During the winter of 2008-2009, the world economy contracted at rates that had not been seen since the Great Depression.
Figure 1 plots world industrial output during the two crises, measured from the peaks in world output, which occurred in June 1929 and April 2008.
Figure 1 World industrial output, now vs. then
Source: Eichengreen and O'Rourke (2009), updated with data graciously provided by the IMF.
During the first twelve months of our own “Great Credit Crisis,” global industrial output fell at about the same rate as was experienced during the first twelve months of the Great Depression. Since the late spring of 2009, however, there has been an impressive recovery, thanks to the unprecedented actions of finance ministries and central banks.
Figure 2 World stock markets, now vs then.
Source: Eichengreen and O'Rourke (2009), based on data from Global Financial Database.
As Figure 2 shows, the recovery in world equity markets has been even more impressive, to the point where concerns are now being raised about a potential new bubble. The question now is to what extent these recoveries in global economic activity and asset markets will be sustainable, given their dependence to date on government stimulus.
The great trade collapse
The most notable feature of the Great Credit Crisis, however, has been the collapse in international trade. As Figure 3 shows, trade fell much more steeply after April 2008 than it did in the year after June 1929, and the recovery to date has been relatively anaemic. World trade fell in August 2009, following three successive months of growth, and still remains 18% below peak. By contrast, trade fell in three successive years during the Great Depression.
Figure 3 The volume of world trade, now vs then.
Sources: Eichengreen and O'Rourke (2009), updated with data from the CPB’s database at www.cpb.nl.
What explains the length and depth of the trade slump experienced after 1929, and what are the crucial lessons that policymakers should draw from that experience? This chapter briefly surveys the literature on the relationship between trade and economic policy during the Great Depression, drawing some conclusions for our own period.
Trade’s collapse: Lessons from the 1930s
To begin with the beginning, consider the causes of the Great Depression. At the time of the Depression itself, observers such as Keynes put the blame squarely on excessively tight monetary policy. The US Federal Reserve started tightening in 1928 in an attempt to halt runaway stock markets, and this lowered investment and aggregate demand. This contractionary impulse was then spread internationally, as other countries were forced to follow suit because of their commitment to the gold standard.
It is important to stress that this monetary interpretation of the Depression is not just Keynesian, since it was given a major intellectual boost by Milton Friedman and Anna Schwartz, writing about the US experience in the 1960s (Friedman and Schwartz 1963). More recent scholarship (e.g. Temin 1989, Eichengreen 1992) has retained the monetary interpretation of the Great Depression, but moved from a purely American to a worldwide perspective.
Eichengreen (1992) and Temin (1989) both agree with Friedman-Schwarz that the Great Depression was largely a monetary phenomenon, but they regard it as an international phenomenon rather than a primarily American one, and as being due to a variety of structural factors, notably the gold standard, rather than to isolated policy mistakes. This interpretation is largely accepted by authors such as Bernanke (2000), whose analysis is essentially complementary to that of Eichengreen and Temin, providing evidence of additional channels through which contractionary monetary policy depressed the economy.
The gold standard spread the initial contractionary impulse and it implied that policy makers were unable to combat the Depression effectively. They could not lower interest rates when this was required in order to combat unemployment, since this would have led to their currencies depreciating. Furthermore, expansionary fiscal policies were also regarded as dangerous, since by increasing imports they threatened to lead to a drain in foreign reserves, which was again incompatible with countries’ gold standard commitments.
The consequences of adherence to gold could be clearly seen in 1931, when several countries raised interest rates as their currencies were attacked, thus prolonging the Depression. It was only when countries left the gold standard that they were able to adopt appropriate monetary policies, and started to recover. Britain did this in 1931, the US in 1933. A small ‘gold bloc’ centred on France resisted until 1936, and experienced the longest Depression of all.
Under the circumstances, it is hardly surprising that countries resorted to wholesale protectionism. With export markets gone in any event – because of falling demand and protectionism elsewhere – the perceived opportunity costs of protecting one’s home market seemed much smaller than usual. In recent work, Eichengreen and Irwin (2009) have shown that it was those countries who stuck to gold the longest who ended up protecting the most. Faced with overvalued currencies and contracting economies, and bereft of other policy options, they imposed higher tariffs, and tighter non-tariff barriers to trade. Countries which abandoned the gold standard and allowed their currencies to depreciate used monetary policy to reflate their economies rather than protection.
Flawed macroeconomic policies, therefore, can explain both the extent of the Great Depression, and the shift to protectionism. But what was the impact of protectionism on the interwar economy, and in particular on the extent of world trade?
