Friday, March 30, 2018

Vox Popoli: Mailvox: today is not the 1930s

MP explains why Smoot-Hawley is deemed to have been so important in the 1930s, and why tariffs cannot be a similar concern today even if we accept Jude Wanniski's original case for its connection to the Great Depression:
I was reading some of your earlier threads and I noticed you had questions as to how the Smoot-Hawley Tariff came to be associated with causing the Great Depression.

The idea was first proposed by Jude Wanniski in his book “The Way the World Works.” Specifically, it is in Chapter 7, “The Stock Market and the Wedge.”

 I recently read the first 10 chapters of Jude’s book and I can say it is excellent overall and well worth reading, but the conclusions are vastly different from the normal interpretations of Smoot-Hawley. Basically, Jude was tracking the reportage of the Smoot-Hawley legislation as it was winding its way through Congress. Every time the legislation experienced a setback, the stock market would rally. Every time it experienced a success, the stock market would decline. When Hoover finally signed the Smoot-Hawley tariff into law, the market took a massive dive. Thus, you have the evidence of the Smoot-Hawley tariff causing the Great Depression.

This is good as far as it goes, but it begs the question as to why the market was so concerned about the tariff to begin with. Was the market really worried about reciprocal tariffs or a decline in economic activity? It turns out that the evidence in Jude’s chapter points to a different reason:

The stock market was tracking the tariff legislation because it was worried about a bond market dislocation. This is my analysis piecing together the evidence presented in chapter 7 of Jude’s book.

 Basically, before WWI, America was the world’s biggest debtor nation, importing capital from all over the world to build and invest in the United States. During and after WWI, America became the world’s biggest creditor. Out of the national income of $30 billion, Woodrow Wilson lent $11 billion to England and France to fight WWI. After the war, America lent an additional $14.7 billion for private and public investment, a lending boom that continued to grow throughout the roaring 20’s. This means that during probably the biggest boomtime in US history up to the period, where the economy grew to $100 billion before the crash, the United States was accumulating a massive bond portfolio where a sizeable percentage of assets were concentrated in foreign bonds.

 Because the US was on a gold standard where $20 bought an ounce of gold, the only way for foreign entities to pay for their dollar-denominated debts was to sell to the United States, exchange goods for cash, and then meet the terms of their bond agreements. To guarantee that they could sell goods, gain cash and pay debts, European firms were dumping product in the United States.

The dumping was at first concentrated in the agricultural sector and it was wreaking havoc on farmers. Because farmers accounted for 25% of the population, they managed to push the Fordney-McCumber Act of 1922, a tariff of not only 34.8%, but with a Tariff Commission whose duty was to equalize production costs as a condition for any tariff removal. Yet, throughout the 1920’s, not only did the dumping continue, it moved upmarket. Wisconsin Senators, by the late 1920’s, were complaining about Belgian cement undercutting Wisconsin cement companies.

Jude’s book provides great insight into what was going on in the 1920’s American economy. Warren Harding ran on a campaign of “returning to normalcy” by repealing the high income taxes of the war years. This caused the US economy to boom. By 1925, the top marginal tax rate was reduced to 25% and the US economy was roaring along.

Unfortunately, the malfeasance of the Wilson administration led the United States to lend enormous amounts of money to the rest of the world, a practice that continued among private sector banks throughout the 1920’s. JP Morgan would lend money to Belgian cement makers that would then export government-subsidized cement to the US, sell it, and then service the bonds, which reflected in higher stock prices for JP Morgan and Belgian cement companies, but would wreak havoc on local businesses that then lobbied for tariff protection.  This process was repeated across hundreds of different industries.

The stock market was not worried that the drop in international trade would tank the US economy. International trade was small as a percentage of the US economy, roughly 4% total. But, that 4% of international trade was servicing the accumulated lending that amounted to anywhere from 30-50% of the value of the entire US economy. The tariff meant that firms would not be able to service the money lent to them by Americans and, thus, lead to massive bond defaults.

What happens to the value of company stock if the company defaults on its bonds? The stock goes to zero.

That is what the market was paying attention to and why it was reacting the way it did to the Smoot-Hawley tariff.

We can see why today tariffs will not have the same effect that they did in 1929: the US is not the world’s biggest creditor. Our debtor status means that we are not vulnerable to a bond-market dislocation. Other nations are. We can safely go back to raising tariffs and building the United States.

Of course, this also explains why creditor nations such as Germany and South Korea are so inordinately terrified of what are, in reality, very small and modest tariffs. It's not just their massive export sectors that are potentially at risk, but the huge financial Ponzi schemes that have been constructed on top of them. The various camels we call economies are overloaded with debt and there are an awful lot of things that look like straws these days.