On the (de)stabilization role of protectionism

In this paper, we analyze the impacts of an increase in tariffs by the government of a small open economy with high public debt and facing borrowing constraints on the financial market, a scenario typical of many emerging economies. Our main conclusion is that tariffs have a destabilizing impact. More precisely, under low interest rates and a large enough share of imported goods, increased tariffs may lead to the existence of two equilibria with two Balanced Growth Paths (BGP) – low and high. While the existence of high BGP is still ensured, due to high growth performances sustaining the debt level, higher tariffs also make low BGP feasible due to the government’s ability to obtain more resources from the consumption of imported goods and thus compensate for low growth performances.

We also demonstrate that high BGP is always characterized by sunspot fluctuations, while low BGP is always a saddle point.  Supposing that agents expect an increase in growth: under high BGP, they may borrow, consume, and invest more via international borrowing (preventing a crowdingout effect, as the borrowing constraint is loose) and they will expect higher public spending. For given tariffs, therefore, the government’s revenue can increase significantly, leading to an increase in public spending that generates a higher growth rate. The expectations are thus self-fulfilling. In contrast, low BGP is characterized by low growth performances and thus a lower public debt/ spending to capital ratio. This implies tighter credit constraint, since the collateral needed to support borrowing is relatively low. Inflows of capital thus remain limited. Being more constrained, the agents consume less and decrease their investment in productive capital, even if they are expecting more growth. Unable to rely on tariffs in this case, the government does not invest enough and growth cannot increase, since there is limited income from consumption and tariffs. The expectations cannot be self-fulfilling and the equilibrium remains locally determinate.

Finally, we conduct a comparative statics exercise on the impact of tariffs on stationary equilibria. We find that the high balanced growth rate is negatively affected by tariffs, while the low balanced growth rate is positively impacted. This difference arises from the sources of growth: in the high steady state, growth relies on government spending, whereas in the low steady state, growth is driven by private capital and investment. Increasing tariffs yields two opposing effects. Households invest less due to reduced income, but the government gains additional resources for public spending. In the high growth equilibrium, the negative impact on household income dominates, leading to a decline in growth. In the low growth equilibrium, the increase in government spending compensates for the loss in household income, resulting in higher growth. Overall, our findings therefore suggest a trade-off between growth and stability.