Avoiding the 1930s-style protectionism: Lessons for today

Is there a risk of a 1930s-style increase in protectionism? Fortunately, the world economy in the 2000s is very different from the world economy in the 1930s.

(pages 8-11 of printed journal)

By Douglas A Irwin

A statement released by the G-20 leaders on 2 April 2009 emphatically noted: "We will not repeat the historic mistakes of protectionism of previous eras." What historic mistakes of previous eras were the leaders referring to?

Almost unquestionably, the reference was to the Great Depression of the 1930s. Indeed, the world's current economic and financial crisis - complete with plummeting stock markets, collapsing world trade, sharply rising unemployment rates, and even the threat of deflation - has prompted many comparisons to the Depression. The 1929-32 period, which saw economic activity collapse around the world, was marked by a severe outbreak of protectionism and breakdown of the world trading system. The rise in trade barriers is believed to have intensified the Depression and to have hindered the economic recovery. And the trade barriers imposed under the 'emergency' conditions of the day remained in place for a period that stretched into decades, blocking the expansion of world trade even though the original justification for the barriers had long since passed.

In order to avoid repeating the calamity of the 1930s, it is necessary to understand precisely what happened to the world trading system during that terrible decade. Therefore, I will present a brief account of the deterioration in trade relations at that time and examine the similarities and differences between the situation then and today. I conclude that conditions are different enough today such that a 1930s-style resort to protectionism is unnecessary and unlikely.

The trade policy breakdown in the 1930s

Almost everyone with a rudimentary understanding of the 1930s knows that the period was marked by greater protectionism - the infamous Smoot-Hawley tariff in the US stands out in the public imagination - and collapsing trade. But was there any rhyme or reason to the mad scramble to block imports? Most accounts suggest that all countries succumbed to the pressure to close markets to foreign goods. In fact, there was a logical progression to events as they unfolded in the early 1930s and there was a high degree of variation in the extent to which countries limited trade.

To understand the breakdown in the world economy, it is essential to appreciate that the international monetary system was based on the gold standard. This regime of fixed exchange rates linked countries to one another and ensured that shocks to one country would be quickly transmitted to others. In addition, the gold standard tied the hands of monetary authorities, who were obligated to maintain the value of their currency in terms of its gold parity. The loss of monetary autonomy meant that the policymakers lacked an important policy instrument (an independent monetary policy) to help adjust to any such shocks. This has always been a theme of Max Corden's work on the interrelationship between the macroeconomic policy and trade policy.

It is commonly believed that the US led the movement toward greater protectionism when President Herbert Hoover signed the Smoot-Hawley tariff act in June 1930. Yet the impact of the Smoot-Hawley tariff on world trade was relatively limited. About two thirds of US imports entered the country duty free, and only six per cent of Europe's exports were destined for the US market. Although the US action provoked intense bitterness and resentment abroad, it did not lead to the collapse of the world trading system.

The series of events that really began to undermine the trading system started with the failure of Creditanstalt, Austria's largest bank, in June 1931. This failure contributed to a financial panic that spread to neighboring countries and around the world. In particular, a financial crisis in Germany, which caused depositors to begin massive withdrawals of funds and demand gold in exchange for marks, prompted Germany to impose strict controls on foreign exchange transactions that impeded trade and capital flows alike. Many other countries followed suit to stem the loss of gold and foreign exchange reserves.

Other countries responded differently to the financial pressure. Britain, for example, and other sterling bloc countries, allowed their currencies to depreciate against gold and other currencies. This allowed them to use expansionary monetary policies to help recover more quickly from the Depression. Unfortunately, while there were sound domestic economic reasons for Britain's action, it led to the breakdown of international trade relations. Britain's devaluation triggered a defensive response by countries that remained on the gold standard as they sought to offset the competitive advantage gained by sterling area producers. Hence, another round of countries imposed exchange controls in late 1931. Exchange controls - which restricted the use of foreign exchange, not only to prevent capital flight but to reduce spending on imports as well - were among the most restrictive trade practices of the early 1930s.

The economic crisis of mid- to late-1931 was much more responsible for the deterioration in trade policy around the world than the Smoot-Hawley tariff had been. In its World Economic Survey 1931/32, the League of Nations said that:

It is impossible in any brief summary to make anything like a complete statement of all the various devices brought into use to restrict trade. Especially after the abandonment of the gold standard by Great Britain in September 1931, there has been a veritable panic, which has piled new tariffs on old, turned licensing systems into prohibitions, monopolies and contingents; denounced existing commercial agreements; created more and more rigid exchange controls issuing in debt moratoria and paralysing trade; and substituted a slight and temporary framework of clearing agreements for previous existing treaties . . . There has never before been such a wholesale and widespread retreat from international economic co-operation.

The next year, the League of Nations argued: 'By the middle of 1932, it was obvious that the international trading mechanism was in real danger of being smashed as completely as the international monetary system had been.' Thus, by 1932, a wide range of controls and restrictions - higher tariffs, new import quotas, controls on foreign exchange transactions - had been imposed on world trade around the world. The volume of world trade fell 26 per cent between 1929 and 1932, as figure 1 shows. In addition, countries began forming preferential trading areas, most notably the Imperial Preferences of the British Empire. This balkanised trade in exclusive trade blocs and complemented bilateral clearing arrangements as the multilateral pattern of trade and payments was in shambles.

