Beggar-thy-neighbour policy rears ugly head
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The world is experiencing a sharp contraction in demand, led by the United States, a country whose soaring household consumption of the past 10 years was matched by a sharp reduction in its household savings rate. As long as Americans could draw down savings to increase consumption, Asian countries, intent on stockpiling foreign currency reserves by increasing domestic production faster than domestic consumption, had a ready market for their growing capacity.
But with the collapse in US real estate and equity markets and the contraction in bank lending, the US is no longer able or willing to absorb the huge expansion in capacity engineered by Asian countries. This means that US imports and Asian exports will probably decline.
The last time the world saw a major globally co-ordinated collapse in financial markets and a contraction in global demand, in the 1930s, the contraction was exacerbated by beggar-thy-neighbour trade policies, in which countries tried to increase exports or reduce imports, always at the expense of their trading partners. There is, not surprisingly, a great deal of concern as to whether we will see a re-enactment of policies that contributed to the 1930s collapse in world trade, which exacerbated the global crisis and contributed heavily to the collapse in global demand.
The villain of that story has always been the notorious Smoot-Hawley Tariff Act. Smoot-Hawley, for those who need reminding, was an increased tariff on imports passed by the US legislators in June 17, 1930. The US economy had been plagued in the 1920s with industrial and agricultural overcapacity caused by substantial increases in labour productivity following significant investment in the agricultural and industrial sectors and the mass migration from the countryside to the city. Although capacity surged, domestic demand did not rise nearly as quickly.
For much of the 1920s, the US was able to export the excess production to a war-ravaged Europe and a booming Latin America, but towards the end of the decade slowing world growth created capacity problems throughout the world economy. In 1927 and 1928 unemployment pressures prompted US senators to respond with tariff rises, which they did in 1930, in order to boost domestic demand for domestic production.
The important thing to remember about Smoot-Hawley is the underlying conditions that led to it. The US was at that time, like China today, running massive current account surpluses. In 1929 it exported 75 per cent more to Europe than it imported. When global demand began shrinking, unemployment rose. Not surprisingly the act sparked retaliatory acts from other countries, and world trade collapsed - US exports to Europe dropped 67 per cent over the next three years.
Today, just as countries in the 1920s with large current account surpluses, absorbed most of the contraction in global demand, much of the global adjustment in the current crisis must be absorbed by current-account-surplus countries, the most important of which is China.
Like in the 1930s, if there is today a drop in global demand, it is countries with too little demand, the surplus countries, who will need to adjust more than countries with too much demand. Because of the importance of the export sector to domestic growth and employment, if their exports drop quickly there may be significant political pressure for these countries to engineer moves to support their export industries. Since most of them lack large domestic markets, the result is not likely to be direct import tariffs.
What we are more likely to see is export subsidies and competitive devaluations, which have the same impact on international trade as import tariffs. Already in China policymakers are raising export rebates, and there is increasing talk of allowing the currency to depreciate. Other Asian countries are also considering ways to strengthen their share of the declining export market, and all this is happening even before the real impact of the global slowdown begins to appear. The risk is that countries that rely on current account surpluses, like the US in the 1930s, respond to the global contraction in demand by intervening in their trade relationships. If the pie is shrinking, attempts to grab greater shares of the pie can only come at the expense of other countries, and their inevitable retaliation will eventually result in slower overall demand growth.
Nearly 70 years after the Depression we may yet see another round of Smoot-Hawley legislation, but there is no reason to assume it can only take the form it did 70 years ago.
Michael Pettis is professor of finance at Peking University
