Uneasy Money

The role of the Hawley-Smoot Tariff (aka Smoot-Hawley Tariff) in causing the Great Depression has been an ongoing subject of controversy for close to a century. Ron Batchelder and I wrote a paper (“Debt, Deflation and the Great Depression”) published in this volume (Money and Banking: The American Experience) that offered an explanation of the mechanism by which the tariff contributed to the Great Depression. That paper was written before and inspired another paper “Pre-Keynesian Theories of the Great Depression: What Ever Happened to Hawtrey and Cassell“) I am now revising the paper for republication, and here is the new version of the relevant section discussing the Hawley-Smoot Tariff.

Monetary disorder was not the only legacy of World War I. The war also left a huge burden of financial obligations in its wake. The European allies had borrowed vast sums from the United States to finance their war efforts, and the Treaty of Versailles imposed on Germany the obligation to pay heavy reparations to the allies, particularly to France.

We need not discuss the controversial question whether the burden imposed on Germany was too great to have been discharged. The relevant question for our purposes is by what means the reparations and war debts could be paid, or, at least, carried forward without causing a default on the obligations. To simplify the discussion, we concentrate on the relationship between the U.S. and Germany, because many of the other obligations of the allies to the U.S. were offset by those of Germany to the allies.[1]

The debt to the U.S. could be extinguished either by a net payment in goods reflected in a German balance-of-trade surplus and a U.S. balance-of-trade deficit, or by a transfer of gold from Germany to the U.S. Stretching out the debt would have required the U.S., in effect to lend Germany the funds required to service its obligations.

For most of the 1920s, the U.S. did in fact lend heavily to Germany, thereby lending Germany the funds to meet its financial obligations to the U.S. (and its European creditors). U.S. lending was not explicitly for that purpose, but on the consolidated national balance sheets, U.S. lending offset German financial obligations, obviating any real transfer.

Thus, to avoid a transfer, in goods or specie, from Germany to the U.S., continued U.S. lending to Germany was necessary. But the sharp tightening of monetary policy by the Federal Reserve in 1928 raised domestic interest rates to near record levels and curtailed lending abroad, as foreign borrowers were discouraged from seeking funds in U.S. capital markets. Avoiding an immediate transfer from Germany to the U.S. was no longer possible except by default. To effect the necessary transfer in goods, Germany would have been required to shift resources from its non-tradable-goods sector to its tradable-goods sector, which would require reducing spending on, and the relative prices of, non-tradable goods. Thus, Germany began to slide into a recession in 1928.

In 1929 the United States began making the transfer even more difficult when the newly installed Hoover administration reaffirmed the Republican campaign commitment to raising U.S. tariffs, thereby imposing a tax on the goods transfer through which Germany could discharge its obligations. Although the bill to increase tariffs that became the infamous Hawley-Smoot Act was not passed until 1930, the commitment to raise tariffs made it increasingly unlikely that the U.S. would allow the debts owed it to be discharged by a transfer of goods. The only other means by which Germany could discharge its obligations was a transfer of gold. Anticipating that its obligations to the U.S. could be discharged only by transferring gold, Germany took steps to increase its gold holdings to be able to meet its debt obligations. The increased German demand for gold was reflected in a defensive tightening of monetary policy to raise domestic interest rates to reduce spending and to induce an inflow of gold to Germany.

The connection between Germany’s debt obligations and its demand for gold sheds light on the deflationary macroeconomic consequences of the Hawley-Smoot tariff. Given the huge debts owed to the United States, the tariff imposed a deflationary monetary policy on all U.S. debtors as they attempted to accumulate sufficient gold to be able to service their debt obligations to the U.S. But, under the gold standard, the United States could not shield itself from the deflationary effects that its trade policy was imposing on its debtors.[2]

The U.S. could have counteracted these macroeconomic pressures by a sufficiently expansive monetary policy, thereby satisfying the demand of other countries for gold. Monetary expansion would have continued, by different means, the former policy of lending to debtors, enabling them to extend their obligations. But preoccupied with, or distracted by the stock-market boom, U.S. monetary authorities were oblivious to the impossible alternatives that were being forced on U.S. debtors by a combination of tight U.S. monetary policy and a protectionist trade policy.

As the prospects that protectionist legislation would pass steadily improved even as tight U.S. monetary policy was being maintained, deflationary signs became increasingly clear and alarming. The panic of October 1929, in our view, was not, as much Great Depression historiography describes it, the breaking of a speculative bubble, but a correct realization that a toxic confluence of monetary and trade policies was leading the world over a deflationary precipice.

Once the deflation took hold, the nature of the gold standard with a fixed price of gold was such that gold would likely appreciate against weak currencies that were likely to be formally devalued, or allowed to float, relative to gold. A vicious cycle of increasing speculative demand for gold in anticipation of currency devaluation further intensified the deflationary pressures (Hamilton, 1988). Moreover, successive devaluations by one country at a time increased the deflationary pressure in the remaining gold-standard countries. A uniform all-around devaluation might have had some chance of quickly controlling the deflationary process, but piecemeal deflation could only prolong the deflationary pressure on nations that remained on the gold standard.

FOOTNOTES

[1] The United States, as a matter of law, always resisted such a comparison, contending that the war debts were commercial obligations in no way comparable to the politically imposed reparations. However, as a final matter, there was obviously a strict correspondence between the two sets of obligations. The total size of German obligations was never precisely determined. However, those obligations were certainly several times the size of the war debts owed the United States. Focusing simply on the U.S.-German relationship is therefore simply a heuristic device.

[2] Viewed from a different perspective, the tariff aimed at transferring wealth from the foreign debtors to the U.S. government by taxing debt payments on debt already fixed in nominal terms. Moreover, deflation from whatever source increased the real value of the fixed nominal debts owed the U.S.