Smoot-Hawley Tariff: Courting Infamy

Justice Litle discusses the Smoot-Hawley Tariff Act of 1930 — “the most destructive example of boneheaded protectionism in US History” — and how politicians today seem determined to make the same mistake.

“A society of sheep must in time beget a government of wolves.”
— Bertrand de Jouvenel

“The wolf careth not, how many the sheep be.” — Virgil

Courting Infamy

REED SMOOT AND Willis Chatman Hawley were surely decent fellows. The distinguished senator from Utah had no intention of courting infamy; neither did his fellow Republican from Oregon.

But court infamy they did. The Smoot-Hawley Tariff Act of 1930 stands as perhaps the most destructive example of boneheaded protectionism in U.S. history. There is even a memorial Web page at the U.S. State Department site.

It wasn’t all their fault, of course. Smoot and Hawley were merely playing a bad hand as best they could…a hand they were dealt through the gross incompetence of the Federal Reserve. When it comes to the Great Depression, the Fed has gotten off mostly scot-free in the history books: In reality, its poor policymaking bears more responsibility for what followed than the rampant speculations or the ’29 crash itself. The Economist notes:

“In 1929, most of the world was on the gold standard. Allowed to work, this system should have helped stabilize the American economy. As demand there slowed, its imports fell, its balance of payments moved further into surplus and — under the ordinary ‘rules of the game’ — gold should have flowed into the country, expanding the money supply and buoying the economy. But this mechanism was deliberately shut down by the Fed, which was still worried about the effect of easier credit on speculation. The inflow of gold was ‘sterilized’ by the sale of government debt, and money grew tighter…

“Abroad, meanwhile, outflows of gold had their customary effect of reducing the money supply and curbing demand. Governments everywhere then tried to reduce imports through tariffs, with America kicking things off with the Smoot-Hawley Act of 1930. The effort was futile: The monetary pressure wasn’t eased, and collapsing trade only added to the plight of industry. The Fed’s policy, together with Smoot-Hawley, had turned the gold standard into a global-recession machine.”

The crash simply got the ball rolling. After screeching to a halt on the heels of drastic rate hikes, America was forced to tighten its belt and cut back on consumption. This meant spending less on imports while rebuilding a current account surplus through continued exports. Once a reasonable surplus had built up, a gradual business recovery should have followed via natural expansion of money and credit, thanks to replenished gold reserves in the coffers of the banks.

But the inexperienced Fed, fighting yesterday’s war, made a horrid mess of things in maintaining austerity far beyond its point of benefit. Like an ignorant doctor just knowledgeable enough to do great harm, the Fed continued to bleed its sick patient long after the poison had been drained. (The Fed then administered its coup de grace by kicking the legs out from under the country’s banks, abolishing their informal support system and replacing it with thin air.)

Smoot-Hawley Tariff: Blaming Foreigners

This was the woefully anemic backdrop from which Sen. Smoot and Rep. Hawley strode forth, possessed by that ever-present political itch to “do something” when constituents are howling. Oblivious to the Fed’s bad medicine, they laid the blame at the feet of foreigners…and the Smoot-Hawley Tariff Act of 1930 was born.

As the State Department notes, the purpose of the act was modest. It was meant only to “increase the protection afforded domestic farmers against foreign agricultural imports,” According to the State Department Web site. Sounds quite reasonable on its face, no? But give a mouse a cookie, and he’ll want a glass of milk. The State Department continues: “Once the tariff schedule revision process got started, it proved impossible to stop. Calls for increased protection flooded in…soon, a bill meant to provide relief for farmers became a means to raise tariffs in all sectors of the economy.”

Signing the bill into law, President Hoover ignored vigorous protest from 30-plus countries. Smoot-Hawley triggered a massive protectionist backlash that essentially crippled the global economy as America’s trade partners retaliated. Historian Charles Kindleberger estimates the total volume of world trade, already battered by the events of 1929, to have fallen another two-thirds by 1933.

