Is the world in a trade war?

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Protectionism has been the worst nightmare of policymakers since the earliest days of the financial crisis. It has become an article of faith among economists that protectionist policies during the 1930s exacerbated the Great Depression, and everyone knows full well that adopting similar practices today would have the same disastrous impact on the Great Recession. But we have to ask if the world’s leaders are repeating the same mistakes anyway. Guido Mantega, Brazil’s Finance Minister, thinks we are. In comments earlier this week, Mantega declared that the world is already involved in “a trade war and an exchange rate war,” which would force Brazil to take action to defend its own economic interests.

It’s hard to argue Mantega‘s wrong. Though there hasn’t yet been a single, sweeping event signaling a worldwide descent into protectionism — like the passage of the notorious Smoot-Hawley tariff of 1930 – there has been mounting evidence that policymakers around the world are increasingly flirting with beggar-thy-neighbor policies. When these dots are connected, they form an arrow pointing in a very dangerous direction for the entire world economy.

Just look at what’s happened over the past couple weeks. On Sept. 15, Japan intervened in currency markets for the first time in six years to depress the yen, hoping to make its exports more competitive in world markets. The move immediately sparked fears of “competitive devaluations” – the notion that country after country would respond by weakening their currencies as well in an effort to capture more of the world’s exports at the expense of competitors. In fact, we’ve already seen ample signs of just that type of mentality. The chief culprit is China, which refuses to allow the yuan to appreciate, thus protecting its own export industries while stifling others. The U.S., by pressuring China to allow the yuan to strengthen more quickly, is effectively pursuing the same agenda as Japan – attempting to depress the value of the dollar to support its own exports for its own recovery.

Similar danger signals are emerging on the trade front. The U.S. House of Representatives could vote as early as today on a bill that would allow the government to slap punitive duties on goods from countries that perpetually undervalue their currencies – in other words, China. On Sunday, China – perhaps as a warning to U.S. policymakers – imposed ridiculous tariffs on imported American poultry — as much as 105%!

No wonder Brazil’s Mantega is worried. If the three biggest economies in the world – the U.S., China and Japan – are fooling around with their currencies and imposing barriers to trade, how much more encouragement does everyone else need to join in? Mantega warned that in response Brazil could buy dollars to curtail the strengthening of its own currency and improve its antidumping laws to protect Brazilian industry from unfair competition.

To a certain extent, such behavior by the world’s policymakers is understandable. Political leaders everywhere are under pressure to create jobs and speed up the anemic recovery. With domestic demand weakened in most of the developed world, policymakers are naturally looking abroad to consumers in other countries to generate their recoveries, while simultaneously striving to protect as much employment at home as they can.

But what may seem logical or necessary for one government adds up to a global catastrophe. The problem is that once policymakers in one country take action to protect their economy, it forces politicians in other countries to follow. Then, the snowball rolling downhill turns into an avalanche. Moral indignation at the injustice perpetrated by others becomes contagious. And we have the 1930s all over again.

How likely is this scenario? There is some confidence that the world’s leaders still remember the disasters of the 1930s and in the end will avoid recreating them. In such an interconnected world, policymakers know that too many companies and too many jobs are dependent on trade and sales in foreign countries to risk shutting those opportunities off in tit-for-tat protectionist battles. We all know that protectionism doesn’t achieve its objectives; instead it costs jobs and hurts consumers. In other words, the world’s leaders will continue to play nice, and the fears of a 1930s rerun are overblown.

But others look at recent events and worry we’ve passed that point. Policymakers around the globe already seem willing to damage their own economies to satisfy political interests at home or stand up against the perceived unfair practices of trading partners. The Wall Street Journal, in an editorial, saw just that in China’s poultry tariffs. In hiking the tariffs, China is hurting its own people, by increasing the cost of food. But that didn’t stop Beijing, which, the Journal argues, would rather make a political point:

What’s really going on here is that Beijing is trying to send President Obama and Congress a message about trade policy…Other countries won’t keep their borders open to American products if Washington is simultaneously closing America’s own ports to foreign products…As for American lawmakers—and Mr. Obama—the chicken case is a warning. Merely because retaliation hurts China’s own economy doesn’t mean Beijing won’t give in to political pressures to respond to American protectionism. We’re blithely told that a full-scale trade war a la the 1930s can’t break out again because everyone knows better. But that’s what we were told about the other lessons of Depression economics, and our leaders have already remade nearly every one of those mistakes. In a game of trade chicken, everybody will lose.

