How to Prevent a Currency War

BERKELEY – Three years into the financial crisis, one might think that the world could put Great Depression analogies behind it. But they are back, and with more force than ever. Now the fear is that currency warfare, leading to tariffs and retaliation, could cause disruptions to the international trading system as serious as those of the 1930’s.

There’s good reason to worry, for the experience of the 1930’s suggests that exchange-rate disputes can be even more dangerous than deep slumps in terms of generating protectionist pressures.

In fact, it was not countries experiencing the worst economic downturns and the highest unemployment rates that raised tariffs and tightened quotas most dramatically in the 1930’s. Comparing countries, there was no relationship between either the depth and duration of the output collapse and the increase in levels of protection, or the magnitude of the rise in unemployment and the extent of protectionism.

The reason why countries hit harder in the 1930’s were not more inclined to respond by protecting industry from foreign competition is straightforward. The onset of the Great Depression saw a collapse of demand, which in turn led to a sharp fall in imports. As a result, levels of import penetration actually fell, quite sharply, in virtually every country. Producers had problems, to be sure, but import competition was the least of them.