Tariffs and Monetary Policy: A Toxic Mix

Michael D. Bordo and Mickey D. Levy

Shadow Open Market Committee

Princeton Club, New York City, New York

September 27, 2019

*Bordo is Distinguished Professor at Rutgers University and Distinguished Visiting Scholar at the Hoover

Institution; Levy is Chief Economist for the Americas and Asia at Berenberg Capital Markets. Both are

members of the Shadow Open Market Committee.

Tariffs and Monetary Policy: A Toxic Mix

Michael D. Bordo and Mickey D. Levy*

Shadow Open Market Committee

September 27, 2019

The ratcheting up of tariffs and the Fed’s discretionary conduct of monetary policy are a toxic mix for

economic performance. Escalating tariffs and President Trump’s erratic and unpredictable trade policy

and threats are harming global economic performance, distorting monetary policy and undermining the

Fed’s credibility and independence.

President Trump’s objectives to force China to open access to its markets for international trade, reduce

capital controls, modify unfair treatment of intellectual property, and address cybersecurity issues and

other US national security issues are important and laudable goals with sizable benefits. However, the

costs of escalating tariffs are mounting, and the tactic of relying exclusively on barriers to trade and

protectionism is misguided and potentially dangerous.

The economic costs to the US so far have been relatively modest, dampening industrial

production and business investment. However, the tariffs and policy uncertainties have had a

significantly larger impact on China, accentuating its structural economic slowdown, and other nations

that have significant exposure to international trade and investment overseas, particularly Japan, South

Korea and Germany. As a result, global trade volumes and industrial production are falling. Weaker

global growth is now reducing the demand for US goods and slowing gains in US employment.

The Fed has achieved its dual mandate, but it has resumed monetary easing, cutting its policy rate in

response to perceived downside risks associated with trade policy uncertainties. Combined with

President Trump’s inappropriate public pressure on the Fed to cut rates, the Fed’s heightened focus on

uncertainties and diminished reliance on data dependence increases the risks of a policy mistake that

may undercut its public credibility and independence. The July rate reduction will have little if any

impact in offsetting the negative shock of tariffs on investment and productive capacity, but by reducing

the buffer from the zero lower bound (ZLB), it reduces the Fed’s flexibility to implement effective

countercyclical policy in response to a future economic downturn.

The history of tariffs and the ebbs and flows of globalization provide critical lessons and caution about

the significant downside risks of the current thrust of US trade policies. The recent era of

globalization may have already begun to fade, and the current re-emergence of tariffs-the US is

certainly leading, but not the only nation imposing tariffs-is accentuating this drift toward protectionism.

In the face of an escalation of trade barriers, the Fed must continue to pursue its dual mandate but not

extend monetary policy beyond its capabilities. The Fed should make clear that escalating trade barriers

and policy uncertainties that impose supply constraints on productive capacity and distort global

distribution channels are beyond the scope of monetary policy to remedy. It must also emphasize the

importance of it being independent to conduct policy without political interference or pressure. It

should rebuff inappropriate pressures from the Administration while maintaining its politically neutral

stance.

Escalating Tariffs and Their Economic Costs

While campaigning for the US presidency, Donald Trump railed against the current world trade order

and touted “America First” with a tilt toward protectionism. These two themes have become a reality,

as disruptions to existing trade agreements and a wave of escalating tariffs, particularly aimed at China,

have dominated the environment. In 2017, President Trump’s primary policy thrusts were aimed at

easing burdensome regulations and tax cuts and reform. Economic performance improved decidedly.

Beginning in late 2017, Trump began ramping up tariffs. Most of the tariffs have been imposed without

explicit approval of Congress, based on the Administration’s interpretation of existing legislation that

either protects industries from imports or addresses foreign trade behavior (particularly of China) that is

perceived to be unfair, threatens national security or is considered a national emergency.

Trump’s trade policy initiatives have been driven by a combination of beliefs. Trump dislikes bilateral

trade deficits, despite the fallacy that bilateral trade deficits impose economic costs, and tilts toward

mercantilism. Trump distrusts China—its ideology, its policies and strengthened economic position and

its threat to US supremacy and security. Anecdotal evidence of China’s theft of US intellectual property

is abundant. Trump distrusts globalism and the established governmental channels for conducting

diplomacy, and favors rough and tumble one-on-one negotiating.

