The Second Great Depression

Right now, things are so bad that every time you turn on the TV, flip to the op-ed page, or fire up the internets, it’s almost impossible to avoid histrionic comparisons to the Great Depression. 6 in 10 Americans think the country is headed for a depression. Are we? Well, nothing is set in stone, and this is obviously an enormously complicated question. (Translation: I don’t know, but I doubt it.) In this post I want to look at one particular piece of the puzzle: the role of trade policy.

The Great Depression was in large part such a great depression because a recession was severely aggravated by poor government policy choices. On the one hand, an excessively tight monetary policy choked the economy. On the other, international commerce and trade were massively constrained by the infamous Smoot-Hawley Tariff, a very misguided attempt to protect American jobs and industry that ravaged the economy.

When looking for parallels to our own time, it’s reasonable to ask whether the backlash against financial globalization will spill over into the other pillar of globalization, international trade. Very smart people have recently fretted about this possibility. And that would be disastrous: whatever your thoughts on trade, it is an absolutely essential driver of economic growth.

The good news is, free trade is relatively safe. Unlike international finance, trade is regulated and enshrined in an international organization: the World Trade Organization, which is the successor organization to the General Agreement on Tariffs and Trade (GATT); the product of 60 years of multilateral trade negotiations that have successively lowered barriers to trade; and an organization with arguably the world’s strongest international adjudication body that protects the integrity of WTO trade rules. During the interwar period, when the Great Depression occurred and Smoot-Hawley was passed, you had nothing remotely comparable to the WTO. Any politicians who want to pass a new Smoot-Hawley (the Brown-Tancredo Tariff, perhaps?) must be willing to undo 60 years of foreign economic policy, infuriate all of our trade partners, and completely cede any credibility the US has in observing its treaty obligations. A tall order, indeed.

Plus, as I’ve noted before, integration is much deeper now than it was in the 1930s. Production is sourced all over the world, wherever it is most efficient. Trade in tasks. I guarantee you that if Congress were to threaten a new massive tariff, international firms would lobby very strongly behind the scenes to block it.

A more legitimate worry is whether transportation costs will strangle international trade (same link as above). But as I’ve also noted, this too is unlikely.

So take solace: perhaps trade isn’t moving forward, but it’s certainly in little danger of going backwards as well.

(Photo by teotwawki)

Distance makes the heart grow fonder

Last week, I blogged about the rising cost of transportation and whether it would unravel global supply chains, a key component of global economic integration. My answer: rising oil costs matter, but probably not enough to do real damage in the 1 -3 year outlook. In my mind, the real question is whether another decade of rising oil prices dampens new investment in delocalized production chains.

Now we have this fascinating analysis from C. Meissner and D. Novy via VoxEU, which argues that higher shipping costs are unlikely to affect international trade. Using a gravity model, the authors contend that transportation costs actually fell faster in the first era of globalization than the current one (defined as 1945 - present), and that in our era, falling transportation costs have only accounted for about a third of the increase in trade.

Drawing on other research, they further argue that the tariff equivalent of international trade (i.e. the total additional cost to producing something abroad and moving it across domestic borders to markets) is about 74%, only a third of which is transportation-related. This is a reassuring analysis, which implies that countries should still be able to trade in the face of higher transportation costs. The authors also note that protectionist measures in the interwar period effectively strangled international trade and conclude that "unless there is a backlash in the form of rising protectionism, world trade has the potential to keep growing strongly over the coming decades."

Given our present global situation, this raises two questions. First, how worried should we be about a strong upswing in protectionism? I'm not suggesting that we are near a point politically or economically where we could plausibly see a new Smoot-Hawley Tariff. But protectionism is always a worry, given public scepticism about globalization and sluggish economic performance. According to the always insightful Dan Drezner and his Protectionism Advisory System, our current warning level is: Edge of the Cliff (level 2 of 5).

