Will the US please stop waging trade wars that they keep losing?

The trade war of the 1930s wasn’t the actual cause or main driver of the Great Depression.

But it still had immediate and long-term costs.
And just like today, the US got out-played by the rest of the world.

I recently listened to a lecture by Professor Jeff Borland of the University of Melbourne. The topic was What happened in the global trade war in the Great Depression? An historical perspective on Trump and tariffs. And two main points emerged from the discussion:

1.       The trade war of the 1930s wasn’t the actual cause or main driver of the Great Depression; and

2.       To the extent that you can actually do a trade war ‘right’, the US stuffed up that trade war too.

THE GOLD STANDARD

The Gold Standard – the international monetary system of the day – was the main cause of the Great Depression (as I’ve discussed previously). It was a truly destructive system, not only causing the Depression, but hindering any recovery and encouraging beggar-thy-neighbour trade and financial policies.

When the US started hording gold reserves during the ‘Roaring 20s’ (ironically as a hedge against future crises) rather than printing money to ‘sterilise’ these gold inflows, other countries followed suit (starting with France). Countries maintained high interest rates and refrained from printing money to keep inflation rates down and attract gold, so they didn’t run out of reserves in the face of this global rush for gold. This crippled global consumption and investment and drove global inflation rates into a deflationary spiral – now known as the Great Depression.

And to add insult to injury, the Gold Standard prevented exchange rates from adjusting to support an economic recovery. It also prevented countries from lowering interest rates and flooding their financial markets with liquidity to end the downward spiral because this would risk breaking their ‘pegging’. And internationally coordinated monetary stimulus and/or system-wide wage cuts to restore balance while preserving the Gold Standard proved to be administrative fantasies. So the downward spiral continued.

Countries were very hesitant to abandon the Gold Standard. Germany in particular, was especially paranoid of a repeat of its 1920s hyperinflation[1] and didn’t want to risk a depreciating exchange rate triggering another inflationary episode. So even upon the collapse of a major Austrian bank, and the ensuing financial crisis, Germany imposed tariffs and capital controls, rather than abandoning the Gold Standard. And these capital controls froze the assets of many European countries that had invested in Germany, thereby spreading the crisis to the rest of Europe.

Britain did abandon in September 1931 (countries that abandoned earliest tended to recover fastest and had the smallest falls – even modest increases – in imports from 1929-35). And this triggered other countries to either follow suit (including Australia and other Sterling Bloc countries), impose capital controls (including Uruguay, Greece, Czechoslovakia, Colombia and Iceland), or ratchet up their trade barriers even further (including France, Canada, South Africa, Germany, and the Netherlands) to offset Britain’s new competitive advantage (devaluation) without leaving the Gold Standard.

So this, rather than the trade war, was the main cause and driver of the Great Depression – countries not adhering to the rules of the international monetary system, and then stubbornly remaining within the confines of that system while in the midst of the crisis.

THE TRADE WAR

Paul Krugman wrote that economics’ ‘dirty little secret’ is that, while a trade war is unambiguously bad, we tend to oversell it.

Firstly, the Depression itself can actually be seen to have worsened the trade war, rather than the other way around. This is because tariffs were denominated in dollar terms, rather than percentage terms, and massive price deflation associated with the Depression caused these tariffs to rise in percentage terms, thereby automatically worsening the trade war. World trade did collapse during the Great Depression by 25-30%. But again, the collapse in trade was mostly driven by falling incomes associated with the Depression itself, rather than falling incomes being driven by the collapse in trade. In the US specifically, only about 10% of their reduction in imports was from the Smoot-Hawley Act that triggered the trade war; about 20% from the automatic deflation-induced tariff increases; and the remainder from Depression-driven falls in GDP.

I’ve also written previously about how the Depression was actually a driver of the trade war, rather than the other way around. Because of the above constraints of the Gold Standard, and the administrative obstacles to internationally coordinated monetary policy or system-wide wage cuts, tariffs and capital controls were seen as the only viable option to reflate the economy via price levels and import substitution.