A chronology of Trump’s trade policies-the tariffs and other barriers to trade, administrative rationale,

and threats-highlights the clear escalation and broadening use of tariffs and foreign retaliation--

beginning with solar panels and washing machines (January 2018); steel and aluminum (March 2018);

China (March 2018 to present); and automobiles (Chudik 2019 and Fajgelbaum, Goldberg, Kennedy and

Khandelwal 2019). To date, tariffs have been increased on an estimated $283 billion of imports,

primarily imports from China, but also imports from Japan, South Korea, Canada and Mexico. Trading

partners have retaliated with $121 billion of tariffs on goods and services imported from the US (Amiti,

Redding and Weinstein 2019). These imposed tariffs have been interspersed with threats of more tariffs

and disruptions, back peddling and adjustments that have heightened uncertainty about future trade

policies (Bown and Irwin 2019).

Several of President Trump’s public statements stand out as profound. In March 2018, immediately

after imposing tariffs on aluminum and steel imports, Trump stated “trade wars are good, and easy to

win”. The subsequent escalation of tariffs seems to reflect a miscalculation that China would be more

willing to negotiate than has actually been the case. While the US negotiations with China have gone far

beyond trade to include issues of treatment of intellectual property, cyber security, cross-border

investment and financial policies, and national security issues, Trump’s December 2018 statement “I am

a tariff man” highlights his preference for imposing tariffs, despite their economic costs. Like many

historic diplomatic skirmishes, this one has escalated, and both parties face difficult issues. China’s

potential economic growth is slowing independently of the tariffs and dragging down global economies,

and its leaders face many economic, financial and non-economic issues that complicate the path to

resolution. Until a US-China agreement on trade policies is reached, economic performance will suffer.

To date the negative effects on the US economy have been moderate, but more pronounced on global

performance. The negative effects of policy-related uncertainties on trade, industrial production and

investment have been as large if not larger than the direct impacts of the tariffs. This is most apparent

in declining global trade volumes and industrial production, disruptions to global supply chains, loss in

business confidence and widespread anecdotal evidence (Chart 1).

Estimates of the impact of the tariffs vary widely, but are negative and sizable. Conventional trade

models find that tariffs have increased the costs of US imported goods, imposing burdens on US

manufacturers and their production chains, and raising costs to consumers. Amiti, Redding and

Weinstein (2019) estimate the tariffs have increased the cost of US manufacturing by 1 percent, and are

forcing a reorganization of global supply chains. A model that estimates the impacts on targeted import

and export varieties finds large impacts of tariffs on reducing import volumes and complete pass-

through to prices paid by US importers and sizable reduction in US exports (Fajgelbaum, et al 2019).

They estimate the net impact on US GDP is 0.4 percent. A sustained drag on business investment

reduces the capital stock and lowers productive capacity and potential growth.

The heightened uncertainty related to economic policy weighs heavily in business decisions and

economic performance. We note that the economic policy uncertainty index developed by Baker, Davis

and Bloom (2016) has a simple 49 percent correlation with US business investment (Chart 2). The

softening of global trade volumes and business activity since 2018 is not surprising in light of the spike in

the economic policy uncertainty measure that mirrors the erratic ramping up of tariffs.

More rigorous empirical research based on different measures of policy uncertainty estimate large

impacts on business activity. Based on a World Trade Uncertainty (WTU) Index derived from the

Economist Intelligence Unit (EIU) country reports, Ahir, Bloom and Furceri (2019) estimate that the

jump in their WTU index beginning in 2017 through Q12019 reduces global growth by up to 0.75

percentage points in 2019. Based on a measure of trade uncertainty aggregated over the EU, US, China

and UK based on text-mining techniques, Ebeke and Siminitz (2018) estimate that the investment-to

GDP ratio in the EuroArea is on average 0.75 percentage points lower for five quarters following a one-

standard deviation increase in the level of trade uncertainty. They find that the negative impacts of

policy uncertainty are much larger for nations that rely more heavily on tradeable goods.

In a recently released (August 2019) study, researchers at the Federal Reserve Board develop different

measures of trade policy uncertainty-one on a firm level and two aggregate indicators based on the US

economy using newspaper coverage and data volatility on import tariffs-and test for their impacts on

investment (Caldara, Iacoviello, Molligo, Prestipino and Raffo 2019). They estimate that the rise in trade

policy uncertainty in 2017 and 2018 predicts a decline in aggregate investment of between 1 and 2

percent. This internal Fed research study has contributed to the Fed’s heightened concerns about trade

policy uncertainties.

