Protectionism was a Result of the Great Depression, Not a Cause of It

In the 17 March 2009 voxeu.org paper "The protectionist temptation: Lessons from the Great Depression for today," Barry Eichengreen and Douglas Irwin argue that protectionism was a result of the Great Depression, not a cause of it.

What do we know about the spread of protectionism during the Great Depression and what are the implications for today’s crisis? This column says the lesson is that countries should coordinate their fiscal and monetary measures. If some do and some don’t, the trade policy consequences could once again be most unfortunate.

The Great Depression of the 1930s was marked by a severe outbreak of protectionism. Many fear that, unless policymakers are on guard, protectionist pressures could once again spin out of control. What do we know about the spread of protectionism then, and what are the implications for today?

While many aspects of the Great Depression continue to be debated, there is all-but-universal agreement that the adoption of restrictive trade policies was destructive and counterproductive and that similarly succumbing to protectionism in our current slump should be avoided at all cost. Lacking other instruments with which to support economic activity, governments erected tariff and nontariff barriers to trade in a desperate effort to direct spending to merchandise produced at home rather than abroad. But with other governments responding in kind, the distribution of demand across countries remained unchanged at the end of this round of global tariff hikes. The main effect was to destroy trade which, despite the economic recovery in most countries after 1933, failed to reach its 1929 peak, as measured by volume, by the end of the decade (Figure 1). The benefits of comparative advantage were lost. Recrimination over beggar-thy-neighbour trade policies made it more difficult to agree on other measures to halt the slump.

Figure 1. World trade and production, 1926-1938


The impression one gleans from both contemporary and modern accounts is that trade policy was thrown into complete chaos, with every country scrambling to impose higher barriers. But, in fact, this was not exactly the case (Eichengreen and Irwin, forthcoming). Although recourse to trade restrictions was widespread, there was considerable variation in how far countries moved in this direction. Figure 2 illustrates this for tariffs. Tariff rates rose sharply in some countries but not others. The history of the 1930s would have been very different had other countries responded in the manner of, say, Denmark, Sweden and Japan. It is important to understand why they did not.

Figure 2. Average tariff on imports, 1928-1938, percentage


The answer, in a nutshell, is the exchange rate regime and the policies associated with it. Countries that remained on the gold standard, keeping their currencies fixed against gold, were more inclined to impose trade restrictions. With other countries devaluing and gaining competitiveness at their expense, they adopted restrictive policies to strengthen the balance of payments and fend off gold losses. Lacking other instruments with which to address the deepening slump, they used tariffs and similar measures to shift demand toward domestic production and thereby stem the rise in unemployment.

In contrast, countries abandoning the gold standard and allowing their currencies to depreciate saw their balances of payments strengthen. They gained gold rather than losing it. As importantly, they now had other instruments with which to address the unemployment problem. Cutting the currency loose from gold freed up monetary policy. Without a gold parity to defend, interest rates could be cut, and central banks No longer bound by the gold standard rules could act as lenders of last resort. They now possessed other tools with which to ameliorate the Depression. These worked, as shown in Figure 3. As a result, governments were not forced to resort to trade protection.

Figure 3. Change in industrial production, by country group


This relationship is quite general, as we show in Figure 4. It also carries over to non-tariff barriers to trade such as exchange controls and import quotas.

Figure 4. Exchange rate depreciation and the change in import tariffs, 1929-1935


This finding has important implications for policy makers responding to the Great Recession of 2009. The message for today would appear to be “to avoid protectionism, stimulate.” But how? In the 1930s, stimulus meant monetary stimulus. The case for fiscal stimulus was neither well understood nor generally accepted. Monetary stimulus benefited the initiating country but had a negative impact on its trading partners, as shown by Eichengreen and Sachs (1985). The positive impact on its neighbours of the faster growth induced by the shift to “cheap money” was dominated by the negative impact of the tendency for its currency to depreciate when it cut interest rates. Thus, stimulus in one country increased the pressure for its neighbours to respond in protectionist fashion.

