Trading Trump

The results of this week’s US election went widely unanticipated by polls and markets. Now that Trump is switching from candidate mode to presidential mode, many questions remain surrounding the composition of the Trump administration and what that could mean for policy with Republican control over the presidency and both houses of Congress over at least the next two years.

Focusing on trade policy, Trump made numerous remarks on the campaign trail about closing US borders to imports: particularly renegotiating key agreements currently in force and engaging in economic warfare with China. It is fairly likely that most of this will be chalked up as cheap talk. Renegotiating existing agreements is extremely difficult and rarely leads to significant changes (partly down to the two-level game described in the previous post). There may be increased use of temporary safeguards to restrict import competition in some (politically important) declining industries, but a more vigorous fiscal policy would be more effective in either assisting or economically relocating those losing out from trade. Similarly, there’s little to be done with China over trade-related issues that would not lead directly to retaliation. There’s a lack of evidence of ongoing currency manipulation, but China’s industrial policy may run afoul of WTO standards on some goods, allowing for the use of temporary measures. Across the board, any move to protection will negatively impact Trumps core supporters first, through higher consumer prices.

The remaining question is what this would mean for agreements currently in the works. Given the lack of enthusiasm in Congress prior to the election over the TPP, it’s not likely that there will be any change in the very low probability that the US signs the agreement in the near future. TTIP faces a similarly bleak future, complicated significantly by uncertainty surrounding Brexit. 

Trading Trump

International negotiations as a two-level game

One of the recurring themes in IPE research is that domestic politics can have a significant impact on international outcomes. From institutions (Broz & Plouffe 2010; Mansfield, Milner & Pevehouse 2007) to the influence of partisanship (Putnam 1988; Milner & Rosendorff 1997), variations at the domestic level shape both policy makers’ actions and policy outcomes.

The past couple of days give us two nice illustrations of these dynamics.

In Europe, the Walloon regional parliament has blocked ratification of CEFTA, the free-trade agreement between Canada and the EU. In this case, there’s something more like a four-level game at play: a sub-national body blocks ratification at the national level, which prevents ratification at the EU level. The fourth level in the negotiating game is between Canada and the EU. Of the CEFTA features to which the Walloons objected, it is perhaps a bit ironic that agriculture takes center stage, illustrating in a microcosm the issues facing progression in the WTO’s Doha negotiations. In a nutshell, the two biggest complications are the institutionalization of agricultural protection in developed countries (which reduces their negotiating space), and the large number of potential veto players involved in the negotiating process.

In the second example, Theresa May finds herself constrained by a Parliament skeptical of the government’s Brexit strategy (as well as a domestic public increasingly feeling buyer’s remorse over Brexit) and an EU council unwilling to make anything close to the concessions promised by the pro-Brexit campaigners earlier this year. The difference in this case from the usual two-level negotiating game is that EU preferences are not necessarily in favor of Brexit occurring. In a trade or investment deal, negotiating governments have interests in seeing talks lead to a successful conclusion and ratification. The EU has strong incentives to maintain a hard line to prevent further defections in the future. It will be interesting to see which side wins out, although that may have to wait until the ongoing case against the UK government (over Parliament’s right to vote on Article 50) is concluded.

International negotiations as a two-level game

Hello there, impending recession

All signs now point to recessionary forces coming into play in the British economy. Consumer spending has slowed, as the pound’s drop is being passed through prices to consumers. The effects of sticky prices are very apparent across the UK economy, from wine importers announcing price hikes, to a highly publicized rift between Tesco (a value-oriented supermarket chain) and Unilever. Decreased consumer expenditures poses problems for UK firms that don’t export; these tend to be small businesses, and combined with slowdown in forms of spending, is likely to lead to considerable market reallocation (in other words, small businesses will fail at higher rates). For consumers, rising prices and stagnant wages indicate that spending is unlikely to turn around in the near future.

The interesting question is whether this will impact the May government’s Brexit strategy (to the extent that there the negotiating approach could be said to resemble any strategic behavior). While the vote was fueled by anti-immigrant sentiment, tangible price increases (experiences with inflation) have potential to erode public support for the government, replacing immigrants as the public’s number one bogeyman. Mark Carney has been quick to publicly assert the Bank of England’s independence, so it will be interesting to see how the government adapts.

Hello there, impending recession

Weak Sterling and Economic Growth

Recent figures appear give the UK fairly healthy GDP growth projections for this year relative to other OECD members. While this has been interpreted by Brexit apologists as a sign of prosperity to come, such an interpretation is gravely mistaken.

Britain’s current ‘growth’ comes down to two things: the basic math behind growth accounting and the weak pound.

The £ and FOREX

We’ll look at the latter first. A currency’s value is determined on the foreign exchange (FOREX) market. Governments can choose from a range of policy options when it comes to managing the currency on this market, ranging from letting market forces fully determine its value (a ‘pure float’) to fixing its value to that of another currency (known as a ‘peg’).(1)

The UK government generally adopts a policy that allows the pound to freely float on the FOREX market.(2) It manages monetary policy by targeting an interest rate and adjusting the available supply of money. The value of the currency itself is set by the clearing of supply and demand on the FOREX market. FOREX supply and demand are driven by international flows that require a particular currency, such as trade, investment, tourism, and remittances. Tourism in the UK and export sales increase demand for the pound and are, in turn, bolstered by its relatively weak position when compared to other major currencies.

