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The Ghosts of Smoot and Hawley

Opening skirmishes of a new trade war?

Mar 9, 2009, Vol. 14, No. 24 • By IRWIN M. STELZER
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The ghosts of Republicans Reed Smoot and Willis C. Hawley are haunting the corridors of power. The Utah senator and the congressman from Oregon cosponsored the bill that raised tariffs on some 20,000 imported items--increases that came to a whopping 60 percent on some 3,200 items. Despite pleas from no fewer than 1,028 economists and Henry Ford, President Hoover signed the bill into law on June 17, 1930.

It worked, sort of. Merchandise imports fell by $1.738 billion in the next year and half. Unfortunately, our trading partners retaliated, and our merchandise exports fell by even more--by $2.232 billion. Whether these declines were due to the protectionist measures that spread around the world we will never know: After all, it is unreasonable to expect the volume of global trade to increase, or even be maintained, in the face of a worldwide economic collapse, even without new artificial barriers to trade.

The rest, as they say, is history. Well, not quite. It is fashionable to blame the prolongation of the Depression on this act of protectionism. But at the time exports accounted for only 5 percent of our GDP, and policy errors, there were plenty. The Federal Reserve Board was still to tighten the money supply, and Franklin Roosevelt would raise taxes and burden the economy with a host of regulations, including some that effectively imposed cartel-style restrictions on large segments of the economy.

Still, Smoot-Hawley to this day is widely cited as one of the major errors made during the Great Depression. Which is why the fear of a round of protectionism dominated conversations at the recent meeting of the world's movers and shakers in Davos, and why the leaders of the G20 nations, due to gather in London in April, will be seeking assurances from President Obama that his protectionist rhetoric has been shed like so much of what he now dismisses as campaign talk.

What has the leaders of the world unnerved is the "Buy American" provision of the stimulus package. It seemed obvious to many congressmen, especially Democrats beholden to the trade unions, that the stimulus money should be spent in America to create jobs for Americans. Besides, Obama had promised to toughen the provisions of the dozen bilateral trade agreements the Bush administration negotiated with several nations, to redo the North American Free Trade Agreement that President Clinton negotiated with Mexico and Canada, and to crack down on American corporations that export jobs.

Torn between promises to trade unions to rein in trade and a desire not to offend foreign leaders so early in his administration, the man whom Charles Krauthammer has called "The Great Equivocator" emulated FDR's vagueness. Obama refused to urge Congress to delete the clause that has set our trading partners' teeth on edge. Buy American remains. But a man who can one day sign a bill calling for $787 billion in stimulus spending, the next day commit a possible $275 billion to mortgage relief, and then convene a national conference on fiscal responsibility--followed almost instantly by a speech to Congress calling for massive spending on health care, education, and green energy, among other things--is not to be held to any standard of consistency, even the debased one applied to ordinary politicians.

So Obama followed support for Buy American with a television broadcast during his visit to Canada, one of our NAFTA partners. Seeming to repudiate Candidate Obama, President Obama told a Canadian television audience,

I think if you look at history, one of the most important things during a worldwide recession of the sort we're seeing now is that each country does not resort to "beggar thy neighbor" policies, protectionist policies, that can end up further contracting world trade. .  .  . We are going to abide by our World Trade Organization and NAFTA obligations just as we always have.

Turned free trader, Obama had inserted several escape clauses in the Buy American requirement. No action will be taken that conflicts with our obligations to the World Trade Organization (WTO) or with our trade agreements. Stimulus funds can be spent on foreign procurement when buying domestic products would be "inconsistent with the public interest," when homemade manufactured goods "are not produced in sufficient and reasonably available quantities and of a satisfactory quality," or when the costs of a project would be driven up by more than 25 percent. The result is a bill that allows the president to tell the unions that he is protecting American workers, while assuring world leaders that he will have no truck with protectionism.

We will know more when the administration moves from general statements to specific actions. WTO regulations contain their own escape clauses, which is why Chen Deming, China's minister of commerce, warns that "caution must be taken even in employing trade protection measures consistent with World Trade Organization rules." The first test of both Buy American loopholes and WTO rules will come when the steel industry files antidumping and other charges against Chinese and other steelmakers. Which it will. "There is no such thing as free trade. All trade is managed," Daniel DiMicco, head of steelmaker Nucor Corp., said to the Wall Street Journal. He might have had in mind India's decision to boost tariffs on steel imports.

