Category: Essentials of Economics: Ch 14

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Commercial banking: the emerging risks from the shadow-banking sector

Recently, a flurry of bankruptcies among non-bank financial intermediaries (NBFIs) in the USA has drawn attention to the risks associated with alternative credit channels in the shadow-banking sector – lending which is not financed with deposits. There is concern that this could be the start of a wave of bankruptcies among such NBFIs, especially given concerns about a potential downswing in the economic cycle – a time when defaults are more likely.

While providing alternative sources of funding, the opacity of lending in the shadow-banking sector means it is not clear what risks NBFIs face themselves and, more significantly, what risks they pose to the financial system as a whole. There is particular concern about the impact on regulated banks.

Already, JP Morgan Chase in its third quarter earnings report announced a $170m charge stemming from the bankruptcy of Tricolor, which specialised in sub-prime car financing. Mid-sized banks, Western Alliance and Zions Bancorp, have reported losses from loans to a group of distressed real estate funds. This has highlighted the interconnectedness between NBFIs and regulated banking, and the potential for problems in the shadow-banking sector to have a direct impact on mainstream banks.

In this blog, we will trace the secular trends in the financial systems of more advanced economies which have given rise to alternative credit channels and, in turn, to potential banking crises. We will explain the relationship between regulated banks and shadow banks, analysing the risks involved, the potential impact on the financial system and the policy implications.

What are the secular trends in banking?

The traditional model of commercial banking involved taking deposits and using them to finance loans to households and firms. However, cycles of banking crises, regulatory changes and financial innovation over the past 50 years produced new models.

First, banks diversified away from direct lending to providing other banking services – on-balance sheet activities, such as investing in financial securities, and off-balance sheet activities, such as acting as agents in the sale of financial securities.

Second, alternative credit channels based on financial markets have grown in significance.

In the 1980s, international regulations around traditional banking activities – taking deposits and making loans – were being formalised by the Bank for International Settlements (BIS) under what became known as the Basel framework (see, for example, Economics section 18.2 or Economics for Business section 28.2). For the first time, this stipulated liquidity and capital requirements for international banks relating to their traditional lending activities. However, at the same time the deregulation of financial markets and financial innovation provided banks with opportunities to derive revenues from a range of other financial services.

After the financial crisis, liquidity and capital requirements for banks were tightened further through the Basel III regulations. Commercial banks had to have even higher levels of capital as a buffer for bad debts associated with direct lending. A higher level of capital to cover potential losses increases the marginal cost of lending, since each pound of additional loan requires additional capital. This reduced the marginal return, and consequently, the incentive to lend directly.

These regulatory developments created an incentive to pursue activities which do not require as much capital, since their marginal cost is lower and potential return is higher. Consequently, banks have placed less emphasis on lending and more on purchasing short-term and long-term financial securities and generating non-interest income from off-balance sheet activities. For instance, research by the Bank of England found that during the 1980s, interest income accounted for more than two-thirds of total income for large international banks. In contemporary times, non-interest income tends to be greater than interest income. Figure 1 illustrates the declining proportion of total assets represented by commercial and consumer loans for all regulated US banks. (Click here for a PowerPoint.)

With banks originating less lending, activity has migrated to different avenues in the shadow-banking sector. This sector has always existed, but deregulation and financial innovation created opportunities for the growth of shadow banking – lending which is not financed with deposits. Traditionally, non-bank financial intermediaries (NBFIs), such as pension funds, hedge funds and insurance companies, use funds from investors to buy securities through financial markets. However, new types of NBFIs have emerged which originate loans themselves, notably private credit institutions. As Figure 2 illustrates, a lot of the expansion in the activities of NBFIs has been the due to increased lending by these institutions (defined as ‘other financial institutions (OFIs)). Note that the NBFI line includes OFIs. (Click here for a PowerPoint.)

Since, NBFIs operate outside conventional regulatory frameworks, their credit intermediation and maturity transformation are not subject to the same capital requirements or oversight that banks are. As a result, they do not need to have the same level of capital to insulate against loan losses. Therefore, lending in the shadow-banking sector has a lower marginal cost compared to equivalent lending in the banking sector. Consequently, it generates a higher rate of return. This can explain the large growth in the assets of OFIs illustrated in Figure 2.

