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U.S. Avoid Trade War? We're Already In One!

Politics / Protectionism Aug 29, 2011 - 06:49 AM GMT

By: Ian_Fletcher

Politics

Best Financial Markets Analysis ArticleWhenever protectionists like myself demand that the U.S. government do something to stand up for America in global trade, we are shouted down with the stern admonition, "You'll start a trade war."


I wish.

The reality is that nobody in America is going to start a trade war, for the simple reason that we are already in one. Foreign governments understand, as ours does not, that international trade is an arena of national rivalry, and they play the game in their own national interests. Our government is hostage to an outdated 19th-century economic theory of global harmony, and on this basis conducts our trade relations with blissful naiveté.

Am I saying that our policy is determined by a theory? No. It's quite obviously determined by the campaign contributions of the multinational (aka "who cares about America?") corporations who profit from it. But it is this theory that makes their demands respectable. All the money in the world couldn't bribe Congress to pass a law requiring everyone to roller-skate to work; policy always requires some non-laughable justification.

Thanks for nothing, David Ricardo. You've made a fine mess.

The curious thing about the concept of trade war is that, unlike actual shooting war, it has no historical precedent. In fact, there has never been a significant trade war, "significant" in the sense of having done serious economic damage. All history records are minor skirmishes at best.

Go ahead. Try and name a trade war. The Great Trade War of 1834? Nope. The Great Trade War of 1921? Nope Again. There isn't one.

The standard example free traders give is that America's Smoot-Hawley tariff of 1930 either caused the Great Depression or made it spread around the world. But this canard does not survive serious examination, and has actually been denied by almost every economist who has actually researched the question in depth -- a group ranging from Paul Krugman on the left to Milton Friedman on the right.

The Depression's cause was monetary. The Fed allowed the money supply to balloon during the late 1920s, piling up in the stock market as a bubble. It then panicked, miscalculated, and let it collapse by a third by 1933, depriving the economy of the liquidity it needed to breathe. Trade had nothing to do with it.

As for the charge that Smoot caused the Depression to spread worldwide: it was too small a change to have plausibly so large an effect. For a start, it only applied to about one-third of America's trade: about 1.3 percent of our GDP. Our average tariff on dutiable goods went from 44.6 to 53.2 percent -- not a terribly big jump. Tariffs were higher in almost every year from 1821 to 1914. Our tariff went up in 1861, 1864, 1890, and 1922 without producing global depressions, and the recessions of 1873 and 1893 managed to spread worldwide without tariff increases.

As the economic historian (and free trader!) William Bernstein puts it in his book A Splendid Exchange: How Trade Shaped the World,

Between 1929 and 1932, real GDP fell 17 percent worldwide, and by 26 percent in the United States, but most economic historians now believe that only a miniscule part of that huge loss of both world GDP and the United States' GDP can be ascribed to the tariff wars. .. At the time of Smoot-Hawley's passage, trade volume accounted for only about 9 percent of world economic output. Had all international trade been eliminated, and had no domestic use for the previously exported goods been found, world GDP would have fallen by the same amount -- 9 percent. Between 1930 and 1933, worldwide trade volume fell off by one-third to one-half. Depending on how the falloff is measured, this computes to 3 to 5 percent of world GDP, and these losses were partially made up by more expensive domestic goods. Thus, the damage done could not possibly have exceeded 1 or 2 percent of world GDP -- nowhere near the 17 percent falloff seen during the Great Depression... The inescapable conclusion: contrary to public perception, Smoot-Hawley did not cause, or even significantly deepen, the Great Depression.

The oft-bandied idea that Smoot-Hawley started a global trade war of endless cycles of tit-for-tat retaliation is also mythical. According to the official State Department report on this very question in 1931:

With the exception of discriminations in France, the extent of discrimination against American commerce is very slight...By far the largest number of countries do not discriminate against the commerce of the United States in any way.

That is to say, foreign nations did indeed raise their tariffs after the passage of Smoot, but this was a broad-brush response to the Depression itself, aimed at all other foreign nations without distinction, not a retaliation against the U.S. for its own tariff. The doom-loop of spiraling tit-for-tat retaliation between trading partners that paralyzes free traders with fear today simply did not happen.

"Notorious" Smoot-Hawley is a deliberately fabricated myth, plain and simple. We should not allow this myth to paralyze our policy-making in the present day.

There is a basic unresolved paradox at the bottom of the very concept of trade war. If, as free traders insist, free trade is beneficial whether or not one's trading partners reciprocate, then why would any rational nation start one, no matter how provoked? The only way to explain this is to assume that major national governments like the Chinese and the U.S. -- governments which, whatever bad things they may have done, have managed to hold nuclear weapons for decades without nuking each other over trivial spats -- are not players of realpolitik, but schoolchildren.

When the moneymen in Beijing, Tokyo, Berlin, and the other nations currently running trade surpluses against the U.S. start to ponder the financial realpolitik of exaggerated retaliation against the U.S. for any measures we may employ to bring our trade back into balance, they will discover the advantage is with us, not them. Because they are the ones with trade surpluses to lose, not us.

So our present position of weakness is, paradoxically, actually a position of strength.

Likewise, China can supposedly suddenly stop buying our Treasury Debt if we rock the boat. But this would immediately reduce the value of the trillion or so they already hold -- not to mention destroying, by making their hostility overt, the fragile (and desperately-tended) delusion in the U.S. that America and China are still benign economic "partners" in a win-win economic relationship.

At the end of the day, China cannot force us to do anything economically that we don't choose to. America is still a nuclear power. We can -- an irresponsible but not impossible scenario--
repudiate our debt to them (or stop paying the interest) as the ultimate counter-move to anything they might contemplate. More plausibly, we might simply restore the tax on the interest on foreign-held bonds that was repealed in 1984 thanks to Treasury Secretary Donald Regan.

Thus a certain amount of back-and-forth token retaliation (and loud squealing) is indeed likely if America starts defending its interests in trade as diligently as our trading partners have been defending theirs, but that's it. The rest of the world engages in these struggles all the time without doing much harm; it will be no different if we join the party.

Until we do, America's trade pacifism will simply continue to invite foreign economic aggression.

Ian Fletcher is the author of the new book Free Trade Doesn’t Work: What Should Replace It and Why (USBIC, $24.95)  He is an Adjunct Fellow at the San Francisco office of the U.S. Business and Industry Council, a Washington think tank founded in 1933.  He was previously an economist in private practice, mostly serving hedge funds and private equity firms. He may be contacted at ian.fletcher@usbic.net.

© 2011 Copyright  Ian Fletcher - All Rights Reserved

Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.


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