It’s starting to feel a little bit like June 1930. And that’s worrying.
In that month President Herbert Hoover, despite deep misgivings, signed the Tariff Act of 1930, known as the Smoot-Hawley Tariff after its two authors, into law. By raising U.S. tariffs, the act set in motion a competitive trade war that devastated the global economy and helped create the Great Depression.
Watching the unilateral decision by the Japanese to intervene in the currency markets to force down the price of the yen in order to protect Japanese exports, I’ve started to worry about a replay of that history. This time the starring role would go to competitive, beggar-your-neighbor currency interventions and not to any tariff.
But the effect could be the same: Each of the world’s governments acting to protect the interests of its own economy would kill off growth in the global economy.
It’s still just a worry mind you. And we won’t head down this path to lower economic growth unless Japan gives signs that it’s not content with a relatively small drop in the yen and Europe and China star to retaliate to protect their own exports. But the consequences would be so disastrous that I think it’s worth understanding how this yen intervention could trigger Smoot-Hawley II.
Let’s start with a little history. The main goal of the tariff was to protect U.S. jobs and farmers after the U.S. economy entered what would become the Great Depression after the 1929 stock market crash. The tariff, championed by Senator Reed Smoot (Rep. Utah) and Congressman Willis Hawley (Rep. Oregon), raised U.S. tariffs on over 20,000 imported goods. On some goods the increase took tariffs up to 60%. The overall effective tariff rate climbed to 19.8% in 1933 from 13.5% in 1929.
Economists debate exactly how important the tariff was in creating the Great Depression. Although the overall tariff levels were the second highest in U.S. history, the United States then, as now, wasn’t an export driven economy. In 1929 imports accounted for just 4.2% of U.S. GDP and exports only 5%. Economists such as Milton Friedman and Anna Schwartz have argued (see their 1963 book A Monetary History of the United States 1867-1960) that monetary policy was a far more important cause of the Great Depression than tariffs or other demand-side policies.
But Smoot-Hawley definitely set off a competitive global trade war that began even before the bill was actually law. By September 1929 the Hoover administration had received protests and threats of retaliation from 23 trading partners. Canada was the first to retaliate: in May 1930 the country raised tariffs on 30% of U.S. exports to Canada.
In the next few years from 1929-1933, as the Great Depression bit and as other countries raised tariffs to protect their own industries—or found alternatives to trading with the United States—U.S. exports would fall by 61%. U.S. imports fell even faster—by 66%. And total world trade collapsed, sinking by 66% from 1929 to 1934.
It’s the last part of this history that makes me worried about the global economy right now. Japan has moved to sell trillions of yen in an effort to drive down the price of its own currency against those of its major trading partners. The intervention is designed to aid Japan’s exporters who have been killed as the yen has climbed to 83 to the dollar before the intervention. The Japanese government has argued that it needed to intervene because other countries (China is the name that can’t be spoken) are manipulating their exchange rates to subsidize their own exporters.
I can certainly understand the temptation to intervene and protect Japanese exporters, and there is no doubt in my mind that China (and other countries) are keeping their currencies artificially cheap, but the argument that Japan needs to intervene in the currency markets because the yen is too strong simply doesn’t hold water. Once you correct for years and years of Japanese deflation, the real yen dollar exchange rate is pretty much where it has been for the last 25 years. Before the intervention the real yen dollar exchange rate index was 100.2. The average for 1986 through 2010 was 100 on that index.
What Japanese exporters are really protesting is the end of the super cheap yen of 2002-2007 that fueled the Japanese export-led recovery of those years. And what they’re looking for is a return to the good old days when (in 1995) Japanese exporters had 95% of the global DVD market, and 40% of the global market for memory chips. By 2006 the market share in those two categories had tumbled to 20% and 10%, respectively.
The real problem for the Japanese economy and Japanese exporters have steadily lost their competitive edge in the global economy.
And the real problem for the global economy is that the world’s great exporting economies—China, Germany, and Japan—as well as smaller exporting economies—remain dependent on exports to the world’s great importing economies (such as the United States.) For example, Japan has done relatively little (and I think I’m being kind here) to increase domestic consumer demand and has very successfully used tariff and non-tariff barriers to protect inefficient domestic sectors. And so has China, of course. The current dispute, now heading to the World Trade Organization, over a domestic Chinese credit card processor blocking its partner Visa (V) from processing credit card transactions in China is just the most recent high-profile example.
The danger in all this is that this model of 21st century mercantilism leads governments to the dangerous conclusion that the best way to grow is to protect your domestic market (read Spain and wool in the seventeenth century) and to export as much as you can to overseas customers. Just about anything that increases exports in that policy scenario is justified.
So faced with a cheap yuan, Japan intervenes to drive down the yen. The European Union protests mightily—even though it’s exports have had the advantage of a cheaper euro for the last six months or more. (And who says the Greek credit crisis doesn’t have an upside?) China, which has been under pressure to let the yuan rise against the U.S. dollar and other currencies, is at this moment, I’m sure, thinking about whether it can afford not to cheapen the yuan given the Japanese intervention.