Figure 1: World Trade and World Production, 1926-1938

Figure 1

Source: League of Nations

Eventually, all countries left the gold standard. The US de-linked the dollar from gold in April 1933 and allowed the dollar to depreciate. The remaining gold bloc countries - France, the Netherlands, Belgium and Switzerland - clung to gold but eventually abandoned the standard in 1936 (in the case of Belgium, 1935). The timing of a country's recovery during the Depression is intimately linked to when it abandoned the gold standard because it allowed countries to reduce interest rates and expand the money supply, relieving financial distress and promoting recovery. Britain and the European sterling area, which left gold in 1931, experienced a relatively mild recession, whereas the gold bloc countries, which did not leave until 1936, suffered a prolonged economic downturn.  

This suggests that the best strategy to have combated the Depression would have been a suspension of the gold standard or a coordinated change in the gold parities such that all countries could have pursued monetary reflation even with fixed exchange rates. Instead, there was no international coordination, countries left the gold standard in a haphazard fashion, and those that did, intensified the economic problems faced by those remaining tied to gold. Unfortunately, the world trading system was a casualty of this process. 

Understanding the 1930s breakdown

What should we learn from the breakdown in world trade relations in the early 1930s? In a recent paper, Barry Eichengreen and I have argued that the move toward protectionism was intimately related to the real or perceived constraints on macroeconomic policy instruments. Countries that clung to the gold standard were unable to use monetary policy to prevent the slide from recession to Depression. In addition, fiscal policy was constrained by the prevailing economic orthodoxy that governments should run balanced budgets even in bad times; hence, it was thought, there should be fiscal retrenchment in an economic downturn, not a fiscal expansion. Therefore, since many countries ruled out the use of monetary or fiscal policy to address the Depression, the turn to protectionism was simply an alternative, albeit inferior way of reducing capital outflows and the loss of gold and foreign exchange reserves.

In this sense, devaluation, exchange controls and trade restrictions were substitute policy instruments. This is something that Max Corden has written about in the second edition of his classic book, Trade Policy and Economic Welfare. As he put it: 'The inability to use the exchange rate as a policy instrument provides an incentive to impose or increase restrictive trade policies at times of crisis, and thus leads to protectionist measures which often fail to be reduced when the short-term crisis is at an end.' Indeed, during the Depression, countries that chose to devalue their currencies tended not to employ exchange controls or resort to trade protection. Alternatively, countries that could not or would not devalue almost invariably imposed exchange controls or adopted protectionist trade measures. Furthermore, many of the trade controls adopted in the early 1930s were not removed until well after World War II.

Similarities and differences to today

What can we take away from the historical experience of the 1930s that might help us think about the current world slump? Without doubt, there will be an increase in protectionist measures during the current recession. Many such measures are WTO-legal. The use of antidumping duties is very countercyclical and inevitably rises as economic growth falters. In addition, for most developing countries, bound tariffs are much higher than applied tariffs. If they wanted to do so, these countries could increase their duties on imports without violating WTO commitments. Finally, in areas where WTO agreements are weak, such as government procurement, the temptation to impose buy-local requirements, such as the 'Buy America' provision in the stimulus bill, may prove irresistible.

But is there a risk of a 1930s-style increase in protectionism? Fortunately, the world economy in the 2000s is very different from the world economy in the 1930s. Most of the differences augur well for preventing another outbreak of protectionism.

First, countries today have many more policy instruments for dealing with the current severe recession. Governments are significantly less constrained in terms of using monetary and fiscal policy to address the economic crisis. In the 1930s, governments took no responsibility for propping up financial institutions and were unable to pursue reflationary monetary policies because of the gold standard. Today, expansionary monetary and fiscal policy measures have been used in the US, the European Union, China, and elsewhere to offset the recession. While governments may be under political pressure to protect certain producer interests, policymakers are not under the illusion that protectionism can provide a macroeconomic stimulus on par with monetary and fiscal policy.

Second, in the early 1930s, countries imposed higher trade barriers unilaterally without violating any international agreements or anticipating much foreign reaction. Today, WTO agreements restrict the use of such discretionary trade policy. Countries that are tempted to violate WTO agreements can have no illusion that they will avoid swift foreign retaliation if they choose to do so. When a country is certain that its exports will face new impediments abroad if it chooses to impose WTO-inconsistent import restrictions, that country will think twice about restricting imports.

Third, the share of the workforce in sectors directly affected by international trade - mainly agriculture and manufacturing - is much lower today than in the 1930s. In the case of the US, for example, about 44 per cent of the labour force was in agriculture, mining, and manufacturing in 1930 and hence might benefit from import restrictions. Today, that share is about 14 per cent. The service sector of the economy is much more insulated from foreign competition, which means the scope for beneficial expenditure-switching policies is that much lower.

Fourth, unlike the early 1930s, foreign investment has transformed the world economy. Leading firms around the world have become so multinational in their production operations and supply chains that they have a vested interest in resisting protectionism. Many industries that faced import competition in the past, such as televisions and automobiles and semiconductors, have found that international diversification or joint ventures with foreign partners are a more profitable way of coping with global competition than simply stopping goods at the border. Many domestic industries no longer have much of an incentive to ask for import restrictions because foreign rivals now produce in the domestic market, eliminating the benefits of trade barriers for domestic firms. For example, unlike the early 1980s, US automakers are not asking for trade protection because it would not solve any of their problems; they are diversified into other markets with equity stakes in foreign producers, and other foreign firms operate large production facilities in the US.

These important differences suggest that a protectionist trade war need not break out like the 1930s. With more economic policy instruments in play today, the need to resort to trade restrictions should be less of a problem. Yet, severe recessions are always dangerous periods for trade policy, and policymakers should remain on guard against measures that have external ramifications and might lead to countervailing policies in other countries.

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A condensed version of the Annual Max Corden Lecture delivered at the University of Melbourne on 30 July 2009.

Professor Douglas Irwin is Robert E. Maxwell '23 Professor of Arts and Sciences in the Economics Department of Dartmouth College at Hanover New Hampshire.

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