Protectionism, Recession, Recovery: Looking Back and Looking Forward

In thinking of protectionism, the Great Depression, the Great Recession, and what might come next, here are two interesting angles.

Governments with their backs against the wall

Ideally, stabilisation using monetary and fiscal policy, alongside actions by the private sector, should restrain the decline in consumption, and yield conditions which are not too harsh for households. At the time of the Great Depression, much less was known of economics. Pegging the currency to gold meant giving up monetary policy autonomy; the US Fed succumbed to contractionary monetary policy once you take into account the closure of banks; the fiscal policy response at the time was miniscule.

It has been argued that the the Smoot-Hawley Tariff Act came about in the US in June 1930, at a point in time where the politicians were coming under enormous pressure to do something. After seven months of inaction by macro policy, with mounting difficulties in the economy, the politicians succumbed to protectionism. This appears to have been of decisive importance in sending the world down the destructive path of competitive trade barriers and cometitive devaluation. In the graph made famous by Barry Eichengreen and Kevin H. O’Rourke, at month 7 there was almost no decline in world trade. Douglas A. Irwin is worth reading on this.

Protectionism adversely impacts the recovery

Greg Mankiw and Scott Sumner point out one more channel through which Smoot-Hawley damaged prospects for the recovery was through the impact of protectionism on confidence.

The private sector saw protectionism as symbolising government backing away from responsible thinking in economics, and responded with a weakening of investment demand. This served to exacerbate the downturn.

Will this time be different?

The bulk of world GDP is now endowed with inflation targeting central banks. This ensures that monetary policy will be counter-cyclical: under bad business cycle conditions, inflation forecasts will drop below targets, and central banks will use every trick in their book to push inflation back up to target.

Fiscal policy has responded well this time around, thanks to better understanding of business cycles when compared with 1929. But there is little headroom to go further.

The world has as little ability to rein in some players engaging in competitive devaluation (e.g. China) today, as was the case in 1930. But with the bulk of world GDP being placed with inflation targeting central banks, the extent to which such tactics will be used will be relatively limited.

So far, we have had an upsurge of protectionism, but nothing on the scale of that seen from 1930 onwards. This could partly reflect the dramatic actions which governments have undertaken through monetary and fiscal policy, through which politicians have been able to reduce the domestic political difficulties that go along with business cycle downturns. But if, in coming months, the world economy remains mired in recession, then we could get fresh pressure to do something. In a recent voxEU post, Jeffrey Frieden points out that the path of adjustment of macroeconomic imbalances and currency distortions will involve political pain along the way, which could spillover into protectionism.

Some protectionist decisions could reflect bargaining tactics aimed at getting China to reduce or end their market manipulation of the currency market. But if there is an upsurge of protectionism beyond this, it will further damage the recovery by hurting investment, giving a spiral of bad economy -> protectionism -> reduced investment demand -> worse economy.

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1 comment to Protectionism, Recession, Recovery: Looking Back and Looking Forward

  • James H. Murphy

    I am an engineer and can not help myself. I am sorry but I can not bring myself to let other people interpret data for me. I have always been suspicious of liberal arts majors and numbers but lately I am growing more and more suspicious of economist and numbers. Here is why. Look at figure 1 of the Eichengreen and O’Rourke article referenced. Note the 12 month and 24 month values for Great Depression values labeled June 1929 = 100. By the 24 month value most of the total decline in world industrial production had taken place. June 1929 was a high point.

    These data points are inconsistent with blaming the Smoot-Hawley trade protection for making the Great Depression worse. The world industrial production peaked in June 1929. Smoot-Hawley was passed in June 1930, 12 months after peak world trade, but did not go into effect until June 1931, 24 months after the peak. By then most of the decline had already happened. Something other that tariffs caused this.

    But wait, there is more. Advocates of free trade like to say trade declined 66 percent. That is true but it was 66 percent of a small number. Total trade was 6 percent of GDP before the Great Depression and declined to 2 percent. Much too small a decline to justify the boogieman status Smoot-Hawley has been given.

    But then there is even more. The Smoot-Hawley trade protection was not a radical departure. At the time it was introduced the US was already the world’s most trade protected nation and had been for more than a hundred years.

    In the world according to free traders the US was a free trading country until Mr. Smoot and Mr. Hawley got together and invented trade protection in 1930. But it is wrong! The real world experience of US trade protection is much more positive that the free traders want to admit. Trade protection began in 1828 when one of the few things Andrew Jackson and Henry Clay agreed on was that America needed protective tariffs. So they passed the “Tariff of Abomination” that was the highest tariffs we have ever had. Higher than the Smoot-Hawley tariffs of a hundred years latter. These high tariffs upset the then Vice-President John C. Calhoun who set off a Constitutional crisis by urging nullification of the tariff within South Carolina. They compromised and cut the tariff from about 62 percent to about 40 percent.

    Tariffs went up and down but generally drifted lower in the following years ending at about 20 percent just before the Civil War. According to free traders a trade protected economy without foreign competition should have high prices, shoddy products, and producers should have no incentive to innovate. Society should slide into mediocrity and poverty. That was never the US experience with trade protection. Contrary to free traders, the economy was growing with higher wages, lower prices, and much innovation.

    After the first few months of the Civil War Congress decided to protect industry from foreign competition in war time and passed the Morrill and War tariffs which jacked tariffs up to just under 50 percent. After the war tariffs oscillated but stayed high until the first decade of the twentieth century. Again, contrary to free traders, the economy was growing with higher wages, lower prices, and much innovation. During this time we overtook free trade Great Britain.

    In the first part of the twentieth century it was thought that the way to respond to industrial monopolies was to expose them to foreign competition. Tariffs were lowered to below 20 percent. That was soon abandoned in favor of anti trust legislation. By the 1920s tariffs were back in the range of 40 percent where they were when Mr. Smoot and Mr. Hawley introduced their new tariffs that raised tariffs to just below 60 percent.

    Smoot-Hawley tariffs went into effect in June 1931 but did not last long. In 1934 Roosevelt started lowering them. When the Great Depression got worse in 1937 tariffs were long back to pre Smoot-Hawley levels. Tariffs continued to decline to current low levels.

    The American experience with trade protection was a positive experience not to be feared.

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