Recent US and global economic data trends reflect the negative impact of tariffs and policy

uncertainties, and nations with larger trade exposure have been hit hard. US real exports, which had

grown at a 4 percent average annual rate in the two years ending in 2Q2018, have fallen 1.7 percent in

the last year. Industrial production, following a sizable increase in 2017 and early 2018, flattened and

has fallen 1.3 percent since late 2018. Business fixed investment growth has slowed dramatically, from

a 5.6 percent pace in the two years ending Q2 2018 to 2.6 percent in the last year—and it fell in Q2

2019 and recent declines in durable goods shipments point to another decline in Q3 2019 Other factors

may be at play, but the negative impacts of the tariffs and related uncertainties on exports, industrial

production, business investment and confidence have offset the positive impulses of the Trump

Administration’s deregulatory and tax reform initiatives.

Global trade volumes have declined 1.4 percent year-over-year, a marked reversal from its strong gains

that averaged over 4 percent annually before tariffs were ramped up in mid-2018. Global industrial

production is declining, with pronounced declines among China’s largest trading partners that rely on

manufacturing exports. Production is down 1.1 percent year-over-year in Japan, -0.4 percent in South

Korea and -4.6 percent in Germany. This is generating declines in productivity that have begun to spill

into domestic economic activity. China’s growth has clearly softened, and various measures suggest

that its official data overstate actual economic performance. Along with China’s natural deceleration of

its potential growth, the US tariffs and other trade barriers have adversely affected its high-powered

export-related manufacturing sector. In the year ending July 2019, exports have fallen 0.9 percent while

imports have declined 3.1 percent, compared to their annualized increases of 7.4 percent and 16

percent increases, respectively, in the two prior years. Industrial production has slowed to 4.4 percent

year-over-year, its slowest since early 2009 during the financial crisis and deep global recession.

The longer the tariffs are in place and the longer trade policy uncertainty persists, the larger the

cumulative economic impacts will be (Handley and Limoa 2017). Suppressing business investment will

have a cumulative negative impact on the stock of capital, which if sustained, would depress productive

capacity and longer-run economic performance. The interconnectedness of global supply chains and the

international flow of human capital and ideas presumably increase the economic costs of erratic and

unpredictable trade policies.

The Trump Administration’s goals for China extend well beyond opening up China’s markets, and

include preventing China’s unfair treatment of intellectual property, investment practices that violate

standard global practices and cybersecurity violations. Accomplishing these goals would provide

significant longer-run benefits. But relying exclusively on escalating tariffs and threats of higher trade

barriers as levers to achieve these objectives is inappropriate and costly for economic performance.

Tariffs and Monetary Policy

Tariffs and trade policy uncertainties add several dimensions of difficulty to the Fed’s conduct of

monetary policy. The Fed has achieved its dual mandate, with inflation slightly below the Fed’s 2

percent target, strong labor markets and the unemployment rate at a 50-year low. Where does trade

policy fit into the mix? The Fed’s discretionary approach to conducting monetary policy has lead it to

respond to the actual and anticipated effects of tariffs on US and global economic conditions, inflation

and the US dollar.

Chairman Powell has made it clear that the Fed places a very high priority on avoiding a recession, so

that as long as inflation remains below 2 percent, the Fed will tilt monetary policy against downside

economic risks. The heightened policy uncertainties have led the Fed to put more weight on downside

risks around its economic forecasts and temporarily abandon its “data dependent” conduct of monetary

policy. It has also put the Fed into the position of basing its policy on speculation about trade policy

outcomes and their economic implications.

The Fed cut rates in both July and September, even though the actual data clearly indicated that the

economy is growing in line with the Fed’s forecast (and along the Fed’s estimate of its potential path)

and the Fed characterized labor markets as being strong. Powell emphasized these uncertainties at his

Jackson Hole speech in August (Powell 2019): “In principle, anything that affects the outlook for

employment and inflation could also affect the appropriate stance of monetary policy, and that could

include uncertainty about trade. There are, however, no recent precedents to guide any policy response

to the current situation…Trade policy uncertainty seems to be playing a role in the global slowdown and

in weak manufacturing and capital spending in the United States.”

