual level, but completely loses the plot at the country level? Why are we talking about trade surpluses and deficits at the nationwide level? That part of the argument, I don’t understand.

PANAGARIYA: Now you are actually talking not about the aggregate trade deficit or surplus, but you are talking about the bilateral ones.

RAJAGOPALAN: Bilateral ones, yes.

PANAGARIYA: We have switched to the bilateral ones. Before we come to that, something you said earlier, I just wanted to comment about this, in the Indian context, love for exports and hate for imports arose. If you dig a little deeper, it is precisely because you’re wanting to import that you want to export. They were encouraging more and more exports because of their inability to import.

Somehow, anybody translating that to, “Oh, exports are good, imports are bad”—you are right, actually, in a sense. You are absolutely right. That’s how it is drilled into the citizenry. Actually, deep down, it’s being drilled down because of the fact that you really desperately want to be able to import because you know even your normal production capacity doesn’t get fully used, because you are not able to import certain raw materials, import components, et cetera. There was always excess capacity in production in India during the ’70s and ’80s because of the trade constraint, but it was not because imports are bad. Imports are incredibly valuable.

RAJAGOPALAN: The bilateral versus aggregate, you are not in an aggregate trade deficit. But you are in bilateral trade deficits quite frequently, depending on who your trading partner is. We don’t seem to translate this individual logic that I just explained in your specific case. We translate it in a very bizarre way at the country-wide level. We want to reduce our imports from China, seems to be the latest clarion call. Can you just walk us through what is going on here and why is this a terrible argument?

It’s so harmful to have this bias against imports because imports, buying components, buying cheap technology, having access to global production technology is what enables us to be happier consumers, but also, better more efficient producers because it will be an input in our output. Actually, import bias, I find very harmful for the economy overall. Can you just put this in context for us because I just don’t understand this?

PANAGARIYA: I think things are getting mixed up here. You see what happens is that, it is specific to the case of India-China—even perhaps what I’m going to say applies to U.S.-China, because U.S.-China has the same deficit problem with China. Well, first, actually, track back a little bit before I come to this argument.

First of all, at the aggregate level, you do care about the deficit because that’s largely what defines your current account deficit. You don’t want an overly large current account deficit because that would mean that you are accumulating foreign debt at a very fast pace, which can, if your foreign exchange reserves are not good, if your exports are not vibrant, somewhere can create a crisis. It’s the kind of 1991 balance of payments crisis we have had. Nowadays, after the ’91 crisis, the Reserve Bank of India (RBI) has been very cautious. We have accumulated a vast amount of reserves. It runs the current account quite conservatively.

Anytime it goes beyond 2%, current account deficit goes beyond 2%, the RBI really begins to worry about the exchange rate and all. Aggregate is fine. Therefore, the issue is only the bilateral one. First of all, why is this happening? Certainly, one part of this, the analogy of my personal life of surplus with Columbia University, and deficit with everybody else, is clearly applicable to the countries as well, first of all.

The whole idea of trade is that you buy your goods from the country that sells you the cheapest. You sell your goods to the countries that give you the highest price for your goods. That’s how you do it. It is going to be a hell of a coincidence that the country that sells you the cheapest also gives you the highest price for your goods. Generally, they will be different. Therefore, you would run surplus with somebody and you will run deficits with somebody.

The central bank, RBI, will ensure that on aggregate, your deficit is contained to a couple of percentage points of the GDP. There is an optical illusion here, obviously, that you’re complaining about the bilateral deficit with China but you’re not seeing the fact that you have got a bilateral surplus with the United States. If you actually actively try to reduce your trade with China, your export, your surplus with the United States will also fall. At the end of the day, RBI is going to worry about let’s keep it to 1% to 2% of the GDP.

Aggregate deficit is not going to change. You reduce imports, your exports will ultimately somewhere get impacted. That we don’t see. Now, I think part of the political issue here is that there is a lot of protectionism embedded in this. If the United States is having too many imports from China, India is having too many imports from China, those who are producing import-competing goods, they see that this is an opportunity to seek some protection against a threat.

If these large countries are importing so much from China and without exporting them, something is wrong in China. It’s the vested interest in the import-competing sectors, which would make the greatest noise that China is dumping, that they’re dumping these products on us. This existence of subsidies et cetera, is very hard to verify. China, in any case, is also, after all, it’s a communist country. You make these allegations: “Oh, they are subsidizing their exports and all, and this is how they are competitive.” Of course, if the subsidy was the real reason, then you could have challenged them in the World Trade Organization (WTO). Any kind of output or export subsidies that impact trade are challengeable in the WTO, but we are not doing that.