And in terms of declines in actual GDP too, the trade war can’t really be attributed as a major cause. And today, with the advantage of flexible exchange rates and Central Banks and governments that should now know how to handle a downturn properly, a trade war is very unlikely to trigger a major downturn.

But this isn’t to say the trade war didn’t have significant costs in the 1930s, or that it wouldn’t today. The trade war certainly didn’t help, and still had many costs of its own.

Firstly, a major trade war causes countries to start producing what they formerly imported – goods and services in which they do not possess a comparative advantage. This restructuring of global supply chains is a seriously damaging disruption (think all the jobs lost in the transition towards free trade, but with losses in efficiency). And while demand that is choked off by tariffs and barriers can be largely replaced by demand for domestic produce, the distributional and efficiency losses accumulate over time. A trade war is very hard to unwind, free trade very hard to re-establish. And for all the years that trade barriers persist, these losses from having production in less efficient locations accumulate into significant amounts of lost output, productivity and innovation, well beyond when the trade war starts to unwind. Imagine how long it’ll take to unwind a modern trade war, and the subsequent cumulative losses.

And this isn’t even to mention the political ramifications. The Smoot-Hawley Act did have big impacts on some surrounding countries – Cuba lost an estimated 10% of its national income from the associated US sugar tariff! This no doubt contributed to the subsequent revolution and overthrow of Cuba’s pro-American government in 1933. No one can say this didn’t have very long-lasting consequences.

There’s also the potential for trade wars to develop into actual wars. Keynes noted the ability of free trade to create customers out of potential enemies, thereby facilitating world peace. Who would wage war on a trading partner? I mean, apart from Trump. And no doubt the breakdown of international trade in the 1930s made it all the easier for countries to go to war in WWII. Extensive losses of trade had already occurred. What more could be lost from war? I mean, apart from the obvious.

If WWII was good for anything, it reinforced the need for global cooperation to facilitate recoveries and trade. Trade wars undermine this.

THE US'S STUFF-UP

But what was particularly interesting was how inept the US was in the 1930s trade war too – just like today.

The Smoot-Hawley Act wasn’t a reaction to the Great Depression. It was imposed by the Republicans beforehand in 1929 and intended to protect the agricultural sector which had suffered in the 1920s. But the only agricultural products that had import competition were sugar and wool, which had enjoyed significant tariff protection for decades. More effective agricultural protection would have been subsidies, not tariffs. Furthermore, the Act increased manufacturing tariffs more than agricultural tariffs anyway. This included coal and lumber, which were actually agricultural inputs. This means tariffs on these products actually hindered agriculture to such an extent that the ‘effective’ rate of protection on agriculture from Smoot-Hawley was actually negative.

The Act ended up imposing significant tariff increases on hundreds on imported goods. Smoot himself even used the Act as an excuse to limit the import of what he saw as ‘obscene material’. A news article at the time used the heading “Smoot smites smut”. This should serve as a dire (though still amusing) warning of how easily fondness for protectionism can spread beyond initial intentions.

It is also very similar to what is happening today – US tariffs will save around 26,280 steel and aluminium-producing jobs, while costing 432,747 jobs elsewhere, including industries that use these materials as inputs (such as the car industry).

Both times the US started a trade war. And both times, the US shot themselves in the foot with their first attempt.

What is also similar is the reaction of the rest of the world. Today, the EU, Canada and other countries are retaliating with tariffs on, among other things, Kentucky bourbon, Iowa pork, Wisconsin motorcycles, and Ohio washing machines – key exports, from states that voted for Trump in 2016. China too, is going after US industries with powerful lobby groups that are most likely to successfully pressure Trump into backing down. So while the US is shooting itself in the foot, the rest of the world is expertly attacking Trump’s own base, while leaving themselves plenty of alternative suppliers of such goods.

Similarly in the 1930s, retaliation against Smoot-Hawley came from Canada, Britain and Europe, not in the form of general tariff increases, but in US-specific attacks. Britain increased tariffs on US imports, while decreasing tariffs on imports from its colonies (a policy called Imperial Preference). This offset the losses to itself while maximising the impacts on the US. Europe, while not explicitly raising tariffs on the US exclusively (which would have breached ‘most favoured nation’ rules), did raise tariffs on specific goods which mostly came from the US – so the effect was the same.