The Journal predictably pinned the blame on the Obama administration, but that’s just the newspaper’s usual right-wing nonsense. The real source of the world’s tilt towards self-centered policies is China. Though, as I’ve written before, I think Washington overestimates the benefits the U.S. economy would gain from a stronger yuan, the fact is that the world overall would benefit greatly from a more market-based Chinese currency regime – including China itself. But China isn’t interested in such economic progress. It prefers to run giant current account surpluses and manipulate its currency for its own good, without regard for the impact on the rest of the world. In other words, China is mercantilist, and doesn’t feel the need to play by rules that don’t serve its interests.

How do the U.S. and the rest of the world confront that reality? Does China’s behavior make a trade war inevitable – even necessary? Robert J. Samuelson argued in The Washington Post that taking countermeasures against China is less dangerous than not doing so:

No one familiar with the Smoot-Hawley tariff of 1930 should relish the prospect of a trade war with China — but that seems to be where we’re headed and probably should be where we are headed. Although the Smoot-Hawley tariff did not cause the Great Depression, it contributed to its severity by provoking widespread retaliation. Confronting China’s export subsidies risks a similar tit-for-tat cycle at a time when the global economic recovery is weak. This is a risk, unfortunately, we need to take…China wants a trading system subordinated to its needs: ample export markets to support the jobs necessary to keep the Communist Party in power; captive sources for oil, foodstuffs and other essential raw materials; and technological superiority. Other countries win or lose depending on how well they serve China’s interests. The collision is between two concepts of the world order. As the old order’s main architect and guardian, the United States faces a dreadful choice: resist Chinese ambitions and risk a trade war in which everyone loses; or do nothing and let China remake the trading system. The first would be dangerous; the second, potentially disastrous.

But Samuelson’s course has one fatal flaw. Taking punitive action against China – such as the House currency bill is aiming to do – is unlikely to achieve the intended policy goal – making China more responsible and market-oriented. It’s much more likely – as shown by the poultry penalties — to make Beijing more defensive, less cooperative, and more stubborn in pursuing policies that hurt everyone. No country likes to be bullied into changing policies it considers central to its own interests, especially a very proud and powerful China. So we end up with a trade war that doesn’t get us the desired results.

So what is the solution? There is no easy one. What should be happening right now is a major global adjustment process. Those countries with giant surpluses (China) should be buying more from the world and saving less; those countries with deficits (the U.S.) should be selling more to the world and saving more. That would allow the entire global economy to find balance, thus supporting a healthy recovery from the Great Recession. And stemming the drift towards protectionism.

But, as Martin Wolf of The Financial Times points out, that grand adjustment isn’t being allowed to happen. China wants to keep its current account surplus and force others into deficit; the response from the U.S. and elsewhere is to try to create surpluses of their own. But not everybody can have a current account surplus. Not everyone can export out of crisis. So what’s happening is that those countries that aren’t fiddling with their currencies and trade laws (or aren’t capable of moving markets if they tried) are paying the price, by being pushed towards deficits they don’t want either. Those countries playing by the rules – like Brazil — are being pressured into breaking them.

What we need is a true global compact, aimed at getting rid of the world’s unstable imbalances in a sustainable, coordinated, cooperative way, one that allows the process of global adjustment to take place while minimizing the downside for all parties. The G20 has attempted to put such a framework in place, but it exits on paper only. We need to get from theoretical action to real action. But as Wolf worries, that’s far from easy:

What is needed is a route to these needed global adjustments. That will demand not just a will to co-operate that now seems sorely lacking, but greater imagination about both domestic and international reforms. I would like to be optimistic. But I am not: a world of beggar-my-neighbor policy is most unlikely to end well.

But that might be where we’re headed.

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