The political

economy of
protectionism

THE NEW
NEO-MERCANTILISM:
C U R R E N C Y M A N I P U L AT I O N A S
A FORM OF PROTECTIONISM
Paul F. Cwik

Three waves of mercantilism have arisen in the past few centuries. The first wave
was countered by the classical economists. The second wave (neo-mercantilism) hit
during the inter-war period. Todays third wave uses monetary policy. We explore
the mercantilist waves and argue in favour of a free trade policy. We conclude that
an international system of free banking best protects the economy from currency
manipulation as a form of protectionism.
Keywords: International finance, international trade, interventionism,
mercantilism, protectionism.

Introduction
Todays countries tend not to use traditional
means of tariffs and quotas to protect their
markets. Many countries instead use pretexts
such as health and safety to prevent goods
crossing borders. Another, less visible,
protective method is the manipulation of
currency exchange rates on the international
market to promote exports and trade
surpluses. After examining mercantilism, we
illustrate how mercantilist manipulations fail
to achieve their long-term goals. Finally, we
argue that a sound money policy is preferable
to a manipulative policy.
ecaf_2117 7..11

Mercantilism
Classical economics, the ideas of Hume, Smith
and Ricardo, were a reaction to the governing
economic philosophy of their time
mercantilism. While there was no single set
of policies that all mercantilists held,
mercantilist economic philosophy had several
commonalities. In particular, mercantilism
held that exports were benecial to the nation
while imports were detrimental. The net
inow of capital resulting from this trade
surplus enriched the nation.
The mercantilist argument grew out of the
need to elevate ones nation state above the
rest. This need then fostered the drive to
acquire and to maintain the ability to project

military power worldwide. Just like today,

maintaining a military presence in the
seventeenth and eighteenth centuries was
rather costly. In order to pay for men, horses,
food, guns, ships, ammunition etc., the state
needed money, and, at this time, money was
specie gold and silver. Thus the mercantilist
reasoned this way: if our nation is to be great,
we need to project a military force and that
requires a tremendous amount of money. We
could use our own treasure to accomplish this
task or we could use other countries reserves.
The enacting of policies such as tariffs and
export-stimulating subsidies will minimise
imports and maximise exports. The result will
be a positive trade imbalance, i.e. a trade
surplus. The nation will export more than it
imports and, consequently, there will be an
inow of gold and silver. A portion of this
specie inow can be directed towards our
efforts to project power.
Classical economics is born
The intellectual response to the mercantilist
system was the foundation of modern
economic science. The rst modern economic
argument against English protectionist trade
policies was by David Hume in Of the Balance
of Trade (1752). Hume presented his
argument about the price-specie-ow
mechanism in the following way:

2011 The Author. Economic Affairs 2011 Institute of Economic Affairs. Published by Blackwell Publishing, Oxford

the new neo-mercantilism: currency manipulation as a form of protectionism

Suppose four-fths of all the money in Great Britain to be annihilated

in one night, and the nation reduced to the same condition, with regard
to specie, . . . what would be the consequence? Must not the price of all
labour and commodities sink in proportion, and every thing be sold as
cheap as they were in those ages? What nation could then dispute with
us in any foreign market, or pretend to navigate or to sell manufactures
at the same price, which to us would afford sufcient prot? In how
little time, therefore, must this bring back the money which we had lost,
and raise us to the level of all the neighbouring nations? Where, after we
have arrived, we immediately lose the advantage of the cheapness of
labour and commodities, and the farther owing in of money is stopped
by our fullness and repletion.
Again, suppose that all the money of Great Britain were multiplied
vefold in a night, must not the contrary effect follow? Must not all
labour and commodities rise to such an exorbitant height, that no
neighbouring nations could afford to buy from us; . . . Now, it is
evident, that the same causes which would correct these exorbitant
inequalities, were they to happen miraculously, must prevent their
happening in the common course of nature, and must for ever, in all
neighbouring nations, preserve money nearly proportionable to the art
and industry of each nation.
(Hume [1752] 1826, pp. 351352)

This neutral money argument says that by simply changing

the unit of account, nothing lasting can be accomplished. Only
temporary distortions can occur and then readjustments will
naturally foil the plans of the mercantilist policy-makers. As
we will see below, this insight of distortion reversion directly
corresponds to the modern situation.
Adam Smith built upon the foundational work of his
teacher, Hume. Echoing Hume, Smith explained that gold and
silver were not wealth. The wealth of a nation was not changed
by simply adding or subtracting money to the economy. Smith
argued that mercantilism was fundamentally awed because it
could not achieve its ultimate goals of power and military
might. In fact, Smith argued that mercantilist policies were
backwards:
It is not always necessary to accumulate gold and silver, in order to
enable a country to carry on foreign wars, and to maintain eets and
armies in distant countries. Fleets and armies are maintained, not with
gold and silver, but with consumable goods.
(Smith [1776] 1981, p. 440)

