Smoot-Hawley Revisited

According to a view common among macroeconomists, the Smoot-Hawley tariffs of the 1930s were a poor policy choice, but they were not a main reason for the severity of the Great Depression.  In an interesting blog post, economic historian Scott Sumner calls the second half of this conclusion into question:

In the period around March and April 1930, there were a few “green shoots” in the economy. The stock market recovered a significant chunk of the huge losses in 1929. (I recall the Dow fell well below 200 during the famous crash, and got back up over 260 in April. The 1929 peak had been 381.) Then in May and June everything seemed to fall apart, and stocks crashed again. So what happened in May and June?

The headline news stories during those months were the progress of Smoot-Hawley through Congress. Each time it cleared a major legislative hurdle, the Dow fell sharply. This pattern was obvious to those following the markets, and was frequently commented upon. After it cleared Congress it went to Hoover. The President received a petition from over 1000 economists pleading with him to veto the bill. (A veto would not have been overridden.) Over the weekend Hoover decided to sign the bill, and on Monday the Dow suffered its biggest single day drop of the entire year.

Scott then goes on to propose an explanation of these events that can be viewed as consistent with the textbook Keynesian model. In particular, I interpret Scott as saying that the retreat from free trade reduced business confidence, shifted the investment function I(r) to the left, and thereby reduced aggregate demand.

One general lesson from his discussion is that it is often hard to distinguish shocks to aggregate supply and shocks to aggregate demand.  Policies and events that adversely affect aggregate supply (e.g., trade restrictions) will often reduce the marginal productivity of capital, decrease investment spending for given interest rates, and depress aggregate demand as well.  In the short run, the indirect demand-side effects of "supply shocks" could potentially be larger than the direct supply-side effects.

This is something to keep in mind as our economy enjoys the beginnings of a recovery.