Investment during the great depression: uncertainty and the role of the Smoot-Hawley tariff.

• Author: Archibald, Robert B.

Industry and commerce are now in many instances unable to conclude their plans and many programs of development are waiting or threatened with abandonment, while party politics, bloc politics, personal politics and sectional politics are maneuvering for this or that advantage or to avenge this or that defeat or embarrass this or that political personality.

The House of Representatives has performed its duty. Why cannot the Senate act or frankly acknowledge its incapacity to legislate and let the country know the conditions to which our slowing economic machine must adjust itself to move forward?

John E. Edgerton President, National Association of Manufacturers New York Times, November 11, 1929, Section 1, page 2

1. Introduction

   The political process set in motion in early 1929 that led ultimately to the Smoot-Hawley tariff likely generated a climate of business uncertainty. We test whether this uncertainty affected business fixed investment during 1929 and the early 1930s. The theory of irreversible choice under uncertainty supports the idea that a climate of increased uncertainty can create an investment cycle. Bernanke (1983a) argues that irreversibility of investment decisions means that firms must make timing decisions that trade off extra gains from early commitment against the benefits of waiting for more information. Events with unclear long-run consequences can depress investment by increasing the returns to waiting. Pindyck (1991) likens an irreversible investment opportunity to a financial call option. The standard net present value rule fails since the value of a unit of capital must exceed its purchase and installation price by an amount equal to the value of keeping the investment option alive. Thus, changing economic conditions that affect the perceived riskiness of future cash flows may have an effect that dominates a change in, for instance, real interest rates.

   The effect on investment of trade regime uncertainty should vary based on the international exposure of the industry. If an industry has a large export market, competes with foreign firms in the domestic market, or relies on imported inputs, threatened changes in tariff policies will be very important. This description of exposure likely comprises a sizeable fraction of the economy, including most traded-goods industries. Plus, if the capital/output ratio were higher in trade-exposed industries than in the rest of the economy (which includes labor-intensive services), then the share of an investment decline attributable to trade regime uncertainty could be quite large.

   This paper brings together a number of data sources to evaluate the behavior of investment during the depression. We use cross-sectional net investment data from 1927-1936 at the two-digit standard industrial classification level to build a neoclassical investment function augmented by two measures of international exposure. The exposure variables permit us to test the hypothesis that trade regime uncertainty was related to declines in investment during the downturn that became the Great Depression. Our measures of exposure prove important in explaining investment behavior at the start of the downturn (1929) but not in later years (1930-1933). Thus, the tariff was likely one of the triggers that precipitated the downturn that other factors, such as adherence to the gold standard, then exacerbated into the Great Depression.

2. Lessons from the Great Depression

   Recent years have seen a significant evolution in our understanding of the causal processes at work during the Great Depression. In the traditional view, as Meltzer (1976) has phrased it, the Smoot-Hawley tariff converted a "sizeable recession into a severe depression" (p. 469). This view has roots back to the Depression itself. In the election of 1932, Roosevelt charged Hoover with complete responsibility for the Depression. Among its domestic causes, he argued, was the new tariff regime that inhibited foreign debt repayment and elicited strong trade retaliation. Lewis (1949) provides a postwar expression of this position. Trade policy could have imparted a contractionary shock to the U.S. through a number of channels. Gordon and Wilcox (1981) posit three. Directly, without any retaliation, the resulting increase in the price of U.S. imports and close substitutes altered the division of the nominal income decline between output and prices in 1930-1932, so output fell more than otherwise and prices fell less. Retaliation could also lower aggregate demand through the trade multiplier. Lastly, foreign retaliation against U.S. food exports could have aggravated the decline in farm prices, worsening the banking crisis and in turn the decline in the supply of money due to currency hoarding.(1)

