Analysis: US should steer clear of protectionism

Three years into the financial crisis, one might think that the world could put Great Depression analogies behind it. But they are back, and with more force than ever - however, the fear now is that currency warfare, leading to tariffs and retaliation to tariffs, could cause disruptions to the international trading system as serious as those of the 1930s.

There is good reason to worry, for the experience of the 1930s suggests that exchange-rate disputes can be even more dangerous than deep slumps in terms of generating protectionist pressures.

But it was not those countries experiencing the worst economic downturns and the highest unemployment rates which raised tariffs and tightened quotas most dramatically in the 1930s.

The reason why countries hit hardest were not more inclined to protect industry from foreign competition is straightforward: the onset of the Great Depression saw a collapse of demand, which led to a sharp fall in imports. As a result, levels of import penetration fell in virtually every country.

The same thing happened this time: when the crisis went global in 2008-9, imports fell faster than output. With the decline in trade, foreign competition became less of a problem for import-sensitive sectors and as a result there was only limited resort to protectionism. The World Bank estimates that only 2 per cent of the decline in trade during the crisis was due to increased protectionism. In the 1930s, by contrast, about half of the decline in world trade was due to protectionism.

Why the difference today? The answer is currency disputes. In the 1930s, the countries that raised tariffs and tightened quotas the most were those with the least ability to manage their exchange rates - countries that remained on the gold standard. In 1931, after Britain and some two dozen other countries suspended gold convertibility and allowed their currencies to depreciate, countries that stuck to the gold standard found themselves in a deflationary vice. In a desperate effort to do something to defend their economies, they turned to protectionism.

But trade restrictions were a poor substitute for domestic reflationary measures and they did nothing to stabilise rickety banking systems. By contrast, countries that loosened monetary policies and reflated not only stabilised their financial systems more effectively and recovered faster, but also avoided the toxic protectionism of the day.

Today, the United States is in the position of the gold-standard countries in the 1930s: it can't unilaterally adjust the level of the dollar against the Chinese yuan; employment growth continues to disappoint, and fears of deflation will not go away.

So what can be done to address the situation without a retaliatory free-for-all? In the deflationary 1930s, the most important way that countries could subdue protectionist pressure was to use monetary policy actively to push up the price level and stimulate economic recovery. The same is true today.

The villain of the piece, then, is not China, but the US Federal Reserve Board, which has been reluctant to use all the tools at its disposal to vanquish deflation and jump-start employment growth. Doing so would help to relieve the pressure in Congress to blame someone - in this case China - for America's jobless recovery.

Of course, with China pegging the yuan to the dollar, the Fed would in effect also be reflating the Chinese economy. But this is within its capacity. China's economy is still a fraction of the size of America's, and the Fed's ability to expand its balance sheet is effectively unlimited.

China might not be happy with the result, as inflation there is already too high for comfort. Fortunately, the Chinese government has a ready solution: let its currency appreciate.

l Barry Eichengreen is professor of economics at the University of California, Berkeley