Protect me at my peril

As the great and the good descended on Davos for the annual movers and shakers moving and shaking fest last week, one of the hot topics on the agenda was the rise of "protectionism". As nation states have felt the pain of rising unemployment, diminished tax revenues and growing budget deficits, the paternal inclination has started to move towards "protecting your own". Ironically, given the inter-dependent world we are in, steps towards "protecting your own" could have the opposite effect relatively quickly. Most of the folks in Davos may believe this to be true, but many political leaders will be inclined in the protectionist direction to avoid domestic flair ups, as job losses mount.

Collectively we should be looking to historical parallels to understand the importance of avoiding a protectionist route. Over the last 30 years the world has seen globalization of a kind many believe to be unprecedented, but the truth is that the world has been here before. In the three decades prior to the outbreak of WWI in 1914, trade in goods reached almost as large a proportion of global output as in the past 30 years. Several historians have made the argument that the outbreak of WWI should be understood as a kind of backlash against globalization, heralded by rising tariffs and immigration restrictions in the decade before 1914, and welcomed strongly by Europe's land-owning elite. This ruling, land-owning elite had been undermined for decades by the decline in agricultural prices and emigration of surplus rural labour to the New World.

After the end of the war, economic progress shifted forward and trade restrictions diminished once again, but international trade did not approach its pre war level. A further setback for the rebound in international trade occurred in 1929, after stock markets crashed in the US. Two Republican senators (Willis Hawley and Reed Smoot) sponsored a bill to raise tariffs to the highest levels America had ever seen. In the midst of the economic stress the protectionists won. The result was a reciprocal, tit-for-tat, round of hikes elsewhere, which led to a disastrous collapse in international trade, leading to huge job losses globally. In turn this hastened the demise of the Weimar government in Germany, who were already struggling with a mass of reparation payments left over from the end of the First World War. The government collapsed amidst hyperinflation in the early 1930s, and paved the way for Hitler's rise to power. The rest as they say is history, but the concept of globalization only started to be perceived a positive force again in the 1960s and 70s.

At Davos, I hope that these historical contexts were understood, as participants tried to grasp the consequences of a breakdown in the global trade structures that so many people around the world rely upon. At a simplistic level, international trade creates the opportunity for poorer nations to pull themselves out of poverty, through export led growth and richer countries to benefit from cheaper access to goods and services than could be domestically produced. Chinese growth rates over the past 10 years are testament to this concept, as are the cost of flat screen televisions for the consumer in the UK or the US. I suspect many of the participants at Davos are aware of the context, but the inclination towards protectionism may be too strong for some political leaders to bear. Gordon Brown, notably, has been particularly forthright in his eagerness to counter this inclination. Speaking on Friday, the Prime Minister insisted that "international co-operation is absolutely necessary" to ensure money and bank lending flow to emerging markets. "If we don't do that, then there'll be deleveraging equivalent to deglobalization where the loss of capacity will restrict the growth of the world economy".

These words, to an international audience, completely contradict the shock he has recently expressed at home over the bad, virtually all "foreign", loans made by the now almost nationalised RBS. The Treasury has specifically ordered RBS to increase its lending to British households and companies by £6bn in return for the right to convert £5bn of preference shares into common equity. Bank of England figures out on Friday showed that British financial institutions have responded to government pressures to maintain lending to UK companies and households by reducing foreign currency lending to non-residents by a greater amount in the fourth quarter than at any time since records began in 1990.

This comes against the backdrop of a series of unofficial strikes across Britain over plans by oil companies to give jobs to construction workers from Portugal and Italy. Workers at refineries and power stations in various parts of the UK staged walk outs, some holding placards quoting the words of the Prime Minister; "British jobs for British workers". In heated exchanges, some protesters called on their colleagues to march on Downing Street to protest at the situation. One of these protesters, a shop steward called Kenny Ward, addressed the crowd and told them they had to stand together and take on the "greedy employer". He said: "This is what it's about, it's about collective strength. I'm a victim, you are a victim, there are thousands in this country that are victims to this discrimination, this victimisation of the British worker." Ironically, the oil company at the centre of this dispute, Total SA, is financed by a global syndicate of banks, pension funds, insurance companies and other interested parties, the majority of whom will not be British at all. Kenny Ward and his placard wavers may be victims of the global market for labour, but they were also beneficiaries of the global market for capital that allowed Total SA to finance its British operations, and consequently create the jobs in the first place.