   Much recent research is corrosive to this orthodox view. Eichengreen (1992) argues that the gold standard itself was central in transmitting contractionary shocks from nation to nation. He concludes that nations that abandoned gold fared significantly better in the 1930s than did those who clung to the mechanism longer. Eichengreen (1994) also argues that the collapse of world trade in the 1930s was likely caused by the Depression and not a cause of it.(2) In his view, the tariff was either macroeconomically insignificant or marginally stimulative. "By applying modest inflationary pressure in an environment of low and falling prices, tariffs actually worked to close that Okun's Gap" (Eichengreen 1994, p. 45). He has also shown (Eichengreen 1989) that one can construct a static macro model in which worldwide increases in barriers to trade redirect spending without reducing it. His simulations suggest modest positive output and employment effects of tariffs and retaliation in the 1930s. Romer (1993) also rejects Smoot-Hawley as a causal factor in the Depression. She suggests that the onset and early course of the Great Depression in the U.S., while part of a worldwide phenomenon, can be explained can essentially in a closed economy model. She discounts the role of international trade since U.S. net exports played a smaller role in the decline in output in 1929-1931 than in previous downturns in the 1920s.

   Perhaps the most succinct dismissal of the tariff comes from the first chapter of Temin's (1989) Lessons from the Great Depression. He argues that a tariff, like a devaluation, is an expansionary policy since it diverts demand from foreign to domestic goods. Furthermore, he says (see p. 46)

   It may thereby create inefficiencies, but this is a second-order effect. The Smoot-Hawley tariff also may have hurt countries that exported to the United States. The popular argument, however, is that the tariff caused the American Depression. The argument has to be that the tariff reduced the demand for American exports by inducing retaliatory foreign tariffs. (Eichengreen 1989)

   Exports were 7 percent of GNP in 1929. They fell by 1.5 percent of 1929 GNP in the next two years. Given the fall in world demand in these years from the causes described here, not all of this fall can be ascribed to retaliation from the Smoot-Hawley tariff. Even if it is, real GNP fell over 15 percent in these same years. With any reasonable multiplier, the fall in export demand can only be a small part of the story. And it needs to be offset by the rise in domestic demand from the tariff. Any net contractionary effect of the tariff was small. (Dornbusch and Fischer 1986, pp. 466-470)

   This focus on net exports as the primary channel for international factors to affect domestic demand misses another potentially important consequence of changes in the international business climate. In particular, macro models that do not incorporate uncertainty may understate the effect on investment of cash flow uncertainty from doubts about the future structure of the trade regime.(3) Since internationally exposed industries comprise a large fraction of the economy, neither the ratio of exports to GNP nor changes in net exports is a sufficient indicator of the likely consequences of trade regime change. If a feedback existed from trade regime change to domestic investment, then the tariff may have been a macroeconomically relevant component of the early years of the Depression.(4)

   [TABULAR DATA FOR TABLE 1 OMITTED]

3. The Smoot-Hawley Tariff as a Source of Business Uncertainty

   The Smoot-Hawley Tariff legislation passed the House of Representatives on June 14, 1930, and on the following day, the New York Times published a "Chronology of the Tariff Bill From Jan., 1929 to June, 1930" (section 1, p. 26). Table 1 gives this chronology. If anything, it understates the legislative turmoil surrounding this bill. The initial reason for reconsidering the tariff code was to provide more protection for agricultural products. However, as Taussig (1931) explains in The Tariff History of the United States, log-rolling in the House Ways and Means Committee (chaired by Representative Willis C. Hawley of Oregon) and the Senate Finance Committee (chaired by Senator Reed Smoot of Utah) soon involved duties on many manufactured products as well as agricultural products. The process of log-rolling was enhanced by the organization of the House Ways and Means Committee, in which the 15 members of the Republican majority were each given subcommittees to chair dealing with a particular tariff schedule. Each subcommittee had three members, a subcommittee chair, and two other members who were themselves chairs of other subcommittees. The proceedings were behind closed doors, so there was ample opportunity for vote trading.(5)

   The bill that eventually passed the House represented a considerably larger alteration of the tariff schedules than had been planned originally, and the bill was changed considerably by the Senate Finance Committee. While the bill was before the full Senate, the leadership lost control of the debate to a group of Democrats and progressive Republicans.(6) Taussig explains the...