Trade Wars – A Catalyst For Economic Crisis

In my last article, I used a proven accounting identity to show that the end result of President Trump’s trade tariffs would be to increase the trade deficit, assuming there is no change in the savings rate. The savings rate is important, because if it does not change, then the budget deficit must be financed by any combination of three variables: monetary inflation, the expansion of bank credit, or capital inflows. This is captured in that equation, where the trade balance is the balance of payments, thereby including capital flows as well as goods and services:

(Imports – Exports) = (Investment - Savings) + (Government Spending – Taxes)

It assumes the economy is working normally, and as we shall see, there is no major economic contraction or systemic crisis.

This article explores the implications of the relationship between the twin deficits in the context of the current situation for the United States, which may or may not be on the edge of significant economic retrenchment. It looks at the detail of how trade tariffs act on the economy at the current stage of its credit cycle and the implications for the economic outlook and for monetary policy. It examines the problem through the lens of sound economic theory, but empirical evidence is invoked as well for confirmation.

The empirical evidence

Looking at history, we find that the effect of tariff increases has depended on the stage of the credit cycle. The best clearest examples are the tariffs introduced after the First World War (the Fordney-McCumber tariffs of 1922) early in the credit cycle, and the Smoot-Hawley Tariff Act of 1930 at the end of it. On the face of it, Fordney-McCumber had little effect, while Smoot-Hawley, it is generally agreed, had a significant effect. Of course, this is in the context of a US-centric viewpoint.

The Fordney-McCumber tariffs were introduced early in the US’s credit cycle. At that time, the US economy still had the legacy of wartime production, whereby imported goods and agricultural products were minimal, having been virtually eliminated by wartime economic planning. The impact of tariffs on the US’s domestic economy was therefore barely relevant to the economic situation. Consequently, unlike the European economies which had been ravaged by war, US agricultural and industrial production were both higher in 1920 than they had been in 1913, the year before the outbreak of war. The effect on Europe was another matter.

European economies found themselves needing dollars to pay reparations (in Germany’s case) and to repay war debt in the case of the Allies. US Tariffs made it extremely difficult for the Europeans to earn those dollars. A number of European economies collapsed into hyperinflation as governments continued the wartime practice of money-printing to finance themselves and service wartime obligations.

Another factor affecting America was the collapse of agricultural prices from inflated wartime levels. By 1921, wheat had collapsed from $2.58 a bushel to 92 cents and hogs from 19 cents per pound to under 7 cents. Tariffs did not help farmers, because, at that time, they depended on export markets to a significant degree. And when other countries introduced or increased their tariffs against agricultural products as a response to US tariffs, they proved to be wholly counterproductive for US farmers.

Of course, tariffs were not the sole problem for America’s farmers. Rapid mechanization increased Canada’s wheat yields, the Argentine was increasing beef production and Cuba exporting large quantities of sugar. Consumers were benefiting from catastrophically lower prices despite tariffs. Other than the pain faced by producers, pain which in free markets is only alleviated by redeploying economic resources away from overcapacity in agriculture, the overall economic effect of the Fordney-McCumber tariffs on America was not significant.

Smoot-Hawley was different. Congress voted in favor of it on 31 October 1929, and the stock market clearly saw it coming. The Wall Street Crash commenced on Black Thursday, 24 October, when the market fell 11% that day, before recovering most of the fall. Black Monday followed when the market fell 13%. By the close, on Tuesday 29 October the market had lost over 34% in just fifteen calendar days. 

At today’s stock prices, that would be a loss of over 8,000 Dow points. The stock market continued its fall to a low on 13 November of 198.7 on the Dow, and after rallying for six months entered a pernicious and continual bear market to a final low of 41.22 on 8 July 1932.

It is always a mistake to attribute a market failure to a single cause: the only certainty was the market fell. However, the importance of the Smoot-Hawley vote to the stock market is often missed by economic historians. 

The difference between late-1929 and today perhaps, is that Congress voting for it then was a definite event, whereas Trump’s tariffs are progressing as a fluid mixture of bluff and fact. Another key difference was the dollar’s gold exchange standard of $20.67 to the ounce. So long as the exchange rate was defended, a slump would certainly lead more dramatically to widespread bankruptcies. Markets, therefore, had to discount the enhanced risks from trade protectionism to the economy more immediately compared with today’s fiat currency economy, when it is assumed future investment risk will be ameliorated by monetary expansion.

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Disclaimer: The views and opinions expressed in this article are those of the author(s) and do not reflect those of Goldmoney, unless expressly stated. The article is for general information ...

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