The Recipe for Another Depression

09/21/2010 9:32 am EST


Jim Jubak

Founder and Editor,

Just as the Smoot-Hawley Tariff of 1930 helped put us on a course toward the Great Depression, Japan's recent currency move could begin a downward spiral.

It's starting to feel a little bit like June 1930. And that's worrisome.

In that month, President Herbert Hoover, despite deep misgivings, signed into law the Tariff Act of 1930, better known as the Smoot-Hawley Tariff after its co-sponsors. By raising US tariffs, the act set in motion a 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 and protect Japanese exports, I've started to worry about a replay of that history.

This time the starring role would go to beggar-your-neighbor currency interventions and not to a tariff. But the effect could be the same: Each of the world's governments, in trying to protect the interests of its own economy, would help 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 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."

The Protection Racket

Let's start with a little history. The main goal of the 1930 tariff was to protect US jobs and farmers after the US economy entered what would become the Great Depression following the 1929 stock market crash. The tariff, championed by Senator Reed Smoot, R-Utah, and Representative Willis Hawley, R-Ore., raised US tariffs on more than 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 Depression. Although the overall tariff levels were the second-highest in US history, the United States then, as now, wasn't an export-driven economy. In 1929, imports accounted for just 4.2% of US gross domestic product 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 Depression than tariffs or other demand-side policies.

But Smoot-Hawley definitely set off a global trade war that began even before the bill became law. By September 1929, the Hoover administration had received protests and threats of retaliation from 23 US trading partners. Canada was the first to strike: In May 1930, it raised tariffs 30% on US exports to Canada.

From 1929 to 1933, as the Great Depression bit and other countries raised tariffs to protect their own industries—or found alternatives to trading with the United States—US exports fell 61%. US imports fell even faster, by 66%. World trade collapsed as well, sinking 66% from 1929 to 1934.

A Yen for Intervention

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 currency against those of its major trading partners. The intervention is designed to aid Japan's exporters, who were getting killed before the intervention as the yen climbed to 83 to the dollar. The Japanese government has argued that it needed to intervene because other countries (China is the name it won't say) are manipulating their exchange rates to subsidize their own exporters.

I can understand the temptation to intervene and protect Japanese exporters, and there is no doubt 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 doesn't hold water. Once you correct for years and years of Japanese deflation, the real yen-to-dollar exchange rate is pretty much where it has been for the past 25 years. Before the intervention, the real yen-dollar exchange rate index was at 100.2. The average for 1986 through 2010 was 100 on that index.

What Japanese exporters are really protesting is the end of the supercheap yen of 2002-07 that fueled Japan's 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, Japan's market share in those two categories had tumbled to 20% and 10%, respectively.

The real problem for the Japanese economy is that Japanese exporters have steadily lost their competitive edge in the global economy.

NEXT: Exporters Need Importers


Exporters Need Importers

And the real problem for the global economy is that the world's great exporting economies—China, Germany, and Japan—and 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 successfully used tariff and non-tariff barriers to protect inefficient domestic sectors.

So has China, of course. The most recent high-profile example: A dispute now heading to the World Trade Organization over a domestic Chinese credit card processor blocking its partner Visa (NYSE: V) from processing card transactions in China.

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 17th century—and to export as much as you can to overseas customers. Just about anything that increases exports is justified under that policy scenario.

So faced with a cheap yuan, Japan intervened to drive down the yen. The European Union protested mightily, even though its exports have had the advantage of a cheaper euro for the past six months or more. (Who says the Greek debt crisis hasn't have an upside for someone?)

China, which has been under pressure to let the yuan rise against the US 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 US 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 US could manage to hold the fort for international coordination and pull the world back from the brink of Smoot-Hawley II. Or a policy of global coordination could be overwhelmed by a rush of individual nations seeking to be the cheapest exporter in the world.

How an Export War Would Hurt

The path of Smoot-Hawley II would have two really, really negative effects on the global economy.

First, it would damp global growth. A cheaper yen or yuan or euro would cut the spending power of consumers in Japan or China or the European Union. Corporate exporters might prosper, but domestic consumers would pay the bill—and so would the global economy.

Second, Smoot-Hawley II would put extreme pressure on today's 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 is to jump on the currency-intervention bandwagon and let your currency head for the basement.

That is, by the way, the easiest way to cut imports, too. If a country's currency is worth less, domestic consumers can afford fewer imports (which, of course, could contribute to a Smoot-Hawley-like collapse in global trade).

And what's the easiest way for an importing country like the US to send the dollar exchange rate down? Give up on any efforts at fiscal restraint, of course. There's no way easier to tank the dollar than to let inflation rise at the same time that 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 hope it remains just something that troubles my sleep at 2 am and not something we have to live through.

At the time of publication, Jim Jubak did not own shares of any company mentioned in this column in his personal portfolio.

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Jim Jubak has been writing "Jubak's Journal" and tracking the performance of his market-beating Jubak's Picks portfolio since 1997 on MSN Money. He is the author of a new book, The Jubak Picks, and he writes the Jubak Picks blog. He is also the senior markets editor at

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