Most Americans might remember learning in high school about the Smoot-Hawley tariff and that it had something to do with the Great Depression.
President Hoover, against the recommendations of most of the major economists and industrialists, signed Smoot-Hawley into law on June 17, 1930. The law raised tariffs to record levels on more than 20,000 imported goods.
America’s trading partners retaliated immediately by dramatically increasing their own tariffs. The U.S. export market subsequently collapsed, falling by more than half, and the jobs that depended on those exports disappeared. International trade froze, helping the recession of 1929 become the Great Depression.
Today, living in a somewhat mirrored image of 1930, with precipitous stock market drops and a growing recession, we are again being confronted with a dramatic reduction in world trade. A tariff of mistrust, as daunting as Smoot-Hawley, has seized the world of finance and trade.
Much of international trade is financed by a convenient but arcane document called a letter of credit, an age-old financing concept thought to have been conceived by the Medicis, the ruling family of Florence during the Renaissance.
In principle, a letter of credit is a guarantee from the buyer’s bank to the seller’s bank in another country that the shipment will be paid for. The seller does not have to rely on either the creditworthiness of the buyer or bother with the difficulty of legal action in a foreign country if payment is not made.
Simply put, with a confirmed letter of credit, the seller has a bank guarantee that if the contractual terms of the purchase are met, the purchase will be paid for.
This centuries-old system is now failing. The underlying principle of a letter of credit is trust, based on the concept that banks operating in the international marketplace will trust each other. But now fear, not trust, permeates the financial system. And with fear, a tariff - a wall of mistrust - has arisen
The numbers representing this are startling.
The Baltic Dry Index measures the price of sea voyages and the cost of chartering ships; therefore, it is one of the key barometers of the globalization trade. It has plunged more than 90 percent since May.
HSBC, a leading trade finance bank in New York, has said that the cost of guaranteeing a letter of credit has doubled. That means a $10 million letter of credit that previously cost $50,000 now costs $100,000.
Exporters who already have severe problems obtaining trade finance now find that their buyers cannot open letters of credit or that their own banks will not accept the letters of credit from their buyers’ banks.
Realizing the impact on world trade this is causing, Pascal Lamy, the director general of the World Trade Organization, has invited leaders of trade finance banks, including HSBC, the Royal Bank of Scotland, JPMorgan and Germany’s Commerzbank, to a meeting in Geneva with the International Monetary Fund and the World Bank to find new ways to finance the global exchange of goods and services.
But in much the same way that the U.S. government’s infusion of $250 billion has not stimulated bank lending, it is unlikely that this conference will solve the immediate crisis.