Why protectionism is the biggest threat facing the US

If there's one thing that could send the US economy into another depression, it's a rise in protectionist sentiments, says John Mauldin. Unfortunately, recent events suggest that this is exactly what's happening in Washington. But the US is the country that stands to lose the most by alienating its trade partners...

Long-time readers know that I do not think the world is going to devolve into a soft depression. America's trade deficit and our large and growing debts will have to be dealt with, of course. But I think it will happen in the normal context of the business cycle.

A recession here, a falling dollar there, and slower than trend average growth over the next five years or so...and we get to where the re-set button has been hit.

It will not be fun, but it will not be the end of the world. It is what I call the 'Muddle Through Economy'. I am actually quite optimistic about the investment opportunities once we get through that period, with the usual caveats and asterisks.

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But I have maintained for many years that the one thing which could change my basic optimism is a new wave of protectionism. US Senator Smoot and Representative Hawley infamously sponsored a bill in 1930 that raised tariffs on a variety of products in order to 'protect' American jobs. Of course, the rest of the world retaliated and soon we went from a recession into a global Depression. Unemployment soared and all those jobs we 'saved' went away.

Recessions are part of the business cycle. The Fed and Bank of England cannot stop them, try though they might, nor can Congress or Parliament write legislation outlawing recessions.

And in the main, and with a few exceptions, they have not on balance been all that bad. One can make the argument that they are needed to correct imbalances and 'irrational exuberances' here and there. Typically, unemployment rises a few percent but comes back in a few years, the stock market falls but comes back, and profits fall but go on to make new highs after the 'reset' button is hit.

I am not trying to be cavalier. If it is your job or investment or profits that get hit, it can mean some very long and sleepless nights. Been there. Done that.

But for the vast majority of US citizens, for instance, the last recession had little effect. Unemployment never rose above 7%, and corporate profits came back quite strong. The next recession may be worse, but it will end soon enough. That is the way of the business cycle.

But while recessions are part and parcel of the economic cycle, it takes a government to really mess things up and create a depression. Show me a depression - not a shorter term recession - in a free society that was not the result of government incompetence or some form of direct government involvement. You can't. Usually they are the result of multiple and coordinated government groups all working together to make things better and having the opposite effect.

Yes, I suppose you could say that Smoot and Hawley were just responding to the zeitgeist of the times, that the voters were demanding their jobs be protected, so that the American people got what they deserved. But the US Congress and the Fed aided and abetted. President Hoover should have used a veto. For that alone, he deserved to be defeated two years later.

Last month, an updated version of Smoot and Hawley's Congress put together a veto proof gaggle to stop the United Arab Emirates from buying a British port management company, P&O Ports, that ran six of America's ports. Security was the ostensible reason, but anyone who did their homework knows that national security on any level was never at risk. This congressional tantrum bothers me on several levels.

US ports are run by a number of companies that are not US-based companies. Five ports have Danish firms running them, for instance. Two are run by the Chinese.

Basically these companies move freight. Pick it up here and put it there. They have nothing to do with port security. Port security on America's shores is the province of US Customs and the Coast Guard. And they hire American union workers.

The United Arab Emirates may be the largest non-US port service for the US Navy, too. It's based in Dubai. They are a solid ally and a voice of moderation and stability in an area of the world where such is needed.

Now, someone in the US administration at the middle level should have seen the political implications of the P&O deal. Sadly, the Bush administration does not do a good job of explaining their policies. This should have privately been run up to Congress and vetted there before the approval went through. So, a lot of the blame should be laid onto the administration for having a 'tin ear'.

The next thing we know, US talk radio is going over the edge, calls into Republican congressmen are running 9-1 against the deal in an election year that looks tough for them to begin with, and Democratic Congressmen see a chance to appear concerned about national security and really tweak the President. Before you know it, there is a move to stop the deal.

There is already a process in place, however, that vets foreign investments in the United States with security implications. They are brought before the Committee on Foreign Investment in the United States (CFIUS). This governmental inter-agency group looks at foreign investments, and if one of them sees a red flag, they run it further up the command chain. The P&O deal, after being thoroughly investigated, caused no concern and was approved. But that was before someone in Congress saw an opportunity to make political capital out of the deal.

The CFIUS process works, and it keeps politics more or less out of business deals. But now, Congress has learned it can basically look at any deal and say that it's against the national interest for some foreign company to buy a US company. And every tin pot congressman who wants to posture in front of a camera and who has a company in his district that becomes a target will now want to get involved. Companies that lose a bidding war or that have an axe to grind will complain to Congress: 'I don't want that foreign company competing on my turf and taking US jobs from my employees!'

Shades of Smoot-Hawley! Yet Americans have spent decades persuading nations around the world to open up their countries to investment. And they have. We have over $10 trillion invested outside of the United States, which made American firms $500 billion last year, a little under 5% of our GDP! That is about $1,600 for every man, woman and child in the United States.

That money gets paid out as dividends, gets invested in our economy, and goes to pay our workers. And last year, foreigners increased their investments in the United States by $1.4 trillion, in a wide variety of investments. Without those dollars, the US currency would have collapsed, interest rates would be through the roof and we would be facing (or in!) a REAL recession, not the garden variety ones we have had since 1990.

'A study by the Organization for International Investments finds that about 5.3 million Americans are directly employed by foreign-owned firms with wages averaging $63,000, or about 50% more than the average US wage. Foreigners are not buying up America's wealth; they are investing in ways that add to it," reports the Wall Street Journal.

That means that about 8% of American workers are employed by foreign-owned companies. You can bet they are happy they have the higher-paying jobs. If not, they would simply leave. But the line for those high-paying jobs is long.

Yet now, there are those in Congress who would like to stop that wealth and job creating foreign investment.

'In recent weeks Members of Congress have suggested that the foreign-ownership ban should apply to roads, telecommunications, airlines, broadcasting, shipping, technology firms, water facilities, buildings, real estate and even US Treasury securities.' (The Wall Street Journal editorial, March 10, 2006)

How does this sound to those nations that we are trying to get to open up to Western investments? Why should they cooperate if we re not going to practice what we preach, when it is in our clear interest to do so?

If this was just the P&O deal, I could rest easier. But last year it was the dust-up over China buying a mid-size US oil company that had relatively little US production. We have Senators Charles (Smoot) Schumer and Lindsey (Hawley) Graham cooperating in a bit of bi-partisan idiocy to try and put a 27% tariff on Chinese goods.

And let's be blunt. To suggest such a thing demonstrates either astounding economic ignorance or simple political pandering of the worst kind. Probably both.

Do we really want to raise the price of everything from China by 27%? On items that we no longer make here? Do we want to risk the start another trade war? Or have the Chinese stop buying US Treasuries?

Can you say recession, boys and girls?

By John Mauldin for The Daily Reckoning. You can read more from John and many others at www.dailyreckoning.co.uk.

John Mauldin is the creative force behind the Millennium Wave investment theory, author of the weekly economic e-mail Thoughts from the Frontline, JohnMauldin.com, and a private letter for accredited investors. As well as being a frequent contributor to The Daily Reckoning, Mr Mauldin is a New York Times best-selling author with a unique ability to present complex financial topics and make them understandable to the lay reader. His latest book, Just One Thing, was released in December of 2005.

You can purchase your copy at a 30% discount here: 'Just One Thing'