by Alasdair Macleod, GoldMoney:
I am a Tariff Man. When people or countries come in to raid the great wealth of our Nation, I want them to pay for the privilege of doing so. It will always be the best way to max out our economic power. We are right now taking in $billions in tariffs. MAKE AMERICA RICH AGAIN
@realDonaldTrump tweet 10:04EST, 4 December 2018
It is widely understood by economists of most theoretical persuasions that trade tariffs are a bad idea, but President Trump has laid out his stall. The political class, prodded usually by the vested interests of crony capitalists, always fall for trade protectionism. President Trump’s tariff war is just the latest example that coincidently stretches back to the introduction of central banks. I shall address this coincidence later in this article.
It also surprising that the Chinese leadership enters a tariff war when it professes to defend free trade. Perhaps it doesn’t fully understand why tariff-free trade matters, and like Trump, thinks that a trade surplus is simply a function of cheaper prices. This misconception confuses how trade balances arise with the profitability from lower costs in foreign jurisdictions. That is a different issue. China would be far better to respond to Trump’s tariffs by removing all theirs, and in effect challenging American corporations to see if they can capture market share in China against local manufacturers and service providers.
What if they can? Well, China’s economy will benefit from obtaining goods and services someone else can provide better, freeing up economic resources for more efficient, appropriate and productive use. The underlying point is tariffs are a tax on both consumption and production inputs which impedes economic development. Tariffs are self-harm. We condemn teenagers self-harming, but not when governments do it.
This article explains why China would benefit enormously from the abolition of its own tariffs, as would any country following tariff-free trade policies. The other side of this coin, escalating tariffs, is the highway to economic ruin. The first step in developing this argument is to remind us of the empirical evidence, the awful damage tariffs did to the global economy following the First World War, and the appalling financial and economic consequences when they culminated in America’s Smoot-Hawley Tariff Act of 1930.
The histories of monetary inflation and tariffs are closely linked
Expansion of both bank credit and the commercial bills market in America in the 1920s were an addition to the monetary and price inflation during the First World War. Despite cumulative monetary expansion, America managed to adhere to an exchangeable gold standard until 1933. Similarly, other countries that returned to a post-war gold standard (such as the United Kingdom) did so at pre-war rates of convertibility on massively expanded bases of circulating money. All had to eventually devalue. Other European currencies had simply collapsed by 1924.
Money supply in the US increased 73% between 1913-1919, and wholesale prices doubled. In the UK, money supply increased by 144% and wholesale prices rose by 157%.[i] It was from these elevated bases that the expansion of circulating money continued through the 1920s. While we tend to recall the economic advances from the spread of electric power and the manufacture of automobiles, we gloss over the substantial monetary imbalances. Monetary imbalances result in price imbalances, leading to politically unwelcome trade and capital flows. Governments and central banks attempt to smother the symptoms, which was the underlying reason behind the cooperation between Benjamin Strong at the Fed and Montague Norman at the Bank of England during that decade.
In the First World War, production output was commandeered by governments, which had the effect of eliminating foreign competition. As international trade resumed in the post-war years, this was no longer the case, and businessmen were faced with foreign competitors whose cost bases were in rapidly depreciating currencies. Naturally, they agitated for tariffs to ring-fence their domestic markets. This led to the Emergency Tariff Act of 1921 in America, consolidated in the Fordney-McCumber Tariff of 1922. Foreign nations responded by increasing their own tariffs, and the contraction in international trade was a significant factor behind the currency collapses suffered by the beginning of 1924 in Austria, Bulgaria, Germany, Greece, Russia and Poland. And because the contraction of trade made it virtually impossible for these countries to pay off war debts to America, the supposed benefits of trade protection came at an enormous capital cost to America itself.
In 1922 US import tariffs ranged from 7% to 68%, averaging 38%. While much of Europe was depressed following the War, by 1926 their economies and employment had recovered despite these tariffs, which had become insufficient protection for American businesses. In 1930, the Smoot-Hawley Tariff Act increased import tariffs across the board to an average of 60%.[ii]
Given the history of American businessmen working with politicians towards trade protection, we should not be surprised to see Donald Trump, a businessman-president, reintroduce tariffs to protect American business. His tweeting says everything. His economic illiteracy and political motivation faithfully replicate those of Senator Smoot and Representative Hawley. Furthermore, the unwillingness to learn from history is depressingly familiar, and the outcome has become dismally predictable.