The Fed has long emphasized the importance of being a “risk manager,” but basing monetary policy on

speculation about trade policy uncertainties and hunches on the probabilities of risks moves the Fed’s

discretion beyond data-dependence. It is also inconsistent with the Fed’s traditional approach of

modifying monetary policy to actual economic responses to fiscal policy changes rather than changing

monetary policy in anticipation of pending fiscal legislation and how the Fed perceives that legislation

will affect the economy. The most recent example was in 2017 when the Fed purposely stated that it

would not adjust monetary policy to anticipated changes in fiscal policy.

The Fed’s current assessment that risks are to the downside based on policy-related uncertainties may

end up being correct or incorrect. Such reliance moves the Fed further from any kind of systematic

(rules-like) approach to monetary policy and toward discretion and guessing. This increases the

probability of policy error that may undercut the Fed’s credibility and independence.

A more fundamental factor facing the Fed is whether the erratic ratcheting up of tariffs lowers

aggregate demand or productive capacity (supply) in the economy, and whether the impacts are

temporary or permanent. These issues are critical in determining the appropriateness and efficacy of

monetary responses. Tariffs clearly reduce aggregate demand. Like taxes, they raise prices—of business

operating costs and consumer goods. They also disrupt and distort global supply chains, which reduces

economic efficiencies. Supply chains take time—in many cases, years-to adjust. These factors slow

business investment and GDP growth. Sustained drags on business investment reduce the capital stock

and barriers and disruptions to global supply chains reduce efficiencies. These combine to reduce

productive capacity and sustainable growth in the intermediate-term.

This poses a dilemma for the Fed: while monetary policy stimulus may offset slumps in aggregate

demand, it is incapable of offsetting a trade policy-induced structural shift that reduces productive

capacity. Nor is monetary easing capable of offsetting declines in business investment stemming from

policy-related uncertainties. That is, a Fed rate cut that lowers the real cost of capital will not offset the

constraints that trade barriers and distortions to global supply chains impose on productive capacity

(Levy 2019). Nor will it clear up trade-related uncertainties. Persistent monetary ease in the face of

supply constraints will not stimulate growth, but will have negative consequences. If the monetary

easing actually stimulates aggregate demand, it would generate higher inflation. The lower rates are

not harmless: they generate misallocations of resources, excess reliance on debt and other distortions.

Also, by giving the impression that monetary policy is ineffective, it may undercut the Fed’s credibility.

In real time, the nature of the negative economic impact of trade policy may be uncertain. But if tariffs

are imposed for any sustained period and persistent policy uncertainties weigh on capital spending, then

research strongly suggests that the efficacy of more and more monetary easing is limited. It is critically

important that the Fed incorporates this analysis into its framework for conducting and communicating

its monetary policy.

Another nagging issue facing the Fed is President Trump’s public criticism of the Fed and his intertwining

of the Administration’s trade policies with China Fed policy. Trump’s statements such as “who is our

bigger enemy, Jay Powell or Chairman Xi?” (August 23, 2019) have led some observers to believe that

the Administration’s trade policy tactics are being used as a lever to force the Fed to cut its policy rate.

However inappropriate Trump’s behavior or inaccurate the interpretation, it puts the Fed in a bad

position and serves to undermine the Fed’s credibility in the public’s eye.

These observations provide several suggestions. The Fed should be more systematic and guided by rules

in its conduct of monetary policy, rely more on data dependence and not succumb to basing policy on

hunches about risks and uncertainties. This is particularly true under current circumstances with the

economy growing at potential, labor markets strong, bond yields at historic lows and the Fed’s policy

rate already uncomfortably close to the zero lower bound.

Second, the Fed must be cognizant of the proper scope of monetary policy and not be so quick to cut

rates in response to exogenous factors and policies that reduce economic efficiency and productive

capacity and are beyond the scope of monetary policy.

Third, the Fed should take every step and opportunity to emphasize its independence in pursuing the

dual mandate that was established by Congress. It should also emphasize its political neutrality and

sidestep any political debate.

