Would we again slide to protectionism in the great recession?

I just finished this excellent paper (free version here) by Eichengreen and Irvin. In March the duo had posted about this forthcoming paper  and I have been looking forward to it since then.

The paper has been much talked about in blogs and rightly so. The paper tells you about which countries adopted protectionism measures in Great Depression and the various reasons for the measures. The paper is full of insights and is a must read. As is well known by now, it was gold standard which led the crisis to become a global one. And then whichever country quit gold standard relatively quickly and allowed monetary policy to inflate were the ones to get out quicker than others from the depression. The authors show that countries that could not get out of gold standard were also more likely to imposr trade restrictions than others.

The authors divide the countries into 4 types, with each following its own protectionism policies:

• Sterling bloc countries (UK abandoned the gold standard first and was followed by countries which had close ties with UK like Sweden, Denmark etc)
• Gold Bloc (countries that stayed on gold standard – France Belgium etc and were the worst effected. These restricted trade directly)
• Exchange Controls (countries like Germany which stayed on gold standard but imposed controls to prevent gold outflows)
• Others with depreciated currencies (US etc which also imposed some trade restrictions)

What is surprising is Smoot-Hawley Act was not as much a villain as it is made out to be:

The movement toward more restrictive trade policies became evident almost immediately following the 1929 business cycle peak. The United States enacted the Smoot-Hawley tariff in June 1930, raising the average tariff on dutiable imports from 40 to 47 percent.  Smoot-Hawley provoked retaliatory responses, notably from the country’s largest trading partner, Canada, as well as from a handful of European countries. In comparison to what was to come, however relatively few countries increased their tariffs in late 1930 and early 1931.

 This is not to deny that the increase in American tariffs was deeply resented abroad, in part because the United States was a creditor nation and the move came on top of declining exports to the U.S. market due to the recession. But Smoot-Hawley was not the main trigger for the wave of protectionist measures adopted starting in 1931.

 What was the trigger then?

 The spark that caused the world trading system to collapse was in fact the financial crisis that struck Europe in the summer of 1931.The government of Germany depended on foreign loans to finance its expenditures, and when those loans dried up it triggered a run on the Deutsche mark and a loss of gold. This currency crisis in June forced the government to impose strict controls on foreign exchange transactions.  

In theory Germany could have devalued, but the reparations agreement fixed its obligation in dollars of constant gold content. This meant that devaluing would have had devastating balancesheet effects on the public finances. In any case memories of hyperinflation when the gold standard was in abeyance meant that abandoning the system would have unleashed a collective hysteria.

Hence to limit losses of gold and foreign exchange reserves, Germany imposed controls that affected capital movements as well as trade finance. Hungary implemented capital  controls in July 1931 because its financial system, closely tied to that of Austria, suffered from the fallout from the failure of Austria’s largest bank, the Credit Anstalt. Other countries such as Chile, which was battered by declining copper prices, followed with controls of their own.

Financial pressure then spread to Britain as trade credits extended to Germany by British merchant banks were frozen. A sharp increase in interest rates did little to stem the Bank of England’s gold losses. Against the backdrop of rising unemployment which rendered the Bank reluctant to raise interest rates further, the need for lender-of-last-resort intervention now tipped the balance. On September 19, Britain abandoned the gold standard and allowed sterling to depreciate. Within days, other countries with close trade and financial ties to Britain –Denmark, Finland, Norway, and Sweden among them — allowed their currencies to depreciate relative to gold. Japan, concluding that its recent resumption of gold convertibility had been a mistake, followed in December.

Hmmm. Know the history… Know the history….

It also point Britain did not really need to impose tariffs as was better-off after leaving gold standard. But still went ahead. Why?

Why then did it go ahead with the tariff? The natural answer is politics (Capie 1983,Garside 1998). The Conservative Party had long advocated protectionism and had already moved the country modestly in that direction in the early 1920s; it now gained power in the National Government formed at the height of the crisis.

As I finished the paper and returned to reading blogs this week, I came across this post from Mankiw which says that tariff wars are on in US and China. It was started by Obama by imposing tarriffs on Chinese tyres and China threatens to do the same to US chicken, pork etc. Buiter responds with his usual sharp criticism on Obama move. The saving point in this crisis is that these responses are coming when we are seeing recovery. But still, why ignore the lessons?

Eichengreen and Irvin provide some comaprisons and policy suggestions:

Many observers have noted the parallels between the Great Recession of today and the Great Depression of the 1930s and fear a return of the protectionism seen in the earlier crisis. The message for today would appear to be “to avoid protectionism, stimulate.” But how? In the 1930s stimulus meant monetary stimulus. The case for fiscal stimulus was not understood; indeed it had not been made. Monetary stimulus benefited the initiating country but had a negative impact on its trading partners.

The positive impact on its neighbors of the faster growth induced by the shift to “cheap money” was dominated by the negative impact of the tendency for its currency to depreciate when it cut interest rates. Thus, stimulus in one country increased the pressure for its neighbors to respond in protectionist fashion.

Today the problem is different because policy instruments are different. In addition to monetary stimulus, countries are applying fiscal stimulus to counter the Great Recession. Fiscal stimulus in one country benefits its neighbors as well.  The problem to the contrary is that the country applying the stimulus worries that benefits will spill out to its neighbors, who are free riding. Fiscal stimulus is not costless; it means  incurring public debt that will have to be serviced by the children and grandchildren of the citizens of the country initiating the policy. Insofar as more spending includes more spending on imports, there is the temptation for that country to resort to “Buy America” provisions and their foreign equivalents.

But if the particulars of the problem are different, the solution is the same. Now, as in the 1930s, it is for countries to coordinate their fiscal and monetary measures. If some do and some don’t, the trade policy consequences could again be unfortunate.

I had written a paper explaining these ideas in bit more detail. Hope this new trade war does not spill to others.

Addendum:

Doug Irvin, the coauthor of this paper. views on the Obama move 

 

 

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