Fast-forward 75 years, to 2005, and we may be looking over the edge of another precipice. On April 7, the U.S. Senate voted, by more than a two-thirds margin, to resurrect Smoot-Hawley’s ghost. The Wall Street Journal reports:

“The 67-33 vote came amid procedural sparring over a proposal by Sens. Charles Schumer, a New York Democrat, and Lindsey Graham, a South Carolina Republican, to impose a 27.5% tariff on all Chinese products entering the United States if Beijing doesn’t agree to raise the value of its currency. The United States has long contended that China’s fixed yuan-dollar exchange rate has kept its currency artificially weak and made its exports relatively less expensive, giving its manufacturers an unfair advantage over American competitors in the world market.”

Given China’s commitment to export-led prosperity — and its reliance on America as buyer for a whopping 33% of all Chinese-made goods — Beijing is showing surprising stubbornness in holding its ground. Foreign ministry apparatchik Qing Gang responded to the vote with a blunt observation: “The major reason for this issue is that the United States and Europe, as major importers, have some unreasonable arrangements that are overprotectionist.” In March, Prime Minister Wen Jiabao sounded coolly confident in response to revaluation pressures. “When we decide on this, we must take into account not only our own companies’ interests, but also the impact on the world and neighboring countries.”

Smoot-Hawley Tariff: No Choice in the Matter

What China does not say — or rather, what it is saying between the lines — is far more important. The reality is that China may not have a choice in the matter…a short-term revaluation could simply be too dangerous, no matter how much pressure U.S. politicians exert. This is true for two reasons:

1. The risk of upsetting a delicate balance. China’s financial condition is still highly unstable. The banks are half solvent at best, corruption is still wreaking havoc, and the country’s grossly mismanaged state-owned enterprises (SOEs) are financial black holes. Beijing is tackling these problems, but time is needed to rectify the situation. At the moment, China’s economy is riding high on hot money…speculative capital flows looking for a piece of the “China Growth Story.” These flows are inherently unstable (as Asia learned in 1997). A forced revaluation in the yuan could lead to further speculative frenzy, which in turn could lead to meltdown and devastating withdrawal. Alternatively, moving off the dollar peg could actually lead to a decline in the value of the yuan, as Chinese citizens look to diversify their savings, investors discount the ugliness of the banks and SOEs, and speculators anticipate a coming slowdown. Simply put, China can hardly afford the instability that a revaluation would invite at this point, regardless of how hard it is pushed.

2. The risk of losing ground to local competition. A 30% rise in the yuan would not be a bonanza for the U.S. consumer. In fact, he would hardly see prices move at all. The cost of Chinese labor is so low, relative to American labor, that this boost would hardly make a dent in final pricing. U.S. factories would not gain any significant edge on Chinese ones through a revaluation. The real bonanza would go to China’s local competitors in the Asian region. With every uptick in China’s production costs, neighboring countries become that much more competitive as alternative outsourcing meccas for the big multinationals. Indeed, a sharp revaluation of the yuan would be a cause for celebration in the region (apart from China, of course). Why would China want to hand growth on a silver platter to the other tigers, at the expense of its own economy, by bowing to U.S. protectionist sentiment…and gain nothing from the deal to boot? The logic does not work. We might as well ask Beijing to let us kick it in the shin and charge handsomely for the privilege.

Smoot-Hawley Tariff: The Wolves Don’t Care

So if protectionist calls for revaluation of the yuan are shortsighted and impossible for China to heed, why do politicians persist?

Short answer: because they aren’t burdened by a need for logic or reason.

Slightly longer answer: because for the average politician, the political expediency of “doing something” in the short run is well worth courting disaster in long run — given that it lands on someone else’s doorstep. John Keynes wryly noted, “In the long run, we are all dead.” The D.C. Beltway version of that might be, “In the long run, we’ll all be making big bucks from some political lobbying firm.”

Reed Smoot and Willis Hawley at least had an excuse. They could credibly claim ignorance as to what horrors their protectionist posturing would lead to, and both were eventually forced from political office. Seventy-five years later, the current band of miscreant opportunists in Washington has no similar excuse. It is making political hay by playing to the fear and greed of its constituents, with no concern for what grim harvest may be reaped.

How much nicer it would be if protectionist politicians were simply stupid, as opposed to malevolent. Then we could at least be charitable. “They don’t mean to risk touching off a trade war…it’s not their intention to force one of our biggest creditors into a corner…they simply don’t realize that their protectionist howls have the potential to wreck everything while solving nothing. They don’t have any common sense, you see. Just a lovable bunch of dolts looking out for the locals as best they know how.”