RAJAGOPALAN: No, but even basically, if the Chinese government is subsidizing my T-shirts sitting in India, I am not too upset about that.

PANAGARIYA: No, that’s a separate point. That’s not on the producers.

RAJAGOPALAN: That’s not a producer concern. That’s fair. But the producers couched it as dumping what is, in fact, very well and competitively priced goods.

PANAGARIYA: Yes. The thing is that China is exporting to the United States and to India because they are much more competitive in these products. That’s the point. One, when there is this very large volume of imports coming from one country into India and into the United States also, then you say, “Oh, there’s something wrong in the Chinese economy. They are doing something which is unlawful.” Then you start focusing. Now, that’s one part of the story.

The other part of the story, of course, is that any country seeking trade concessions with a country that is exporting a lot to it is in a good position. I think it gives you a handle. It gives you a handle that I’m importing so much from you, but I’m not able to export. Something is wrong in your system. Fix it. That’s how the United States sees it. They even start fixing the actual quantitative targets, that is the voluntary incentives to import more from the United States.

RAJAGOPALAN: And also other aspects which are not trade related, like intellectual property and things like that, you also have better position to negotiate other things you may want, human rights or better safety codes and treatment of workers or intellectual property, when you’re a very large importer from one single country.

PANAGARIYA: Right. To some degree, this bilateral deficit gives you a handle. That part is okay. If India wants to use this as leverage of this trade deficit with China to get some concessions out of China, that’s okay. I think you know that countries do that. That’s a more strategic move, and taking advantage of it. As far as economics of it is concerned beyond a strategic advantage you want to exercise, I don’t think there’s anything wrong at all with the bilateral deficits with one set of countries and bilateral surpluses with another set of countries.

RAJAGOPALAN: Arvind, why is the unit of analysis always the producer and not the consumer? This is a very big problem I have when we talk about this bias against imports. The bias against imports is really only talking about two out of three parties. One party that it’s talking about is the producer. The second party it’s talking about is the exchequer because they want larger revenues that come in if there are higher tariffs. There are very few producers, usually, in any economy, with a very large number of consumers. This import bias enormously disadvantages consumers.

If you have 20% tariffs on cheap Android Chinese phones, it’s going to really impact Indian consumers, and it’s going to impact the poorest consumers the most. This just seems to be missing from the overall discussion. Usually, the arguments that economists like you and I give is, “Yes, it’s going to disadvantage this group of producers, but cheaper inputs means that other producers have cheaper components and cheaper inputs and they can be more productive.” What about the consumer? That’s all of us.

PANAGARIYA: Trade economists always actually take the side of consumers. I would contest that that’s what we do. In fact, trade economists are the only players in the game who appoint themselves actually to speak for the consumer.

RAJAGOPALAN: Oh, I don’t just mean trade economists. Sorry, I should clarify. I meant the people who are peddling this import bias.

PANAGARIYA: That goes back to the political economy of it that producers are better organized, and consumers are unorganized completely, so therefore, the consumer’s interests are not represented. I think I probably said this before; Henry George wrote it the best. He said, “We are calling this protection but who are we protecting here? The buyer wants to buy it, the seller wants to sell. The government steps in says, ‘I’m not going to let you buy.’ Who is being protected here? The seller is not being protected. The buyer is not being protected. How is this protection?”

This is the age-old problem, the fact that in the political process, producers are always much more dominant players than the consumers are. This is why, as I said, the trade economists are the self-appointed representatives of the consumers.

A very good example in the Indian context which also somewhere I may have said before is the mobile revolution that took place in India during the 2000s. If India had heightened the degree of protection, that mobile revolution which—

RAJAGOPALAN: Would have never happened.

PANAGARIYA: —within a span of eight or 10 years produced a billion mobile phones in the hands of the Indian citizens would have never happened. In that case, it’s very visible. Certainly, the protectionism we are doing right now against the smartphone, for example, that would impact the access to the smartphones. Many people who would buy low-end smartphones would stay for a while with the feature phones.