So, whereas the US actually worsened protection of agriculture and triggered a trade war, the rest of the world was far more direct and effective in its attacks on the US – and the US still gets the blame for starting it all.

DON'T START A TRADE WAR!

I suppose it’s not surprising that the ‘winners’ in a trade war are the second movers. When the rest of the world has a single country to blame for starting it, it’s much easier for them to gang up on the single country than for the single country (even one as big as the US) to beat the rest of the world.

It’s one thing to ignore economists when we warn you against starting a trade war. It’s quite another to ignore us when we’re actually telling you how to fight it better.

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[1] After WWI, the Treaty of Versailles imposed massive war reparations on Germany, which it consequently paid by simply printing massive amounts of its own currency, driving its inflation rate up to 72.6 trillion percent! The US dollar went from buying 0.2-0.25 Mark to 4-5 trillion Mark. There were stories of people in Germany carrying wheelbarrows full of cash to buy a loaf of bread, getting mugged for the wheelbarrow instead of the cash.

Trump is destroying the Western alliances over a problem that doesn't exist.

Trump at the G7 accused his own allies in Europe and Canada of imposing massive trade barriers against the US. These “barriers” are SALES TAXES. They apply to European and Canadian businesses too. So they impose no disadvantage on the US. That’s why the WTO allows them.

Trump is destroying the Western alliances over a problem that DOESN’T EXIST. And Russia and China WILL fill the void.

This is not normal, children!

Trump's trade policy is stuck in the '80s - the 1680s.

Pleasing how similar this article by Catherine Rampell (reproduced below) is to some of my own work (here and here).

“Trump’s trade policy is stuck in the ’80s — the 1680s 

by Catherine Rampell

President Trump often seems as though he’s stuck in the ’80s. But maybe the better comparison is to the 1680s, not the Reagan era. 

Consider his announcement Thursday of new tariffs on steel and aluminium imported from the European Union, Canada and Mexico. These countries not only supply about half of our imports of these metals; they are also among our closest allies.

Astonishingly, the White House claims that alienating these important military allies is necessary “to protect America’s national security.”

These trade policies, and the supposed rationale behind them, bear an uncanny resemblance to classical mercantilism.

What is mercantilism, exactly? As you may remember from some long-ago high school class, it’s an economic philosophy that was prevalent in the 17th and 18th centuries. In a nutshell, mercantilists believed a country should try to maximize exports and minimize imports.

The logic was this: Military power comes from wealth; wealth comes from accumulating gold and silver; and the way you accumulate gold and silver is through trade surpluses. Your merchant ships should go out loaded with attractive goods and came back overflowing with shiny specie.

There basically was no such thing as modern-day trade diplomacy; tariffs were high, and no one would have trusted anyone to stick to trade agreements anyway, since everyone was trying to maintain trade surpluses at once. Which is fundamentally impossible.

It was a zero-sum view of the world. Nothing was win-win, everything was win-lose, and everyone was suspicious of everyone else.

As you also may remember from high school history, then a dude name Adam Smith waltzed onto the scene. 

He (and subsequently other classical economists, such as David Ricardo) turned much of this thinking on its head. Smith showed that real national wealth doesn’t come from amassing piles of gold, which are transitory. Wealth comes from increasing productivity — that is, by figuring out how to make stuff more efficiently, which permanently increases living standards. 

How do you increase productivity? By specializing in what you do well and honing your skills in that area. Then you trade with other people who do other stuff well. Through these transactions, over time, everyone gets richer. 

In other words: Trade is not zero-sum; it’s positive-sum. 

This revelation would eventually revolutionize international relations, trade historian Craig Van Grasstek writes in his upcoming book “Trade and American Leadership: The Paradoxes of Power and Wealth From Alexander Hamilton to Donald Trump.” After all, “It implied that countries could focus more on the cooperative creation of wealth than on appropriating it all to themselves.” 