Issues over protectionism are appearing all around the world, perhaps most significantly in relation to US trade negotiations with China. House Democrats want to require that all iron and steel used in stimulus-funded infrastructure projects should be made in the United States. America's steel producers are happy, especially since they saw their share of the world steel market fall from 7.9% to 7.2% in 2008. This policy is being loosely directed at China, whose trade relations with the US have been souring gradually for the last couple of years, but have deteriorated faster in recent exchanges. American policy-makers have long pushed Beijing to accelerate the appreciation of the yuan, arguing that China's exchange rate policy played a big role in creating global imbalances and that, for the sake both of China's economy and the world economy, the yuan needs to strengthen. With global demand for its products diminishing, the Chinese inclination may be increasingly in the opposite direction - to make the yuan weaker, to sustain its export markets, which really would wind up relations with the US.

Interestingly, every six months the US Treasury is obliged by government order to publish a list of countries which it deems to be "currency manipulators". Once a country appears on the list, formal negotiations to end the manipulation are required to begin. Hank Paulson as Treasury Secretary had rigorously avoided accusing Beijing of being a "currency manipulator" (a term that carries legal implications), yet Tim Geithner has done it in his first week of office. Domestic politics are surely playing a big role in this change of tack. China's bilateral trade surplus with the US has long been an contentious issue in Congress, particularly with Democrats, and with unemployment up, the desire to take a more aggressive tone is increasing. The $800bn stimulus package making its way through Congress already has such dubious "buy American" measures like the one aimed at supporting the US steel market above.

The basic economic analysis - that a stronger yuan is necessary to rebalance China's economy away from exports - is probably right. The world's immediate problem, however, is a dramatic shortfall in demand that will not be magically corrected by exchange rate shifts. The US willfully encouraged the export orientated Chinese economy during the "good times" by buying the flat-screen TVs and refrigerators (etc.) that China was producing en masse, so there is a touch of sour grapes about this dispute now that the US is struggling domestically. The truth is that currency movements will only shift demand between countries, but it will not create it. In the short-term therefore the outlook for the world economy depends on whether governments stimulus packages are successful, not on whether China is "manipulating" its currency. Taking on this aggressive tone, though, has dangerous implications. Domestically Geithners comments may simply encourage anti-Chinese action - Lindsey Graham, a senator who first pushed for a 27.5% standard import tariff against China in 2005, called Geithner's comments "music to my ears". On the Chinese side, officials strongly dispute the idea that their savings surplus had anything to do with the current global mess. An official at China's central bank recently called the idea "ridiculous" and an example of "gangster logic". If trade relations did break into more concrete rounds of tit-for-tat tariffs and subsidies the implications could be substantial, both economically and politically. China's participation in funding the US budget deficits remains key to the US, and it could become an extremely politic weapon if the US continues to wind them up, which wouldn't be good for anybody.

With the global economy in its most dangerous circumstances since the 1930s, the group of leaders at Davos hopefully understand the potentially serious implications of tit-for-tat protectionism. In the globalized world prior to the First World War, the international reliance on free trade in labour, capital and manufacturing created an interdependence between nations that when broken sowed the seeds for global conflict. At the very least the Smoot-Hawley response and similar policies in 1929 turned a stock market crash into the Great Depression. For the oil workers in England, whose jobs are being 'taken' by immigrants, their story while unfortunate is a small subtext in the pros and cons of a globalized world. In the long run, the pros most certainly outweigh the cons, as history has shown.