Smith further argued that it was the wealth found in the

market economy that was antecedent to the ability of a nation
to project military power.1 The ability to project military might
was a consequence of expanding trade for the nation, not the
cause of a nations wealth. The core of Smiths work was a
question of what makes nations rich. He repeatedly argued
that free trade was necessary and mercantilism was, at best, a
temporary distortion:
No regulation of commerce can increase the quantity of industry in any
society beyond what its capital can maintain. It can only divert a part of
it into a direction into which it might not otherwise have gone; and it is
by no means certain that this articial direction is likely to be more
advantageous to the society than that into which it would have gone of
its own accord.
(Smith [1776] 1981, p. 453)

Smith then directly confronted the mercantilist fallacy that

trade decits were ruinous to a nation. He argued not only
that the reverse was true, but he used the American colonies as
his empirical counter-example:
A nation may import to a greater value than it exports for half a
century, perhaps, together; the gold and silver which comes into it
during all this time may be all immediately sent out of it; its circulating
coin may gradually decay, different sorts of paper money being
substituted in its place, and even the debts too which it contracts in the
principal nations with whom it deals, may be gradually increasing; and
yet its real wealth, the exchangeable value of the annual produce of its
lands and labour, may, during the same period, have been increasing in
a much greater proportion. The state of our North American colonies,
and of the trade which they carried on with Great Britain, before the
commencement of the present disturbances [1775], may serve as a proof
that this is by no means an impossible supposition.
(Smith [1776] 1981, pp. 497498)

The works of Hume and Smith were systematised and

elaborated by David Ricardo in his work The Principles of
Political Economy and Taxation (1817). His elaboration
introduced the concept of comparative advantage to the
science of economics.2
From 1838 through to the mid-1840s, the Manchester
School, a group of businessmen led by Richard Cobden and
John Bright, put together a coalition which forced Great
Britain to repeal its corn laws and thereby commit itself nally
to free trade (Grampp, 1960). It was the use of the
HumeSmithRicardo arguments that convinced Parliament
to essentially adopt, unilaterally, a free trade policy.
In combination with the free trade policy, Great Britain
adopted a gold standard. This two-pronged policy led
to a worldwide gold standard, and the free movement of
goods, resources and people. The notable exceptions to the
free movement of people were the Ottoman Empire and
Tsarist Russia. Any country that wanted to integrate itself
into the international division of labour and take advantage
of international comparative advantages had to reciprocate
these policies. These liberal policies produced an era of
growth, peace, and economic and cultural integration the
world had never before seen. While there was some movement
away from these liberal policies at the beginning of the
twentieth century, it was the onset of World War I that ended
the era.
Neo-mercantilists
After the USA enacted the SmootHawley Tariff in 1930,
nations also erected barriers and restrictions on trade. The
result was the decimation of international trade. In the
aftermath of World War II, recovering countries wanted to
rebuild domestic industry. They attempted to stimulate
domestic production through protectionist measures. Former
colonies wanted not just political independence, but economic
independence as well. The result was not a return to the
late-nineteenth-century policy of free trade and the gold
standard. Each nation sought protectionist policies as the
solution to the domestic problems of unemployment and
poverty. It was a return to mercantilism.

