Smoot-Hawley: Destroyer of Worlds

In the latest EconTalk podcast, Thomas Rustici makes an extremely compelling case for the infamous Smoot-Hawley Tariff Act of 1930 having been the main cause that triggered the Great Depression.

For me, this pretty much puts the capstone on our understanding of the Great Depression and all its causes. The consensus view of economists, going back to Milton Friedman and Anna Schwartz's Monetary History of the United States, is that the Black Tuesday stock market crash on October 1929 precipitated a series of bank runs and failures that started contracting the national money supply. As the monetary authority of the US, the Fed could and should have counteracted this calamity by buying assets, pumping enough money into the system to maintain stable inflation expectations. Instead, the Fed made the problem even worse by selling assets, pulling even more money out of circulation, leading to a deflationary spiral that saw the money supply contract by about 30% and forcing 40% of American banks to shut their doors. The sudden and massive deflation meant that wages at their current level were far too high, but various regulations and the general "stickiness" of wages meant not a readjustment of wages to the price level, but rapidly rising unemployment, peaking at 25%. What should have only been a run-of-the-mill recession was made a global economic catastrophe by the incompetence of the Federal Reserve at the time.

This is all fine and good, but something I've always wondered about was "why did the stock market crash in the first place?" In high school American history it's made to sound like divine punishment from the heavens that comes completely unexpectedly to all.

Most economists today would say that the Smoot-Hawley tariff, which sparked a series of trade battles leading to a dramatic contraction of world trade, was a bad policy, but with trade accounting for only 7% of US GDP at the time, couldn't have had too significant of an effect on the Great Depression, accounting for only 2 percentage points of the incredible 33% decline of the economy between 1929-33. And, given that the act was passed in 1930, couldn't have been what started the downfall.

Enter Rustici, who makes the point that the law was being debated in Congress going back to mid-1929, and that the stock market tracked its progress pretty closely. In fact, the crash in October came immediately after 16 pro-free-trade senators log-rolled and jumped on board Smoot-Hawley, pretty much assuring its passage into law. Before it was even signed into law, our major trading partners started enacting retaliatory tariffs. In 1930 US agricultural exports collapsed as a result of the new trade barriers, commodity prices plummeted, and the first bank failures started happening in rural communities with strong ties to exports. The same happened around the world; the first banks to go were the ones that did business with exporters. The Depression started on the farm, and the waves of bank failures went like dominoes, spreading to the city until some of the country's largest banks were toppled, the rest is monetary history.

The stock market crash didn't cause the Great Depression, it was a warning of the havoc protectionism would wreck on the world economy. A warning that unfortunately went unheeded. Smoot-Hawley begot the worst economic meltdown in history, which begot the most devastating war in history. Hopefully someday schools will teach that fear of foreign competition caused the biggest disaster of all time and anybody who says they want to "protect our jobs" really supports the Holocaust.