Risks in shadow banking

Banking involves trade-offs and this is the case whether the activities happen in the regulated or shadow-banking sector. Increasing lending increases profitability. But as lending continues to increase, at some point the risk-return profile becomes less favourable since institutions are lending to increasingly higher-risk borrowers and for higher-risk projects.

In downturns, when rates of defaults rise, such risks become apparent. Borrowers fail and default, causing significant loan losses for lenders. With lower levels of capital, NBFIs will have a lower buffer to insulate investors from these losses, increasing the likelihood of default.

Is this a problem? Well, for a long-time regulators thought not. It was thought that failures in the shadow-banking sector would have no implications for deposit-holders in regulated banks and the payments mechanism. Unfortunately, current developments in the USA have highlighted that this is unlikely to be the case.

The connections between regulated and shadow banking

The financial system is highly interconnected, and each successive financial crisis has shown that systemic risks lurk in obscure places. On the face of it, NBFIs appear separate from regulated banks. But banks’ new business models have not removed them from the lending channel, merely changed their role. Short-term financing used to be conducted and funded by banks. Now, it is conducted by NBFIs, but still financed by banks. Long-term loan financing is no longer on banks’ balance sheets. However, while the lending is conducted by NBFIs, it is largely funded by banks.

NBFIs cannot be repositories of liquidity. Since they do not have deposits and are not part of the payments system, they have no access to official liquidity backstops. So, they do so indirectly by using deposit-taking banks as liquidity insurance. Banks provide this liquidity in a variety of ways:

  • Investing in the securities issued by private capital funds;
  • Providing bridge financing to credit managers to securitise credit card receivables;
  • Providing prime broker financing to a hedge fund engaged in proprietary trading.

Furthermore, banks have increasingly made loans to NBFIs. Data for US commercial banks lending to the shadow-banking sector are publicly available only since 2015. But, as Figure 3 illustrates, it has seen a steady upward trend with a surge in activity in 2025. (Click here for a PowerPoint.)

Banks had an incentive to diversify into these activities since they are a source of revenue requiring less regulatory capital. The model requires risk and return to follow capital out of the banking system into the shadow-banking sector. However, while risky capital and its associated expected return have moved in the shadow-banking system, not all of the liquidity and credit default risk may have done so. Ultimately, some of that risk may be borne by the deposit-holders of the banks.

This is not an issue if banks are fully aware of the risks. However, problems arise when banks do not know the full risks they are taking.

There are reasons why this may be the case. Credit markets involve significant asymmetric information between lenders and borrowers. This creates conditions for the classic problems of moral hazard and adverse selection.

Moral hazard is a hidden action problem, whereby borrowers take greater risks because they share the possible downside losses with the lender. Adverse selection is the hidden information problem, whereby lenders do not have full information about the riskiness of borrowers or their activities.

The economics of information suggests that banks exploit scale, scope and learning economies to overcome the costs associated with asymmetric information in lending. However, that applies to direct lending when banks have full information about credit default risk on their loan book. When banks finance lending indirectly through NBFIs, there is an extension of the intermediation chain, and while banks may know the NBFIs, they will have much less information about the risks associated with the lending they are ‘underwriting’. This heightens their problems of asymmetric information associated with credit default risk.

What are the risks at present?

The level of debt in the global economy is at unprecedented levels. Data from the International Monetary Fund (IMF) show that it rose to $351 trillion dollars in 2024, approximately 235% of weighted global gross domestic product (GDP). It is in this environment that private credit channels through NBFIs have been expanding. With this, it is more likely that NBFIs’ trade-off between credit risk and return has tilted greatly in favour of the former. Some point to the recent collapse of Tricolor and First Brands – both intermediary financing companies funded by private credit – as evidence of elevated levels of risk.

Many are pointing out that the failures observed in the USA so far have a whiff of fraud associated with them, with suggestions of multiple loans being secured against the same working capital. However, such behaviour is symptomatic of ‘late-cycle’ lending, where the incentive to squeeze more profit from lending in a more competitive environment leads to short-cuts – short-cuts that banks, at one stage removed along the intermediation chain, will have less information about.

It is in a downturn that such risks become apparent. Widening credit spreads and the reduced availability of credit causes financial stress for higher-risk borrowers. Inevitably, that higher risk will lead to higher defaults, more provision for loan losses and write-downs in the value of loan assets.

