Jeremy Warner: Depression and the protectionist threat

Outlook Another grim set of manufacturing figures, with UK industrial production down a further 2.6 per cent in January, bringing its year-on-year fall to 11.4 per cent, has raised the question afresh of whether Britain should be following its European neighbours with root and branch aid and support for struggling manufacturers.

There's been plenty of action in rescuing banks, but little direct support outside the £2.3bn loan guarantee scheme for auto manufacturers to help the rest of the commercial sector through the downturn, and even the auto package isn't proportionately nearly as big as similarly conceived aid on the Continent.

Government subsidy for industry is, in essence, just another form of protectionism, yet in circumstances where there is a synchronised global collapse in demand, it can perhaps be excused as a way of keeping otherwise viable companies and skills alive until conditions recover and they can begin operating normally again.

That's the justification, in any case, yet as the recession deepens, the danger is of a growing deluge of beggar-thy-neighbour protectionist measures which will end up destroying all the hard-won gains of the single European market and the wider trade liberalisation agenda.

Interestingly, the current calamit-ous fall-off in world trade seems substantially to be outpacing that of aggregate demand and overall economic shrinkage. That may in the main be down to an absence of trade finance – another victim of the credit crunch – but it might also have something to do with growing protectionism. We draw much of our fear of protectionism from experience in the 1930s and the infamous Hawley-Smoot Tariff Act, which raised import duties in the US to record levels. Demand was by then already so subdued that the new tariffs may not in truth have had the devastating economic impact sometimes attributed to them. You can have as much in the way of import duties as you like, but in circumstances where nobody is buying anything, they are unlikely to help your own industries very much.

Yet the geo-political impact of these measures was extreme, and certainly contributed to the rise of militarism in Europe and the Far East. Everyone is familiar with what happened in Europe as Germany and Russia retreated from the world economy to seek refuge in centrally dictated, autonomous economic blocs. In the Far East, Imperial Japan aspired to much the same thing with its "Greater East Asian Co-prosperity Scheme", essentially a plan to capture regional markets and natural resources through military means.

Few would seriously suggest history is about to be played out in quite the same way this time. Hopefully, we've moved on a bit since then. In the developed world at least, there are few signs of the political extremism that gave rise to the rampant militarism of that time. For anything as crude as Hawley-Smoot to be re-enacted would require the whole framework of the World Trade Organisation to break down, and this doesn't seem at all likely, even with the world economy as flat on its back as it is now.

Today, protectionism takes subtler, less obtrusive forms – subsidy, soft loans, Buy American, British jobs for British workers, and so on. Yet there is a growing weight of it, and this doesn't bode at all well for a recovery in trade and economic activity.

One of the many unfortunate consequences of the credit crunch has been the repatriation of credit, a phenomenon that again finds worrying parallels with what occurred in the 1930s. Banks that are being rescued by national governments are under pressure to apply what little leverage and balance sheet strength they have left to their own home markets.

The process is self-feeding; as foreign bankers withdraw, domestic banks are forced to rein in their international lending to help plug the gap left in credit at home. Many governments have made liquidity and other forms of banking support conditional on increased home lending.

The consequences are particularly acute for emerging markets that have become dependent on big inflows of foreign capital. In the past year, these flows have collapsed, causing some countries to fall back on the tender mercies of the International Monetary Fund.

As I say, protectionism takes many different forms. Wage assistance for short-time working and as an alternative to redundancy is the latest fad to sweep European Union member states. For countries with relatively high levels of social security benefit, it makes some sense. Paying workers to do nothing but to be ready to reapply themselves when the economy picks up may seem preferable to paying them dole and having their skills lost for ever to the ranks of the long-term unemployed.

Should Britain be joining Europe in the rush to wage subsidy? Unilaterally, the Welsh Assembly has already announced a scheme, backed by European money, for supporting jobs in small and medium-sized enterprises. Yet even for a Government which is changing its ideological spots as quickly as this one, it sticks in the craw, for it runs counter to some of the key principles of the flexible labour market Labour has for so long championed.

It also interferes with the process of creative destruction, which brutal though it might be, is a core function of the economic cycle. Instead of out with the old and in with the new, zombie manufacturers, kept alive on a steady drip feed of state aid, would take their place alongside the zombie banks.

In the Netherlands, companies have to demonstrate that they have suffered a 30 per cent sales collapse within a two-month period but would otherwise be viable before they are allowed to draw on publicly funded wage subsidy. Yet there are obviously extreme practical difficulties in calibrating this kind of aid.

The only fair way of applying it would be to make it available to all, yet that might be prohibitively expensive and would by no means command universal support in the business community, where some welcome the present cull of inefficient and weak as a competitive boon.

Ministers are giving little away. Philosophically, they don't like the idea of wage subsidy, but if everyone else is doing it, can they really afford to stay out of the game? If it can be sold as a way of preserving skills, or perhaps helping people retrain, then perhaps there might be a way. In any case, manufacturing production and sales cannot keep collapsing at the present calamitous rate without some eventual and fairly dire consequences for employment.

The danger is that decisions on which plants remain open and which are axed will soon become dependent on the degree of government aid available, rather than any consideration of long-term viability and merit. Much of Barack Obama's rhetoric is overtly protectionist – that's how he got elected president – as is that of some European leaders. The game on free trade seems to be up. It's hard to believe it will end up as bad as the 1930s, but we are fast sliding into a more protectionist world.

Still, it ill becomes Britain, which as an entrepot nation has more to lose than most from the closing up of national borders, to complain too loudly about state subsidy on the Continent and the Buy American policies of the US. Here in the UK, we have our own form of of the Hawley-Smoot Tariff Act. It's called the exchange rate and it's worth any number of import duties to British industry right now. Regrettably, it doesn't yet seem to be doing any good. When demand is as weak globally as it is at the moment, competitive devaluation seems to be as impotent as protectionism.