The Guardian’s economics editor Larry Elliott writes here about the potential of Trump’s trade war to herald a return to the 1930s, a decade of rising protectionism and shrinking world trade.
He makes the important point that the EU and China run trade surpluses, and are therefore likely to suffer more than the US from tit-for-tat protectionist policies. However this does not mean that, to quote Mr Trump, trade wars are ‘good and easy to win’.
I have often written about the case for selective and temporary protection for infant industries in developing countries. For several decades after World War Two, the threat of the spread of communism gave the US, as global capitalist hegemon, a strong incentive to promote successful capitalist development across the world. Developing countries were therefore given policy space to promote their domestic industries, even as trade became more free in the rich world.
Today the World Trade Organisation and its rich member states are not so lenient. The latter have proved hypocritical when it comes to their own history of protectionist development. However there are other ways in which poor countries can nurture infant industries. In addition, the advent of complex global supply chains and the dominance of large multinational enterprises mean that the way in which late developers can integrate successfully into the world economy has become quite different in recent decades.
Trade theory and policy
The belief in free trade among orthodox economists nowadays is almost universal. Protectionist policies such as tariffs and quotas create static welfare losses, inefficiency in production, higher prices and lower consumption.
In less mainstream theories of international trade, protecting and promoting infant industries can work if it gives rise to processes of capabilities accumulation involving learning-by-doing during production in particular companies and sectors with the potential for rapid productivity growth.
The static welfare losses of orthodox theory may still be there, but they will be dominated in the medium term by dynamic improvements in productivity as rising investment embodying learning and technological development leads to increasing competitiveness and the ability to export onto the world market.
If global conditions are conducive to rising trade between nations (not always a given, as in the 1930s), this kind of strategic integration with an expanding world market offers the potential for more rapid growth. Orthodox theories of trade intervention tend to neglect the potential effect of protectionism on investment and growth in productivity.
A temporary period of protectionism may also reduce the adjustment costs in industries subject to economic shocks such as falls in market prices and demand, or sudden cost increases.
Industries with increasing returns to scale can also benefit, as a rising demand for their output can lead to lower average costs and increased competitiveness as domestic production is substituted for imports. This can potentially stimulate increased investment, further reducing costs in a virtuous circle of cumulative causation.
Back to the 1930s
The 1930s is generally remembered as a period of protectionism among the world’s rich countries, but the British economy actually performed well, especially when compared with the second half of the 1920s. In their book Protectionism and Economic Revival (1990), Michael Kitson and Solomos Solomou analyse the effects of the General Tariff of 1932 on British economic performance. They find that it led to a trend improvement in growth via import substitution and macroeconomic effects.
Britain had returned to the Gold Standard in 1925, so that the sterling exchange rate was fixed to a particular value of gold. However, as Keynes argued, this was at too high a rate, making exports uncompetitive and resulting in slow growth and high levels of unemployment.
The General Tariff largely benefited staple industries such as textiles which had been suffering from excess capacity and job losses as a consequence of the depression. The effect was to substitute domestic production for imports, boosting aggregate demand, employment and industrial productivity, leading to an improved trend growth performance.
Kitson and Solomou look at whether or not the improved performance was instead due to the devaluation of sterling and cuts in interest rates which followed Britain leaving the Gold Standard. Although these may have had some impact, they find that exports did not perform much better due to the trade barriers already in place in much of the rest of the capitalist world, as well as a rise in overall prices triggered by the devaluation.
It seems that the selective protection of particular industries producing in competition with imports had a greater effect than the more general impact of a weaker currency. The improvement in trade performance was mainly reflected in import substitution rather than export promotion.
The authors stress that even if the General Tariff did improve British economic performance in the 1930s, such a policy would not necessarily do so in all historical contexts. Initial conditions such as high unemployment and surplus capacity alongside rising global protectionism created potential for the policy to improve medium term performance.
A different world
In today’s world economy, with integrated supply chains, the increased importance of non-price factors in sales, specialisation and technology, protectionism may not be so effective, especially if it leads to retaliation.
For the British case in the 1930s, even if tariffs led to improved performance for a number of years, it is also possible that, by protecting declining industries, they prevented structural changes leading to the emergence of more advanced industries in the longer term. So shorter term economic and social benefits in terms of faster growth and reduced unemployment may be at the expense of longer term dynamism.
This is an important point to remember in today’s environment of, once more, rising pressures for protectionism. Countries with current account surpluses stand to lose more from a trade war involving significant retaliation, and the distribution of gains and losses will inevitably be uneven, both between and within countries.
In general, the focus for both poor and rich countries should be on promoting growth in productivity, alongside direct interventions to reduce poverty and inequality and manage structural change with active labour market policies.
Poorer nations should be given more policy space and allowed to integrate strategically with the world economy in a way that promotes the development that is so essential to poverty reduction. This idea is perhaps more controversial than it should be given the historical record.
If late developers benefit from such interventionist policies and can catch up somewhat with their rich neighbours, this will lead to a greater volume of global trade than if they had remained poor. Of course, it will also mean more competition for established companies in rich countries, a development which some of them may not like.
Policies that lead to shrinking world trade are a poor solution to the economic and social problems besetting today’s rich countries, even if historically they have worked at particular times and in particular contexts. International cooperation to reduce global imbalances between current account surplus and deficit countries would be part of a first best solution, but seems increasingly unlikely at the moment.