In Praise of Smoot-Hawley?

Smoot-Hawley may have helped reduce the depth of the Great Depression.

The Smoot-Hawley Tariff Act was passed in response to protectionist sentiments at the beginning of the Great Depression in June of 1930. US tariffs, already averaging 40% due to previous legislation, were increased an average of 20% or so, initiating retaliatory tariff increases by US trading partners. It is generally credited with worsening the international economic situation, and aggravating the Great Depression.

We will consider a depression to start with an excess of supply over demand, due to a contraction in demand. Excess inventory leads producers to cut back on production, and further to cut back on factors of production, particularly labor. However, labor is the ultimate consumer, and by cutting back on labor, producers ultimately cut back on the final demand for their own products. This leads to a vicious cycle: Job cuts lead to reduced demand leads to job cuts etc.

In order for the cycle to end, supply must eventually equal demand. Since the cycle starts with an excess of supply, supply must decrease at a rate greater than demand, in order for the two to eventually become equal. This forms the bottom of the depression. One process that tends to happen is that, as the number of workers in a firm decreases, a point is reached where the marginal physical product (units per worker) decreases. Under these circumstances, supply indeed decreases faster than demand.

Other policies which help to maintain demand, such as unemployment benefits and deficit spending, also work to reduce the severity of a depression. The collapse of credit, by reducing demand, works to aggravate a depression. At the beginning of the Great Depression, between 1930 and 1933,the money supply declined by about a third.

With a reduction of trade, supply of goods and services is also effectively decreased. This is especially the case with a country operating with a trade deficit, but it is well known this decrease happens even under the conditions of balanced trade.

Consider the case of two countries, which trade two goods. If the countries impose barriers to trade, such as a tariff, each country becomes short in one good and has a surplus in the other. (To phrase it more precisely, the price of the first good goes up above the expense of production, while the price of the other good goes below its production cost. However, it is now apparent that markets do not always clear immediately, that surpluses and so also that shortages may exist, and may persist. If a good is a factor, other shortages may result.) Since the good a country is short in it produces less efficiently than the good it produces in surplus, when the now excess factors of production are transferred from producing the good in surplus to the good in shortage, the new total of production will be less than before. The combined supply of the two goods will be reduced. Further, during the transition period, the good in surplus will no longer be produced in surplus, but production of the good in shortage will not have begun, since it is still being capitalized. Also, during the transition period, the cost of the transformation of capital will increase demand.

In 1934, President Roosevelt signed the Reciprocal Trade agreement, liberalizing trade and undoing much of the tariff legislation. But by 1933, the Depression had already bottomed out.

This analysis suggests that the Smoot-Hawley Act, by helping to more rapidly reduce the surplus supply, helped supply and demand to equalize at higher price and quantity levels than they otherwise would have. Despite the negative effect the act had on business confidence, the Smoot-Hawley Act may have reduced the severity of the Great Depression.

This raises the issue of the general application of restrictions to free trade. In a sense, free trade maximizes the supply of goods and services to the world economy. It also maximizes international competitive pressures. Is this desirable? Is it desirable that only the most efficient producers survive? That is, is it desirable that the producer surplus be minimized?

It also suggests that a certain level of restrictions on trade may be beneficial for global economic stability. With some restrictions, balance of payments may be maintained. With unrestricted free trade, imbalances will almost certainly occur. Some have touted the benefits of trading goods for over-valued pieces of paper, but that paper represents debt, and the promise to repay in goods and services, which may come at an inconvenient time for a hard pressed economy.
I will not go into the well known equalization of factor prices under free trade, except to mention that it suggests US professors in economics will eventually be paid the same as their Chinese counterparts.

The analysis can be generalized to internal trade and specialization at all levels of social structure, due to the effects of comparative advantage. The relentless drive to specialization, while it increases the quantity of goods and services produced, may be socially destabilizing, and perhaps policies should be adopted that ameliorate these pressures.

I have simplified the discussion of supply and demand. The real discussion is more complicated, involving the shifting of the "Aggregate Demand curve" to the left, and the "Aggregate Supply curve" also bending to the left at the lower level of demand, so that the equilibrium point where they cross, where quantity demanded equals quantity supplied, is at a lower level, as may be the price, etc. The process stops when the equilibrium price level, which may be lower than originally the case, is greater than the cost of production, at the new price level. The reason the demand curve, and following it the supply curve, doesn't just spring back is because demand is money. No money, no demand. And money has been taken out of the demand side of the system. One answer is to gradually pump money back into the system, on the demand side. Under these circumstances, giving money to producers is useless, and worse, since they need no longer produce to make money. And so can lay off more people, etc. So is giving money to bankers. They have no reason to lend to the unemployed, nor to producers who have no demand for their product.