What China Can Learn From 1929

Everyone knows the story. For a decade a rising superpower has drawn huge investments in new manufacturing plants, which draw millions of migrants from the countryside. The resulting productivity boom makes this nation the factory of the world, producing far more goods than it can consume. Its trade surplus rises toward an astonishing 0.5 percent of world GDP. Foreign-currency reserves surge, making it the largest holder of reserves in history, which it uses to fund the trade deficits of its export customers. Then suddenly, a global banking crisis interrupts the flow of funding, and exports fade.

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This is not China in 2008. It's the United States in 1929. During the 1920s the United States exported its massive industrial overcapacity, mainly to Europe, until the stock-market and banking crashes of 1929 to 1931 undercut consumption, at home and abroad.

John Maynard Keynes argued at the time that as the nation with the largest trade surplus, the United States had to play the leading role in the global adjustment. Just as foreign overconsumption had come to an end, U.S. overproduction also had to end. There were two ways the country could balance domestic production and consumption. It could engineer massive fiscal expansion to replace declining global demand, or it could close down factories and lay off workers.

The United States saw another way. Why not create additional demand at home by discouraging Americans from buying foreign products? As part of this strategy, the U.S. Congress passed the notorious Smoot-Hawley Tariff Act in 1930, which sharply raised the cost of foreign imports. Congress hoped to increase the trade surplus, which effectively would force most of the adjustment in U.S. overcapacity onto foreigners while minimizing U.S. pain.

Not surprisingly, other countries refused to cooperate and insisted that the United States fix its overcapacity problem at home, not by shifting it abroad. They retaliated by erecting their own trade barriers, and within three years international trade plummeted by nearly 70 percent.

This pushed the overcapacity problem back onto the United States. Domestic consumption had to match domestic production. Since the U.S. government was unwilling or unable to engineer a sufficient expansion of demand, the country was compelled to close factories and learned, to its horror, that in a trade war the seemingly strong trade-surplus countries are actually more vulnerable than trade-deficit countries. The global balance of payments is very demanding. It will compensate one way or the other.