As for NAFTA, it now seems that when Obama's economic adviser, Austan Goolsbee, quietly told the Canadians last February to stay calm, campaigning has little to do with governing, he had it right. Obama still wants to incorporate "fairer" provisions in a revised NAFTA agreement, and says he hopes Canadian and American economic teams can come up with environmental and labor-standard rules that "are not disruptive to the extraordinarily important trade relationships that exist between the United States and Canada." But not just now, when the world teeters on the brink of a depression. Which is fine with his protectionist supporters, so long as in the end he delivers on his promise. If he doesn't, "there will be a whole lot of really upset people," warned Lori Wallach, director of Public Citizen's Global Trade Watch division, in the Washington Post.

In sum, Obama is not the out-and-out protectionist he promised to be when wooing the Democratic left, and angry factory workers in Michigan, Indiana, Pennsylvania, and other states. But neither has he been persuaded that free trade is a principle around which he can build his policy. From a free trader's perspective, things are not as bad as it seemed they might be during the primary and presidential campaigns. But not-as-bad-as-it-might-have-been is not the same as a good trade policy. John McCain tried to have Buy American deleted from the bill, and with good reason: Our trading partners are taking that restriction, no matter how many escape clauses it now contains, as an excuse to retaliate.

It is also likely that governors will try to "buy local," and it will be almost impossible to prevent them from rigging their bidding processes to maximize the number of jobs created in their states, WTO or no WTO. The early phases of the spending will likely go to repair work (paint the bridges, fill the pot holes) rather than new infrastructure projects. These will be labor- rather than materials-intensive, so Buy American will not play much of a role. Where it will matter is with so-called "green investments" at the top of the Obama-Pelosi agenda. Most solar panels and wind turbines are manufactured overseas, and domestic manufacturers have full order books. The administration will have to decide whether it wants to place orders with overseas suppliers, who can get the stuff to us relatively quickly, or wait the several years it would take for domestic manufacturers to expand production capacity. My guess is that the impatient greens in the administration, who anyhow do not share Congress's protectionist proclivities, will opt for speed, and push for use of the not-available-in-America provisions of the stimulus act.

We will, of course, never really know whether such protectionist measures as the Obama administration might adopt have a significant effect on world trade, which is shrinking for the first time in more than 25 years as a natural result of the recession: The International Monetary Fund estimates that the volume of global trade will decline 2.8 percent this year, after expanding 4.1 percent last year, with the world's largest exporters, China and the United States, leading the declines. We will never be able to measure whether that shrinkage was due primarily to recession or to protectionist measures.

But we can make some qualitative judgments. Think of trade in three of its aspects--the movement of people, capital, and goods.

People: The falling costs of transportation, the increased availability of information about jobs, television programs revealing the disparity in living standards, the natural desire of people to better themselves, the availability of generous benefits in some countries--all of these have contributed to a worldwide movement of people from poorer to richer countries. Here, it has taken the form of an influx of Mexican and Central American workers, some legal, others not. The collapse of the construction industry, the rise in unemployment, and perhaps a bit of better control of our southern border have made the United States a less attractive destination. Indeed, many of these workers have given up looking for jobs, and are returning home. That is true, not only here but around the world. Polish laborers, who dominated the construction trades in Britain, are heading home in droves. Only the poorest of the poor, mostly Africans, or those intent on immigrating to do harm to their destination countries, remain on the move. In short, the movement of people, one of the important components of any free-trade regime, is slowing, and not because of new protectionist restrictions.

Capital: Then there is capital--the resource once controlled by banks, now largely in the hands of governments that have been compelled to bail out these institutions. "That a retrenchment in cross-border credit is under way is beyond doubt," reports the Economist. Some blatant protectionism is inevitable in a situation in which governments are providing banks with the wherewithal to make loans: Politicians want that capital to be made available to their constituents, not to some foreigner who can't vote for them.

Banks everywhere are shrinking their balance sheets. And since it is far easier to assess the creditworthiness of domestic borrowers than of those in distant lands, they are naturally inclined to give preference to the hometown boys. That is prudent lending, not protectionism. Still, protectionism is on the rise. Greek banks are not permitted to send bailout funds abroad; Holland's ING has promised to lend $32 billion to Dutch businesses and consumers in return for government help; Switzerland's new restrictions on leverage (the amount of lending relative to the bank's capital) exclude lending to Swiss firms from the calculation, creating an incentive to keep capital at home; other governments are letting it be known to banks seeking a handout that they don't expect the funds to leak out to other countries.