RAJAGOPALAN: Even more basically, the import bias being more about the producer than anyone else—a few years ago, I was in Mumbai during the Ganpati Festival. There is a demand shock for Ganpati idols during that time because every home will get one and then they will, of course, dissolve it in the sea. That’s the ritual. Everywhere you go in Mumbai, shops will have these Ganpati idols. That year, I asked them who is making these. They said, “Ma’am, they’re all imported from China.”

The Chinese entrepreneur is aware of this highly local cultural festival, is able to make these idols that can actually satisfy human taste, is able to do it better and cheaper. Most Mumbai families, at this point, apparently have access to a Ganpati idol that is produced in China. There was some outrage over it while I was there. To me, this doesn’t seem like it’s hurting anybody. In general, one would assume that the more families who could afford a Ganpati idol simply to dissolve in the sea a few weeks later, the better.

If it’s too expensive, fewer families might be able to engage in it. This is the sort of thing that I always think about, as an example where if the exporting country from which India is importing can actually make something so culturally specific better and cheaper, then perhaps we should let them do it.

PANAGARIYA: Well, I wouldn’t say that nobody is hurting because the producers who could otherwise produce those idols are the ones who are hurting. It again goes back to the producer interests. Consumer interests are better served, obviously, by the imports. It’s not limited to the Ganpati statues, there are Rakhis, the kites or patangs, all these which are all cultural products.

We have to sit back rather than slap these anti-dumping duties, etc. on the imports from China. We need to sit back and say, “What are we doing wrong that this is happening? Why are our producers not able to compete? Where are the bottlenecks?”

RAJAGOPALAN: What are the relevant constraints that we can’t produce at scale and produce so cheap?

PANAGARIYA: Yes. The moment you say, “Okay, I’ll provide protection,” then basically you have said, “Okay, you have a handicap but to live with the handicap, I will smooth out the highway for you by simply not letting anybody else enter on the roads.”

RAJAGOPALAN: Now related to bias against imports, but a separate argument in itself, is import substitution. This is the big one when it comes to trade protectionism for developing countries. Import substitution policies were absolutely the mainstream prescription especially post World War II for developing countries. Free trade is a luxury that only developed economies can engage in and afford, and developing countries must have import substitution policies. This was sort of the idea.

Now, what is the reason that this became the orthodoxy post World War II? Now you’re seeing import substitution arguments return. Anytime there’s a crisis like the global financial crisis, or now the COVID pandemic crisis, import substitution just comes back in a big way in all the arguments, in policy circles, in newspapers and so on.

Can you tell us a little bit about the original argument as a prescription for developing countries in the ’50s and ’60s? Is there any merit in returning to import substitution policies as India is attempting to do now?

PANAGARIYA: Okay, you’re absolutely right. This is a very omnipresent kind of issue historically or contemporarily, wherever you’re looking at this. In one form or the other, it keeps coming back. Now, of course, the older argument, as I mentioned earlier, resulted from this export pessimism that the primary product is what these countries will export.

That argument is now out the window because the Koreans and Taiwanese showed us that you can export manufacturing products, labor intensive manufacturing products from the beginning. You don’t have to, and there is no elasticity pessimism issue associated with that. That was primarily academic, at least in India’s context, and was very different, which we’ll come to in some future episode. I will not touch on the Indian context, which is actually quite dramatically different.

Why this has such an appeal, one is, of course, that when you’re importing something, demand is certain, it’s there. For example, even today when smartphones are being imported or feature phones are being imported, you know that there is domestic demand for it. There is no uncertainty. With exports, you don’t know who is going to buy this. But here you know that you got your buyers here.

That makes import substitution attractive. Why are we importing? We can produce it at home. It also coincides nicely with the nationalistic examples you mentioned, Ganesh statues, things like rakhis, etc. are even more in that direction, that these are our cultural goods. There is that demand certainty which is very important.

Also, I think ministries like to demonstrate success. What is the easiest thing to do to demonstrate success? Well, if demand is there, just keep out the imports. You can easily demonstrate success. Even in the Indian context, I remember, I’m sure you also must have noticed, that our previous Minister for IT, Ravi Shankar Prasad, he loved to go out and say, “Look, I created these new 200”—or some very large number—“of manufacturers of mobile phones.” He would sell it as a huge success, but I’ve never heard anybody bragging about export success that they produced in the Indian context. I can’t think of anyone where you would say, “Export successes are not claimed by the policy guys.”

