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Japan's intervention to drive down the yen is more dangerous than it looks--remember Smoot-Hawley and the Great Depression?
09/21/2010 8:30 am EST
In that month President Herbert Hoover, despite deep misgivings, signed the Tariff Act of 1930, known as the Smoot-Hawley Tariff after its two authors, into law. By raising U.S. tariffs, the act set in motion a competitive trade war that devastated the global economy and helped create the Great Depression.
Watching the unilateral decision by the Japanese to intervene in the currency markets to force down the price of the yen in order to protect Japanese exports, I’ve started to worry about a replay of that history. This time the starring role would go to competitive, beggar-your-neighbor currency interventions and not to any tariff.
But the effect could be the same: Each of the world’s governments acting to protect the interests of its own economy would kill off growth in the global economy.
It’s still just a worry mind you. And we won’t head down this path to lower economic growth unless Japan gives signs that it’s not content with a relatively small drop in the yen and Europe and China star to retaliate to protect their own exports. But the consequences would be so disastrous that I think it’s worth understanding how this yen intervention could trigger Smoot-Hawley II.
Let’s start with a little history. The main goal of the tariff was to protect U.S. jobs and farmers after the U.S. economy entered what would become the Great Depression after the 1929 stock market crash. The tariff, championed by Senator Reed Smoot (Rep. Utah) and Congressman Willis Hawley (Rep. Oregon), raised U.S. tariffs on over 20,000 imported goods. On some goods the increase took tariffs up to 60%. The overall effective tariff rate climbed to 19.8% in 1933 from 13.5% in 1929.
Economists debate exactly how important the tariff was in creating the Great Depression. Although the overall tariff levels were the second highest in U.S. history, the United States then, as now, wasn’t an export driven economy. In 1929 imports accounted for just 4.2% of U.S. GDP and exports only 5%. Economists such as Milton Friedman and Anna Schwartz have argued (see their 1963 book A Monetary History of the United States 1867-1960) that monetary policy was a far more important cause of the Great Depression than tariffs or other demand-side policies.
But Smoot-Hawley definitely set off a competitive global trade war that began even before the bill was actually law. By September 1929 the Hoover administration had received protests and threats of retaliation from 23 trading partners. Canada was the first to retaliate: in May 1930 the country raised tariffs on 30% of U.S. exports to Canada.
In the next few years from 1929-1933, as the Great Depression bit and as other countries raised tariffs to protect their own industries—or found alternatives to trading with the United States—U.S. exports would fall by 61%. U.S. imports fell even faster—by 66%. And total world trade collapsed, sinking by 66% from 1929 to 1934.
It’s the last part of this history that makes me worried about the global economy right now. Japan has moved to sell trillions of yen in an effort to drive down the price of its own currency against those of its major trading partners. The intervention is designed to aid Japan’s exporters who have been killed as the yen has climbed to 83 to the dollar before the intervention. The Japanese government has argued that it needed to intervene because other countries (China is the name that can’t be spoken) are manipulating their exchange rates to subsidize their own exporters.
I can certainly understand the temptation to intervene and protect Japanese exporters, and there is no doubt in my mind that China (and other countries) are keeping their currencies artificially cheap, but the argument that Japan needs to intervene in the currency markets because the yen is too strong simply doesn’t hold water. Once you correct for years and years of Japanese deflation, the real yen dollar exchange rate is pretty much where it has been for the last 25 years. Before the intervention the real yen dollar exchange rate index was 100.2. The average for 1986 through 2010 was 100 on that index.
What Japanese exporters are really protesting is the end of the super cheap yen of 2002-2007 that fueled the Japanese export-led recovery of those years. And what they’re looking for is a return to the good old days when (in 1995) Japanese exporters had 95% of the global DVD market, and 40% of the global market for memory chips. By 2006 the market share in those two categories had tumbled to 20% and 10%, respectively.
The real problem for the Japanese economy and Japanese exporters have steadily lost their competitive edge in the global economy.
And the real problem for the global economy is that the world’s great exporting economies—China, Germany, and Japan—as well as smaller exporting economies—remain dependent on exports to the world’s great importing economies (such as the United States.) For example, Japan has done relatively little (and I think I’m being kind here) to increase domestic consumer demand and has very successfully used tariff and non-tariff barriers to protect inefficient domestic sectors. And so has China, of course. The current dispute, now heading to the World Trade Organization, over a domestic Chinese credit card processor blocking its partner Visa (V) from processing credit card transactions in China is just the most recent high-profile example.
The danger in all this is that this model of 21st century mercantilism leads governments to the dangerous conclusion that the best way to grow is to protect your domestic market (read Spain and wool in the seventeenth century) and to export as much as you can to overseas customers. Just about anything that increases exports in that policy scenario is justified.
So faced with a cheap yuan, Japan intervenes to drive down the yen. The European Union protests mightily—even though it’s exports have had the advantage of a cheaper euro for the last six months or more. (And who says the Greek credit crisis doesn’t have an upside?) China, which has been under pressure to let the yuan rise against the U.S. dollar and other currencies, is at this moment, I’m sure, thinking about whether it can afford not to cheapen the yuan given the Japanese intervention.
So far, thanks mostly to the United States, the world hasn’t jumped whole hog into competitive currency interventions (or currency manipulations, if you’d prefer). The U.S. continues to push ahead with the idea of international coordination as the best way to guide a global economic recovery and to continue to press China to let the yuan appreciate more rapidly.
I think we’re balanced right now at a point where the situation could go either way. The U.S could manage to successfully hold the fort for international cooperation and coordination and pull the world back from the brink of Smoot-Hawley II. Or a policy of global coordination could get overwhelmed by a rush of individual nations to be the cheapest exporter in the world.
The path of Smoot-Hawley II has two really, really negative effects on the global economy.
First, it damps global growth. Remember that a cheaper yen or yuan or euro cuts the spending power of domestic consumers in Japan, China and the European Union. Since their currency is worth less, they can buy less—especially of imports. Corporate exporters may prosper but domestic consumers pay the bill—and so does the global economy.
Second, Smoot-Hawley II would put extreme pressure on current importing economies to grow exports and cut imports. It’s extremely difficult to turn a country without a strong export tradition into an exporting powerhouse but the easiest way to do it is to jump on the currency intervention band wagon and let your currency head for the basement.
That is, by the way, the easiest way to cut imports too. If your currency is worth less, domestic consumers can afford fewer imports. (Which of course just contributes to a Smoot-Hawley-like collapse in global trade.)
And what’s the easiest way for an importing country like the United States to send the dollar exchange rate down? Give up on any efforts at fiscal restraint, of course. No way easier to tank the dollar than to let inflation rise at the same time as the government ignores the budget deficit.
Once you head down the path, unfortunately, it’s very hard to control the fall in your currency or to get political leaders who have a bias toward deficit spending built into their DNA to reverse direction.
See why Smoot-Hawley II could get really nasty, really fast, and for a really long period?
Let’s just hope that it remains something that troubles my sleep at 2 a.m. and not something we have to live through.