The net result of all of this might be some fragmentation of capital markets, with funds "trapped" in some countries that could efficiently be made available to foreign businesses. But only "might." It seems more rather than less likely that businesses will find their way through this newly grown thicket, perhaps by relying more on bond markets for borrowed funds than on banks--a trend that recent figures suggest might just be under way.

Besides, at least in America, the increasing involvement of government in the banking business, and the concomitant pressure on the banks to confine lending to domestic firms, might be a passing phenomenon. The banks have every incentive to get the government off their backs as soon as they are in a financial position to do so--no more government ownership, no more drain from payments on the preferred stock held by the government, less reason to listen to Barney Frank's views on the optimal allocation of capital, or confine lending to consumers willing to buy battery-powered Schumermobiles. And fewer direct constraints on executive compensation.

Goods: So much for labor and capital. The international movement of both of these resources will decline, partly in response to natural economic forces (the recession), partly in response to (im)moral suasion by governments, partly in response to out-and-out protectionism. Turn to goods--the T-shirts and sneakers in Wal-Mart, the flat-screen TVs at Best Buy, the solar panels and wind turbines, the steel for bridges--and the problem is more complicated.

America buys more from our trading partners than they buy from us. This has been true for decades. Forget for the moment whether running such deficits is a good or a bad thing--good, because we are taking advantage of the lower cost products available from abroad, or bad, because we are recklessly spending more than we earn abroad. The political consequence, especially now that we are in recession and jobs are disappearing by the hundreds of thousands every month, is a call for protection from more efficient foreign competitors. But protection from foreign competition is a policy that dare not speak its name--lest the ghosts of Smoot and Hawley be trundled out in response.

So we are asked by injured parties to stop the flow of goods produced by cheap foreign labor or using exploited child labor, or goods produced in factories that do not meet our health, safety, and environmental standards, or stuff that comes to us from the bad guys (think oil), or "currency manipulators" (think China). What's more, the argument that a government that can bail out feckless, greedy bankers certainly can find it in its heart and wallet to do something for autoworkers, steelworkers, and other Americans, resonates with bailout weary voters. No protectionism, just an insistence on "fair trade." No tariffs, just more vigorously applied antidumping regulations. No import restrictions, just a wink and a nod to governors that they would do well to use their stimulus-package billions to create jobs right here at home, and subsidies for import substitutes such as ethanol. No narrow protectionism, says Britain's home secretary, merely "greater support to domestic workers." And no pressure on U.S. companies to keep jobs at home, especially "good-paying" jobs, just an end to what the president calls "tax breaks for companies shipping jobs overseas." Language can indeed corrupt thought, as George Orwell pointed out, and the use of substitutes for "We want protection from competition" corrupts discussion of trade policy.

All of these euphemisms for protectionism have been around for a while, and none is as elastic, and therefore as lethal, as the call for "fair trade," a fact of which New York senator Chuck Schumer is well aware. All he wants is a fair deal from China, which he argues is manipulating its currency so as to keep its value low, thereby making its exports cheaper here, and our exports dearer in China. His solution: a 27.5 percent tariff on Chinese goods entering the United States, a figure half way between the 15 percent and 40 percent that experts estimate to be the yuan's undervaluation.

There is no question that the Chinese authorities manage--manipulate, if you prefer--the value of their currency. Dominique Strauss-Kahn, managing director of the International Monetary Fund (IMF), says that the yuan remains "significantly undervalued," and Eswar Prasad, formerly head of the IMF's China division, says it is "fundamentally misaligned," even though the yuan's value has risen in recent years by more than 20 percent against the dollar, 23 percent against the euro, and still more against the currencies of emerging nations.

Schumer is unimpressed, both with that fact and the more important consequences of a possible disruption of our economic relations with China. They send us goods, we send back bits of paper with pictures of presidents on it, they send back some of those dollars to pay for Treasury IOUs, thereby keeping interest rates here lower than they would otherwise be. The bad news is that those lower interest rates contributed to the boom in house prices and other asset values, and to profligate borrowing by businesses and consumers. The worse news is that if we choose to clamp down on that trade during a period in which recession is our biggest problem, China will cut its purchases of Treasury securities, interest rates will rise, and much of the benefit (if there is any--a point in dispute) of stimulus spending will be offset.

So far, that does not seem likely. Luo Ping, director-general of the China Banking Regulatory Commission, in a burst of candor, conceded that purchases of Treasury bonds are his country's only option. "Except for U.S. Treasuries, what can you hold? Gold? You don't hold Japanese government bonds or U.K. bonds. U.S. Treasuries are the safe haven. For everyone, including China, it is the only option."