The export successes—our IT software, very early success that happened, it was not a success that even the government said that we actually created that success. I’m sure government played some role somewhere but largely, we always see that as success of the entrepreneurs, et cetera, but import successes, we all claim. Auto industry we make a claim because we provided the protection. For ministries, it’s a great thing,

Also, it finds traction politically because the damage that import substitution does, and this is an old point made by Frédéric Bastiat, where he said that the good that protection does is apparent to the naked eye, but the harm it does is spread throughout the economy and it can be seen only by an expert eye. This reduced exports, which inevitably happens when you reduce imports, is too indirect for others to detect. You only see the benefit side of it. You don’t see the cost side of it.

In fact, the cost side is higher than the benefit side. Therefore, cost-benefit analysis is against import substitution, but you just don’t see the cost side. That also makes the import substitution more attractive. Among the politicians, there’s also this belief that they can simultaneously reduce imports and increase exports. Then this also just ties into imports are bad and exports are good, et cetera.

We all know, if you look at the data, that there’s no country that has reduced imports and did not reduce exports. In some particular year, it may have happened, but if you look at the long-term trends, exports and imports certainly move together. Take any time period, any country, this is a practically iron-clad rule.

RAJAGOPALAN: The flip is also true. The more you export, the more you must import.

PANAGARIYA: Import, yes. I sometimes say that if you compare Indian and China, for example, in the 2000s and later, India’s export response was much weaker than the export response that was happening in China. I often said this, that part of India’s problem is that the import response has been very muted. When we opened to trade, we went from complete prohibition on trade, almost—

RAJAGOPALAN: Effectively.

PANAGARIYA: —effectively, in prohibitive barriers, to relatively open. By 2007-08, the top tariff rate had come down to 10%, with some exceptions, and yet imports didn’t expand as much. Had the imports expended, simultaneously, exports would’ve expended as well. I often attribute actually the muted export performance to muted import response. These are the factors which explain why the import substitution remains an attractive thing. Even people who otherwise believe in trade often fall for it. They fall for it.

Historically, if you look at what is currently happening in India, it is to some degree similar to what happened in the 1970s in South Korea. The economy grew. Imports grew. Because exports grew, imports grew. By 1973, imports had become large enough where the policymaker said, “Yes, we can produce these things at home. Why are we importing?” With us, a similar thing has happened now, imports did grow. At peak, imports had become about almost 30% of the GDP compared with 10% in ’91.

A policymaker thinks that, “Oh, this is a large amount. Why am I importing? I can produce them at home.” They also think that this is a net addition to GDP, whatever I do because they don’t see the negative effect that simultaneously happens on exports. That is the problem. They just think that by adding this, I am actually adding to the GDP. There is no subtraction happening. It’s only addition that is happening.

RAJAGOPALAN: They confuse the political entity with an economic entity. The economic process is global. It’s deeply intricate. It’s highly decentralized, who’s producing what, how they’re competing on price, how there’s a new producer, an entrepreneur in a new country who might suddenly provide you something cheaper, but the national entities remain the same.

The way the policymakers think about it is us versus them in a country sense without thinking about producers and consumers as just individual firms or individual entrepreneurs who might be doing a very intricate global social cooperation in some sense.

PANAGARIYA: There is another sort of fallacy which enhances this import substitution, and that is not understanding the massive protection import substitution often ends up providing. Let’s take this example. This goes back to our old idea of the effective rate of protection as opposed to the nominal rate of protection.

I want to take a little example and explain exactly how this protection gets so understated actually when you look at the tariff rates. Think of the mobile smartphone. The smartphone, for simplicity, think that it costs $100 to import it. The smartphone is made up of a large number of components which account for about $90 of its cost.

Under free trade, let’s say, if you import smartphone, you can get it for $100. And if you were to import only components, they’ll cost $90. Then any local manufacturer who can assemble the components for $10 or less, can effectively compete with the imported smartphones. There is this margin of $10 for assembly per smartphone that is available to those, and anybody who can carry out that activity can compete.

Now, suppose the government says that there is a large number of smartphones being imported. Why can’t we manufacture them at home? Let’s give some modest protection to the domestic producers and we’ll impose a 10% custom duty on the imports of smartphones.