Former President of the Federal Reserve Bank of New York Bill Dudley weighed in on this issue with a

statement (Dudley 2019) that required an explanatory follow-up that illustrated the bind the Fed is in,

but Dudley really stumbled badly and his suggestions would jeopardize the Fed’s credibility as an

apolitical, nonpartisan policymaker. Dudley correctly viewed Trump’s escalating tariff policies as

harming the economy and Trump’s barbs at the Fed as encouraging the Fed to become politicized. But

while Dudley later disavowed (Dudley 2019) his original suggestion that the Fed should consider

adjusting monetary policy to influence the upcoming presidential election, he still recommended that

the Fed should play different political angles in its responses and communications to Trump’s economic

policies. Moreover, he presumed that monetary policy is capable of offsetting the trade policies even

though they are imposing structural constraints on the economy, which are beyond the Fed’s control.

Dudley also suggested that the Fed’s policies should hinge in part on how the Fed perceives they will

affect future trade policy. These notions suggest that the Fed should pursue political tactics in order to

remain nonpolitical and they convey a misunderstanding of the proper role of the Fed and monetary

policy (Thornton 2019). The best way for the Fed to maintain political neutrality and operational

independence is to conduct monetary policy independently of political pressures and how it perceives

that its policies may affect other (non-monetary) policies, with a full understanding of the proper scope

of monetary policy and to communicate these publicly. This involves standing up to President Trump

and steering clear of any politics or partisan maneuvering.

The Big Risk: Ending the Second Era of Globalization

The Trump tariffs on China and other countries, the retaliation against the US, and the increase in trade

policy uncertainty has resonance for what happened to the global economy during the interwar period

when the first great era of globalization collapsed and contributed to a plunge into autarky and

depression.

Although history never repeats it often rhymes. Hence understanding the lessons from the past can aid

us in avoiding a recurrence of its serious policy errors. The world has experienced two eras of

globalization in the past two centuries, Chart 3 (Bordo 2017). An understanding of what happened to

end the first era of globalization is a very important cautionary tale for the considerable risks that the

global economy faces from the current trade policies pursued by the Trump administration.

The first era of globalization from the mid nineteenth century to August 1914 experienced a massive

transformation in international trade, financial globalization and mass migration. The growth of trade

relative to population and income began in earnest in the early nineteenth century, driven by

technological change that vastly reduced the costs of shipping goods (the steamship and railroads) and

political stability (The Treaty of Vienna and the Pax Britannica).

Empirical evidence for global trade integration comes in two dimensions: 1) the growth of trade

relative to income and 2) convergence in the prices of traded goods (Findlay and O’Rourke 2004). On

both dimensions, although the process of international integration began with the opening up of the

world with the Age of Discovery in the sixteenth century, the major thrust in globalization did not really

occur until after the Napoleonic Wars.

The growth of trade from 1500 to 1800 averaged a little over one per cent per year, far outpacing

population growth of 0.25 per cent. Between 1815 and 1914 trade measured by exports grew by 3.5 per

cent versus income growth of 2.7 per cent. Commodity prices converged dramatically in the nineteenth

century. For example, reflecting the sharp decline in transportation costs, the price of wheat in Liverpool

relative to those in Chicago fell from 58% to 16% in 1913. In addition to falling transport costs,

globalization was spread by big reductions in tariff protection, beginning with Britain’s reduction of the

corn tariffs after the Napoleonic Wars, culminating in their repeal in 1846. The movement towards free

trade spread across Europe in a series of reciprocal agreements beginning with the Cobden Chevalier

Treaty in 1860 between Great Britain and France. Within the next two decades virtually all of Europe

reduced tariffs (to the 10-15 percent range from 35 percent) in a series of bilateral agreements

incorporating Most Favored Nation clauses.

Financial market integration also burgeoned between 1870 and 1914. Many of the instruments of

international finance such as the bill of exchange were invented in Italy in the Middle Ages and were

perfected in Amsterdam in the seventeenth century (Goetzmann 2016). London succeeded Amsterdam

as the key center of international finance by the nineteenth century. Obstfeld and Taylor (2004) portray

the first era of financial globalization in the nineteenth century as centered in London, but including the

other advanced Western European countries as participants. Capital flowed from the mature economies

of Western Europe which had by then gone through the industrial revolution and had reduced the

marginal productivity of capital (real rate of return) to the countries of new settlement that had

abundant resources and higher real returns (Bordo 2002). The stock of global foreign assets relative to

world GDP reached a peak of 20 percent in 1913 and was not surpassed again until late in the twentieth

century. The British held the lion’s share of overseas investments in 1914 at 57 percent, then France at

22 percent, Germany 17 percent, and the Netherlands at 3 percent. These claims financed up to half of

the capital stock of Argentina and 20 percent for Canada and Australia. Net capital outflows reached a

peak of 9 percent of GDP for Great Britain just before World War I. For Canada net capital inflows in the

decade before the war were on a similar scale. The key factors that fostered the rapid development of

global finance were technological change (the telegraph and the transatlantic cable) which was first laid

between Britain and North America in 1866 starting a network still used today, and the classical gold

standard with London as the center.

