The credit crisis took an ugly turn this week, when a number of countries banned rice exports, causing the price of the staple to soar above $1,000 per tonne, treble its level a year ago. Politically and economically, the world has moved decisively in the direction of protectionism and seems likely to continue further along the protectionist path. It’s worth looking at what this trend may entail and how we might minimize its costs.

The most damaging aspect of the current burst of protectionism is the refusal by countries supplying food staples to export to their usual customers; this could actually make people starve. It is worth noting that this crisis is almost entirely the result of government action. First, the George W. Bush administration and the EU instituted counterproductive (both environmentally and economically) subsidies for ethanol production, by means far less efficient than the sugar cane based ethanol being produced in Brazil. That caused a supply shortage in corn and other crops that would not otherwise have occurred. Second, governments especially in the United States printed excessive amounts of fiat money, causing an immense speculative bubble. Finally, the panic was exacerbated by an unwise speech by the public sector bureaucrat, World Bank President Robert Zoellick, who advocated a “new deal” for world food production – inevitably involving vast taxpayer subsidies through the World Bank – and thereby turned popular concern about price rises into panic.

This is not to say that globalization itself has been an unqualified success. The idea that by totally freeing trade, immigration and investment wealth could be optimized at low cost is a fantasy beloved only of academic economists. In reality, globalization of immigration, investment and trade each involves tradeoffs, and the tradeoffs are different, since each has different characteristics. Only by treating each factor separately, and by taking seriously the arguments both popular and economic against its globalization, can truly damaging protectionism be resisted.

In the case of trade, David Ricardo’s 1817 Doctrine of Comparative Advantage states that each product should be manufactured in the country where its relative production cost is least, and that such an arrangement is optimal for all. This is however a purely static analysis that ignores the tendency of national capabilities to change over time. In the modern world, with rapid transportation, good education systems and instant communications, such capabilities can change very rapidly. There is thus no assurance that outsourcing computer software production to India, or high-tech manufacturing to China, will in reality produce benefits for the outsourcing countries. Indian computer software writers and Chinese high-tech engineers may simply acquire the techniques and know-how they need and set up in competition. Globalization of trade is generally beneficial to inhabitants even of rich countries – the benefits of cheaper garments and electronic goods are undoubted — but the losers are not simply concentrated in dying industries but may be the apparently successful toilers in growth sectors.

Another problem with global free trade, becoming increasingly apparent, is that of global monopolies or oligopolies. Once an industry becomes globally oligopolistic the rules of free competition tending to reduce prices and increase quality become less salient, and the benefits of further globalization can no longer be assured. In aircraft, for example, it is not clear that the world benefits from having only two major civil aircraft manufacturers. Similarly in financial services, the growth and globalization of financial service providers has meant that when a downturn occurs, it is global in scope, and produces problems of illiquidity in markets far distant from those in which the problem initiated. It is a complete mystery why the Japanese stock market should have dropped 25% in the first quarter of 2008, when its banks had little exposure to the US housing sector and its economy was continuing to grow satisfactorily. Steel, oil and mineral extraction are other sectors in which globalization appears problematic, although in automobiles a welcome contrary tendency has appeared, of new manufacturers in emerging markets themselves achieving the scale and capabilities necessary to compete internationally.

Freedom of investment is another principle much beloved by theoreticians that in practice causes difficulties. The problem is that economics does not exist in a vacuum from foreign policy. In natural resources, for example the normal ambition of most Third World governments is to seize control of any minerals discovered on their territory. Given that tendency and the existence of companies controlled or effectively controlled by governments hostile to Western interests, free foreign investment is a chimera. On the other hand, since its problems are political rather than economic, free foreign investment remains an appropriate ideal to establish. The two caveats should be national security, broadly defined, and the need to avoid monopolies, whether global, as in aircraft, or regional, as in Russia’s attempt to dominate the European gas market.

The case for unrestricted immigration is much weaker than that for free trade, and its damage to the high-wage host country much more obvious. Because of the fierce competition produced by global free trade, wages for the unskilled in a completely free world market are driven down to subsistence levels. Malthus said this in 1798 and given the excessive global population growth produced by modern medicine, it remains true. Even globally, the modest overall income improvement from the equalizing effect of free immigration is overwhelmed by its huge and unattractive social costs, which impose economic penalties in the form of crime, unemployment and ghettoization

To protect the lower-skilled inhabitants of rich countries, and prevent intolerable social strains through Latin American-style income differentials within society, it is thus necessary to restrict immigration. The barber in Boston makes ten times the wage of the barber providing an identical service in Lagos; it is appropriate that he should. Fantasizing that the low-skill worker should get an education making him superior to his immigrant competitor is elitist nonsense; if he’d been able to get into Harvard he would have gone there, while further years of drudgery at a community college are not going to provide him with any significant extra competitive ability.

At the high skill level, the much lamented shortage of US engineers and surplus of lawyers is almost entirely due to the H1B visa system, which allows in competitors to graduate engineers, driving down their wages, while preventing easy qualification by foreign graduate lawyers, giving domestic lawyers a protected position.