2011 The Author. Economic Affairs 2011 Institute of Economic Affairs. Published by Blackwell Publishing, Oxford

iea e c o n o m i c
Nevertheless, the power of the arguments of comparative
advantage still held sway in the economics profession. Most
economists still argued in favour of (mostly) free trade and the
benets of comparative advantage. International organisations
(such as the General Agreement on Tariffs and Trade GATT)
were set up to negotiate the reduction of tariffs and quotas.
However, businesses preferred to be protected from
competition. As countries such as Japan, South Korea, Hong
Kong etc. recovered and grew in the 1950s and 1960s, they
posed a threat to established rms. The mercantilist argument
shifted from rebuilding domestic industry to that of protecting
jobs at home.
By the 1980s, free trade arguments made sufcient
headway that only a few politicians could openly advocate
protectionist tariffs. In the 1990s, the North American Free
Trade Agreement (NAFTA) and the EU emerged as regional
trade pacts to liberate trade in specied zones. The ground
shifted from blatant protectionist tariffs and quotas to more
subtle forms of protectionism. These forms of protectionism
manifested themselves in areas such as health, safety and
environmental protection, but more importantly in the form
of protectionism through currency manipulation.
The new neo-mercantilism
Protectionism through currency manipulation
Protectionism through currency manipulation is a modern
creation and is something that no mercantilist nation-states
could have ever dreamt of achieving. The modern world no
longer tethers its various monies to any commodity. Instead,
the modern world uses competing at currencies. Specically,
modern monies are not limited in the amount that can be
created. The result is that each currency oats relative to one
another and can be manipulated by co-ordinating the policies
of various central banks.
Since the end of World War II, the US dollar has been the
worlds reserve currency. The closing of the gold window by
President Nixon in August 1971 decoupled the dollar and gold.
Since that time, the US Federal Reserve has had the ability to
literally create dollars out of nothing. Unlike past currencies,
physically printing the notes is no longer needed; dollars are
created with just a few keystrokes. The result is that, at
virtually no production cost, any amount of currency can be
created or destroyed. Every country that has the ability to do
so has adopted this monetary system. It is within this
international system that countries are able to manipulate
their currencies to achieve their mercantilist policy goals.
The benchmark against which we should compare this
worldwide at system is a homogeneous international
currency. The USA does not track the balance of trade between
its various states because it is recognised that a single currency
will ebb and ow through the nation as the market responds
to changes in supply and demand. Similarly, if international
political boundaries were erased and the world used a single
uniform money, then the focus on trade imbalances and
monetary ows would evaporate. Such ows cannot be
stopped. Interfering with the market mechanism creates
inefciencies, disrupts the economy and generates imbalances
that need correcting. Every time anyone makes a purchase,

a f f a i r s o c t o b e r 2 0 11

money changes hands it ows. To completely stop this

would be to eliminate money and markets.
Currency flows and its problems for central banks
Hayek (1937, pp. 5760) identies three sources for currency
ows across international boundaries. The rst is that trade,
i.e. the forces of supply and demand, signals the comparative
advantages in production and the relative scarcity of goods
and services. Production of particular goods is shifted to areas
that exhibit the largest degree of comparative advantage. The
second source arises as a result of interest rate differentials
between international capital markets. If country As interest
rates are higher than those of country B (ceteris paribus), then
capital will ow to the nation with the higher rate until a new
equilibrium is reached. The third source is not [due] to
changes in the demand for capital as investment, but to
changes in the demand for cash as liquidity reserves (Hayek
[1937] 1989, p. 62). Within this third source are investors
expectations and their assessment of the central banks
reputation and credibility.
With international currency ows, the central bank faces a
myriad of policy goals with which it must contend. First, there
is popular concern with sustaining a trade decit and with
those jobs directly tied to the export industries. Secondly, if
there is signicant capital outow, then present and future
economic growth is hampered. Since the central banks ability
to inuence the market is through the expansion and
contraction of the money supply, three additional factors must
also be considered: changes in domestic interest rates, changes
in the domestic price level and changes in the exchange rate.
To make the already difcult job harder, these policy goals
tend to conict with one another. For example, if the central
bank would like to promote economic growth by keeping
interest rates low, such a policy leads to capital outows,
increases in the domestic price level and depreciates the
currency on the international market. If, instead, the central
bank allows the currency to appreciate relative to other
currencies, then export markets suffer and domestic interest
rates rise relative to those of foreign trading partners.
Chinas trade surpluses3
For over a decade, China has had a trade surplus with both the
USA and the UK. During the same period, the UK has had a
relatively small trade surplus with the USA (peaking in 2005),
but recently had a trade decit for Q1 2011.4
The US government has insisted that the trade decit with
China is a continuing problem and is exacerbated by a
deliberate Chinese government policy to keep the yuan
undervalued. This perspective stems from a neo-mercantilist
view that trade decits are harmful. This view is
neo-mercantilist because the mindset places primacy upon
exports over imports. If we import more than we export then
they are taking our jobs and our prots. Trade is reduced to
a zero-sum game in which winning comes at the expense of the
losers.
The sad fact is that it is not only the US government that
has succumbed to this fallacy; the Chinese are victims of
it as well. The US government argues that the Chinese are

