- Economic shocks are a main reason for recessions.
- Oil price shocks and financial shocks are two primary causes.
- We tried protectionism in the 1930s; that didn't end well.
Like many market watchers, I monitor a number of economic indicators, which I periodically revisit to assess the current economic backdrop (here's a link to my most recent piece). The idea behind this constant re-assessment is that an adverse movement will telegraph that a recession is coming, or at least more probable. But, it's also important to remember that what usually causes a recession is some type of economic shock to the economy - an event that in some manner causes a widespread dislocation so severe that economic activity slows and then contracts. There is ample evidence of these events in the historical record. Oil price spikes and financial shocks are two that we are more familiar with. But trade wars are another. We started one in the 1930s; that lead to a worldwide depression. Considering the nearly exponential increase in global integration since then, a trade war would have just as devastating an impact today.
Let's look at the predominate economic shocks that have caused a recession in the past.
After WWII, the US economy became entirely dependent on oil. Consumers needed it to power their cars; it also provided fuel for trucking transportation, which to this day is vital to the domestic economy. And let's not forget how central the auto manufacturing industry was to US growth in the 50s, 60s, and 70s. When oil prices spiked, consumers reallocated their spending from other goods and services to energy. This can be fatal for the domestic economy because consumer spending accounts for 70% of economic growth. This explains why oil price shocks are a primary reason behind most recessions. James Hamilton, who regularly blogs over at Econbrowser has done a tremendous amount of research on this topic. Here's a link to a paper that explains how oil price shocks are behind a majority of post-WWII US recessions.
The financial system stands at the center of the U.S. economy. Economists conceptualize this with the "circular flow" diagram:
In general, financial institutions take small amounts of money in the form of deposits and insurance payments, bundle these payments into larger sums, and then loan money to businesses. Just like oil prices mentioned above, the US economy (actually, any developed economy) must have a well-functioning financial system to grow. When there's a problem with this system, the economy stops growing. The Great Depression and the Great Recession are both examples of a contraction caused by some type of failure of the financial system. (If you'd like to read more about both, here's a link to Irving Fisher's "The Debt-Deflation Theory of the Great Depression" which conceptualizes both events with remarkable accuracy).
While Paul Volcker's raising interest rates in the early 1980s wasn't a financial meltdown, it's also an example of the financial system causing a recession. However, in that case, it was the Federal Reserve deliberately raising interest rates to slow the economy. And the stock market collapse of the late 1990s also qualifies as a precursor to the early 2000s recession.
The best example of the negative impact of trade wars is the Smoot-Hawley Act, passed in 1930. Here is a brief explanation of the Act and its impacts [emphasis added]:
The Smoot-Hawley Tariff Act of 1930 raised taxes on imports substantially on top of an earlier rise in 1922. The goal was to protect American manufacturers from competition from foreign imports. International trade was a small enough percentage of the American economy at the time that most economists ascribe the tariff a secondary role as a contributor to the Depression in the 38 U.S. However, it had far worse implications at the international level. The Smoot-Hawley tariff was matched by a series of protectionist measures by countries throughout the world. As each nation tried to protect its home production interests through higher tariffs and restrictions on imports, world trade spiraled downward. By 1933 the total imports for 75 countries had fallen to roughly one-third of the level seen in 1929 (Kindleberger 1986).
This chart shows the negative impact:
Trade is now far more central to the US and global economies. The IMF wrote several articles over the last 10 years, showing that weak trade flows were a primary reason for weak global growth (here is one example; see also their World Economic Outlooks during this time). Despite numerous comments and articles about the death of US exports, they're actually growing relative to GDP.
The chart calculated total exports as a percent of GDP. Back in the 1930s, they were far less important to the US economy. Now, they represent about 13% of real GDP.
The increase in trade has allowed countries with a lower standard of living to produce less sophisticated goods (textiles being a price example), while more developed countries (such as China) are manufacturing higher-quality goods. And supply chains are now global; they're based on the free flow of goods across borders. A trade war in this environment would deliver a fatal blow to global growth, which is finally hitting on all cylinders. It is literally the worst policy option available.
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