Evaluate the historical evidence on two mechanisms through which the General Tariff may have influenced the economic recovery during the 1930s.
The General Tariff of 1932 implemented in interwar Britain might be argued to be a significant policy that allowed Britain to recovery strongly after the 1930 recession. Evidence shows that Britain’s recovery was milder and recovery stronger than USA and Germany. There are several mechanisms that the General Tariff could work through to influence the economic recovery including import substitution, effective protection rates (Capie), macroeconomic effects, and the trade blocs. This essay will focus on import substitution and macroeconomic effects, and evidence seems to suggest that tariffs do indeed aid economic recovery in the 1930s.
The import substitution argument suggests that when the general tariff was implemented, imports become more expensive, so people would switch from consuming imports to consuming domestic goods. This results in an increase in net exports (NX) and an increase in domestic consumption (C) that would together lead to an increase in GDP that characterises any economic recovery. A useful framework for evaluating this is the import replacement rate (IRR), where IRR = [del Y – del X]/ del M, so that would be the difference between the change in production and exports divided by the change in imports. If import substitution were effective, then IRR would be close to one, as every unit of production that is not exported offsets a fall in imports directly.
Richardson (1967) used the IRR framework to calculate the effect of tariffs in various industries. He divided them into two groups – the newly protected industries, and the non-newly protected industries. Interestingly, Richardson found that IRR was about 3 for the newly protected industries and IRR = 2 for the non-newly protected industries. This implies that the effect of the tariff was rather weak in import substitution. He uses this premise to later argue that it was the housing boom that led to the recovery.
Vartis and Solomou (1990) criticised Richardson’s methodology. Firstly, even with Richardson’s figures on British trade, exports of newly protected industries increased more and imports fell more than the non-newly protected group. Thus, they argue that Richardson’s measure effectively measures the life cycle of the industry, rather than import substitution. As such, they compared two periods – one before 1930 and another after to observe the effects of the tariff. Then, they found that higher tariffs did lead to higher production, suggesting some grounds for the import substitution argument.
Broadberry and Crafts (2011) conducted a more detailed analysis of the import substitution argument. Instead of the two-way classification that Vartis and Solomou used, Broadberry and Crafts used a three-way classification – they kept the non-newly protected group, and divided the newly protected group into two – those below 10% tariffs and those above. Using a difference in difference methodology, they found that only the newly protected group with tariffs above 10% experienced significant growth, so it was not tariffs itself that mattered, but relative tariffs. Lloyd and Solomou reviewed this article and noted two issues in Broadberry and Crafts’ thesis: (1) there was a methodology issue when we lump the entire 0-10% tariff group together as having no tariffs and 9% tariffs clearly gives different effects (2) there was a classification issue: in particular, rope, twine and bacon clearly had more than 10% tariffs, but Broadberry and Crafts put them in the 0-10% group. With this in mind, Lloyd and Solomou conducted a similar study, and concluded that growth was still positive for the >10% group. Unlikely Broadberry and Crafts who argued that there was no long run productivity differences with additional protection, Solomou and Lloyd suggested that there could be some productivity effects.
Evaluating the import substitution mechanism, evidence seems to suggest that there was positive growth effects on particular industries that had additional protection, though the growth for the economy as a whole through the tariffs might be rather dubious. Hence, we turn to macroeconomic effects next.
Before looking at macroeconomic evidence, it would be useful to understand the theory behind how tariffs can lead to macroeconomic growth. Y = C + I + G + NX, and tariffs have a role in increasing NX and increasing C, due to expenditure switching from exports to imports. For this argument to work, we need evidence for the following: (1) there was an increase in NX and C (2) multiplier effect was positive.
Evidence shows that NX was not a primary cause for Britain’s recovery in the 1930s, because there was effectively a collapse in world trade in the 1930s when almost all countries were protecting. Eichengreen and Irwin (1992), however, qualify that Britain’s trade agreements still put it in a position such that it created trade without diverting trade by having a trade bloc with its empire. Theoretically, if we look at the policy trilemma, we do have good reasons to believe that NX could not increase. The policy trilemma suggests that countries can only have two out of the three objectives: (1) fixed exchange rate (2) independent monetary policy (3) free capital flows. Britain, as the world’s banker, would not restrict capital flows, so it had a choice between (1) and (2). After the devaluation (exit from gold) in 1931, it changed its trilemma position to have an independent monetary policy and forgoing fixed exchange rate. In this position, output Y is determined in the money market, and by comparative statics we know that NX cannot change. If imports were to fall with tariffs, exports have to fall to balance the trade, so exchange rate has to appreciate. The appreciation of exchange rate will work right against the devaluation in 1931. However, we should qualify that Britain was in a managed float system in the 1930s, so it was unlikely to have an uncontrollable downward or upward spiral of exchange rate. This should also be placed in the context of collapsing world trade, so the increase in NX is not a good account.
Consumption increasing is consistent with evidence. In light of low incomes in primary producing countries and in US, much of UK’s recovery in the 1930s was domestically driven, and this would be attributed to the increase in consumption. This is especially true in the housing market: while the housing market took up about 3% of the GDP, it accounted for 17% of the change in GDP between 1932 and 1934, suggesting that consumption here was significant. Richardson noted that a new development block developed here due to the demand created by housing, so this was a strong impetus for recovery. In contrast, Eichengreen notes that less than 10% of the new jobs created during recovery were attributed to any export-linked sector. It should be qualified that while consumption increased, its link to tariffs is rather weak, since most scholars attributed it more to the cheap money policy in 1932.
Keynesians would argue that the multiplier effect during the interwar period was strong. Kahn estimated it to be 1.87 and Keynes between 2 and 3.55. This meant that an exogenous increase in aggregate demand through tariffs can lead to a more than proportionate increase in GDP, and tariffs would then be an effective channel to help with the 1930s recovery.
However, newer evidence suggests otherwise. Crafts and Mills (2012) re-estimated the multiplier during the interwar period and suggested that the multiplier would only be 0.5 to 0.8, due to “psychological crowding out”. Ricardian equivalence occurs when an increase in G results in people expecting taxes to increase in the future, so they would save instead of consume. Since the multiplier effect was contingent on rounds of consumption and high marginal propensity to consume, they would greatly weaken the multiplier. In the context of the interwar period, the government had already incurred large debts from WWI, so any public expenditure would lead to pessimism and more savings rather than spending. As such, it is possible that there is a positive but small multiplier effect, which clearly challenges the role of tariffs.
It is difficult to evaluate the role that tariffs played in Britain’s 1930 recovery as a whole, because the 1932 tariff occurred together with several other policies, and it is difficult to delineate their effects. On the field of import substitution, the effects are clearer because comparative statics can be done across industries as the scholars have done. On the macro-economy, the effects are less clear. Evidence suggests that NX growth was limited, and the recovery was stimulated largely internally, premised on a large housing boom, which can be attributed more to interest rates than tariffs. Estimates on the multiplier are also rather debatable due to the differences in methodologies used. If we look beyond these two mechanisms and into Capie’s study of effective protection rates, and subsequent works by Kitson, Solomou and Weale, we will find that even the effects on individual industries are less clear, and zero correlation was also found by the latter group. As such, historical evidence is not particularly clear on the tariff mechanisms, but it still remains as a useful explanation to understand the 1930s recovery.