2011 The Author. Economic Affairs 2011 Institute of Economic Affairs. Published by Blackwell Publishing, Oxford

10

the new neo-mercantilism: currency manipulation as a form of protectionism

purposefully keeping the yuan pegged to the dollar below the

market rate. Some have argued that the yuan is undervalued
by as much as 40% (Crutsinger, 2011). The simple logic of
keeping your currency undervalued is that it makes your
countrys exports cheaper on the foreign markets. As a result,
your industries have a competitive advantage. This advantage
then is translated into domestic jobs. The jobs are then the
basis for domestic consumption and an increasing gross
domestic product (GDP).
How is this imbalance maintained?
The Chinese government has pegged the yuan to the dollar.
When China exports more to the USA than it imports, there is
an imbalance in the balance of payments. The imbalance is
counterbalanced by a ow of dollars into China. The dollars
are then held by the Chinese Central Bank and converted into
yuan. So for every dollar owing into China, approximately 6.5
yuan are created and injected into the Chinese economy. The
effect of such money creation is the rise in prices in China. As
Hume recognised in 1752, this imbalance would only be
temporary under a commodity standard because there is a
natural rebalancing that takes place. However, by decoupling
the currency from any tether, it oats against all other goods,
services and currencies. This oating exchange rate between
two at currencies allows both central banks to manipulate the
currencies, but there are limitations to the ability of each.
While the central banks may be the biggest players in a
particular currency market, they cannot hold back the entire
market if it moves as a whole.
Without further intervention, the Chinese currency would
depreciate on the open market as the amount of yuan
circulating in the world economy increases. To avoid massive
domestic ination, the Chinese government uses the dollars
gained from its trade surplus to make purchases of US
Treasuries. This conversion of US dollars into US debt
dampens the inationary effects of the trade surplus, which
allows the situation to persist without immediately being
subject to Humes rebalancing effect. Humes rebalancing
effect does not entirely disappear; it is merely delayed, as the
accumulation of US debt cannot last forever.
The inefficiencies of the new neo-mercantilist policies
The policy of undervaluing domestic currency is intuitive only
at a supercial level. Economic theory demonstrates that not
only is the policy unworkable in the long run and unable to
maintain its goals, but it also harms the domestic country in
two ways. The rst aspect, echoing Smiths argument, is the
articial stimulation of international demand generates
a general misallocation of domestic production and
malinvestment in capital goods. Capital goods are
heterogeneous and have varying degrees of specicity. When
market signals are disrupted by government intervention, the
market aligns in a manner that can be signicantly different
from the underlying reality. Thus, when market conditions
change back to their true nature, it can be a very painful and
difcult process to realign the capital structure to the
underlying reality. This realignment is more popularly known
as a recession.

The second inefciency is generated when the country

needs to import a resource to make the goods it will later
export. China imports oil not only to make petrol, but also
as a major component in the production of plastics. If the
Chinese yuan is undervalued on the international market,
then China pays a higher price than it otherwise would to
import oil (and other imported resources). The economic
impact is that this skews domestic resources above and
beyond what would normally be used. The cost of production
will be above the free market level, placing an extra burden
upon the consumers (both foreign and domestic) of these
goods. Since domestic consumers do not have the benet of
using (over-valued) dollars to purchase these goods, the
impact will be greater on them than it is on foreign
consumers.
The unworkability of the new neo-mercantilism
Unfortunately, most economic analysis that centres on
international trade and currency ows uses aggregates,
masking the underlying differentials propelling markets. Trade
never occurs between nations or countries. Trade of goods and
services take place between individuals and businesses. Prot
opportunities are based upon particular price differentials. It is
the particulars that drive the transactions and each transaction
results in a trade imbalance. For example, every time I shop at
my local grocery store I increase and extend my personal trade
decit. I have always left cash at the store and imported
goods back to my house. Nevertheless, I am not worse-off
because of this ever growing trade decit. In fact, it would be
considerably less efcient if I had to grow my own vegetables.
All trades occur to exploit mutually benecial gains for both
trading parties. The aggregates are a short-cut to describe this
process, but we should never forget that the aggregate is not
something that can be separated from the underlying
microeconomic forces.
Additionally, the idea of a price level is also an illusion.
Money is constantly owing between exchanges. The use of a
price level assumes that all prices move uniformly (or at least
nearly uniformly) and that money ows in a neutral manner.
However, the manner in which currency enters (or is
withdrawn from) the system changes relative prices and
thereby shifts production and consumption patterns. The
microeconomic distortions that result from monetary
expansions and contractions have been well-known since
Richard Cantillon described them in 1730.5,6
When the central bank engages in currency manipulation,
it presumes that its actions take place at the macroeconomic
level and only affect macroeconomic variables. This
presumption is unfounded because all central bank actions
take place with specic trading partners at specic moments
and in specic amounts. Suppose that the central bank would
like to devalue its currency by expanding the money supply by
2%. Assuming that hitting this target is even possible, the new
money does not magically appear uniformly across the
economic system. Even when the central bank undertakes
sterilised intervention, it must purchase bonds from and
supply currency to specic entities at specic times and in
specic amounts. Each action is unique. No two actions will
have the same effect. Furthermore, if the underlying trade

