Global Trade System Has Long Been in Transition
The Origins of the Post-War Trading System
While President Trump’s tariffs and tariff threats have seemingly turned trading norms on their heads, many in the media and elsewhere have bemoaned the end of what they refer to as the long-standing U.S.-led global trading system, or words to that effect. These commentators imply that the system has prevailed for more than eighty years since the end of the Second World War and perhaps also that it is responsible for global prosperity. There is a kernel of truth in these assertions, but only a kernel. They also miss a great deal of critical reality, for the system they imply as constant has morphed considerably over time, was not as U.S. led as they imply, and was never sustainable.
The global system, if that is the right word for it, has its origins in Washington’s very narrow foreign policy interests at the end of the Second World War. The Truman administration and its State Department worried that the poverty implicit in the wartime devastation of Europe and Japan would allow communism to take root in these places. Accordingly, they set out to rebuild these regions and bring them to prosperity as quickly as possible.
As part of that self-interested effort, Washington channeled huge flows of aid overseas, the Marshall Plan being the most famous. In a still more extensive effort to rebuild industry, the administration pursued a trade policy that allowed goods from Europe and Japan to flow freely into the United States even as it allowed counties in these regions to use tariffs and other trade restrictions to protect their own weak economies from American competition. To further facilitate overseas development, Washington established the Bretton Woods currency structure which fixed the value of the U.S. dollar much richer than other currencies, making foreign products cheap to American buyers and American products expensive to foreign buyers. Combined, these arrangements gave Japanese and European producers great competitive advantages over their American counterparts. It only worked because the U.S. economy at the time was overwhelmingly stronger than other economies.
From Bretton Woods to Trade Imbalances
Recognizing that these arrangements would become unsustainable after the inevitable revival of European and Japanese industry, Washington laid the groundwork for a transition at the same time. Through the U.S. inspired General Agreement on Tariffs and Trade (GATT), the precursor to the World Trade Organization (WTO), American diplomats pushed for the gradual removal of the tariffs and other trade barriers that Europe and Japan were using to protect their industries. GATT efforts made progress in the 1950s and 1960s in a series of so-called tariff-reduction “rounds.” But because Europe and Japan were aware of the benefits to their industries of tariffs and other trade restraints, progress on tariff reduction became increasingly difficult. Especially because American farming was so efficient, agriculture became a major sticking point, though far from the only one.
As Europe and Japan caught up with American industry in the 1970s, slow progress on tariff reductions and the continuation of the Bretton Woods currency arrangements made global trade arrangements increasingly difficult to sustain. They effectively encouraged Americans to consume more of the world’s output than the United States produced domestically. That was painfully obvious in this country’s ever-widening trade deficit, which more than doubled in the 1970s and more than doubled again in subsequent decades. Matters persisted in this unbalanced way because the dollar’s premier position as the world’s trading currency, the so-called global reserve, enabled Washington to borrow freely and so run policies of fiscal largesse that allowed Americans to continue consuming more than they produced.
Richard Nixon was the first president to address this fundamental unsustainability, though probably inadvertently. Worried over ever-larger U.S. trade deficits, he focused less on trade restraints than on the currency arrangements fixed in the Bretton Woods system. He approached Germany and Japan and asked them to revalue their currencies – the deutschemark and the yen respectively – upwards against the U.S. dollar so that American producers faced less of a pricing disadvantage in global markets, and Americans would have to pay more for imported goods. Because the existing arrangements greatly benefitted German and Japanese industries, they flatly refused. Nixon in response took the dollar off its gold peg in August 1971. The dollar crashed and a bulwark of the global trading system, the Bretton Woods arrangements, fell apart.
The dollar’s crash had a host of negative ramifications. Because it effectively reduced the global buying power of American consumers, the economy fell into recession. Because the Federal Reserve (Fed) printed money to soften this blow to American living standards, a powerful inflationary surge ensued, though these were not the only causes of the inflation. And because the dollar’s decline, dramatic as it was, still did not fully erase the pricing disadvantages facing American industry, the U.S. economy continued to consume more than it produced. Government borrowing continued on a grand scale, budget deficits remained high, and the economy’s trade deficit continued to expand.
The Rise of Free Trade Agreements
This fundamental unsustainability invited a new transformation in the 1980s. Nations, in an effort to balance trade flows sought what are called “free-trade agreements” (FTAs). The enlargement of the European Free Trade Association (EFTA), precursor to the European Union (EU), was one such effort. By reducing tariffs among its members, it evened out some imbalances within Europe but because external tariffs and other trade impediments remained in place, big imbalance between Europe and the United States untouched. A bit earlier, the United States tried to do something similar between itself, Mexico, and Canada by establishing the North American Free Trade Association (NAFTA). This might have helped smooth imbalances between these three countries, but it did nothing for trade flows between the United States, Europe, and Japan.
The fundamental unsustainability of global trade arrangements remained. Indeed, these efforts, of which the Trans-Pacific Partnership (TPP) was one, hardly merit their use of the words “free trade.” Because each such arrangement contains major exclusions, they might equally be called “exclusionary trade agreements” (ETAs). Europe excluded North America and Japan, NAFTA excluded Europe and Japan, the TPP would have excluded Europe and China, Asia’s largest economy.
Trump’s Tariffs and the Next Transition
Trump’s tariffs impose yet another transition on this constantly morphing system. Whether this change makes the system sustainable depends on Trump’s objectives. These, of course, remain obscure, as does so much in this administration. If Trump follows the goal he has alluded to in the past to use tariffs to pressure other nations to remove the trade restraints that have long disadvantaged American producers and privilege American consumers, then global trade might move toward a more balanced and sustainable reality. Such a result would remove the last great inequities that were established in the wake of the Second World War and that both Europe and Japan have largely held onto, and more recently China has established. Such a situation would allow U.S. domestic production to enter foreign markets on a more competitive footing and presumably balance trade flow, at last ending the pattern in which the United States consumes more than it produces. Indeed, it is just such an objective that Treasury Secretary Scott Bessent alluded to in a recent speech before the Institute of International Finance.
But this happy end is far from the only possible outcome. It is entirely possible that Trump has no such intention and sees the tariffs purely as a power play. If this is true, there would be no rebalancing. Even if Trump seeks a tandem tariff reduction, as he says, and as is implied by his use of the word “reciprocal,” this country’s trading partners might still respond to new U.S. tariffs by upping the ante with new tariffs of their own. That is what China has done and continues to threaten. The EU as well as other countries have threatened the same. In that case, consumers the world over would face a loss of buying power, likely sufficient to precipitate a global recession. U.S. tariffs in the 1930s, the so-called Smoot-Hawley tariffs, had just this effect and contributed meaningfully to the depth and duration of the Great Depression. Depending on how central banks reacted, such a situation today could add an inflationary burden to the economic downturn.
If Trump sincerely wants the rebalancing he has alluded to and Secretary Bessent has described, he is nonetheless playing a very risky game. He may have the tolerance for such risks, but few people do, especially the perennially nervous folks who run financial markets and invest. Accordingly, markets will remain volatile until the president’s aims and responses overseas become clear. If the happy scenario works out and at last trade begins to move toward balance, it could create quite a market rally. If not, it will be a rough ride. In the interim, it will be a rough ride anyway.
