Protectionism: who does it really protect?

The world financial downturn could see a drift towards economic nationalism

(Reuters)

Peter Holmes analyses whether the explosive 1930s mix of protectionism, extremism and conflict could happen again in today’s financial crisis

For many economists, the political nightmare of the 1930s was caused by a retreat into protectionism. This worsened the depression through falling trade, leading to massive unemployment and, ultimately, the rise of fascist aggression.

Links between the economics and the ensuing conflicts of the time have been made by economists and historians. Adam Tooze argued that Nazi expansionism had economic motives. Others suggest that the military conflict between the US and Japan was very much triggered by the US blockade of Japan.

The old adage ‘if goods don’t cross frontiers, soldiers will’ became a driving force in the creation of the GATT and the EU.

The old adage ‘if goods don’t cross frontiers, soldiers will’ became a driving force in the creation of the GATT and the EU. The latter started with the European Coal and Steel Community – established to jointly manage the resources that France and Germany had perennially fought over.

But sceptics, who nonetheless accept that economic causes fed instability, see protectionism as merely a secondary villain. In a recent lecture in London, the Nobel Prize winning economist Paul Krugman referred to the “Noble lie” that the depression of the 1930s was caused by protectionism. He claimed the crisis of the 1930s was caused by deflationary macro policies, and that the route out of the current crisis has to be through fiscal stimulus.

Wikipedia

Could trade protectionism bring about a 1930s style depression?

This is not to deny that the crisis will impact on trade in a big way. In fact the collapse in trade and production since 2007 has followe the pattern which occured from 1929 onwards. Nor can we deny that protectionism is a danger. But what is both reassuring and scary is how far trade has fallen without a massive recourse to protectionism.

The reassuring part is the newly launched Global Trade alert (http://www.globaltradealert.org) which lists fewer protectionist measures taken by trading nations than one might have feared.

The scary part however is how far and fast trade has fallen. China’s exports in May were 26% down on a year before. India’s exports were 30% down on the year before (though the rate of decline is easing off). So far most of the protection that has occurred has been within the rules, eg more or less WTO (World Trade Organisation) compatible contingent protection, keeping to the letter, if not the spirit of the WTO rule-book.

Krugman agreed with Peter Sutherland (former WTO Director General) that the case for free trade really depended as much as anything on the systemic and potentially security-related issues. The WTO system is the primary example of the rule of law in international relations. For it to be jeopardised would represent more than just a loss of the gains from economic specialisation.

By far the largest threat would clearly be in China. Unemployment was already heading for an all time high in January

The protectionist threat may threaten the emerging global rules-based regimes we are moving towards. But the collapse in trade itself poses great threats to stability and therefore, potentially to security.

By far the largest threat would clearly be in China. Unemployment was already heading for an all time high in January, and this year’s university graduates are reported to be having trouble finding jobs. China is still growing but needs to keep up more than 6% per annum GDP (gross domestic product) growth to avoid rising unemployment.

China has denounced protectionism and adopted expansionary fiscal policy. I heard one Chinese government adviser remark ‘We have all learned the lessons of the 1930s haven’t we?’.

Reuters

In China, unemployment is at an all time high, posing a potential threat to stability and security

But if the crisis spreads and leads to persistent social unrest, the Communist party will clearly come under pressure to adopt a hard line both to suppress dissent and to rethink its strategy of trade openness and the other economic liberalisation measures.

Whether China’s new financial strength will in any case set it on a collision course with the US is hard to tell. China seems to have little option but to hold on to its dollars, but if this leads to serious frustration there could be a political backlash. The Shanghai Cooperation Organisation linking Russia, China and Central Asia could have an important role, especially if Iran joins as planned.

Among the rest of the BRIC (Brazil, Russia, India and China) countries, the impact of the crisis is more complex. Brazil has a more conservative financial system and less exposure to international trade. But its industrial production fell sharply in late 2008.

Russia is affected by oil prices rather than the volume of industrial exports – and potentially by financial instability. The internal impact could have external consequences.

Despite India’s fall in exports, it is less financially exposed. But there could possibly be feedback from the crisis to India’s various separatist movements, leading to external instability. It seems less likely that this would be linked to protectionism.

Pakistan could be even more vulnerable. Its industry is feeling threatened by the prospect of a free trade agreement between the EU and India, and there could be direct political backlash if the EU is unable to respond to Pakistan’s wish for some sort of parallel market opening.

Other very vulnerable regions are in the southern Mediterranean. Algeria is in a similar position to Russia. Islamic fundamentalism can be fuelled by the existence of large numbers of unemployed young people, above all when the Islamic groups provide the only welfare services.

My reading of the situation is, following Paul Krugman, that the worst horror story scenarios look less likely than they did six months ago. Things may well be getting worse but the collapse is slowing down (for example, investment is reported to have risen in China in May).

Krugman also said that we may need more fiscal stimulus. If a successful macro policy can be found using existing instruments, we may be able to avoid the worst fiscal stimulus of all: rearmament. But it presently looks as if there will be pressure to reduce rather than increase military spending (at least in the West) when the worst is over.

Serious protectionism 1930s style would be a further twist of the knife economically and a fearsome danger politically

Economic instability has the potential to lead to increase economic nationalism and perhaps also political nationalism, with potential for conflict. At the time of writing protectionist noises are louder in the US than in the EU, but there is serious potential for political dissent. For the time being the rhetoric of cooperation is continuing.

This crisis may have disproportionate effects on developing countries and could further destabilise already unstable but strategically important countries, such as Pakistan. And the realignment of global economic power starkly revealed by the crisis surely has implications for the global strategic balance.

In sum, the crisis has great potential to generate internal political instability across the world. Trade is already hard hit. Serious protectionism 1930s style would be a further twist of the knife economically and a fearsome danger politically. But this can probably be held off, if (and it is a big if) the macro side of the crisis can be mastered.

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