Consistent with its emphasis on monetary policy mistakes, the existing literature has not been kind to the argument that the Smoot-Hawley tariff created the Great Depression. Indeed, the extent of falling income and output during the period was so great that Smoot-Hawley was not even a major factor underlying the trade collapse of the time. For example, Irwin (1998) finds that even in the absence of any change in tariff rates (but accounting for the income declines of the period), US imports would have declined by 32% between 1930:II and 1932:III, as compared with the 41% reduction that actually took place. Even in the absence of the Smoot-Hawley revisions to tariff schedules (but accounting for the impact of income declines, and of deflation on average tariff levels), US imports would have fallen by 38% over the period, or by almost as much as actually occurred. Trade declines were primarily due to falling income, with deflation also playing an important role; Smoot-Hawley tariffs were a bit-player in the trade collapse.
All of this is consistent with the experience of the Great Credit Crisis. The collapse in world trade has occurred without a wholesale outbreak of protectionism. Falling output, rather than rising barriers to trade, seems to have been the main culprit on this occasion as well.
What about the impact of protectionism on GDP? Once again, the existing literature has tended to find that tariffs in the 1930s were not such a big deal, in the context of the general collapse of the period. In some peripheral countries, such as Ireland, protection may even have had some beneficial effects in the short run, giving rise to a burst of import substitution which created jobs at a time of mass unemployment and limited opportunities abroad.
The real impact of interwar protectionism
However, none of this should be taken to imply that interwar protectionism was a benign phenomenon. It was not.
As a beggar-thy-neighbour policy, any short-term gains achieved by one country were at the expense of others. More seriously, protection created new political constituencies opposed to free trade who, in many cases, were able to successfully lobby for a continuation of protection after the crisis was over. Ireland remained inward-looking through the 1950s with disastrous effects on growth and employment. In other regions of the world, such as Latin America, the protectionist legacies of the Great Depression can still be discerned as late as the 1970s.
Even worse were the geopolitical consequences of protectionism. These helped to fuel the international tensions of the period. For example, in Japan the Smoot-Hawley tariff and British imperial protectionism helped to undermine the political position of the more liberal elements, and strengthened the hand of those who claimed that imperialism, rather than trade, was the right way to ensure adequate supplies of primary products.
Today’s crisis and international politics
Thus far, the impact of the Great Credit Crisis on the international political system has probably on balance been positive. The impetus which it has given to the rise of the G20, at the expense of the G7, has been an especially welcome development, at the start of a century in which the world will have to face the twin challenges of climate change and a rapidly shifting geopolitical equilibrium. An outbreak of trade tensions would undo a lot of these achievements, and make the world a riskier place.
The lesson of the interwar period is that if we want to avoid such a scenario, we need to avoid two things:
- The first is a slump which continues into 2010 or 2011.
Human systems are resilient, and can surmount crises of only one year's duration with relative ease. It is when these crises continue for several years that radical change occurs. It was only in 1931 that the British abandoned free trade, a decision which gave rise to a wave of tit-for-tat retaliation elsewhere. It was only in 1932 that the Nazis became the biggest party in Germany. Our present world economic system, with its generally liberal orientation, will presumably survive relatively unscathed if the present recovery proves durable. A double-dip recession, however, would have unpredictable consequences. Policymakers have a responsibility to minimise the possibility of such an eventuality, for example, by not withdrawing stimulus too early.
- The second thing we need to avoid is severe exchange rate misalignments, at a time of rising unemployment.
The evidence in Eichengreen and Irwin (2009) shows clearly that exchange-rate overvaluation and protectionism went hand in hand during the interwar period. The issue of the renminbi peg to the dollar is one that needs to be confronted sooner rather than later, for everyone's sake.
Bernanke, B.S. (2000). Essays on the Great Depression. Princeton: Princeton University Press.
Eichengreen, B. (1989). The Political Economy of the Smoot-Hawley Tariff, Research in Economic History 12: 1-43.
Eichengreen, B. (1992). Golden Fetters: The Gold Standard and the Great Depression 1919-1939. Oxford: Oxford University Press.
Eichengreen, B. and D.A. Irwin (2009). The Protectionist Temptation: Lessons from the Great Depression for Today. VoxEU.org
Eichengreen, B. and K.H. O’Rourke. (2009). A Tale of Two Depressions.
Friedman, M. and A.J. Schwartz. (1963). A Monetary History of the US, 1867-1960. Princeton: Princeton University Press.
Irwin, D.A. (1998). The Smoot-Hawley Tariff: A Quantitative Assessment. Review of Economics and Statistics 80: 326-334.
Temin, P. (1989). Lessons from the Great Depression. Cambridge MA: MIT Press.