However fallible are free trade theories, most protectionist policies offer no chance of improvement. In general, markets work better than governments, which is why free trade was thought to be optimal in the first place. Modified free trade, in the form of the current cat’s cradle of bilateral agreements, subsidies for non-economic objectives and deals like the Colombia and Korea Free Trade Agreements that may sometime pass Congress but not anytime soon adds substantial costs to the world economy without providing the protections against unfettered competition that a suspicious public demands.

Autarky, the policy favored by Third World governments that generally see chances of self-enrichment from imposing restrictions, is to be fought. Autarky in natural resources reduces production, since it prevents the latest technology from being brought to bear on the complex questions of exploration and extraction maximization. The current trend for countries to take increasing control over their own oil resources, forcing out the multinationals, is the one thing that could truly bring the “Peak Oil” nightmare to pass – a future in which we are condemned to use ever-diminishing supplies of oil without yet having discovered adequate substitutes. Russian oil production, thought to be the great new “swing source” of non-OPEC expansion, appears to have peaked in the face of expropriation and embezzlement, while autarkic Mexico, Nigeria and Venezuela have all seen substantial recent production declines in spite of high prices. There are a few counterexamples: Iraq’s oil reserves have doubled since grown-up oil companies were allowed back to explore there in 2003, while Brazilian oil discoveries have been substantial recently, because Petrobras has become open to foreign exploration and production partners.

In food, autarky is hugely counterproductive; the riots in rice consuming countries because of export bans by rice surplus countries are the starkest recent example of protectionism’s many downsides. Subsidy programs rapidly become inordinately expensive as prices rise, and by subsidizing the consumption of temporarily scarce goods they exacerbate the shortages that produced the initial price rises. Even in manufactured goods, where it was once thought desirable for every Third World country to have its own steel mill, autarky can impose huge costs for very little if any benefit. Governments are no better at choosing winning sectors than they are at setting prices; the results of their failure are legion, and their costs generally far greater than those imposed by excessive free trade.

Since unrestricted globalization imposes substantial costs, and unreflective protectionism imposes even greater ones, we need to find a solution that modifies globalization to restrain the costs it imposes, without losing its benefits. As far as possible, that solution should be market-driven rather than government-led, and it must recognize that trade, international investment and immigration, while related questions, have differing characteristics that need to be recognized.

The Doha Round of trade talks should be revived, partly because trade talks appear to have the “bicycle” quality that motion itself is beneficial. Because it ensures that countries of all economic positions attempt to reach agreement, a Doha agreement, and even the Doha process is far more beneficial to world trade than a series of bilateral deals which attempt to discriminate unfairly against third parties. Colombia can feel itself aggrieved if the US does not ratify its FTA, because Peru, Panama, Mexico and Central America all have FTAs with the United States, giving them a politically and economically unjustified advantage against Colombia in selling goods and services to the US and attracting investment from it.

However, the strong focus of the revived Doha talks should be on reducing the politically directed high tariff barriers in such areas as agriculture, and on banning subsidies, rather than on lowering modest general tariffs. In a world of freely floating exchange rates, without a Gold Standard or equivalent, there is a substantial economic case for moderate tariffs, which preserve each country or trading bloc’s home market as a protected area, preventing temporary fluctuations in exchange rates from driving almost-competitive local producers out of business. If the euro/dollar exchange rate can move in 6 years from $0.85 to $1.60, without any significant differentials in inflation, there needs to be a mechanism preventing unnecessary bankruptcies and forced sales of companies trapped on the wrong side of an extreme exchange rate. By definition, the additional costs imposed by a modest tariff will be modest, and it will tend to lessen oligopolization of global production, since each producer will have a competitive advantage in its own country/bloc.

Whereas tariffs provide revenue to feed the ever-expanding maw of government, subsidies cost money and are thus doubly damaging both to taxpayers and the world economy. It is not surprising that the Doha talks are moribund; the attitude of the Bush administration and the EU, in expanding agriculture subsidies and inventing an entirely new and pernicious subsidy for ethanol production, while piously claiming to favor free trade, reached levels of hypocrisy and economic illiteracy that the Brazilian, Malian or Indian delegations could not be expected to stomach.

A further need is for higher worldwide interest rates and lower worldwide liquidity. Much of the recent run-up in commodity prices has been due to excessive economic expansion, combined with over-abundant capital for speculators seeking to exacerbate price movements. A global tightening of interest rates, beginning in the United States where the economic imbalance is greatest, will rapidly reduce the fever in commodities markets, thereby reducing the temptation towards autarky. It will also rebalance the US trade deficit, which will lessen the non-market central bank demand for Treasury securities, forcing a tightening of the excessively expansionary US fiscal position.

Immigration is the area where restrictions are most beneficial to the less educated populations of rich countries, because it attacks the huge sector of the economy that is not internationally tradeable. Immigration should thus be tightly restricted, both at the high-skill and low-skill levels, with tight quotas for the former and tight restrictions against illegal entry by the latter.

Globalization in its extreme form has failed, and could never have succeeded. We in the rich West now need to ensure that the inevitable reaction towards protectionism provides the maximum protection of Western living standards at the minimum possible global economic cost.

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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)