While investors in NBFIs are first in line to bear the losses, they are not the only ones exposed. At moments of stress, the credit lines that banks have provided get drawn and that increases the exposure of banks to the risks associated with NBFIs and whoever they have lent to. As NBFIs fail, the financing provided by banks will not be repaid and they will thus have to absorb losses associated with the lending of the NBFIs. So, while it appears that risk has left the banking system, it hasn’t. Ultimately, the liquidity and credit default risk of the non-bank sector is financed by bank deposits.

Furthermore, the opaqueness of the exposure of banks to risks in the shadow-banking sector may have issues for the wider financial system. In 2008, banks became wary of lending to each other during the financial crisis because they didn’t know the exposure of counterparty institutions to losses from securitised debt instruments. Now, as more and more banks reveal exposures to NBFIs, concerns about the unknown position of other banks may produce a repeat of the credit crunch which occurred then. A seizing up of credit markets will worsen any downturn. However, unlike 2008, the financial resources available to central banks and governments to deal with any consequences are severely limited.

Only time and the path of the US economy will reveal the extent of any contagion related to lending in the shadow-banking sector. However, central banks are already worried about the risks associated with the shadow-banking sector and have been taking steps to identify and ameliorate them. Events in the USA over the past few weeks may accelerate the process and bring more of that lending within the regulatory cordon.

Articles

Academic paper

Data

Questions

  1. Explain why the need to hold more capital raises its cost for banks.
  2. Why does this reduce the lending they undertake?
  3. What is the attraction of ‘off-balance sheet transactions’ for regulated banks?
  4. Analyse the asymmetric information that banks face when providing liquidity to non-bank financial institutions (NBFIs).
  5. Examine the dangers for the financial system associated with regulated banks’ exposure to NBFIs?
  6. Discuss some policy recommendations regarding bank lending to NBFIs.
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Gold: why the world’s oldest safe haven is back in the spotlight

The gold market has become one of the most talked-about commodity markets in 2025, with prices reaching record highs. This is largely due to increased demand from investors, who see gold as a ‘safe haven’ during times of economic and political uncertainty. Central banks are also buying more gold as a way to reduce their reliance on currencies like the US dollar. With many analysts predicting prices could reach over $4000 per ounce in the next year, the gold market is showcasing how supply and demand, confidence, and global events can all influence a commodity market.

The commodities market is where basic agricultural products, raw materials and metals, such as gold, are bought and sold, often in large quantities and across global exchanges. Commodities are typically traded either in their physical form (like gold bars) at current market prices (spot prices) or through financial contracts, where investors buy or sell in futures markets. These are where a price is agreed today to buy or sell on a specific future date.

As with other commodities, the price of gold is determined by supply and demand. Demand for gold typically rises during times of economic uncertainty as investors want a safer store of value. This results in an increase in its price. Supply and demand, and hence price, also respond to other factors, including interest rates, currency movements, economic growth and growth prospects, and geopolitical events.

Record high prices

This year, the gold market has seen a remarkable rally, with the price of gold hitting a record high. Demand for the precious metal has resulted in spot prices surging over 35% to date (see the chart: click here for a PowerPoint). Rising prices earlier this year have been attributed to the US President, Donald Trump, announcing wide-ranging tariffs which have upset global trade. On 2 September, the spot gold price hit $3508.50 per ounce, continuing its upwards trend.

The price has also been lifted by expectations that the Federal Reserve (the US central bank) will cut its key interest rate, making gold an even more attractive prospect for investors. If the Federal Reserve cuts interest rates, the price of gold usually increases. This is because gold does not pay any interest or yield, so when interest rates are high, investors can earn better returns from alternatives, such as savings accounts or bonds. However, when interest rates fall, those returns become less attractive, making gold relatively more appealing.

Lower interest rates also tend to weaken the US dollar, which makes gold cheaper for foreign buyers, increasing global demand. Since gold is priced in dollars, a weaker dollar usually leads to higher gold prices.

Additionally, interest rate cuts are often a response to economic problems or uncertainty. As gold is viewed as a safer asset for investors during times of economic uncertainty, investors will typically increase their demand.

Unlike the market for currencies or shares, gold doesn’t rely on the performance of a government or company. This makes it attractive when people are worried about things like inflation, recession, war or stock market crashes. Gold is thus seen as a ‘safe haven’.

Gold and the Federal Reserve

The rise in the price of gold by more than a third this year can be linked to the US election last year, according to the director of research at BullionVault (see the BBC article below). Attitudes of the Trump administration towards the Federal Reserve have created concerns among investors. Fears that the US administration could erode the independence of the world’s most important central bank have fuelled the latest flows into the metal, which is traditionally viewed as a hedge against inflation.