So far, thanks mostly to the United States, the world hasn’t jumped whole hog into competitive currency interventions (or currency manipulations, if you’d prefer). The U.S. continues to push ahead with the idea of international coordination as the best way to guide a global economic recovery and to continue to press China to let the yuan appreciate more rapidly.
I think we’re balanced right now at a point where the situation could go either way. The U.S could manage to successfully hold the fort for international cooperation and coordination and pull the world back from the brink of Smoot-Hawley II. Or a policy of global coordination could get overwhelmed by a rush of individual nations to be the cheapest exporter in the world.
The path of Smoot-Hawley II has two really, really negative effects on the global economy.
First, it damps global growth. Remember that a cheaper yen or yuan or euro cuts the spending power of domestic consumers in Japan, China and the European Union. Since their currency is worth less, they can buy less—especially of imports. Corporate exporters may prosper but domestic consumers pay the bill—and so does the global economy.
Second, Smoot-Hawley II would put extreme pressure on current importing economies to grow exports and cut imports. It’s extremely difficult to turn a country without a strong export tradition into an exporting powerhouse but the easiest way to do it is to jump on the currency intervention band wagon and let your currency head for the basement.
That is, by the way, the easiest way to cut imports too. If your currency is worth less, domestic consumers can afford fewer imports. (Which of course just contributes to a Smoot-Hawley-like collapse in global trade.)
And what’s the easiest way for an importing country like the United States to send the dollar exchange rate down? Give up on any efforts at fiscal restraint, of course. No way easier to tank the dollar than to let inflation rise at the same time as the government ignores the budget deficit.
Once you head down the path, unfortunately, it’s very hard to control the fall in your currency or to get political leaders who have a bias toward deficit spending built into their DNA to reverse direction.
See why Smoot-Hawley II could get really nasty, really fast, and for a really long period?
Let’s just hope that it remains something that troubles my sleep at 2 a.m. and not something we have to live through.
Aw shucks Sig, (blush). I think you’re cute too.
Thanks for the tip on Carpe Diem.
Rheldmann, before questioning our collective intelligence, would you rather Americans invent, design and create things like personal computers, IPods, the internet, Neato Terminator movies, rock and roll, search engines, a double-double from In and Out, etc. ad nauseum and let other nations have the low margin business of manufacturing the above? I would.
And not all Americans did the inventing or creating or otherwise are at the controls of Google, Apple, etc. but those companies are decidedly American, and it was an inventive and entrepreneurial culture that invited and allowed foreign borns to flourish. God help us if we close our borders to the world’s explorers.
I’ve worked in a factory- on the line. You can have it. Romanticizing manufacturing line work is curious- my experience is it was about as unfulfilling as it gets. Hardly something to aspire to for my fellow citizens. Let the chinese do it. They need the work. WE can do better.
South, we often disagree, but I always appreciate your input.
Vespertine–The crowd here generally hates serious discussion so I’m not going to get into much of this. I recommend visiting the Carpe Diem blog and picking a fight (especially with Morganovich) if it is answers you are truly searching for.
Three basic arguments against your reasoning that you’ll come across are 1) American standard of living has dramatically improved, especially when considering total compensation (ex:looking at apples to apples healthcare comps) 2) manufacturing in the US has expanded over the last 40-50 years (we’re still the most productive) 3) A country doesn’t become wealthy by making things–that’s how to get out of poverty. A country is made wealthy by advanced services. Basically, revelling the good ol’ days when the majority were in manufacturing is being stone aged. Hoping to go back to 1950 is akin to asking for the return to an agrarian society. Also, look up the Nobel Prize winning work on Lewis Turning Point (maybe we need another since we have so many low skilled workers being labeled “chronically unemployed” at this point).
Good luck.
Touché Vespertine!
The global economy has come at a great cost to the american worker and threatens not only our cost of living, but our very freedom. Will the World Bank come knocking on our door one day demanding austerity measures?
If you don’t have a job because it has been exported overseas, it does not matter how cheap an item sells at Walmart, you cannot afford to buy it.
Germany, Japan and China are not stupid, but I question if the same can be said about us.
Vespertine, nice take.
I think your question how has a globalized economy “materially benefited the average working American” is somewhat loaded.
The average american’s standard of living has increased dramatically over the last approximately 40 years. We have more knickknacks and other material garbage then ever before. Virtually every material item that can be purchased at Walmart is vastly cheaper and more obtainable to the average american than was the case forty years ago. We’re fatter, we live longer, we suffer fewer pediatric diseases. Not just the upper or the upper middle or even the middle classes among us, but virtually all of us.