It may look like, 10, 20%, that’s not such a big deal, but think what happens now. The price of the imported smart phone has gone up to $120. Components can still be imported at $90. The margin between the $120 and $90 has now gone up to $30. Now, previously, under free trade, you had to be so efficient as to assemble the smartphone in just $10 per unit of cost. Now you can do up to $30. The protection is not 20%, protection on assembly activity is 200%. It’s a 200% protection.

You are encouraging massive inefficiency here. It’s no surprise that when you do this kind of tariff, very large number of manufacturers come in. Look even you and I could sit down and assemble a smartphone for that kind of margin. You got a 200% advantage over the best competitor. You are not going to get these super-efficient and super-productive assembly manufacturers. You’re going to end up with actually all these inefficient guys who think that as long as the protection remains, we can survive.

This is the damage. Now that’s one problem. It compounds. So the mobile industry becomes vibrant. And then the politicians and the government bureaucracy, all of them say, “Look, we created a mobile industry that hardly existed. We have done it. Now we have to increase the success." Which means, let’s have more value-added. Let’s extend protection to maybe half of these components. I’m just taking an example. You take half of the components, slap a 20% duty on these components. Now the 10% duty on those components ends up adding $4.50 to the cost. What was importable for $90 now has a 20% duty, so it’s $9. It’s $9 of duty. From $90, you go to $99. Well, $99 and $120, the gap is now reduced to $21. Now, what will happen to all those fly-by-night assembly manufacturers whose cost was between $21 to $30 per mobile phone? They are all gone. Either that, or you increase the protection to the final mobile import.

RAJAGOPALAN: Usually the latter because they lobby for it.

PANAGARIYA: Once you are becoming a manufacturer, if you don’t do that, then you’ll create unemployment. The government also sympathizes, 20% will go to 30%. This cascading happens and then more components are protected. More protection at the final stage. You are really adding all of these costs. This obsession also with value-added per unit is so misplaced. Because if you do this kind of protectionism and increase the value-added, do you think that the final assembled smartphone will be competitive?

Even here, you will have to raise the tariff rate just to offset the impact of this 20% duty on half of the component imports by nine percentage points. 20% will have to go to 29%. Your domestic guy is producing mobile phone at $129. If the other components are also done, then you have to put another 9%, and then it goes to 38%, and so $138. Who is going to buy in the global marketplace what is available for $100 for $138? You’ll never capture the global marketplace.

RAJAGOPALAN: No one.

PANAGARIYA: You’re never going to do that. This obsession with high value-added per unit is so misplaced because anybody can manufacture entire 100% value-added product of anything. You can produce an airplane, 100% domestic value-added, but it’s only the captive buyers at home who can buy it. You’ll never capture the global marketplace.

RAJAGOPALAN: You’ve just described the Indian auto industry, start to finish.

PANAGARIYA: It is, exactly. They can’t survive it. This is why they hardly have even 1% share in the global marketplace. My favorite example here is, particularly with respect to this obsession with what value-added per unit, look at China. Now, iPhone, supposedly 1,600 different parts to it. Current supply chains are spread over about 200 different firms, which are spread over 43 different countries.

Now, China has total value-added in this iPhone of about 10%, but it’s a hundred million plus iPhones. That’s a lot of total value-added. You can produce 100% mobile smartphone in India, all parts, components, everything homemade, but how many buyers are you going to get? Not many. Total value-added is constrained by your domestic market, which is also domestic market at that very high price. Even domestic price at $138 for a $100 smartphone will shrink. You’ll never get the global marketplace.

What did you achieve? Along total value-added, you lost out whatever you gained on per unit value-added. This problem actually has now become much more serious than it was perhaps in the ’60s and ’70s because the transportation costs were high, so you had a competitive advantage in, let’s say, clothing. You could have the entire material, including fabric or including fiber, et cetera. Maybe you could produce because crisscrossing that importing fiber or importing fabric, et cetera, will add to your cost because transportation costs are so high.

Today, transportation costs have really plummeted. Then production processes have become more complex also. At the same time, it has also become much easier to break up the production process into many more—this break up existed before. You gave that Adam Smith example of making a needle, et cetera. The specialization along different parts existed before, but today it’s much more. This breakability of the production process, put together with the very low transport costs, has meant that suppliers have got much more spread out.

Each activity is undertaken by the one who can do it the best, and that one takes most of the global market. You don’t work on value-added per unit, but you act on total value-added, even if it’s in a very small number of components. That is what you need to do. Today India’s competitive advantage largely lies in labor-intensive activities. Then capture all the assembly activities, for example, or capture some very labor-intensive services, whatever it is.