Adherence to gold convertibility by the major nations of the world ensured stable exchange rates and

acted as a commitment mechanism or a “good housekeeping seal of approval’ for countries seeking

access to the London capital market (Bordo and Rockoff 1996).

Finally, like global commodity markets and capital flows, international migration surged in the

nineteenth century and declined after World War I. The waves of migration in the later nineteenth

century were driven largely by economic factors (the lure of higher real wages in the Americas and the

supply-enhancing reduced transportation costs).

All of this came to an end with World War I and subsequently the Great Depression, but many of the

seeds of its own destruction were planted earlier. In turn globalization may have contributed to the

wave of nationalism that led to World War I. The consequences of trade and factor mobility in the

Golden Age were the convergence of real wages and per capita incomes between the core countries of

Western Europe and much of the periphery. This reflected the operation of classical trade theory.

These forces had important effects on the distribution of income. The massive migrations in the 1870 to

1914 period reduced the returns to land –owners in the land-scarce, labor abundant countries of

Europe. At the same time immigration threatened to worsen the income distribution for unskilled

workers in countries of recent settlement, as immigrants competed with established workers for jobs in

certain sectors. A political backlash ensued in each region. In Europe, landowners in France and

Germany successfully lobbied for increased tariff protection of agriculture in the last two decades of the

nineteenth century.

By the end of the century, the era of mass migration gave way to a wave of restrictions on the

movement of people. The May 1882 US Chinese Exclusion Act was the culmination of decades of social

and political lobbying against immigrants, particularly from China. At the end of 1901, Australia, with a

much shorter history of immigration than the US, passed its own Immigration Restriction Act aimed at

stopping non-white immigration. Other countries of new settlement introduced their own similar

restrictions after 1919 and by the early 1920s free migration ceased. The political and social limits to

globalization through migration had therefore already been reached in the decades before 1914.

Financial globalization also led to a backlash but much later in the interwar period. Open capital

accounts were associated with private investment booms and busts leading to financial crises (both

currency and banking crises). Capital flowed from the capital rich mature countries of Western Europe

to the capital scarce peripheral countries. But many lacked the institutional development to fully

convert the new funds into productive investments and hence the funds fueled asset price booms

(Bordo and Meissner 2017). In the absence of central banks (e.g., the US, Canada , Australia ) or in the

case of peripheral countries that had them but were unable to adhere to the gold standard (Southern

Europe, Latin America), currency crises and banking panics would lead to severe economic distress and

sovereign debt crises.

Moreover the classical gold standard that underpinned the first era of globalization was under attack.

Under the gold standard, the world price level incurred long swings of deflation and inflation reflecting

the growth of the real economy relative to the glacially slow growth of the world gold stock. Gold

shortages (deflation) would ultimately stimulate technical innovation in gold mining and new discoveries

(Bordo 1981, Rockoff 1984). But the timing of these events was adventitious (Keynes 1925). In the US

and elsewhere the Great Deflation of 1873 to 1896 led to a populist outcry against gold and in favor of

free silver and bimetallism (Eichengreen 2018).

The eruption of World War I in 1914 marked the end of the first era of globalization. Virtually all

countries left the gold standard de jure or de facto once Britain suspended convertibility of sterling into

gold after the financial crisis in 1914 (Roberts 2013). Both exchange controls and capital controls were

widely imposed (Eichengreen 1992). World War I disrupted trade with tariffs and quotas. Following the

war the movement towards protection increased.

The U.S. was the worst offender with the Fordney McCumber Act of 1922 and then the Smoot Hawley

Tariff of 1930. Other countries retaliated, e.g., Great Britain with the Ottawa agreement of 1932

establishing Imperial preference and discriminating against the US. The Great Depression led to

increasing tariffs to stimulate recovery. By the eve of World War II multilateral trade collapsed into

system of bilateral trade and quotas. Finally, capital flows virtually ceased in the early 1930s following

widespread sovereign debt defaults and the imposition of controls.

