Protectionism by Another Name?

One thing you can probably get 99% of economists to agree on is that a global trade war in the middle of a global recession is a bad idea. If every country increases import tariffs, hoping to protect its domestic industry from foreign competition, global trade will fall in all directions, hurting everybody. Put another way, increased tariffs are a negative-sum game.To date, we haven’t seen much in the way of higher trade barriers during this crisis, although you could argue that some bailouts constitute subsidies favoring local over foreign companies. Instead, however, we are seeing friction over currency valuations. If you want to boost your net exports but don’t want to do the obviously unfriendly thing and increase tariffs, the other option is to devalue your currency: a weaker currency increases the price of imported goods and reduces the price of exported goods, hence reducing imports and increasing exports.

Yesterday, Tim Geithner accused China of “manipulating its currency,” something we’ve heard periodically over the last several years but not in much in the last few months. (Of course, Geithner then said that “a strong dollar is in America’s national interest,” whatever that means.)  Switzerland threatened to intervene on foreign exchange markets to suppress the value of the Swiss franc. And the French finance minister criticized the U.K. for letting the pound depreciate. (Hat tip Macro Man for the last two.)

Theoretically, devaluing your currency is not as bad as import tariffs. If every country tries to devalue its currency at the same time, exchange rates will remain the same; this is a zero-sum game in that sense. It’s a little more complicated, because there are at least two ways of devaluing your currency. One is for the central government to sell its own currency and buy everyone else’s currency on the foreign exchange market. The other, however, is to run an expansionary monetary policy (lower interest rates, more money creation, etc.), which is inflationary. So one possible outcome is that every country runs an expansionary monetary policy, exchange rates remain the same, but commodity prices go up because there is more money floating around. In today’s environment of low or negative inflation expectations, however, that might not be such a terrible thing.

But the other side of competitive currency devaluations is that not all countries are equally well armed. In particular, countries that use the euro cannot devalue their currencies, because they don’t control their monetary policy and they don’t have the scale to intervene significantly on the market for euros. In short, other countries can devalue their currencies at the expense of Eurozone members. This is one of the reasons why, as we (and Martin Feldstein) have warned, the economic crisis will increase tensions within the Eurozone. The New York Times just ran an article on this exact topic:

Germany, France and the Scandinavian countries are mounting billion-dollar stimulus plans and erecting fences to protect their banks. But the peripheral economies are being left to twist in the market winds.

This is a good indicator that fears about the Eurozone are going mainstream.


Originally published at the Baseline Scenario and reproduced here with the author’s permission.

2 Responses to "Protectionism by Another Name?"

  1. Bernard Gress   January 25, 2009 at 10:23 am

    The reason “99%” of economists agree that a global trade war is bad is that during the depression one policy that was pursued was to put tariffs on foreign goods, which resulted in everyone else also cutting imports, resulting in a further collapse in demand. The difference, however, is that at that time America had a trade surplus with the rest of the world. Now we have a trade deficit with everyone, especially China. This is because China, and pretty much everyone else too, is pursuing mercantilist policies against us. They have no interest in the common good, only in their own. They declared trade wars on us about 30 years ago. If we cut back our imports from them, they will not respond by cutting imports from us because they can’t. Our exports to them are things they either have to have, i.e. food, or things they are desperate to finish stealing, i.e. high technology. So Kwak’s arguments are specious.

  2. Anonymous   January 25, 2009 at 7:07 pm

    Too right Bernard – China has to let their currency appreciate and their citizens get richer and consume more – it’s not the rest of the world’s fault that they have very poor citizens, haven’t empowered their people and quite frankly have too many people and exploit / dominate human rights – even when they were getting richer they didn’t let enough go to their citizens because of their need for ultimate power and control at the top.