RAJAGOPALAN: Shoelaces. Shoelaces are labor-intensive.

PANAGARIYA: Exactly. Spread it and take over the entire global marketplace rather than doing everything more value-added. Now, whether it’s true, I’ve not verified, but like our PLI scheme, the Production Link Incentive scheme, somebody was telling me, so I have to check this, but if it is true, then it is really fatal because they’re saying that you get this incentive if you produce 80% of the value-added domestically. That’s a surefire recipe that anybody who takes advantage of that subsidy is not going to be competitive in the global marketplace. It’s a double whammy—

RAJAGOPALAN: It is a double whammy.

PANAGARIYA: —for the country, because also the subsidies, in many cases, are being provided for highly capital-intensive industries. If you do find some takers, what you’re doing is you are massively moving capital, which is a very scarce factor.

RAJAGOPALAN: —relative to labour.

PANAGARIYA: —into these highly capital-intensive sectors, which will create no jobs.

RAJAGOPALAN: No, actually there is more. I think it’s triple whammy. You’re providing these subsidies at the cost of the taxpayer, so that’s one problem.

PANAGARIYA: That’s right. That’s true.

RAJAGOPALAN: The second is the Indian consumer pays far more for a car or something that has similar protection than they would pay if they imported that car or compared to the global consumer. The third is the Indian manufacturer has been completely coddled into becoming not competitive and is not able to export in the global market. It’s multiple whammies. It’s not just double whammy.

PANAGARIYA: Yes, and the scarce capital being utilized.

RAJAGOPALAN: And the scarce capital being utilized. There are so many distortions that are being created. This is actually an incredibly helpful exposition on the import substitution aspect.

PANAGARIYA: There is something in India called phased manufacturing program, PMP. It is a favorite of our bureaucrats. This created massive problems. I gave you, earlier, the tube light example.

That was exactly the phased manufacturing program that will give you license to produce, provided after four years, you also source the components that go into tube lights from home, from domestic suppliers. This is the PMP. It didn’t succeed at all, actually. What happened was that the quality of those domestic tube lights only went down because the local guys, whatever parts they manufactured, the fellows had to buy. Therefore, the quality of the tube lights that were manufactured was very poor also.

There are multiple failures of that program that happened, but that has been now resurrected. You can hear Piyush Goyal talking about phased manufacturing program. I remember Hasmukh Adhia, who was the revenue secretary, was talking about this phased manufacturing program as if 20 years, 30 years passed and we completely were asleep and suddenly woke up and say, “Oh, we have to do phased manufacturing program again.” It’s tragic.

RAJAGOPALAN: It really is. It keeps coming back. I can’t even imagine how frustrated you are having worked on trade your entire career. For me, each time I read these arguments in popular press, or when ministers are talking about it, I just feel so frustrated and annoyed because it feels like this is settled. We understand this as economists, but we haven’t managed to communicate this more generally. Of course, there are all these political economy issues of consumers not being able to collectivize and organize, and producers being able to do that and so on and so forth.

PANAGARIYA: No, and frustration—let me say, no frustration here because there are so few of us who are making that case and yet we have succeeded ultimately, so it’s not so bad. We did actually score pretty good success.

RAJAGOPALAN: It also means our jobs are not going to be obsolete or substituted any time in the near future.

PANAGARIYA: That’s true. For sure, if protectionism doesn’t go away, then trade economists will not have to go away either. That’s true. I think one needs to see some successes happening and I think we’ve scored quite a bit of success, actually. These reversals do happen, will happen and all, but that is why.

RAJAGOPALAN: Sometimes you get a big win which cuts through the seen and the unseen problem, like the big bang liberalization that happened in 1991. You can really see, everybody can see the benefits of that kind of opening up. There are these nice wins that sometimes become very seen and can help propel other arguments.

PANAGARIYA: Not just ’91, but right now also.

RAJAGOPALAN: Continue.

PANAGARIYA: Right now is very similar actually. Very similar mutually reinforcing, like I said, the Insolvency and Bankruptcy Code, the GST, third-year labor law reforms and fourth-year corporate profit tax knocked down to 70% for new manufacturers and 225% for the rest. These are very mutually reinforcing reforms. The benefit could be multiplied yet more if we also worked on trade side.

