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Neomercantilism is a policy regime that encourages exports, discourages imports, controls capital movement, and centralizes currency decisions in the hands of a central government. The objective of neo-mercantilist policies is to increase the level of foreign reserves held by the government, allowing more effective monetary policy and fiscal policy.
Rise of mercantilism
As feudalism became incapable of regulating the new methods of production and distribution, mercantilism emerged as a system for managing economic growth through international trade. It was a form of merchant capitalism relying on protectionism. It was developed in the sixteenth century by the European nation-states to enrich their own countries by encouraging exports and limiting imports. In modern terms, the intention was to achieve a "favorable" balance of trade.
The East India Company is one of the best examples of the collaboration of state and merchants in exploiting market opportunities. The benefits that occurred as a result were:
- it slowly encouraged the evolution of regional into nation states;
- a commercial class emerged which, in return for paying taxes, received state protection in the form of monopolies and tariffs;
- once colonies were established, managing the transport of private goods and the volume of trade enriched the imperialist states and provided both significant employment for the general population and opportunities for upward class mobility for the more enterprising individuals.
In The Wealth of Nations, Adam Smith criticised the implicit political corruption of mercantilism in limiting the benefits of trade to the elite classes, and asserted that free trade should benefit all interested parties. Smith considered mercantilism a system where one country increases its power by getting excess gold on foreign transactions and it is a system created by merchants in order to get monopolies and easy profits.
Some people believe that, because Britain adopted his call for free trade policies, it fell behind the United States and Germany by 1880, having gained its dominance under the mercantilism of Cromwell and Elizabeth I (when according to Adam Smith, England was less mercantilist than Spain and Portugal, who decayed much due to their colonial mercantilist policies. The success of the United States and Germany drove the reintroduction of protectionist regulations in the rest of Europe.
Neomercantilism is founded on the use of control of capital movement and discouraging of domestic consumption as a means of increasing foreign reserves and promoting capital development. This involves protectionism on a host of levels: both protection of domestic producers, discouraging of consumer imports, structural barriers to prevent entry of foreign companies into domestic markets, manipulation of the currency value against foreign currencies and limitations on foreign ownership of domestic corporations. While all nations engage in these activities to one degree or another, neo-mercantilism makes them the focus of economic policy. The purpose is to develop export markets to developed countries, and selectively acquire strategic capital, while keeping ownership of the asset base in domestic hands.
This use of protectionism is criticized on grounds that go back to Adam Smith's The Wealth of Nations, which was aimed directly at classical mercantilist policies, and whose arguments are applied to neo-mercantilism. Namely that protectionism is effective as a means of fostering economic independence and national stability; and questioning the conclusion that it allows for sustainable development of the nation's industrial base in the most efficient manner. Instead market economics has for over two centuries argued that increasing competition within the nation which will more effectively promote capital development and efficient allocation of resources. "Free traders" argue that by closing an economy, resources will be spent duplicating products that could more effectively be bought from abroad, and that there will be less development of exports which offer a comparative advantage. Market economists also argue that protection denies a nation's own consumers the opportunity to buy at cheaper market prices when quotas or tariffs are imposed on imports.
The subsidy of goods has also been advocated under neomercantilism. The fair trade movement claims that the protection of stability in emerging economies by guaranteeing a minimum purchase of goods at prices above those available in the current world markets, can contribute to restoring economic and social balance as well as promote social justice. Proponents of the movement argue that this may help to avoid the instability generated by the influence of global corporations on developed and developing nations.
Neomercantilists claim that "free trade" results in a negative philosophy that a nation that is not competitive deserves to decline and perish, just like an under-performing corporation should. They argue that "free trade" does not work well whenever dumping is practiced or the international rules do not take into account the differences between wages, costs environmental regulations, and benets from nation to nation. For instance, there is a major difference in the cost of labour between a "First World" and "Third World" country for two equally skilled (or unskilled) sets of workers. When this economic reality is exploited by "First World" manufacturers, the benefits accrue to "First World" shareholders and consumers (and slightly improved work condition of exploited Third World workers) at the expense of privileged "First World" workers and their status in the "middle class".
An unquestioningly open policy in such circumstances may effectively devalue "first world" human capital investments in favor of financial capital investments. Consider for example, a person deciding whether to invest in training as an engineer or in a portfolio of financial assets. Offshoring dramatically increases the effective supply of engineers, and as a result, their price will tend to decline (or grow at a slower rate). This decline will be increased by the lower cost of living in non-first world countries that would allow an engineer there to live much better on a lower nominal salary than their first world counterpart (see purchasing power parity). This obviously is resulting in a huge immigration of skilled professionals from first world countries to the third world, seeking a better quality of life.
