Barry Eichengreen is Professor of Economics at the University of California, Berkeley; Pitt Professor of American History and Institutions at the University of Cambridge; and a former senior policy adviser at the International Monetary Fund.
PORTO – One thing is now certain about the upcoming presidential election in the United States: the next president will not be a committed free trader. The presumptive Democratic nominee, Hillary Clinton, is at best a lukewarm supporter of freer trade, and of the Trans-Pacific Partnership in particular. Her Republican counterpart, Donald Trump, is downright hostile to trade deals that would throw open US markets. Breaking with modern Republican tradition, Trump envisages a 35% tariff on imported cars and parts produced by Ford plants in Mexico and a 45% tariff on imports from China.
Economists are all but unanimous in arguing that the macroeconomic effects of Trump's plan would be disastrous. Repudiation of free and open trade would devastate confidence and depress investment. Other countries would retaliate by imposing tariffs of their own, flattening US exports. The consequences would resemble those of the Smoot-Hawley Tariff, enacted by the US Congress in 1930 and signed by an earlier, disgraced Republican president, Herbert Hoover – a measure that exacerbated the Great Depression.
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But just because economists agree doesn't mean they're right. When the economy is in a liquidity trap – when demand is deficient, prices are stagnant or falling, and interest rates approach zero – normal macroeconomic logic goes out the window. That conclusion applies to the macroeconomic effects of tariff protection in general, and to the Smoot-Hawley Tariff in particular. This is a point I demonstrated in an academic paper written – I hesitate to admit – fully 30 years ago.
Consider the following thought experiment. President Trump signs a bill slapping a tariff on imports from China. This shifts US spending toward goods produced by domestic firms. It puts upward pressure on US prices, which is helpful when there is a risk of deflation.
But then President Xi Jinping retaliates with a Chinese tariff, which shifts demand away from US goods. From the standpoint of American consumers, the only effect is that imports from China (now subject to tax) and their US-produced substitutes are both more costly than before.
Under normal circumstances, this would be an undesirable outcome. But when deflation looms, upward pressure on prices is just what the doctor ordered. Higher prices encourage firms to raise production and households to increase their spending. They also reduce the burden of debts. And because inflation is still too low, owing to depressed macroeconomic conditions, there is no need for the Fed to raise interest rates and offset any inflationary effects of the increase in spending.
To prevent this thought experiment from being misconstrued, I want to be clear: there are other, better ways of raising prices and stimulating economic activity in liquidity-trap conditions. The obvious alternative to import tariffs is plain-vanilla fiscal policy – tax cuts and increases in public spending.
Still, the point about tariffs is important. Just as tariff protection is not a macroeconomic problem in deflationary, liquidity-trap-like conditions, freer trade, the economist's familiar nostrum, is not a solution. Those seeking a cure for the current malaise of "secular stagnation" – slow growth and sub-2% inflation – shouldn't claim too much for the beneficial macroeconomic effects of trade agreements. And they shouldn't invoke the old saw that Smoot-Hawley caused the Great Depression, because it didn't. False claims, even when made in pursuit of good causes, do no one any good.
But Smoot-Hawley did have a variety of other damaging consequences. First, it disrupted the operation of the international financial system. Free trade and free international capital flows go together. Countries that borrow abroad must export in order to service their debts. Smoot-Hawley and foreign retaliation made exporting more difficult. The result was widespread defaults on foreign debts, financial distress, and the collapse of international capital flows.
Second, trade wars fanned geopolitical tensions. The French Chamber of Deputies was outraged by American taxation of French specialty exports and urged an economic war against the US. The UK taxed imports from the US while giving special preferences to its Commonwealth and Empire, angering Hoover and his successor, Franklin Delano Roosevelt. Canadian Prime Minister Mackenzie King warned of an outbreak of "border warfare," diplomacy-speak for deteriorating political relations. Efforts to stabilize the international monetary system and end the global slump were set back by these diplomatic conflicts.
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Worse, US, British, French, and Canadian leaders were at one another's throats at a time when they should have been working together to advance other common goals. After all, economic policy aside, there was an even greater threat in the 1930s, namely the rise of Hitler and German re-militarization. Unilateral resort to trade restrictions, by making diplomatic cooperation more difficult, complicated efforts to mobilize a coalition of the willing to contain the Nazi threat.
Tariff protection may not be bad macroeconomic policy in a liquidity trap. But this doesn't make it good foreign policy – for Trump or anyone else.