The Doha round of trade talks collapsed again Thursday, with the Indian trade minister Kamal Nath walking out of the talks in protest against the failure of the United States and the EU to offer further concessions. While this failure only knocks a few more nails into the coffin of a deal already moribund, it’s worth examining what a protectionist world will look like, and why free trade globalization, apparently so economically successful, has in the real world of politics become unattainable.

Free trade is something of a shibboleth among professional economists. Learning the subtleties of David Ricardo’s 1817 Doctrine of Comparative Advantage often draws them to the subject in college. It is the first economic theorem they meet for which the results aren’t intuitively obvious and knowing about it raises them intellectually nicely above the common herd. Thus in a group of economists free trade and even free movement of labor often become icons, worshipped unquestioningly against all opposition.

Many such economic objects of veneration suffer from one enormous problem: they rest on assumptions that are very often wrong. The Efficient Market Hypothesis, for example rests on assumptions about capital markets that are provably incorrect; it is thus little surprise when it repeatedly fails to apply. Similarly Ricardo himself (a highly practical man who made a fortune as a stockbroker sufficient to buy him Gatcombe Park, a residence now elevated to Royal Family status) recognized that the Doctrine of Comparative Advantage fell down when factors of production were mobile.

In the modern Internet economy not only are the factors of production mobile but the intellectual property that transforms factors of production into output is itself easily transferred. Thus Catherine Mann of the Petersen Institute, using Ricardo to justify outsourcing software production to India, failed to recognize that Indians trained to carry out software production soon learn the more creative skills that had been thought the provenance of higher paid US software engineers. By doing so, they quickly climb up the value chain to capture the fortress of highly paid US jobs at the top.

If the Doctrine of Comparative Advantage is invalid, then so is most of the case for free trade. Curiously, the case for free trade is strongest and the gains from free trade greatest in precisely the areas such as steel, textiles and agriculture in which the United States and the EU protect their home industries most vigorously. This is typical of government policy; economic rationality plays very little role in it, while it is instead directed towards the needs of the interests with the strongest lobbies.

The benefits of free trade in steel, for example, can be illustrated by the story of William Morris, Lord Nuffield, in the period immediately after World War II. Morris, founder and Chairman of Britain’s largest automobile manufacturer, had used the latter years of the war to prepare designs and tooling for automobiles to attack the US market, in which he saw that the absence of German and indeed French competition would for several years give him a competitive advantage. He knew that the tinny little cars like the Morris 8 which satisfied the British and Empire markets would be hopeless in the much larger United States, which also by that stage had better roads. Hence he prepared models which were large and over-equipped by British standards, but would suit the US market nicely as compact automobiles, smaller than the behemoths towards which Detroit was gravitating.

Morris didn’t have a problem with US automobile tariffs; these were relatively low, since the US industry didn’t fear foreign competition. His problem was British tariffs on steel, which prevented him from importing steel from the efficient US mills and forced him to use steel from the tiny and hopelessly inefficient British mills. If the British Treasury had had the sense to devalue sterling, even this problem could have been overcome but Maynard Keynes, in charge of policy, was at that stage fixated on maintaining the exchange rate at $4.03 = 1 pound. Hence the Morris attack on the US market was stillborn, and the US move towards compact imported automobiles had to wait for the advent of Volkswagen 15 years later.

It has now become clear that whether or not we want free trade, we are not going to get it. This will impose costs at many levels:

• The rationalization of the world’s steel industries that is currently being carried out by Lakshmi Mittal and others will face increasing barriers in the next recession as countries attempt to protect their declining and uncompetitive mills.
• US pharmaceutical and media companies will lose huge amounts of money to knockoffs, as they will be unable to enforce patents and copyrights effectively in emerging markets.
• India’s Tata Motors may succeed in building a $2,500 automobile, but non-tariff barriers and environmental regulations of exquisite complexity will ensure that it is never seen in any other country with an automobile industry to protect – including notably China, where the cheapest automobile currently costs $6,000.
• Agricultural products will become increasingly expensive, with domestic farmers protected not only in their production of basic foodstuffs but also by such monstrosities as EU sugar beet production, Japanese rice and beef import restrictions and the US program to produce ethanol expensively and environmentally counterproductively from corn instead of sugar cane.
• The downward push on US and EU inflation from outsourcing manufacturing to China will reverse (it has in any case lessened greatly) as tariffs obstruct global production optimization.