RAJAGOPALAN: Also streamline those reforms. GST can be streamlined so much more.

PANAGARIYA: No, but that’s happening. A lot of IBC also needs to have some streamlining involved, but that’s a constant. The big thing has happened. There will be bumps on the road. You have to clean those up. GST bumps, for example, have been cleaned up, which is why you’re seeing this massive expansion in tax revenues. The GST platform was working very poorly earlier, but that has been sorted out. People like the public finance experts like Govinda Rao, he says that this GST revenue will go up a lot more.

RAJAGOPALAN: I actually think the revenues will go up the more we simplify the GST structure. This rate proliferation that has taken place—

PANAGARIYA: No, that will also happen.

RAJAGOPALAN: —for various political economy reasons, I think that needs to really come back down. I recently wrote a paper.

PANAGARIYA: There is also the outstanding issue of bringing the petroleum products into the GST as well. Look, India is a very difficult country. Today, of course, we have seen that Prime Minister Modi had to finally get back down on the farm law reforms. He has agreed to repeal them.

RAJAGOPALAN: The reforms don’t have a linear path. They go in fits and starts.

Coordination Externalities

RAJAGOPALAN: I want to move on next to this idea of coordination externalities. This is one more externality argument in favor of protectionism. If I understand it correctly this is basically Rosenstein-Rodan’s work. This is mostly in Eastern Europe, but it argues that the government needs to engineer production of many items simultaneously rather than focusing on a single item.

Here there’s the question of externalities that can propel processes, not just the goods. This is the rough model. Of course, this is in the context of erstwhile Soviet Union and then transition economies, some of these models. What is this coordination externality argument and does it have any merit for having any kind of trade protectionism?

PANAGARIYA: Shruti, this is one argument where there is absolutely no validity to it for protection. There may be validity, conceptually, for some kind of intervention but for protection, it has zero validity. It’s very simple, I’ll tell you. Take a very, very simple example, that you need to brush your teeth. You need a brush and you need toothpaste. Now, suppose I can make a toothbrush, but it will sell only if you produce toothpaste. If you don’t produce toothpaste then my brush is no good.

Of course, if you produce toothpaste and I don’t produce toothbrush, then your production of toothpaste is no good. It’s not going to get anything so there is a coordination failure problem. If the government steps in and incentivizes each of us to produce it, promises that if you incur any losses I will cover all your losses, then each of us produces and there are no losses that are happening, and the government really actually doesn’t have to spend any money on covering either your losses or mine and the problem is solved.

Now think about the possibility of international trade. If toothpaste can be imported, I don’t need any coordination. I can go ahead happily produce toothbrush and toothpaste will be imported and the problem is solved. In fact, protection will precisely be the wrong thing to do in this case because it is going to hamper; it will in fact, what can be coordinated internationally will fall out of coordination.

That argument originally Rosenstein-Rodan made. It was entirely in the context of a closed economy. To apply it in an open economy is actually completely the wrong argument. Dani Rodrik, again, here is the one leading the charge and he makes this argument in the context of South Korea and Taiwan and all, that coordination problem is what the Taiwanese and South Korean government solved in the ’60s and ’70s.

Now, first of all, for that, he has to really assume that there are certain activities that required coordination that were nontraded, that simply trade was not possible. Certainly then, it can’t be an argument of protection because if you’re assuming that the product itself is completely nontraded, which is the only context in which coordination failure can happen, then it’s not a trade issue in the first place. The protection, certainly, may be an argument for any kind of other intervention; it cannot be an argument for protection.

In fact, trade actually is what helps you solve the coordination problem. If you go back—I’m old enough to remember when this development literature was coming through, and we had this literature, the same kind of issue, but in terms of balanced and unbalanced growth. Balanced growth guys were always worried about the demand side of it. It was Rosenstein-Rodan style that if you do certain activities altogether, then there is demand therefore for each other. You need to do a big shoe factory in a closed economy, then you will pay these workers higher wages than what you’re paying them in agriculture, but what are these workers going to spend these higher wages on, because they can buy only a small fraction of the shoes that they’re producing?

On the other hand, if you could make a massive investment and invest simultaneously in shoes, clothing, other consumer products, then they will have demand for each other’s products, and therefore, they will clear the market. That was Rosenstein-Rodan’s original argument. Obviously, it’s assuming the existence of very large-scale economies so that each of these activities has to be done on a certain scale. Because if there were no scale economies, then there is no reason any entrepreneur could come in and produce because production costs are constant, so you can produce all these different products. One entrepreneur could do it and have a diversified basket of production. Automatically the market will solve the problem.