According to the BBC article, Derren Nathan from Hargreaves Lansdown claims that it is Trump’s ‘attempts to undermine the independence of the Federal Reserve Bank’ that were ‘driving renewed interest in safe haven assets, including gold’. Investors are concerned that a politicised Fed would be more inclined to cut interest rates than would otherwise be the case, sending long-term inflation expectations higher.

This could lead to fears that future interest rates would then be pushed higher. This would increase the yields on longer-term government bonds by pushing down their price, as investors demand higher compensation for the increased risk of higher future interest rates reducing the value of their fixed-rate investments. This would force the US Treasury to pay higher interest on new bonds, making it more expensive to service US government debt.

Expected price rises for 2026

As we saw above, it is predicted that the price of gold will rise to $4000 per ounce next year. However, if the market sees investors move away from dollar assets, such as US Treasuries, the price increases would be even higher. Daan Struyven, co-head of global commodities research at Goldman Sachs explains ‘If 1 per cent of the privately owned US Treasury market were to flow to gold, the gold price would rise to nearly $5000 per troy ounce’ (see Financial Times article below).

If the Federal Reserve does come under political pressure, it could affect the stability of the US economy and beyond. When gold prices rise sharply, demand usually falls in countries like China and India, which are the world’s largest buyers of gold jewellery. However, in 2025, this trend has changed. Instead of reducing their gold purchases, people in these countries have started buying investment gold, such as bars and coins, showing a shift in consumer behaviour from jewellery to investment assets.

At the same time, global events are also influencing the gold market. Suki Cooper, a metals analyst at Standard Chartered, said that events like Russia’s invasion of Ukraine have added to political uncertainty, which tends to increase demand for gold as a safe-haven asset. She also highlighted how changes in international trade policies have disrupted supply chains and contributed to higher inflation, both of which have made gold more attractive to investors. Additionally, a weaker US dollar earlier in the year made gold cheaper for buyers using other currencies, which boosted global demand even further.

Conclusion

Although the gold market is expected to remain strong over the next six months, some uncertainty remains. Many analysts predict that gold prices will stay high or even increase further, especially if interest rates in the US are cut as expected. Continued global instability, is also likely to keep demand for gold as a safe haven high. At the same time, if inflation stays elevated or trade disruptions continue, more investors may turn to gold to protect their wealth.

However, if economic conditions stabilise or interest rates rise again, gold demand could fall slightly, leading to a potential dip in prices. Overall, the outlook for gold remains positive, but sensitive to changes in global economic and political events.

Articles

Data

Questions

  1. What factors influence the price of a commodity such as gold on the global market?
  2. Use a demand and supply diagram to illustrate what has been happening to the gold price in recent months.
  3. Find out what has been happening to silver prices. Are the explanations for the price changes the same as for gold?
  4. Why might investors choose to buy gold during times of economic or political uncertainty?
  5. How will changes in interest rates affect both the demand for and the price of gold?
  6. What are the possible consequences of rising gold prices for countries like India and China, where there is a traditionally high demand for gold jewellery?
  7. How do global events impact commodity markets? Use gold as an example in your answer.
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Rising global uncertainty and its effects

In a blog in October 2024, we looked at global uncertainty and how it can be captured in a World Uncertainty Index. The blog stated that ‘We continue to live through incredibly turbulent times. In the past decade or so we have experienced a global financial crisis, a global health emergency, seen the UK’s departure from the European Union, and witnessed increasing levels of geopolitical tension and conflict’.

Since then, Donald Trump has been elected for a second term and has introduced sweeping tariffs. What is more, the tariffs announced on so-called ‘Liberation Day‘ have not remained fixed, but have fluctuated with negotiations and threatened retaliation. The resulting uncertainty makes it very hard for businesses to plan and many have been unwilling to commit to investment decisions. The uncertainty has been compounded by geopolitical events, such as the continuing war in Ukraine, the war in Gaza and the June 13 Israeli attack on Iran.

The World Uncertainty Index (WUI) tracks uncertainty around the world by applying a form of text mining known as ‘term frequency’ to the country reports produced by the Economist Intelligence Unit (EIU). The words searched for are ‘uncertain’, ‘uncertainty’ and ‘uncertainties’ and the number of times they occur as percentage of the total words is recorded. To produce the WUI this figure is then multiplied by 1m. A higher WUI number indicates a greater level of uncertainty.