Trump seems to have missed this lesson, however.

Like an 18th-century mercantilist, Trump perceives no mutual gains from trade. In any transaction, he sees only a winner and a loser. And the winner is determined by who has the trade surplus.

Since there’s no way everyone could come out ahead, there’s no point in trying to create a system of rules oriented toward that outcome. Plus, he seems to believe everyone’s going to cheat anyway — including, and perhaps especially, our supposed friends. 

“Frankly, our friends did more damage to us than our enemies,” Trump said in March. “Because we didn’t deal with our enemies, we dealt with our friends, and we dealt incompetently.”

Also, like those mercantilists of yore, he conflates our balance of trade with national security, though the exact connection between the two remains a bit muddled. 

Unfortunately, Trump has proved a poor trade negotiator, as evidenced by both the public fighting within his own trade team, and the fact that the European Union, Mexico and China are retaliating with tariffs on U.S. products from politically sensitive states (Iowa pork, Kentucky bourbon, Wisconsin-manufactured Harley-Davidsons). 

Perhaps more embarrassing, Trump even turns out to be a pretty lousy mercantilist.

Even 18th-century mercantilists knew that if you were trying to use tariffs to boost your trade surplus, you wanted to tax imports of finished goods, not the inputs that your domestic industry needs to make those high-value, finished-good exports.

Trump still hasn’t figured this out. In protecting U.S. steel and aluminium, he is threatening the much larger manufacturing industries that purchase these materials to make, and then sell, high-value exports such as cars and appliances. 

And steel and aluminium are hardly alone in this respect. In April, after Trump announced a list of 1,333 Chinese products that could be subject to tariffs, Peterson Institute for International Economics senior fellow Chad Bown found that about 85 percent of them were intermediate inputs and capital equipment.

John Maynard Keynes once said that men who fancy themselves independent thinkers are usually just slaves to some defunct economist. But what do you call a man who can’t even manage to get his guiding economic anachronism right?”

Trump can't even do a trade war right.

Trade wars are bad, mkay? But if you happen to find yourself in one (or were stupid enough to start one yourself), you at least need to get a couple of things right.

And Trump has messed up both, as beautifully explored by Catherine Rampell in her recent article (Trump is waging a trade war in the dumbest way possible), reproduced below.

While it is estimated that Trump’s tariffs on steel and aluminium may save 26,280 steel and aluminium-producing jobs in the US, these commodities are also key inputs in other sectors, including the car industry. Consequently, 432,747 jobs are estimated to be lost because of these higher import prices. That’s a job loss-to-gain ratio of worse than 16:1! As Rampell previously noted, “even 19^th century Mercantilists knew to put tariffs on finished goods, not inputs.”

And overlooking the fact (though you absolutely shouldn’t) that Trump isn’t launching a trade war against the US’s adversaries – he’s launching it against the very Western alliances that created the post-WWII world order – the rest of the world (including key strategic allies the EU and Canada) has proven itself far better at this game than Trump.

The key in a trade war is to attack the areas that are especially important to your adversary, but less important to you – an adversary’s key strategic industry that you can easily replace with imports from another country, or your own production.

But Trump’s tariffs are essentially global, and US-made steel and aluminium is not a perfect substitute for that which is imported. This leaves US producers with little alternative but to pay higher prices for steel and aluminium. And because the US imports steel and aluminium from many countries, the cost to those countries is spread relatively thinly.

So Trump neglected this point. But the rest of the world didn’t. They are retaliating with their own tariffs on Kentucky bourbon, Iowa pork, Wisconsin motorcycles, and Ohio washing machines, among others. These are all key exports for these states – all of whom voted for Trump in the 2016 election. The rest of the world is expertly attacking Trump’s own base, while leaving itself plenty of other potential suppliers of these (or similar) products. Trump’s strategy on the other hand, is essentially “give me all your money or I’ll shoot myself in the foot” (Rampell).

I suppose we shouldn’t be surprised that someone who doesn’t even know not to start a trade war, also doesn’t know how to properly fight one.