Faced with such prospects, rational economic agents will tend to avoid investing in human capital in areas that are vulnerable to such government-induced devaluation. Instead, they will shift training toward areas that are "protected by regulation" (for example: careers in law, medicine, government) or social tradition (tenured academia), or socio-cultural factors (sales) or local physical requirements (nursing, medicine, construction). Alternatively, rational economic agents in "first world" economies may choose to invest in financial assets instead of human capital—further eroding the long term ability of the "first world" country to produce and grow. As predicted by Adam Smith, this effect would reduce the inequality between First World and Third World countries, increasing overall fairness.
Additionally, since cost of goods sold tends to be a larger component of total revenue than profits for most industries, production within a country may keep a larger portion of the total wealth within the local economy in comparison to dividends of profits and reduced prices on consumer goods. Furthermore, infrastructure investments may be reduced when production is shifted offshore. Over the longer term, such reduced local investments may reduce longer term productivity and economic growth. Neomercantilist economies on the other hand are often characterised by "higher long term growth rates" (that tend to flatten when neomercantilist policies are halted). This claim unfortunately is not verified among developed nations, where Australia is both the main proponent of international free trade and among the first world countries, the one with the higher sustained growth during the last fifteen years. Also, as of February 2009, Australia is also the only developed country who is not officially in recession.
The language of neomercantilist policies repeats the claims of earlier centuries that protective measures benefit the nation as a whole and that governmental intervention secures the "wealth of the nation" for future generations. In doing so, neomercantilist admit that the interests of large corporations might as often be represented and protected as pushed aside for the national interest.
As a neomercantilist nation's industrial production capacity and improving research and development grow as a threat to the hegemon's (who usually unilaterally practices free-trade as Britain in the 19th century and the US in the late 20th century) domestic markets, so protectionism is the usual response, initially through political and, when necessary, military means (see World War I).
Examples of neomercantilism
United States and Germany in 19th century
By 1880 the United States passed the British Empire in economic strength—ahead of Germany, second in strength, due to Bismarck's adherence to similar neomercantilist policies.
After 1900, Britain was unable to remain an effective hegemon, having followed its "free trade" philosophy since the 1840s, but the United States was still pursuing policies of its American School rooted in Hamilton's three reports, that it had embraced in the 1860s under Abraham Lincoln. Germany followed Otto von Bismarck's policies based on Friedrich List's "National System", and American economic practices—allowing both powers to continue their dominance in world economics and power. Germany chose to use its strength to pursue a 'balance of power' with the British Empire leading indirectly to World War I, whereas the United States refrained from European power struggles through its foreign policy of 'isolationism' or non-interventionism in foreign conflicts.
Classic liberal economic theory states that free trade, sound money, and prosperity are mutually interdependent parts of a single economic policy but, when inflation intruded into the world trade system, protectionism followed.
In Two Hegemonies, Pigman describes a hegemon's principal function as, "...underwriting a liberal international trading system that is beneficial to the hegemon but, paradoxically, even more beneficial to its potential rivals." As it grows in significance, the hegemon expands its sphere of influence to include interests that have to be promoted through liberal economic policies. During this period, the hegemon will benefit directly from the increased international trade. But other economies also prosper. They are not burdened with high defence spending and the costs associated with overseas development, though these costs may be balanced or outweighed by the international domination of markets and resources. The "hegemon's dilemma" is whether to revert to neomercantilist policies if its hegemony is threatened, or to continue free trade and risk a relative decline.
Game theory analysis – trade policy as iterated prisoner's dilemma
Trade policy is perhaps best viewed economically as an ongoing "iterated / repeated" prisoner's dilemma game.
The prisoner's dilemma is not a zero-sum game. Everyone would be better off if all players cooperated than if they defected. (Mutual cooperation is a Pareto improvement over mutual defection.) Unfortunately, each player has an incentive to defect against their opponent. By defecting a player can defend themselves against an opponent's defection, and can exploit a cooperating opponent. In single-shot prisoner's dilemma, the economically dominant action is to defect.
However, trade policy is formed over time—and is better modelled by iterated /repeated prisoner's dilemma. Key early work in this area includes research by David Kreps, and by Robert Axelrod. One of the most important developments in game theory is the development of the folk theorem when applied to iterated prisoner's dilemma games.