In 1930, the reactions of the US’s trade partners, who followed Smoot-Hawley by increasing their protectionist tariffs as well, were equally predictable and economically illogical. Commodity prices had begun to fall in anticipation of the collapse in trade. This had a devastating effect on US farmers, who had been a core reason behind tariffs in all the debates on trade in Congress, even before the First World War.
The US stockmarket crashed in late-1929 ahead of the first major vote on the Smoot-Hawley Act on 31 October. Traders could see which way it was going, and correctly anticipated the economic effects. Bizarrely, politicians put the stock market collapse down to a lack of business confidence that would be cured by a swift introduction of the Smoot-Hawley Act.[iii]
Optimists might argue that the lessons of the 1920-1930s were the first time the negative effects of tariffs became obvious to politicians and the wider public, and therefore are unlikely to be repeated. Not so. In May 1930, a month after Smoot-Hawley was passed by Congress, a petition signed by over a thousand economists asked President Hoover to veto it. Today’s economic establishment is similarly united against tariffs, but if anything, President Trump is less open to persuasion on trade than was President Hoover.[iv]
Today, stock markets seem poised on a cliff-edge while America targets China with tariffs. On Monday, there was a one-day relief rally in stockmarkets, reflecting the ninety-day postponement of new US tariffs against China. But stock prices did not hold and have begun what could turn out into a devastating financial panic, replicating the value-destruction on Wall Street in October 1929.
The history of political inanity from ninety years ago suggests the love of tariffs is so deeply imbedded in the political class’s psyche that empirical evidence will be ignored. It insinuates that we are early in a continuing tariff war rather than nearing a settlement, and the economic consequences of trade policy are in danger of tipping us into a repeat of the Great Depression.
We still have the tariff battle between the US and the EU ahead of us. That was put on ice while China was dealt with, and we can be certain that Trump will return to that subject in due course. The EU is itself highly protectionist, and therefore a red rag to Trump’s bull. We can only hope that escalating threats never materialise as action. But that is the hope born from despair. If it is left to politicians, tariffs will more likely only ratchet upwards.
Farming and the money are different this time
There were two significant differences between the 1920-1930 period and now which should be mentioned. The first was grain and farmland prices were further undermined by overproduction, due to the rapid adoption of mechanisation and new pesticides. The prices of all agricultural produce collapsed, impoverishing farmers around the world. The dust-bowl conditions of the 1930s did the rest to finish off farmers in North America.
The second difference is in the money. The slump in demand for raw materials in the Great Depression led to a collapse in commodity prices, measured in dollars. At the time, so far as the public was concerned, dollars were gold substitutes, being exchangeable for gold at $20.67 to the ounce. Therefore, the collapse in prices reflected an increased purchasing power for gold, and the eventual policy response was to rescind dollar convertibility in 1933 and then to devalue it by 40% the following January.
If we suffer a repeat of the trade-driven slump of the 1930s, it will be measured in the fiat currencies of today. At the least, we know central banks will offset any tendency for falling prices by inflating the money supply. That is already official policy. Monetary inflation will not resolve the underlying problems, only serving to conceal them. Central banks will attempt to achieve a Blondin-like wire-walking balance between the money quantity and price stability. This cannot be managed without raising both interest rates and the cost of borrowing for governments, and we must therefore conclude that a tariff-driven economic slump will threaten to undermine the dollar and all fiat currencies linked to it.
Why trade imbalances have nothing to do with prices
It is time to address the theory behind trade imbalances. We have seen the empirical evidence, that politicians are easily persuaded the excess of imports over exports is due to unfair competition. Even American corporations tend to locate their manufacturing in the cheapest locations to maximise their profits, and they will often close their operations in more expensive locations to reduce costs. This has riled President Trump when he complains about trade deficits.[v]But the reason for trade imbalances has nothing to do with unpatriotic behaviour or price competition. It is endemic to fiat currencies.