Chuck Schumer, the “other” senator from New York, may be a lot of things. Stupid he is not. The same goes for Sen. Graham of South Carolina. These gentlemen did not just fall off the turnip truck. They are not ignorant of history, and they are certainly not ignorant of Smoot-Hawley. Chances are they know full well what they are risking…and it makes no difference. Because politics is all just a game, you see. The object of the game is not to act in good faith in accordance to long-run principles. It’s to maximize short-term opportunities, long run be damned. This is why de Jouvenel’s quote holds true. When sheep clamor for protection without thinking through their demands or realizing what they ask for, they eventually find wolves to deliver the goods…wolves ready to sacrifice long-term interests on the altar of political expediency.

Smoot-Hawley Tariff: A Duty to Educate

Next time you run across a fellow citizen in favor of protectionism, don’t criticize him or belittle him. Educate him. The only hope we have against a government of wolves is to educate the sheep that are being led to the slaughter. Spread the word as to why protectionism is dangerous and why popular arguments in favor of protectionism are based on logical fallacies and appeals to emotion that ultimately don’t hold up.

The most common criticism of protectionism is that it raises prices for the consumer being “protected.” How is it of value for you and me, the consumers, to pay double for our boxer shorts, triple for our peanut butter, quadruple for the sugar in our coffee and tea? This objection is wholly valid, but it’s only the tip of the iceberg, and it is easily parried by the opposition. “Yes, you may pay more as a consumer,” the patriotic protectionist counters, “but it’s worth it to protect American jobs…worth it to protect the American way.”

“Perhaps,” you counter, “but let’s go deeper. Is it worth it to hobble the creative destruction that is the very essence of free-market progress? Is it worth it to distort asset allocation with the heavy hand of government, lowering the efficiency of markets in the process? Is it worth it to invite trade barriers against our own high-margin exports? Is it worth it to cling to lower-margin industries and risk a slide into obsolescence because we refuse to continue moving up the economic ladder?”

Smoot-Hawley Tariff: The Ladder of Progress

Picture the global economy as a ladder, with varying countries on different rungs. It used to be that the rich countries had the ladder all to themselves, with Second and Third World economies all lumped in a heap at the bottom. But now, something beneficial is happening…the developed world economies are climbing at an accelerated pace. They are joining the forward march of progress at an accelerated pace. This is a good thing — indeed, an excellent thing.

But it involves pain and change.

To maintain their standard of living, the rich world economies cannot stand still. If they stay on the same rung, they will eventually be crowded out by the developing economies on their way up. Take the United States, still on the top rung (for the moment). In the first half of the 20th century, the United States exploded in size and strength as a farming, manufacturing, and industrial power. In the latter half of the 20th century, the United States began its ascent to the next rung of the ladder, developing into a service- and information-based economy.

This step to the next rung — to information and services — allowed for higher profit margins and a higher standard of living overall. But it also involved leaving the activities of the previous rung behind. As developing countries take advantage of inexpensive technology and leapfrog entire generations of “legacy” communication systems, they rapidly develop a taste for — what else? -entry-level manufacturing and industrial production, our old stomping grounds. They are ready and willing to take up the rungs that the rich world economies have left behind, and they are catching up as quickly as they can. (Rich countries will still be powerhouses in manufacturing, by the way; as with farming, they will simply be doing it with vastly improved technology and vastly reduced labor inputs.)

Those who would be protectionist want to hinder this inexorable change. But since it cannot be truly hindered, foot-dragging only causes problems. The rise of China, India, and other developing countries means staying put is no longer an option. The rich world economies have to advance further in the direction they are already headed: toward service-oriented, knowledge-based, and innovation-powered economies. The longer they stall, the more their standards of living will be slowly ground away. The competition is but a few rungs down and catching up fast.

This is why the protectionist wolves aren’t just playing with matches in the short term…they are also threatening prosperity in the long term. We must not be sheep, and we must not let the lessons of Smoot-Hawley go unheeded.

Long live free trade,
Justice Litle
April 14, 2005