Tariffs, Deflation and the Depression of 1930
Keith Rankin, 7 August 1998
The discussion in the Herald's correspondence section about the importance of the Smoot-Hawley tariff as a contributing cause of the Great Depression is very pertinent to today's global economy. Indeed, the lessons of the breakdown of the international economy in 1929-1932 are a central theme in the writings of Paul Krugman, the world renown MIT economist who is presenting the 1988 Robb Lectures in Auckland this week (August 10-13).
A. Chan (letters, 5 August) sees the American Smoot-Hawley tariff in particular and the growth of tariff protection in general as being a central cause of the Depression. The argument is that the financial crisis in the American economy in late 1929 was in the midst of a natural correction by mid-1930. The 1930 tariff, it is argued, was a means of snatching protectionist defeat from the jaws of free market victory. The 1930 tariff thus is seen by many supporters of free-trade as the reason why the downturn became a depression, and therefore as the single cause of the Great Depression.
In Mr. Chan's version of the story, American exporters rather than American importers were the main victims of the tariff. He claims that the problems faced by American exporters after 1930 were the main cause of the bank failures which in turn were the cause of the nationwide depression. And thanks to retaliatory protection, all other developed countries suffered the same fate, with the failure of exports leading to a more general debacle.
Of course, the true story is unlikely to be that simple. The USA is the country in which the failure of the export sector is least likely to cause a depression, because exports are small relative to the size of the US economy. But exports were important to one region; the grain belt of the mid-west. Failure in the mid-west dates back to 1927, well before the 1930 tariff. It was market forces - falling prices of agricultural products world-wide in the late 1920s - that decimated the mid-west economy and created the dustbowls. Those market forces were the product of international deflation.
The two most prominent arguments in America about the causes of the 1930 world Depression are monetarist and Keynesian. Both arguments almost certainly contain elements of truth.
The monetarist argument is that, in the year after the financial panic of October 1929, the Federal Reserve Bank did too little too late to ease monetary policy. This lesson was learnt, so in the wake of the stockmarket crash of 1987 - in America if not in New Zealand - the Fed acted to ensure that money was easily available at low interest. The policy worked in the USA, where high rates of economic growth were restored by 1988. The policy adopted in New Zealand in 1987 was much like the faulty policy in the USA in 1929. Interestingly, our central bank has learned that lesson, and has shown the same leadership in 1998 that the Fed showed in 1987.
The Keynesian argument is that there was a slow growth in demand for consumer goods in the late 1920s, in part because of rapidly growing inequality. The corporate capitalism of America in particular was predicated on mass production, and dependent on a growing mass market to buy its products. Inadequate wage growth led to a glut of consumer goods that had to be liquidated after the financial crisis. The liquidation process involved rapid price deflation, and many factory closures.
A third argument, a variation of the Keynesian argument, came from liberal economists, such as Paul Krugman, who specialise in international economics. They noted the emergence in the 1920s of a kind of perverse economic nationalism, by which each country took steps to maximise its exports while at the same time minimising its imports.
In the 1920s the preferred method of rationing imports was fiscal deflation, not protection. Throughout the 1920s, tariff protection did exist, but at the same levels as in the pre-World War I economy. Thus, the 1920s were not a decade of protectionism.
Fiscal deflation works by acting to reduce domestic expenditure. The idea is that if a nation cuts its spending by say 10%, then it will cut its import bill by 10%. The understanding was that fiscal deflation would lead to a low-wage low-tax environment which would enhance the competitiveness of a nation's export sector.
The problem is that, when every country was doing the same thing, no country could gain a competitive advantage but all countries would move into a deflationary spiral, because spending was falling everywhere. Exports decreased. Poverty increased, especially amongst primary producers.
There are ways of rationing imports other than through expenditure restraint. Devaluation became more popular than fiscal deflation as the depression progressed. This became possible as countries left the fixed exchange rate system known as the gold standard. Those countries that devalued earlier (eg Britain) recovered from the Depression much more quickly than the late devaluers.
Competitive devaluations have been cited by some writers as a key cause of the Depression. Certainly the devaluation of Britain in 1931 had an adverse impact on the USA in 1932. But the world's nations could not devalue all at once, so devaluations cannot do the kind of damage that fiscal deflation can do.
It was the countries that resisted devaluation that turned first to tariff protection (eg USA, which devalued in 1933) or exchange controls (eg Germany). Protection is the third way to ration imports, and there was a wave of protectionism in the 1930s.
Tariff protection actually paved the way for the recovery of the international economy. Protectionism was a result of the Depression, not a cause. Even J.M. Keynes, the most famous economist of the era (and, like Krugman, very much an internationalist), favoured "national self-sufficiency" in 1933. He saw that each country had to find its own solution, but that no country could risk a reflation unless it could ensure that the extra spending would lead to domestic employment growth.
Keynes understood that the international economy could not recover until each national economy was restored to full health. The immediate problem was to reverse the disastrous effects of the "beggar-thy-neighbour" fiscal deflations that had caused the falls in world commodity prices, the falls in world trade volumes, and the falls in the values of financial assets. His blueprint for the recovery of the international economy was presented to the international conference at Bretton Woods, New Hampshire, in 1944.
There are many lesson for us today. The first lesson is that government expenditure cutbacks are the worst policy for correcting a balance of payments problem. The second lesson is that the devaluation of an overvalued currency does provide a major boost to the devaluing country, while doing neither good nor harm to the international economy.
A third lesson is that, tariff protection can, in circumstances of global unemployment, lead to the growth of the international economy, while in circumstances of global full employment tariffs lead to the sub-optimal outcomes that free-traders warn us of. In the circumstances of the early 1930s, the international economy could only be restored through the separate reflation of each national economy. In this respect, the late 1990s are more like the 1930s than the 1960s.
In 1998, the world economy is poised to go through a rather painful period of deflation. Will we learn the lesson of history: that, while the growth of tariff protection did not cause the Great Depression, it did enable the substantial recovery?
In America's case, the recovery needed much more: the devaluation of 1933 and the expenditure programme of Roosevelt's "New Deal". The Smoot-Hawley tariff acted as a challenge to other countries to look to themselves for a domestic solution, rather than relying on America's consumers to get them out of trouble.
Rankin File | 1998 titles