The situation today has some similarities to the interwar period but some key differences. Tariffs were

increased markedly in both episodes but so far the magnitude and scope of the imposed tariffs are

dramatically less today than in the 1930s. Also, while migration is being restricted, the scale and

magnitude of the restrictions are a small fraction of those in the 1930s.

The differences are considerable:

1) So far the widespread imposition of capital controls that occurred in the interwar has not

occurred.

2) The structure of the world economy has changed. The advanced economies, which by the

interwar period had already shifted from primary production (agriculture) to manufacturing,

have now become much more dependent on services. The economies of many of the emerging

countries (e.g., China and East Asia) have grown and matured to where the advanced countries

were in earlier decades. This suggests that tariffs on manufacturing will have more of an impact

on the emerging countries.

3) There also has been greater integration in the production process across the globe. The most

important development was the global supply chain, which had developed slowly in the 1980s

between the advanced countries of North America, Europe and Japan on the one hand and

China and other emerging Asian economies on the other (Baldwin 2016). The development of

just-in-time production techniques led to the formation of completely integrated global

enterprises, operating world-wide and combining advanced countries knowhow with emerging

market lower cost labor (e.g. Walmart).There is evidence that the Trump tariffs have disrupted

these processes but the global supply chain had already run into diseconomies of scale which

has led many multi-national corporations to localize their production (Economist 2019)

Despite these considerable differences between present and historic conditions, there still is a risk that

the rise in tariffs and other barriers and increased trade policy uncertainty may lead to a recessionary

chain of events.

Fortunately so far the effects of the US tariffs and the retaliation are far less than what occurred in the

1930s. Research on Smoot Hawley suggests that those onerous tariffs were not the primary cause of the

Great Depression, rather a serious exacerbating force (Irwin 2019). Crucini and Kahn (1996 and 2003)

show that based on a DSGE model,

the Smoot Hawley tariffs and the retaliation that follows created a recession that would be comparable

to the garden variety recessions of the post WWII era with real GDP falling by about 2%. Moreover their

research finds that accounting for the impact of the tariffs on intermediate goods in the supply chain

accounted for most of the drop in output. Today’s much more integrated and developed supply chains

(with China as the linchpin) increase the potential economic costs of a trade war. Indeed cutting China

out of the supply chain, which President Trump recently urged in a tweet, could accentuate the negative

impact. The process of substituting production away from China to other emerging countries would

eventually alleviate the problem, but such adjustments are very costly and take considerable time. It is

important to remember that it took several decades of learning-by-doing for China to have become so

tightly integrated with the US and Europe, and it will be very costly for the other emerging market

economies to replicate this.

On the other hand, policy makers today have a far deeper understanding of how to stabilize the

economy (even when interest rates hit the zero lower bound) with a broader array of policy tools that

did not exist 80 years ago. The presence of monetary and fiscal policy tools, automatic stabilizers and

international monetary and fiscal policy coordination, as well as the heightened sophistication of

financial markets and capital flows greatly reduces the likelihood of a 1930s-type disaster.

The risk remains, however, that further increases in trade protection and barriers that slow the flows of

migration will reverse the economic advances of the second era of globalization (which accelerated

following the collapse of Bretton Woods in the 1970s). This would greatly harm US economic

performance and lower long-run growth prospects. In present value terms this would translate into

significant losses in standards of living and well- being. This would be a tragedy because it would have

been caused by preventable policy errors.

Chart 1. World Trade Volume

Source: Netherlands Bureau for Economic Policy Analysis

Chart 2. Policy Uncertainty and US Business Fixed Investment

Sources: Baker, Bloom and Davis (2016) and Berenberg Capital Markets.

Chart 3. The Wave of Globalization

References

Ahir, Hites, Bloom, Nicholas, and Furceri, Davide, “Caution: Trade uncertainty is rising and can harm the

global economy”, voxEU, July 2019.

Amiti, Mary, Redding, Stephen and Weinstein, David, “The Impact of the 2018 Trade War on U.S. Prices

and Welfare”, Center for Economic Policy Research, March 2019.

Baker, S, Bloom, N and Davis, S, “Measuring Economic Policy Uncertainty”, The Quarterly Journal of

Economics, 2016.