Second, if trade continues to expand, should be worried about the kind of trade we end up with? With the Doha Round on the ropes, the future of multilateral trade is murky. However, as I've said repeatedly, further economic regionalism seems almost certain. It will be interesting to observe what effect preferential trade agreements have not just on channeling trade flows, but the overall volume of trade as well.

The death of the death of...Chrysler?

Given my co-author's recent discussion of transportation costs, Chrysler's announcement today that it is aiming to cut supply chain costs 25% within the next three years seems particularly relevant.

It's certainly a strange time to announce such a thing. With manufacturing centers all over the world (that are expensive and take a long time to construct), insanely complex shipping systems, and heavy products, car companies are the last corporations that should be able to cut costs so quickly and dramatically. On paper, Chrysler, as the smallest and least diversified of the big 3, should lose the most from rising oil prices. But apparently, "reducing complexity and maintaining a stable production schedule" is all you need to do (sounds easy enough, right?).

Remember that Chrysler is a private company; if it was traded I would be inclined to believe this was a PR stunt to prop up share prices. But as a Cerberus holding, the company has no public responsibilities. So what gives?

Chrysler has been taking a lot of heat lately for keeping their financial cards so close to their vest. An announcement like this is meant for one of two things. It is either a way to assure those associated with the company (and skeptical market types) that Cerberus is serious about actually streamlining the company and getting it back into the black OR it's a ploy to convince a number of Chinese foreign firms wishing to enter the domestic automobile market that Chrysler will be a bargain when it (soon) goes up for sale. What do you think?

The death of the death of distance

Recently, there's been some chatter in the news and blogosphere about the how the high price of oil is putting some serious dents in the 'death of distance' theory, a subset Tom Friedman's ubiquitous 'flat worldism' (or is it flatism? I can never remember: I gave up trying to finish the World is Flat on my third try.) The gist of it is: high shipping costs mitigate the advantages you would get from delocalizing production, and if oil prices don't fall, we will see a reversal of a key component of globalization in the future.

Anyways, this is rather old hat - I remember reading a lot of doomsaying about transportation costs earlier this summer when it looked like oil was on a runaway train to $200. But the issue clearly still has traction, as oil prices are unlikely to drop signficantly anytime soon. Research shows that shipping costs clearly play a big role in determining trade volumes. For starters, we have the standard gravity model, which predicts trade volumes based on two variables: GDP size of the two trading nations and the distance between them. Perhaps unsurprisingly, as distance increases, trade declines. And for anyone who truly wants to get into the nitty gritty, I direct you to this NBER paper, which uses the gravity model to show how rising shipping costs helped destroy the last great era of globalization (give or take 1870-1914.)

My first thought is that the price of oil will have to get substantially higher to really reverse global integration. You don't create delocalized production chains overnight - they're the result of significant research and preparation, and they usually take the form of foreign direct investment. FDI, which often represents tangible physical investment, is by nature fairly illiquid. Also, shipping is still a fairly low portion of overall production costs, and certainly much less than labor costs. It would take very high shipping costs for the (cost of shipping + cost of labor in developing country) to exceed (cost of labor in rich country).

Still, there have been complaints that price-sensitive industries are under pressure. Chinese textiles and basic manufactures reportedly produced the slimmest of profit margins. This is a concern, but only if it's an industry-wide problem. In this case, the price of these goods will go up; if not, it will weed out inefficient producers very, very fast.

In my opinion, these concerns are most important in the 10-15 year outlook. If oil prices continue to trend upwards as they have for the past decade, what effect will that have on delocalized production? It's really difficult to make any sort of accurate forecast that far into the future, but one thing seems clear to me. If shipping costs become prohibitive, the biggest losers wouldn't be first-world consumers, it'd be third-world countries that rely on their comparative advantage in labor for economic development.

Don't let this keep you up at night (unless you happen to manage supply chain logistics for a living), but it's certainly something to keep an eye on. Both from a development standpoint and a business standpoint.