“Trump is waging a trade war in the dumbest way possible

By Catherine Rampell

President Trump says we need to be “smarter” in how we deal with other countries. And yet his approach to extracting concessions from our trading partners has proved very, very dumb.

Notwithstanding Trump’s Twitter declarations, trade wars are neither good nor easy to win. In a trade war, every side loses, experiencing lost jobs, crippled businesses and higher prices for consumers. We learned that the last time we had a full-blown global trade war — in the 1930s after Congress passed sweeping tariffs that exacerbated the Great Depression.

Even so, it’s possible for some countries in a trade war to lose more than others. And that’s the position Trump is leaving the United States in, by taking perhaps the worst possible approach to economically bullying other countries.

Most of the time when a U.S. president takes an aggressive new trade action, it’s a tariff that targets a specific country or narrow set of countries. There’s good reason for this: Again, most of the time, these actions are in response to an act of alleged foul play.

Yet another reason to slap tariffs only on imports from selected countries is to limit the pain to U.S. businesses and consumers that purchase those products. We want to make sure we have alternative suppliers available when the imports from one misbehaving country suddenly get pricier.

Again, that’s how we usually think about trade measures. It’s not what happened this time around with steel and aluminium tariffs, however.

Using a rarely invoked authority designed to protect “national security,” Trump has imposed a global tariff on steel and aluminium.

Because it’s a global tariff on a commodity supplied by dozens of countries, each of those other countries is taking a hit. But the hit is relatively small compared to the one we’re experiencing — the one we’ve inflicted on ourselves.

After all, we can’t easily shift supply around to limit U.S. business and consumer pain if we’re slapping tariffs on steel and aluminium produced by almost everyone. And while we do produce these metals here, the exact mix of products that, say, U.S. steel mills make is not identical to the mix of steel products we import. Which means factories here can’t easily convert and scale up their production to meet market demand even if they do have idle capacity.

Unsurprisingly, this has major consequences for the many American firms that purchase steel and aluminium, and that are now less competitive because their costs have skyrocketed.

U.S. steel prices have risen nearly 40 percent since the start of the year, and are now more than 50 percent higher than in both Europe and China, according to the S&P Global Platts benchmark price assessment for hot-rolled coil, the bellwether product.

But that’s not the only reason these tariffs are going to hurt us a lot more than they hurt everyone else. The bigger problem is how other countries, including our friends and military allies, are responding to our protectionist measures.

Collectively Canada, the European Union, Mexico, Russia, India, Japan and Turkey have already announced $40 billion worth of retaliatory tariffs on U.S.-made products. The scale of these retaliatory tariffs isn’t what’s most concerning; it’s the composition. These other countries have been far more strategic about which U.S. products they choose to target than we apparently were in launching this trade war.

That is, their counterpunches are likely to draw more blood than our sloppy opening gambit.

Why? First, these other countries have tried to pick and choose products that their businesses and consumers can easily obtain elsewhere. In fact, when the E.U. recently revised its list of U.S. products subject to retaliation, it decided to remove some items for which non-American close substitutes apparently weren’t available, as the Economist’s Soumaya Keynes pointed out. 

Even worse for Trump, these angry countries are choosing products with political sensitivities in mind. Hence the appearance of Kentucky-made bourbon, Iowa-farmed pork, Wisconsin-manufactured motorcycles and Ohio-made washing machines on these lists.

In short: Our trading partners have fine-tuned the art of minimizing their own pain — and maximizing ours.

Trump clearly believes he’s being “tough” with these other countries, and protecting American jobs, with his ineptly-designed tariffs. In fact, he’s putting many more jobs in other industries at risk. A report released this week by the Trade Partnership, a consulting and research firm, estimated that the ratio of jobs lost to jobs gained from Trump’s trade actions will be about 16 to 1: 26,280 steel and aluminium jobs gained, compared with 432,747 jobs eliminated throughout the rest of the economy.

And that’s presumably not even counting any of the hundreds of jobs now held by Trump’s fellow Republicans on Capitol Hill.”