2011 The Author. Economic Affairs 2011 Institute of Economic Affairs. Published by Blackwell Publishing, Oxford

iea e c o n o m i c
imbalance stems from comparative advantage pressures, then
the situation is only temporary.
Finally, when the central bank causes the exchange rate to
change, the change affects all transactions, not just the
markets that are causing the trade imbalance. The markets
that were not the culprits are now thrown out of balance,
which in turn builds pressures for a future rebalancing.
The thwarting of goals
When a central bank engages in a deliberate policy of currency
devaluation, the consequences on the policy goals outlined
above should be addressed. In other words, what effect does
currency devaluation have on the following: the trade
imbalance, capital ows, domestic interest rates and the
domestic price level? From the analysis above, it is clear that
the devaluation of the currency will move the trade imbalance
towards a trade surplus. However, the depreciating currency
will give investors pause before shifting capital into these
markets. The direction of the ow of capital is caught between
the (temporary) rise in the exporting industries (capital
inow) and the (long run) effects of an increased money
supply, namely the loss of the currencys purchasing power
and higher nominal interest rates (capital outow).
The return to sound money
The market is not something that can be disposed of by
passing legislation. All attempts to circumvent the market are
prone to failure. As long as the articial situation differs from
the underlying reality, market pressures will continue to build
until the market reasserts itself. Trade ourishes under
conditions of stability. Floating exchange rates add a level of
risk and uncertainty to an already precarious market. When
oating exchange rates are coupled with manipulative central
banks that have the power to create and destroy currency at
will, then the risks of international trade skyrocket.
The best solution is to return to a homogeneous standard
in which there is no room for meddling. Some may argue that
this means the classical gold standard. However, as Hayek
(1937, pp. 7475) has pointed out, there are no economic
grounds for gold to be the international standard. The use of
gold has been a political choice. Gold was the choice of the
nineteenth century because it has certain properties that
allowed it to out-compete rival monies. Its main advantage is
that it constrains governments in their ability to manipulate
the currency.
Hayek (1937, p. 77) posits that ultimately the choice that
emerges is between an international central bank and that of a
system of free banking. The drawback of an international
central bank is that it can expand the worlds money supply
unchecked. There will be no refuge to escape the loss of
purchasing power as the money supply is expanded. The world
will be subjected to inationary bubbles followed by
recessionary busts.
Some may argue that a world on a gold standard with
100% reserves might be the best alternative. However, Hayek
(1937, p. 83) has shown that even with 100% reserves, near
monies will emerge. The result is that no matter what is
ofcially dened as money, no sharp line can be drawn

a f f a i r s o c t o b e r 2 0 11

11

between what is and what is not used for money. Even today,
economists cannot agree on a single denition of money. Is it
M1? M2? MZM?
The remaining option is devolving the international
banking system. Paradoxically, the solution is to stop viewing
international trade as a macroeconomic problem. Under a
system of free banking, microeconomic market activities will
direct the ow of currency, credit, goods, services and
resources. Over time, as the various currencies compete, the
world will naturally gravitate back toward specie currencies.
The idea is that the international currency ows that emerge
between nations should trouble us as little as ows between
my home state of North Carolina and neighbouring Virginia.7
1. See Book 4 in The Wealth of Nations.
2. Mises (1949) extends this concept beyond the trading of nation-states and
applies it to all levels of economic activity. He calls it Ricardos law of
association.
3. In 2010, the US trade deficit with China was $273 billion, which was 20.3%
more than 2009 levels (US Census Bureau). The UK trade deficit with China
for 2009 was 17.652 billion (Bundey and Edwards, 2010).
4. See US Census Bureau for US/China: http://www.census.gov/foreign-trade/
balance/c5700.html; for US/UK: http://www.census.gov/foreign-trade/
balance/c4120.html and for UK/US and UK/China see Office for National
Statistics (Bundey and Edwards, 2010), www.ons.gov.uk.
5. These relative price distortions are known as Cantillon Effects because he
was the first to describe them in his book Essai sur la Nature du Commerce en
Gnral. The book passed around Paris as a manuscript for decades before it
was ultimately published in 1755. The generally agreed upon date of it
being written is about 1730 (Brewer, 2001).
6. These Cantillon Effects also form the foundation of modern Austrian Business
Cycle Theory.
7. An excellent elaboration of this idea is found in Hayek (1978).

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Cantillon, R. (1755) [2001] Essai sur la nature du commerce en gnral,
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Paul F. Cwik, PhD, is an Assistant Professor of Economics at Mount
Olive College, North Carolina, USA (PCwik@moc.edu).

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