The monthly global average WUI is shown in Chart 1 (click here for a PowerPoint). It is based on 71 countries. Since 2008 the WUI has averaged a little over 23 000: i.e. 2.3 per cent of the text in EIU reports contains the word ‘uncertainty’ or a close variant. In May 2025, it was almost 79 000 – the highest since the index was first complied in 2008. The previous highest was in March 2020, at the start of the COVID-19 outbreak, when the index rose to just over 56 000.

The second chart shows the World Trade Uncertainty Index (WTUI), published on the same site as the WUI (click here for a PowerPoint). The method adopted in its construction therefore mirrors that for the WUI but counts the number of times in EIU country reports ‘uncertainty’ is mentioned within proximity to a word related to trade, such as ‘protectionism’, ‘NAFTA’, ‘tariff’, ‘trade’, ‘UNCTAD’ or ‘WTO.’

The chart shows that in May 2025, the WTUI had risen to just over 23 000 – the second highest since December 2019, when President Trump imposed a new round of tariffs on Chinese imports and announced that he would restore steel tariffs on Brazil and Argentina. Since 2008, the WTUI has averaged just 2228.

It remains to be seen whether more stability in trade relations and geopolitics will allow WUI and WUTI to decline once more, or whether greater instability will simply lead to greater uncertainty, with damaging consequences for investment and also for consumption and employment.

Articles

Uncertainty Indices

Questions

  1. Explain what is meant by ‘text mining’. What are its strengths and weaknesses in assessing business, consumer and trade uncertainty?
  2. Explain how the UK Monthly EPU Index is derived.
  3. Why has uncertainty increased so dramatically since the start of 2025?
  4. Compare indices based on text mining with confidence indices.
  5. Plot consumer and business/industry confidence indicators for the past 24 months, using EC data. Do they correspond with the WUI?
  6. How may uncertainty affect consumers’ decisions?
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New UK trade deals

The UK signed three trade deals in May – one with the USA, one with India and one with the EU. It is hoped by the government that these trade deals will provide a welcome boost to the UK economy.

The deal with the USA reduced tariffs on UK car exports to the USA from 27.5% to 10%, and on steel and aluminium exports from 25% to 0%. Pharmaceutical exports would also get more favourable treatment and there would be ‘reciprocal market access on beef’ (but with no lowering of food standards). Nevertheless, President Trump’s baseline tariff of 10% on most goods remains, as with other countries. However, a ruling by the US Court of International Trade has found that the Trump’s use of emergency powers to justify the sweeping use of tariffs is wrong. The Trump administration is appealing against the ruling and until the appeal is heard, the tariffs have been reinstated. Also, on May 30, the Trump administration announced that tariffs on steel and aluminium imports would rise from 25% to 50%. It remained to be seen whether this would affect the deal to reduce the rate to zero for British steel and aluminium imports.

The deal with India involves a reduction in tariffs on UK exports – some to zero – and simplified trade rules, faster customs clearance, less paperwork and the freedom for UK businesses to provide telecommunications and construction services. In return, tariffs will be reduced to zero on 99% of Indian exports to the UK. The UK government estimates that deal will result in trade between the two countries increasing by over 30%, with the UK’s GDP expanding by around 0.1 percentage points per year.

UK-EU trade

Perhaps the most significant new trade deal, however, is with the EU. This is a major advance on the current post-Brexit Trade and Cooperation Agreement (TCA). Under the TCA, there are no tariffs or quotas on UK goods exports to the EU or EU goods exports to the UK. However, to ensure that it is EU and UK business that benefits from these ‘trade preferences’, firms must show that their products fulfil ‘rules of origin’ requirements.

Under rules of origin requirements, when a good is imported into the UK from outside the EU and then has value added to it by processing, packaging, cleaning, remixing, preserving, refashioning, etc., it can only count as a UK good if sufficient value or weight is added. The proportions vary by product, but generally goods must have approximately 50 per cent UK content (or 80 per cent of the weight of foodstuffs) to qualify for tariff-free access to the EU. As a result, many goods exported to the EU with a proportion of imported components face tariffs.

