Smoot-Hawley’s significance was as much psychological as economic. “Because the Depression followed so closely on the heels of the tariff increase, many people at the time believed that [Smoot-Hawley] was responsible for the economic disaster,” writes Dartmouth economist Douglas Irwin in his recent history of U.S. trade, “Clashing Over Commerce.”
One crucial lesson of Smoot-Hawley is to leave trade policy alone — that is, don’t resort to protectionism — in any economic crisis that doesn’t automatically involve trade. Protectionism may make things worse and, possibly, much worse.
The Trump administration hasn’t absorbed this history. Its obsession with “trade wars” risks souring the public mood and weakening the world economy. The stock market — to take a clear example — has reacted badly to adverse trade news. But there is an even larger connection through global debt markets.
Contrary (perhaps) to popular wisdom, global debt — the borrowings of consumers, businesses and governments of all major countries — has grown substantially in the past decade, from $97 trillion in 2007 to $169 trillion in 2017, reports a new study by the McKinsey Global Institute. This debt consists of $43 trillion of household debt (including home mortgages), $66 trillion in loans to non-finance businesses (mostly bonds and bank loans) and governments’ debt of $60 trillion.
Many of these debts are denominated in a country’s own currency; that’s largely true of China. But many debts of other countries (say, Brazil) are made in dollars. Interest and principal must be repaid in dollars.
Here’s the connection with protectionism. Anything that limits debtors’ ability to earn the dollars they need to cover their debt payments makes defaults more likely. Protectionism does just that; it discourages trade (that’s the point) by raising tariffs and the price of traded goods. Exports and imports suffer. Too many defaults — especially unexpected defaults — could trigger a panic.
According to many analysts, the greatest dangers lie with bonds issued by non-financial corporations. There were $11.7 trillion of these bonds outstanding at the end of 2017, up from $4.3 trillion in 2007, McKinsey estimates.
Many borrowers are so strong financially — they have ample cash reserves to repay — that the risks are concentrated among weaker companies, especially firms in “emerging market” countries (India, Brazil and the like). McKinsey estimates that as much as a quarter of bonds issued by Brazilian companies could default, as might a fifth of bonds issued by Indian firms. By contrast, only 6 percent of bonds issued by American firms were rated at risk of default.
What’s worrisome is that many of these bonds will mature in the next five years — at least $1.5 trillion annually. They need to be repaid or refinanced. Higher interest rates and protectionism make this harder. The good news is that McKinsey doubts there will be a major financial crackup. “While individual investors in bonds may face losses, defaults in the corporate-bond market are unlikely to have significant ripple effects across the [economy],” writes McKinsey’s Susan Lund in a post on Project Syndicate.
Let’s hope this optimism triumphs. The bad news is that no one really knows. What’s eerie is that Trump’s embrace of protectionism is now assuming the same role as Smoot-Hawley in the 1930s. By slowing economic growth, it darkens the outlook and reduces the ability of debtors to repay their lenders. So much for the lessons of history.