Baldwin, Richard (2016) The Great Convergence. Cambridge: Harvard University Press.

Bordo, Michael (2017) “ The Second Era of Globalization is Not Yet Over: An Historical Perspective’

NBER Working Paper

Bordo , Michael (2002) “ The Globalization of Financial Markets: What Can History Teach Us ?” in

Leonardo Auernheimer (ed) International Financial Markets . Chicago: University of Chicago Press.

Bordo, Michael (1981) “The Classical Gold Standard : Some Lessons for Today” Federal Reserve Bank of

St. Louis Review . Vol 63, No.6. (May).

Bordo, Michael and Christopher Meissner ( 2017) “ Growing Up to Stability? Financial Globalization,

Financial Development and Crises” in Financial Systems and Economic Growth : Credit Crises, and

Regulation from the 19

Century to the Present. (eds) Peter L. Rousseau and Paul Wachtel. New York :

Cambridge University Press

Bordo, Michael and Hugh Rockoff ( 1996) “ The Gold Standard as a “ Good Housekeeping Seal of

Approval” Journal of Economic History 56 (02) pp389-428

Bown, Chad and Irwin, Douglas, “Trump’s Assault on the Global Trading System”, Foreign Affairs,

September/October 2019.

Caldara, Dario, Iacoviello, Mattao, Molligo, Patrick, Prestipino, Andrea, and Raffo, Andrea, “The

Economic Effects of Trade Policy Uncertainty”, Board of Governors of the Federal Reserve System,

August 2019.

Cavallo, Alberto, Cal, Mariana, and Laski, Anne, “The U.S.-China Trade War”, Harvard Business School,

May 2019.

Chudik, Alex, “President Trump’s Tariff Spree”, Federal Reserve Bank of Dallas, June 2019.

Crucini, Mario and James Kahn (1996) “ Tariffs and Economic Activity: Lessons from the Great

Depression” Journal of Monetary Economics 38 ;pp 427-467.

Crucini , Mario and James Kahn (2003) “ Tariffs and the Great Depression Revisited Journal of Monetary

Economics

Dudley, Bill, Bloomberg Opinion, “The Fed Shouldn’t Encourage Trump’s Trade War, August 27, 2019.

Dudley, Bill, Bloomberg Opinion, “What I Meant When I Said ‘Don’t Enable Trump”’, September 4, 2019.

Ebeke, Christian and Siminitz, Jesse, “Trade Uncertainty and Investment in the Euro Area, IMF Working

Paper, December 2018.

The Economist (2019) “Special Report: Global Supply Chains” July 11.

Eichengreen Barry (2018) The Populist Temptation : Economic Grievance and Political Reaction in the

Modern Era. New York: Oxford University Press

Fajgelbaum, Pablo, Goldberg, Pinelopi, Kennedy, Patrick, and Khandelwal, Amit, “the Return to

Protectionism”, NBER Working Paper No. w25638, March 2019.

Findlay, Ronald and Kevin O’Rourke (2004) “ Commodity Market Integration, 1500-2000” in

Globalization in Historical Perspective (eds) Michael D Bordo, Allan Taylor and Jeffrey G. Williamson .

Chicago: University of Chicago Press

Goetzmann, William (2016) Money Changes Everything: How Finance Made Civilization Possible.

Princeton: Princeton University press

Handley, Kyle and Limoa, Nuno, Policy Uncertainty, Trade, and Welfare: Theory and Evidence for China

and the United States, American Economic Review, 2017, 107 (9).

Irwin Douglas (2019) “US Trade Policy in Historical Perspective” NBER Working paper 26256 September.

Levy, Mickey D., “Monetary Policy Realities Facing the ECB, Fed and BoJ: More Easing Won’t Stimulate

Economies”, Center for Financial Stability, July 2019.

Obstfeld , Maurice and Alan Taylor ( 2004) Global Capital Markets: Integration, Crisis and Growth.

Cambridge: Cambridge University Press

Powell, Jerome, “Challenges for Monetary Policy”, Federal Reserve Bank of Kansas City Jackson Hole

Symposium, August 2019.

Rockoff , Hugh ( 1984) “ Some Evidence on the Real Price of Gold, Its Cost of Production and Commodity

Prices” in A Retrospective on the Classical Gold Standard: 1821 to 1931. . (eds) Michael D Bordo and

Anna J Schwartz . Chicago: University of Chicago Press.