Also, the TCA does not include free trade in services. The UK is a major exporter of services, including legal, financial, accounting, IT and engineering. It has a positive trade in services balance with the EU, unlike its negative trade in goods balance. Although some of the barriers which apply to other non-EU countries have been reduced for the UK in the TCA, UK service providers still face barriers which impose costs. For example, some EU countries limit the time that businesspeople providing services can stay in their countries to six months in any twelve. Also, since Brexit, UK artists and musicians have faced restrictions when touring and working in the EU. They can only work up to 90 out of every 180 days. This causes problems for longer tours and for musicians and crew who work in multiple bands or orchestras.

Perhaps the greatest barrier to trade under the TCA has been the large range of non-tariff measures (NTMs), such as customs checks, rules-of-origin and other paperwork, meeting various regulations and standards, and sanitary and phytosanitary checks on foodstuffs, plants and animals. Both the OBR and the Bank of England estimate that these post-Brexit trade restrictions are reducing UK GDP by around 4% and will continue to do so unless trade with the EU becomes freer.

The new UK-EU trade deal

The deal struck in mid-May reduces many of the administrative barriers to trade. Perhaps the most significant are the border checks on food, animal and plant shipments to and from the EU. Many of these checks will be scrapped. The new sanitary and phytosanitary (SPS) agreement allows many UK food products to be exported that previously were banned or proved too administratively costly. To achieve this free movement, the UK will generally follow EU standards, or similar standards so as to avoids harming EU trade. UK food exporters have generally welcomed the deal.

British steel exports to the EU will be protected from new EU rules and tariffs. This should save UK steel some £25m per year. Also, the EU has agreed to recognise UK carbon emissions caps, meaning that UK exports to the EU will avoid around £800m of carbon border taxes.

The post-Brexit fishing deal between the UK and EU, which saw a reduction of 25% in EU fishing quotas in UK waters, will be extended for another 12 years. Many UK fishers, however, had hoped for scrapping EU access to UK waters. The deal also allows various sea foods, including certain shellfish, to be exported to the EU for the first time since Brexit.

Other elements of the deal include a new security and defence partnership, the use of e-gates for UK travellers to the EU and an agreement to work towards a young person’s mobility scheme, allowing young people from the UK/EU to work and travel freely in the EU/UK again for a period of time.

The elements of the deal concerned with trade represent freer trade, but not totally free trade. The UK is not rejoining the customs union or single market. Nevertheless, strong supporters of Brexit have criticised the deal as a movement towards greater alignment of standards and thus a dilution of UK sovereignty. Supporters of greater alignment, on the other hand, argue that the deal does not go far enough and that even freer trade and less red tape would bring greater benefits to the UK.

Articles

UK-US trade deal

UK-India trade deal

UK-EU trade deal

Questions

  1. Outline the main elements of (a) the UK-US trade deal, (b) the UK-India trade deal and (c) the UK-EU trade deal. How much is it claimed that each deal will add to UK GDP?
  2. What trade barriers remain in each of the three deals?
  3. What elements are missing from the UK-EU trade deal that campaigners have been pushing for?
  4. Under what circumstances do free trade deals lead to (a) trade creation; (b) trade diversion?
  5. Would you expect the UK-EU trade deal on balance to lead to trade creation or trade diversion? Explain why.
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President Reagan on tariffs

In a 1987 address to the US nation, Republican President Ronald Reagan discussed the question of tariffs. His message was clear.

You see, at first, when someone says, ‘Let’s impose tariffs on foreign imports,’ it looks like they’re doing the patriotic thing by protecting American products and jobs. And sometimes for a short while it works – but only for a short time. What eventually occurs is:

First, homegrown industries start relying on government protection in the form of high tariffs. They stop competing and stop making the innovative management and technological changes they need to succeed in world markets.
 
And then, while all this is going on, something even worse occurs: high tariffs inevitably lead to retaliation by foreign countries and the triggering of fierce trade wars. The result is more and more tariffs, higher and higher trade barriers, and less and less competition. So, soon, because of the prices made artificially high by tariffs that subsidise inefficiency and poor management, people stop buying.
 
Then the worst happens: markets shrink and collapse; businesses and industries shut down; and millions of people lose their jobs.
 
The memory of all this occurring back in the thirties made me determined when I came to Washington to spare the American people the protectionist legislation that destroys prosperity.
 
Now, it hasn’t always been easy. There are those in this Congress, just as there were back in the ’30s, who want to go for the quick political advantage, who will risk America’s prosperity for the sake of a short-term appeal to some special interest group, who forget that more than five million American jobs are directly tied to the foreign export business and additional millions are tied to imports.
 