Today, in any case, with very large investors available, the big business houses even in the Indian context like the Ambanis and the Tatas, et cetera, very big business houses, they can actually solve the coordination problem. In their context, for example, you want to produce an automobile. Now, you need auto parts and you need all sorts of other ancillary products which contribute to the manufacturing of the automobile. Of course, if trade is possible, then, in any case, you can import these, but even if trade is not possible, they get a piece of land with 100 acres, and then they put up everything that they need in one place. Today large investors can solve that problem.

RAJAGOPALAN: I have a more fundamental question here. Adam Smith, very early on in “The Wealth of Nations,” he tells us that the division of labor and the degree of specialization is going to be limited by the size of the market. When he starts talking about the division of labor in the pin factory, he’s very clear that people are going to dedicate themselves to pulling out the wire in a pin factory 12 hours a day, day after day, and engage in that division of labor and specialization only if they are able to purchase everything else that they need.

If they can’t, you’re not going to get that kind of division of labor. In the Smithian open economy, free trade model, you will get a lot of diversification if the trade is very limited. That is, each person needs to produce multiple things and coordinate. If the trade is relatively frictionless, open and the size of the market is large, then you can get very high degrees of specialization. To me, it seems like it’s endogenous to the model.

There isn’t an exogenous quantity of optimal specialization in any economy, and therefore, coordination. The assumption is I’m going to spend all my time making toothpaste only if I’m confident that we can purchase toothbrushes. Otherwise, the toothpaste won’t be forthcoming in the first place.

What am I missing in this Adam Smith free trade, which endogenizes the degree of division of labor and specialization, vis-à-vis, these models that you just talked about where we’re talking about coordination failures, which need to be engineered? I just don’t understand why. Maybe I’m missing some step or some assumption.

PANAGARIYA: No, I think the basic point comes across in what you are saying. That if I’m an open economy, then, in fact, I don’t need to coordinate and I, in fact, want to specialize. Particularly, if I’m not only open, but I am also relatively small, and every developing country, no matter population-wise, how large, whether it was India or China in the 1950s, it’s a very small economy. If you look until 1980 or so, the GDP in India was smaller than the GDP in South Korea.

We used to smugly talk about South Korea as being quite small relative to us, but the fact of the matter is that the GDP of South Korea exceeded our GDP. Today things have changed after we opened up and also started growing. Really, if you are a relatively small economy, which as I said, all developing countries are when they start off, then you don’t want to undertake too many activities precisely for these reasons that Adam Smith very clearly laid out, that you want to take advantage of the specialization process and import what inputs you don’t produce.

That is what really even allows you to begin to industrialize. If you’re starting with assembly activities, then you can import components and still assemble and get going. This coordination argument is very strict. Look, it’s not a coincidence that Rosenstein-Rodan was the one who first wrote it out because he was a Polish economist.

RAJAGOPALAN: These are closed economies. These are centrally planned economies. When now, instead of the market process, you need an engineered process to do everything that the market could have naturally done, endogenizing the solution to most of the problems that they’ve highlighted.

PANAGARIYA: Actually, as far as protectionism is concerned, this is the weakest argument. In fact, it’s not even an argument really.

RAJAGOPALAN: I’m happy we still went over it even though it doesn’t have much merit in the literature because my problem with protectionism is these arguments never seem to go away. Every decade, they come back in some random, completely made-up context in some industry gathering or some op-ed article. Then everyone is gaga and says, “Yes, we are normally all for free trade, but for the purpose of diversification or for the purpose of coordination, now we need some kind of intervention.”

Actually, this is a good point to set up our next conversation, which we will start talking about India, finally. I think you’ve been very patient with us in explaining and laying the ground for arguments in favor of free trade, and walking us through the merits, mostly demerits of arguments in favor of protectionism.

Starting in the next episode, it’ll be great if we can now focus on Indian political economy, and the history of Indian protectionism starting in colonial times and then continuing through Indian socialism and then of course, the liberalization. Hopefully, we can continue this conversation in that direction, and also touch upon the more recent reforms that you just mentioned.

PANAGARIYA: We shall do that.

RAJAGOPALAN: Thank you so much as always, Arvind.