Imagine this scenario: The United States, in an effort to spur exports and boost domestic producers, institutes a tax on foreign imports, some of the proceeds of which go indirectly to exporters to make their goods more affordable in international markets. Most of Europe then retaliates with tariffs on American exports that raises the cost of American exports in Europe. Japan does the same, erecting some of the highest tariffs in the world. Most of China follows suit. Britain tried to stay aloof of the customs war, but eventually caves, building its own economic borders.
Of course, I’m talking about the interwar period, when in the aftermath of the Great War, the world’s major economies played a game of tariff-one-upsmanship until global trade collapsed and the world entered the Great Depression.
But I’m also talking about today. Let’s consider what actually happens when a country devalues its currency. Switzerland, as we discussed last week, by pegging the franc to the dwindling euro, essentially devalued Swiss money 20%. Swiss consumers and Swiss businesses paid 20% more on imported goods and raw materials. Swiss exporters weren’t subject to that tax, effectively receiving a 20% subsidy for Swiss items sold domestically and being able to export at a lower cost. In other words, Switzerland’s attempt at currency devaluation yielded the exact effect of a 20% protective tariff on imports.
Switzerland wasn’t the only major economy doing this. In fact, the Swiss are the only major economy to have stopped devaluing its currency–to have stopped building a de facto protective tariff around its borders. The United States has gone through three rounds of quantitative easing, and there are increasing calls for a fourth. All signs point to Europe doing the same as early as next week. Japan has been devaluing its currency for twenty years with the same predictable result.
This is what doesn’t make sense: virtually every economist agrees that protective tariffs are almost always bad. Virtually every politician knows that protective tariffs beget even more protective tariffs in retaliation. In fact, the World Trade Organization was created to discourage trade protectionism after the mess of the Great Depression made this painfully obvious to all. Currency devaluations and protective tariffs are exactly the same in effect. And yet, there are still economists of all stripes who argue that currency devaluation is a means to lifting an economy out of its depths.
Actually, they are not exactly the same in one significant aspect. When a country devalues its currency it devalues itself. It devalues the worth of its labor. It devalues the strength of its reserves. It removes incentives for savings and investments, and encourages the export of capital. Currency devaluation creates a worse outcome even than a protective tariff.
So where does today’s spiral currency devaluation end? If the 1920s rush to protective tariffs is any indication, the answer is: not well.
Then, deflation was the result. Years of forcibly escalating prices to prop up exports and subsidize domestic producers ultimately resulted in a collapse causing prices to fall to where they really should have been all along. The price of agricultural goods was the most obvious indicator of this effect. Advances in mechanization, refrigeration, transportation, hybridization, and chemistry resulted in a surplus of agricultural goods worldwide. Too many people were engaged in direct and indirect agricultural work around the world as a result of the worldwide subsidy effect of protective tariffs. When it collapsed, so too did prices. All that the years of protective tariffs did was to take what should have been a gradual de-agriculturalization of the world’s economy and delay it long enough that it became a catastrophic global shock. In other words: deflation wasn’t the cause of the Great Depression; deflation was the logical effect of years of misbegotten economic policies practiced by every major economy in the world. To blame the Depression on deflation, therefore, is as ludicrous as blaming the mercury in a thermometer for causing a heatwave.
Central bankers today fear deflation unnecessarily. So much so that the world’s bankers are doing exactly what they know the world’s politicians did 90 years ago that led to the last Great Depression. This won’t end well.