Protectionist policies are very popular all over the world. Governments are quite fond of anything that favors their citizens over the citizens of another country. It would initially appear to be a political no brainer. Why bother to pursue a policy that appears to harm the locals and help foreigners? Annoying voters in a democracy could mean the end of political power. It could result in social unrest and eventual overthrow for dictators. Instead it is far easier to pass protectionist restrictions on trade that will only result in unhappy trading partners and interminable litigation within the World Trade Organization. But there is a problem. Protectionist policies while seemingly benign always have unintended consequences, which, over time, back fire and harm those whom they are supposed to favor.

 A recent example has to do with the Chinese attempt to protect their production of rare earth elements. The misnamed rare earth elements include 17 elements that are essential for many high-tech devices. Through a concerted policy the Chinese were able to dominate the world supply by driving the price down and their competitors out of business. They now control over 97% of the world supply.

With almost a monopoly on this commodity, the Chinese tried to drive the price up. In September 2010 they halted shipments to Japan, the principal buyer. They also created an internal monopoly. The largest producer, Baotou Iron and Steel Group, took over or bought out smaller mines in the area and the government went on a campaign to close down the many illegal operations.

Initially these methods worked. The price of rare earths sky rocketed and the local Chinese industry reaped record profits. But the protectionist measures that manipulated prices back fired. Rare earths are critically important for some products like fluorescent lighting and military radars, but these products use minimal amounts. About one fifth of the demand came from low end applications like magnets. As the price of rare earths increased, manufacturers of everything from white goods to cars switched to use cheaper iron magnets in their electronics. The result was that prices slid by 30% since July of 2011. Besides driving the price down, the Chinese restrictions increased smuggling, which deprived the government of revenues.

Even worse than substitution the Chinese restrictions forced customers to find alternative sources. Since the rare earths were a necessity in certain military application, the US passed laws to subsidize production outside of China. While in Japan, large corporations like Toyota have financed exploration in other countries, which will rob the Chinese of their monopoly.

China is not the only advocate of protectionist measures. Although often easy to institute, once in existence they are very difficult to reform as India recently illustrated.

India’s retail sector is highly fragmented; made up of tens of millions of mom-and-pop shops and powerful middlemen traders who link farmers to consumers. The inefficiency of this system result in what the Times of India called a “Criminal waste of food” that occurs due to the lack of integrated storage. The inefficiencies increase the final price and deprive farmers of the potential value of their produce.

Recently India’s Congress Party attempted to open up the $450 billion retail sector to hyper efficient western marketers like the American company, Walmart, the British firm, Tesco and ubiquitous Swedish furniture firm IKEA.  The law stopped short of giving the foreigners unrestricted access, but required them to partner with local firms like Pantaloon, Shoppers Stop, Koutons and Trent. The reform lasted a mere nine days.  The political uproar created by local and opposition politicians forced the government to withdraw the program. The result is that the Indian consumer is deprived of less expensive higher quality food and the local partners shareholders were hit with losses of up to 10%.

The irony is that the protectionist policies in India are nothing new. It is just that the shoe is on the other foot. Three hundred years ago the protectionist policies were those of the United Kingdom trying to protect local weavers from a cheaper and better product, cotton textiles imported from India by the East India Company.

The East India Company started to import cotton because they could not get access to the spice trade which was monopolized by the Dutch. So they searched for an alternative, Indian cotton. But the cotton soon drove British silk and wool weavers out of business and they successfully petitioned Parliament for restrictions. The final restrictions only allowed the importation of cotton thread. But this restriction not only increased smuggling, it also encouraged entrepreneurs to create cheaper ways to use the thread. The result was the industrial revolution that put the weavers out of work for good.

All government economic policies, especially protectionist measures, have unintended consequences. Sadly the demands of a few pressure groups easily outweigh the greater good.