Revenge Strategy, Wasting the power of your hate on the guiltless (XXVI). An overture to Smoot-Hawley Tariff Act.

eleonoraescalantestrategy 16 Oct 2019 Leave a Comment

Today we will start to analyze why did we mention the Smoot Hawley Tariff Case as an example of revenge strategies in international trade.

Let´s begin.

“No he hecho nada”, an aquarelle painting by Eleonora Escalante, 2019. On watercolor paper Fabriano5-Fine Grain-300GSM. Size: 11 inches x 17 inches. If you wish to buy it, contact me please.

In order to outset this revenge strategy example; I decided, out of the loop, to visit the website of the Center on Congress, a research center of the Office of the Vice Provost for Research at Indiana University, Bloomington. I wished to observe how a prestigious American University conceives and defines the Smoot Hawley Tariff Act. For this Indiana University Center on Congress Research unit, the Smoot-Hawley historical episode of American trade policy is under a section called Free-Trade and Protectionism.

And clicking on that website timeline, this is what we get:

“The Smoot-Hawley Tariff Act– the Tariff Act of 1930– was passed by Congress a year after the Stock Market Crash when the sentiment in the country to protect ailing American businesses and farmers was strong. President Herbert Hoover signed it into law, despite a petition signed by more than 1,000 economists urging him not to. The tariff increased by 20% of America’s already high tariff rates. Other countries retaliated by raising their tariffs, which reduced global trade and worsened an already weak world economy. U.S. trade with Europe fell by more than two-thirds between 1929 and 1934. Tariff policy would be changed after Hoover lost re-election, and Smoot-Hawley was the last time Congress was involved in setting actual tariff rates”.

When reading the last description: Could you infer why the Smoot Hawley is considered in economic´s history as a failed revenge international trade strategy?

Probably no. It is not easy to understand international trade policies if we don´t know the most basic theories of economics. Particularly for those who have not had a formal education in commerce, I think the following concepts will help you a bit.

To put you on the same page, let´s get back into historic economy trade chronicles to put you in the appropriate context, so you will understand later.

Free Trade: Refers to a situation of a country in which its government doesn´t attempt to restrict what its citizens can buy to another country. Or what can they sell to another nation.
Mercantilism: International Trade Theory that emerged in England by the mid 16th Century. It states that it is in the country´s best interest to export more than it imports. By exporting more, a country can accumulate gold and silver (the mainstays of national wealth) and increase its national wealth and prestige. One of the classical economists supporting this theory was David Hume. The flaw of this theory was that it viewed trade as a zero-sum game. Which is not really true in reality.
Absolute Advantage: Adam Smith kicked off the idea of efficiency when he wrote his book “The Wealth of Nations” in 1776. Smith coined the term “Absolute Advantage” as the situation in which one country is more efficient at producing certain goods than any other country in the world. Smith believed that each country has a “specialization” goal in the production of goods for which they have an absolute advantage and they can trade those goods for other goods produced in other countries.
Comparative Advantage: David Ricardo took the Smith theory and escalated it additionally: One step further with his book Principles of Political Economy (1817). Comparative Advantage states that it makes sense for a country to specialize in the production of those goods that it produces most efficiently; and to buy the goods that it produces less efficiently from other countries, EVEN IF this means buying goods from other countries that it could produce more efficiently itself. The basic message of the theory of David Ricardo is that potential world production is greater with unrestricted free trade than it is with restricted trade. In addition, Ricardo´s theory stresses that trade is a positive-sum game in which all can gain, and it also suggests the philosophy of differentiation beyond raw material production but based on labor productivity and knowledge management.
Heckscher-Ohlin Trade Theory: The Swedish Vikings came in with a new notion (Eli Heckscher in 1919, and Bertil Ohlin in 1933). They argued that the comparative advantage has a different explanation. The comparative advantage arises from differences in each national factor endowments, rather than in differences of productivity. By factor endowments, they meant the extent to which a country is endowed with such resources as land, labor, and capital. Heckscher and Ohlin got it right by admitting that each country has different factor endowments, and these differences explain the factor costs for each nation. This Swedish commonsense appeal theory has been one of the most influential in international economics, much more than Ricardo´s theory. For example, at that time, the USA was a strong exporter of agricultural goods (large fields of arable land), meanwhile, other Asian countries excelled in the export of goods produced in labor-intensive manufacturing such as footwear and textiles.
The Smoot-Hawley Tariff act happened when Heckscher and Ohlin were working and refining their theory.

6. The Leontief Paradox: Wassily Leontief, published a study, in 1953, trying to find evidence to validate the Heckscher-Ohlin Theory, and he discovered that the Vikings theory was a unique rule for all, but it did not explain some countries trading as the USA. Leontief discovered that after WWII, the USA exports were less capital intensive than the USA imports. Why? If the USA was relatively abundant in capital compared to other countries, why was the US exports less capital intensive than its imports? And it appeared for the first time in history, that skilled labor and innovative entrepreneurship were factors of differentiation in trade. And this shocked economists with a difficult dilemma when trying to find international trade patterns. Was Heckscher-Ohlin theory right? Or was the Ricardian theory most suitable?

7. A New Trade Theory: Around 27 years later, by the end of the ’70s, the decade that the majority of the core Generation X was born, a new trade theory emerged. Economists observed that a new constituent was crucial to consider when in international trade: the presence of economies of scale. If a country has specialized industries, and the output of production expands, the recognition of economies of scale triggers the unit costs to decrease. Economies of scale are primarily derived by spreading fixed costs. One of these economists is Paul Krugman who wrote the paper “Increasing returns, monopolistic competition and international trade” at the Journal of International Economics in 1979. Krugman received the 2008 Nobel Economics Prize, by his research to explain patterns of international trade, and for his work in the early 1990s on economic geography. Krugman´s new trade theory observed that the existence of substantial economies of scale implies that the world market will profitably support only the most specialized firms or the early entrants into that industry. This inference opened the door to, the notion of first-mover advantage, and the concepts of barriers of entry. A country may dominate in the export of goods simply because it was lucky enough to have one or more firms among the first to produce that good. The innovation as a cause of first-mover advantage was set in our heads at that time. In addition, Krugman swayed us by trying to learn that luck was not the cause of increasing returns, but he introduced the idea that increasing returns are connected with capital, labor migration, transport costs, tipping points, network effects, and other factors.

8. Competitive Advantage. In parallel to Krugman´s theory, another guru from Harvard was doing his homework. Michael Porter´s competitive advantage research which has been evaluated during the last 40 years, it came also as an integrative result to explain the empty holes of David Ricardo and the Swedish Heckscher and Ohlin theory. Porter´s strategy theory came into place in the 80s. Porter offered a new model to guess the determinants of competitive advantage (factor endowments, demand or buyer conditions power, suppliers or related supporting industries power, industry rivalry degree, potential entrants and substitutes). Porter recognized the factor endowments from Heckscher-Ohlin Theory, but he deepened the hierarchies of those factors, by distinguishing between basic factors (natural resources, climate, location, demographics) and advanced factors (communications, infrastructure, sophisticated and skilled human capital, research facilities and technological know-how).

And here we are on October 16th, 2019, trying to understand the Smoot Hawley Tariff case (1930).

This is it for today. On my next post, we will explain why “the economic damage caused by the beggar-thy-neighbor trade policies that the Smoot Hawley act ushered in, exerted a profound influence on the economic institutions and ideology of the post-world war II world”.

Thank you.
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