For those of us who lived through the Great Depression, the memory of the suffering it caused is deep and searing. And today, many economic analysts and historians argue that high tariff legislation, passed back in that period called the Smoot-Hawley Tariff, greatly deepened the Depression and prevented economic recovery.

He returned to the topic of tariffs in November 1988, when he reflected on the benefits of free and fair trade and the dangers of protectionism.

Here in America, as we reflect on the many things we have to be grateful for, we should take a moment to recognize that one of the key factors behind our nation’s great prosperity is the open trade policy that allows the American people to freely exchange goods and services with free people around the world. The freedom to trade is not a new issue for America.

In 1776 our Founding Fathers signed the Declaration of Independence, charging the British with a number of offenses, among them, and I quote, ‘cutting off our trade with all parts of the world’.
 
And that same year, a Scottish economist named Adam Smith launched another revolution with a book entitled ‘The Wealth of Nations’, which exposed for all time the folly of protectionism. Over the past 200 years, not only has the argument against tariffs and trade barriers won nearly universal agreement among economists but it has also proven itself in the real world, where we have seen free-trading nations prosper while protectionist countries fall behind.
 
America’s most recent experiment with protectionism was a disaster for the working men and women of this country. When Congress passed the Smoot-Hawley tariff in 1930, we were told that it would protect America from foreign competition and save jobs in this country – the same line we hear today. The actual result was the Great Depression, the worst economic catastrophe in our history; one out of four Americans were thrown out of work. Two years later, when I cast my first ballot for President, I voted for Franklin Delano Roosevelt, who opposed protectionism and called for the repeal of that disastrous tariff.
 
Ever since that time, the American people have stayed true to our heritage by rejecting the siren song of protectionism. In recent years, the trade deficit led some misguided politicians to call for protectionism, warning that otherwise we would lose jobs. But they were wrong again. In fact, the United States not only didn’t lose jobs, we created more jobs than all the countries of Western Europe, Canada, and Japan combined. The record is clear that when America’s total trade has increased, American jobs have also increased. And when our total trade has declined, so have the number of jobs.
 
Part of the difficulty in accepting the good news about trade is in our words. We too often talk about trade while using the vocabulary of war. In war, for one side to win, the other must lose. But commerce is not warfare. Trade is an economic alliance that benefits both countries. There are no losers, only winners. And trade helps strengthen the free world.
 
Yet today protectionism is being used by some American politicians as a cheap form of nationalism, a fig leaf for those unwilling to maintain America’s military strength and who lack the resolve to stand up to real enemies – countries that would use violence against us or our allies. Our peaceful trading partners are not our enemies; they are our allies.
 
We should beware of the demagogs who are ready to declare a trade war against our friends – weakening our economy, our national security, and the entire free world – all while cynically waving the American flag. The expansion of the international economy is not a foreign invasion; it is an American triumph, one we worked hard to achieve, and something central to our vision of a peaceful and prosperous world of freedom.
 
After the Second World War, America led the way to dismantle trade barriers and create a world trading system that set the stage for decades of unparalleled economic growth. And in one week, when important multilateral trade talks are held in Montreal, we will be in the forefront of efforts to improve this system. We want to open more markets for our products, to see to it that all nations play by the rules, and to seek improvement in such areas as dispute resolution and agriculture. We also want to bring the benefits of free trade to new areas, including services, investment, and the protection of intellectual property. Our negotiators will be working hard for all of us.
 
Yes, back in 1776, our Founding Fathers believed that free trade was worth fighting for. And we can celebrate their victory because today trade is at the core of the alliance that secure the peace and guarantee our freedom; it is the source of our prosperity and the path to an even brighter future for America.

The questions below address whether these radio addresses by President Reagan are relevant in today’s context of the imposition of tariffs by President Trump.

Videos of Radio Addresses

Articles and postings

Questions

  1. Summarise Ronald Reagan’s arguments.
  2. How would Donald Trump reply to these arguments?
  3. Can tariffs ever be justified on efficiency grounds?
  4. Can tariffs be justified as a bargaining ploy? Can they be used as a means of achieving freer and fairer trade?
  5. Find out why the Smoot-Hawley Tariff Act was introduced in 1930 and what were its consequences.
  6. How does the World Trade Organization seek to promote freer and fairer trade? How does it resolve trade disputes?