Today the problem is different because the policy instruments are different. In addition to monetary stimulus, countries are applying fiscal stimulus to counter the Great Recession. Fiscal stimulus in one country benefits its neighbours as well. The direct impact through faster growth and more import demand is positive, while the indirect impact via upward pressure on world interest rates that crowd out investment at home and abroad is negligible under current conditions. When a country applies fiscal stimulus, other countries are able to export more to it, so they have no reason to respond in a protectionist fashion.

The problem, to the contrary, is that the country applying the stimulus worries that benefits will spill out to its free-riding neighbours. Fiscal stimulus is not costless – it means incurring public debt that will have to be serviced by the children and grandchildren of the citizens of the country initiating the policy. Insofar as more spending includes more spending on imports, there is the temptation for that country to resort to “Buy America” provisions and their foreign equivalents. The protectionist danger is still there, in other words but, insofar as the policy response to this slump is fiscal rather than just monetary, it is the active country, not the passive one, that is subject to the temptation.

But if the details of the problem are different, the solution is the same. Now, as in the 1930s, countries need to coordinate their fiscal and monetary measures. If some do and some don’t, the trade policy consequences could again be most unfortunate.

References

Barry Eichengreen and Douglas A. Irwin (2009), “The Great Depression and the Protectionist Temptation: Who Succumbed and Why?” (forthcoming).

Barry Eichengreen and Jeffrey Sachs (1985), “Exchange Rates and Economic Recovery in the 1930s,” Journal of Economic History 45, 925-946.

Free Trade's Great, but Offshoring Rattles Me

In the May 6, 2007 Washington Post article "Free Trade's Great, but Offshoring Rattles Me," Alan S. Blinder writes:

I'm a free trader down to my toes. Always have been. Yet lately, I'm being treated as a heretic by many of my fellow economists. Why? Because I have stuck my neck out and predicted that the offshoring of service jobs from rich countries such as the United States to poor countries such as India may pose major problems for tens of millions of American workers over the coming decades. In fact, I think offshoring may be the biggest political issue in economics for a generation.

When I say this, many of my fellow free-traders react with a mixture of disbelief, pity and hostility. Blinder, have you lost your mind? (Answer: I think not.) Have you forgotten about the basic economic gains from international trade? (Answer: No.) Are you advocating some form of protectionism? (Answer: No !) Aren't you giving aid and comfort to the enemies of free trade? (Answer: No, I'm trying to save free trade from itself.)

The reason for my alleged apostasy is that the nature of international trade is changing before our eyes. We used to think, roughly, that an item was tradable only if it could be put in a box and shipped. That's no longer true. Nowadays, a growing list of services can be zapped across international borders electronically. It's electrons that move, not boxes. We're all familiar with call centers, but electronic service delivery has already extended to computer programming, a variety of engineering services, accounting, security analysis and a lot else. And much more is on the way.

Why do I say much more? Because two powerful, historical forces are driving these changes, and both are virtually certain to grow stronger over time.

The first is technology, especially information and communications technology, which has been improving at an astonishing pace in recent decades. As the technology advances, the quality of now-familiar modes of communication (such as telephones, videoconferencing and the Internet) will improve, and entirely new forms of communication may be invented. One clear implication of the upward march of technology is that a widening array of services will become deliverable electronically from afar. And it's not just low-skill services such as key punching, transcription and telemarketing. It's also high-skill services such as radiology, architecture and engineering -- maybe even college teaching.

The second driver is the entry of about 1.5 billion "new" workers into the world economy. These folks aren't new to the world, of course. But they live in places such as China, India and the former Soviet bloc -- countries that used to stand outside the world economy. For those who say, "Sure, but most of them are low-skilled workers," I have two answers. First, even a small percentage of 1.5 billion people is a lot of folks. And second, India and China will certainly educate hundreds of millions more in the coming decades. So there will be a lot of willing and able people available to do the jobs that technology will move offshore.