So America is unlikely to get really nasty about China's currency policy, and China is unlikely to stop purchasing Treasuries, even if the dollar declines in value. With the U.S.-Chinese relationship stable, at least for now; Buy American watered down; natural forces causing a reduction in cross-border finance and job-seeking immigration; and the president in what appears to be a partial retreat from the protectionist rhetoric that served him so well in hard-hit manufacturing states, is free trade safe from its enemies?

No. Attacks on the free movement of capital, labor, and goods will appear in many guises. With more job cutbacks in the world's future, we can expect to see other nations imitate Nicolas Sarkozy's instructions to France's automakers--confine layoffs to overseas plants. With credit tight, we can expect to see other nations imitate Britain's Gordon Brown, and urge banks to give preference to domestic borrowers. With jobs scarce, we can expect to see more calls for restrictions on immigrant labor: Striking workers in Britain have forced contractors to limit the number of foreign workers and the prime minister to deny entry to workers from non-EU countries, and we have made it more difficult for companies that receive stimulus funds to obtain visas for skilled foreign workers. With many economies in free fall, we can expect other countries to emulate Russia, which is not a WTO member: "Putin visits a combine harvester factory and decides on the spot he'll raise tariffs. That's how it goes these days," complains one European Union trade official. To paraphrase Churchill, from Karachi in India to Quito in Ecuador, from Moscow in Russia to Paris in France, iron barriers to trade are descending around the world.

It is unrealistic to think that any administration, especially one as beholden to the trade unions as Obama's, or any Congress, especially one as beholden to the trade unions as Pelosi's, will not leap on such actions as an excuse to retaliate. "Free traders within the Obama administration will have to spend most of their time playing defence," worries the Financial Times. Which might not be a bad thing. Adam Smith, no protectionist he, argued in The Wealth of Nations, "There may be good policy in retaliations .  .  . when there is a probability they will procure the repeal of the high duties or prohibitions complained of." In short, when the threat of retaliation might force a trading partner to rescind a trade barrier, retaliation is acceptable.

That leaves Obama a free hand. He knows that it would be a bad idea to trigger a wave of protectionism by insisting on rigid enforcement of Buy American, or by making excessive use of loopholes in WTO regulations. He knows that he needs the Chinese to buy the billions of IOUs that the Treasury will issue to finance his stimulus, mortgage and bank bailout bills, as well as the parts of his longer-term domestic spending agenda that he rolled into the stimulus bill. He knows that much of the spending of stimulus funds will be done by the governors, some of whom will satisfy the trade unions, allowing him to keep his fingerprints off such protectionism as creeps into procurement. He knows, too, that the unions might grumble, but they won't revolt: After all, his recent executive orders more or less require contractors to hire union workers at union wages.

Finally, Obama knows that in the longer run he can insist that our trading partners conform to his notions of labor and environmental standards, which will appease his left and cut off some of the imports from poorer countries. Protectionism in green and seemingly humanitarian disguise. Bad for America, good for Obama. Odd, isn't it: Conservatives are now fighting to preserve the free trade that a Republican president abandoned in 1930, and Democrats, while fashioning themselves the second coming of Franklin Roosevelt, are fighting for the protectionism their hero opposed in his campaign against Herbert Hoover.

The fact is that an America in recession, with Democrats in control of the White House and Congress, is likely to produce a trade policy that periodically lurches towards protectionism but then pulls back from the brink of a trade war; threatens retaliation, but leaves that weapon safely in its holster in most cases; and tries to appease everyone with a say-one-thing-but-do-another series of actions. In the case of the latter, we have an ideal representative in Barack Obama. The world economy will be well served if he uses that talent to fend off pressures from his left for another "virtual declaration of economic war on the rest of the world," as Richard Hofstadter characterized the work of Messrs. Smoot and Hawley.

But in the long run it will take more than the president's ability to appease protectionists without doing serious harm to the world's trading system. Support for free trade has dwindled not only because the recession creates a shortage of jobs. It has dwindled because free trade creates losers as well as winners--cheap garments mean unemployed seamstresses in North Carolina. The losers are innocent bystanders, the victims of collateral damage. And their plight has not been effectively alleviated by the myriad job retraining programs on offer. Until we find some way of sharing the winners' gains with the losers, support for free trade will continue to atrophy. All suggestions welcome.

Irwin M. Stelzer, a contributing editor to THE WEEKLY STANDARD, is director of economic policy studies at the Hudson Institute and a columnist for the Sunday Times (London).