Assuming the world does not enter a protectionist spiral like the 1930s, there will however also be benefits from a moderate rise in protectionism. In financial services, for example, countries will no longer allow all their major banks to be bought up by foreign interests. The British merchant banks are almost all long gone but countries are increasingly discovering that a world in which finance is dictated by a small number of multinational behemoths holds no protections for capital availability and job preservation. There is little economic advantage to the breakup of Cadbury Schweppes, for example, or the absorption of Boots by private equity interests, and there are serious costs involved both directly from the deterioration in quality and service to the consumer and indirectly from the destruction of iconic brand names and century-old businesses. The free trade dogma does not take sufficient account of the costs of excessive corporate churning, which are becoming increasingly apparent.

In Eastern Europe, too, countries are discovering that it was a dangerous mistake to allow the whole of their banking systems to be sold to foreigners. Capital availability to domestic business is restricted in recessions, and businesses are dangerously exposed to foreign takeover and asset-stripping in periods of high liquidity.

In business services, it is likely that the tendency for the business to flow to low cost centers will be lessened. It has become clear that there is no way to preserve levels of service to domestic customers if this happens, and that the outsourcing company is only too likely to lose its high margin business to the foreign competitor it has empowered.

In energy and minerals, there will no longer be an assumption that the product is fungible, and can always be purchased on the world market without regard to supplier relationships. Europe has learned in natural gas that a major supplier can exert excessive and unpleasant power over customers if arrangements are not made to preserve diversity of supplies. The United States is likely to learn this even more forcefully in oil, as the world’s largest oil deposit, the Orinoco tar sands of Venezuela, moves inexorably away from being available to the US market and towards monopolization by the protectionist Chinese.

Economists and their commentator friends have scoffed for the last 15 years at the difficulties being suffered by Germany and Japan, the two most protectionist of rich countries. Today, both countries are doing much better economically than they were, indeed better in most respects than the United States or Britain. Germany’s hostility to foreign bank domination of its financial sector has had two benefits: it has avoided a home mortgage bubble such as those in the US and Britain, whose backlash both financial and social will be felt for at least a decade, and it has avoided most assaults on its major corporations by dodgy fast buck operators in the private equity business. Japan too, with its long term outlook on business, its refusal to destroy its banking system in favor of foreign speculators and its subordination of finance and sales to the business of designing and making things, looks a long term survivor. It is notable, that with the exception of a blip in the decade when Germany was absorbing East Germany, productivity growth in both countries has consistently been higher than in the United States and Britain.

In a protectionist world, Japan and Germany represent the model for the future. Immigration will be sharply restricted, because unlimited immigration, particularly low skill immigration is even more destructive of the economic well-being of the domestic populace than unrestricted free trade. Corporations will last longer, and will devote more of their resources to basic research and development, as did the old Bell Laboratories, because they will know they are preserved from assault by the fast-buck brigade or outsourcing of their operations to the Third World. Interest rates will be higher, and the world economy will be much less dominated by the screen-meddlers of finance.

The emerging markets themselves will grow just about as fast as they would under globalization, some more, some less depending on the quality of their governments, their taxation levels, and the security of their middle class savings. Neither India nor China, the last decade’s great success stories, are freely open markets, and nor were the previous success stories of Japan, Korea and Taiwan.

As Kaiser Wilhelm II and President William McKinley found more than a century ago, rapid economic growth is entirely possible when combined with protectionism, provided only that the protectionism is intelligent and does not protect the old and dying at the expense of the new and dynamic. An intelligently protectionist world will not be significantly poorer, it need not be more belligerent and it will very probably be more comfortable for its inhabitants.

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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.)