Has the system benefited bankers and paper pushers more than blue collar workers? Of course it has. But the “average american worker” has changed as well. No longer is it a guy out of Studs Terkel’s “Working”- a pipefitter, a UAW line worker, a miner or any number of low skilled worker. Now the “average american worker” is a different species of low skilled worker. Are they worse off than 40 years ago? Who knows. But there is no going back now. The country doesn’t have the natural resources needed to operate with imports at 4 or 5% of GDP. Where are we going to get the oil from, just for starters?
Erecting a fence around our economy will be as effective as erecting a fence between the US and Mexico. Neither would achieve the desired outcome but all manner of unintended consequences would make (and have made) the existence of the fence far worse than the alternative.
vespertine,
I can’t argue with much of anything you said (I wish I could). And I’m guessing that the people following Jim are hoping that they will benefit in a way so that they aren’t treated like that masses, as in have it better because they are seeking places to advance their rewards instead of just moving with the masses.
I’d like to preface this commentary with a note of deep appreciation for the contribution Jim has made to advancing the understanding of complex economic phenomena to a lay readership. His incisive analysis and approachable collation of what makes market economies tick has been a great service to all who read him.
That said, I’d like to challenge him and any of his regular readers to explain to me, in clear terms supported by hard numbers, how the global economy that’s been moving briskly ahead for roughly the last forty years, has materially benefited the average working American.
In the United States, the salient feature of globalization during that period has been the gradual erosion of domestic manufacturing industry. More precisely, it has resulted in a bifurcation of manufacturing activity wherein the business-to-business sector of manufacturing continues to thrive, while the business-to-consumer dimension has been largely ceded to China and other low-wage economies.
Some have argued that, contrary to wage pressures, domestic manufacturing contraction is a consequence of increasing production automation and the corresponding need for fewer workers. If so, why, in 2010, do the overwhelming majority of household durables sold in the United States bear labels that read “made in China?” Presumably, highly efficient manufacturing would push the cost of production in the U.S. so low as to negate the benefit of cheap labor abroad.
I’ve also heard it argued that the outsourcing of consumer end-user manufacturing brings to the consumer the benefit of lower prices, which, multiplied across the economy, exerts a quieting effect on inflation.
However, inflation during the golden age of American industry, from roughly about 1900 to 1965, was not a pressing national concern, as it was kept largely in check by robust domestic competition between American producers. Perhaps not coincidentally, the latter years of this period also saw a peak in real wages and corresponding purchasing power by the average working class American. Citing Jubak’s article on a related note, “in 1929, imports accounted for just 4.2% of U.S. gross domestic product and exports only 5%.” This pre-Depression era statistic suggests a mostly autonomous, self-reliant American economy in which trade in general was negligible and in which all trade was near a state of equilibrium. From the standpoint of fiscal, and especially monetary stability, that’s hardly a bad place to be.
A traditional matrix that is often repeated states that about 2/3 of American GDP relies on consumer spending. I believe this is supportable in the long run only if the economy gives consumers money to spend. Historically, broad-based earning opportunity in the United States has been a function of a broadly diversified economy. Anecdotal observation leads me to believe that over the last forty years, with the almost complete evisceration of the business-to-consumer manufacturing sector, the U.S. economy has become less diverse.
It seems to me that corporate leadership in the United States has gradually lost its sense of what serves its own economic interests. Sustainable profitability turns upon sales, and sales upon the means to pay. Henry Ford introduced the five dollar day to assembly line workers a hundred years ago because he understood the necessity of empowering workers to be consumers who could afford the very products they were producing. If 2/3 of the American economy relies on the consumer, then it stands to reason that the 2/3 of the manufacturing sector that has been shipped to China should be repatriated to the U.S. with the object of reviving the historical bedrock of broad-based American prosperity. This could be achieved through renegotiated trade deals, through targeted tax incentives, through tariffs, and, if need be, through the unilateral withdrawal of the United States from the World Trade Organization.
Fears of creditor nations such as China retaliating by cashing out their U.S. Treasury investments could be put to rest with massive currency revaluations, first going up to meet the face value payout of those investments, then down to a level that restores confidence in the purchasing power of our fiat currency. The Fed has surely contemplated this scenario.
I would welcome input on this topic from anyone who can cogently reveal the error of this prescription for remedying the socioeconomic malaise that has been gathering now in the United States for two generations.
Sounds like a case of the Prisoner’s Dilemma in Game Theory.
Bravo on another well rounded article. My questions and comments are:
1. How does this jive with your earlier remarks on not being fiscally constrained at this time? It seems everyone who wants spending is asking for more but not too much, but not telling what too much is.
2. At a G20 Summit, in 2008 I believe, it was agreed upon to not enter competitive devaluation. It seemed to me like a back room deal was made that gave the US an exception. Or maybe they knew there’d be a flight to the USD that would offset spending devaluation.
3. There’s an argument that beggar-thy-neighbor hurts the creditor nations the least, so maybe the US would be hit the mildest (since jobs coming back home might offset losses from global trade collapse). Maybe Eichengreen would disagree.
4. It sucks to need to spend but cannot.