Looking at these two historic forces from the perspective of the world as a whole, one can only get a warm feeling. Improvements in technology will raise living standards, just as they have since the dawn of the Industrial Revolution. And the availability of millions of new electronically deliverable service jobs in, say, India and China will help alleviate poverty on a mass scale. Offshoring will also reduce costs and boost productivity in the United States. So repeat after me: Globalization is good for the world. Which is where economists usually stop.

And where my alleged apostasy starts.

For these same forces don't look so benign from the viewpoint of an American computer programmer or accountant. They've done what they were told to do: They went to college and prepared for well-paid careers with bountiful employment opportunities. But now their bosses are eyeing legions of well-qualified, English-speaking programmers and accountants in India, for example, who will happily work for a fraction of what Americans earn. Such prospective competition puts a damper on wage increases. And if the jobs do move offshore, displaced American workers may lose not only their jobs but also their pensions and health insurance. These people can be forgiven if they have doubts about the virtues of globalization.

We economists assure folks that things will be all right in the end. Both Americans and Indians will be better off. I think that's right. The basic principles of free trade that Adam Smith and David Ricardo taught us two centuries ago remain valid today: Just like people, nations benefit by specializing in the tasks they do best and trading with other nations for the rest. There's nothing new here theoretically.

But I would argue that there's something new about the coming transition to service offshoring. Those two powerful forces mentioned earlier -- technological advancement and the rise of China and India -- suggest that this particular transition will be large, lengthy and painful.

It's going to be lengthy because the technology for moving information across the world will continue to improve for decades, if not forever. So, for those who earn their living performing tasks that are (or will become) deliverable electronically, this is no fleeting problem.

It's also going to be large. How large? In some recent research, I estimated that 30 million to 40 million U.S. jobs are potentially offshorable. These include scientists, mathematicians and editors on the high end and telephone operators, clerks and typists on the low end. Obviously, not all of these jobs are going to India, China or elsewhere. But many will.

It's going to be painful because our country offers such a poor social safety net to cushion the blow for displaced workers. Our unemployment insurance program is stingy by first-world standards. American workers who lose their jobs often lose their health insurance and pension rights as well. And even though many displaced workers will have to change occupations -- a difficult task for anyone -- only a fortunate few will be offered opportunities for retraining. All this needs to change.

What else is to be done? Trade protection won't work. You can't block electrons from crossing national borders. Because U.S. labor cannot compete on price, we must reemphasize the things that have kept us on top of the economic food chain for so long: technology, innovation, entrepreneurship, adaptability and the like. That means more science and engineering, more spending on R&D, keeping our capital markets big and vibrant, and not letting ourselves get locked into "sunset" industries.

In addition, we need to rethink our education system so that it turns out more people who are trained for the jobs that will remain in the United States and fewer for the jobs that will migrate overseas. We cannot, of course, foresee exactly which jobs will go and which will stay. But one good bet is that many electronic service jobs will move offshore, whereas personal service jobs will not. Here are a few examples. Tax accounting is easily offshorable; onsite auditing is not. Computer programming is offshorable; computer repair is not. Architects could be endangered, but builders aren't. Were it not for stiff regulations, radiology would be offshorable; but pediatrics and geriatrics aren't. Lawyers who write contracts can do so at a distance and deliver them electronically; litigators who argue cases in court cannot.

But even if we do everything I've suggested -- which we won't -- American workers will still face a troublesome transition as tens of millions of old jobs are replaced by new ones. There will also be great political strains on the open trading system as millions of white-collar workers who thought their jobs were immune to foreign competition suddenly find that the game has changed -- and not to their liking.

That is why I am going public with my concerns now. If we economists stubbornly insist on chanting "Free trade is good for you" to people who know that it is not, we will quickly become irrelevant to the public debate. Compared with that, a little apostasy should be welcome.

Alan S. Blinder is a professor of economics at Princeton University, vice chairman of Promontory Interfinancial Network and vice chairman of the G7 Group.