So why, then, is the pound’s value low? Low interest rates reduce returns on pound-denominated investments, although interest rates are low across the developed world. The effect is usually to spur investment in physical or human capital, but this is not happening; the lack of foreign investment in the UK is a particularly noticeable source of the pound’s low rate of exchange.(3) Investors are scared away by uncertainty surrounding (hard) Brexit; as I mentioned in a previous post, foreign investment is likely to be highly inelastic (unresponsive) to normal adjustments to monetary policy.

Growth Accounting

A (very) simple growth equation can be expressed as a function like the following:

Y = L + I + T

L = Labor (including human capital)
I = Investment (both domestic and foreign)
T = X – M (trade balance), where X = export value and M = import value

The weak pound is a consequence of both the Bank of England’s expansionary monetary policy and a lack of foreign demand for the £ on the foreign exchange market (driven primarily by a lack of foreign investment in the UK). This has a direct effect on the trade balance, boosting exports and suppressing imports. Consequently short-term growth looks much better than the long-term fundamentals would suggest. The trade balance itself is not particularly sustainable, as the most globally engaged firms trade in both directions. Inputs are frequently imported, and a weak currency increases costs, driving up export prices to compensate. Exports will not remain high post-Brexit as the UK will no longer be a part of the European Common Market, and will have to negotiate trade agreements with key trading partners to regain access to important export (and import) markets. The foremost of these is the EU/EEA, with the US and China close behind; the Brexiteers’ dreams of a ‘new Commonwealth’ built on trade agreements would do nothing to replace the role played by these essential economic partners.

Investment, as discussed above, remains suppressed, especially in the case of foreign sources. Investment and labor are generally the sources of sustained growth; because the labor supply depends on population growth and education, investment is usually promoted as a cheaper means of achieving quicker growth.(4)

The growth contribution of labor comes down to the labor supply (size of the work force) and the abundance of human capital – skilled or educated workers. One of the central planks of the UK government’s Brexit strategy (to the extent that one remains) is increasingly limited immigration, both from the EU and from non-EU and non-Commonwealth countries. Non-EU/Commonwealth immigration to the UK is largely made up of highly-skilled workers or those with significant available resources for investment in the UK economy. Discouraging this sort of human capital inflow where there is an obvious domestic shortage is not a growth-friendly strategy. Neither is the current climate of rampant nationalism, xenophobia, and racism the government’s current discourse both fosters and encourages. On top of the likely event that skilled jobs and workers are relocated to the EU in response to Brexit, numerous existing immigrants are likely to reconsider their futures in an unwelcoming UK, magnifying the policy’s harmful economic effects.(5)

To summarize:
The pound’s weakness is not successfully stimulating activities that would generate sustainable economic growth.
Brexit will reduce the UK’s economic growth by harming trade prospects, hindering investment, and significantly harming the quality of the labor force.(6)

(1) Pegging a currency to gold or another commodity has been advocated by fringe politicians, primarily in the United States, but this is a stupid idea. It was achieved with a fair amount of success in the latter half of the 19th century, but the trade-offs inherent in adopting the Gold Standard led to its unraveling; a similar system was adopted following WWII, which similarly led to significant problems.
(2) In the closing years of the 20th century, it has engaged in what is known as a ‘managed float’, intervening to prevent significant shifts in the pound’s value. Prior to its exit from the European currency mechanism (that later led to the euro), the pound was even pegged to the Deutschemark with bands set to allow for some market-based fluctuations.
(3) It is worth mentioning that most of the listings traded on the FTSE are denominated in US dollars; this is why the FTSE responded very positively to the pound’s ‘flash crash’. Exchange rate-based gains will not sustain the FTSE in the medium term, with Brexit-related fears a more dominant source.
(4) I’m ignoring productivity here, as that is endogenous to both investment and human capital.
(5) EU/EEA and Commonwealth immigrants are also, on average, more skilled/educated than the native British population. Despite the government’s complaints to the contrary, immigration is a net fiscal positive.
(6) If we were to augment this growth model to a more realistic version, productivity would multiply the effects of under-investment and reduced human capital.

Weak Sterling and Economic Growth

Investment and the Bank of England

While the Bank of England elected to maintain the 0.25% base interest rate, there’s been consistent speculation over a rate cut from the Bank of England (BoE) – from 0.25% to 0.10%. This comes in light of a lot of doubts over central bankers’ dwindling powers, particularly in the face of some of the more unique features of the contemporary global economy: the rise of cryptocurrencies and fintech, global low central-bank rates, the broaching of the 0% lower bound, questions relating to the breakdown of the Phillips Curve (which describes the inverse relationship between inflation and unemployment), etc.

The post-Brexit environment presents two key difficulties for the BoE. First, investment is depressed due to the political/institutional uncertainty surrounding the triggering of Article 50 and the lack of clarity surrounding the potential Brexit deal. Second, the pound’s value is depressed due to the same concerns. This means the elasticity (responsiveness) of both investment and exchange-rate value to base rate will be significantly reduced when compared to normal periods.

The aspect of this that tends to be overlooked on the academic side is what this means for the individual. Base interest rates near 0 penalise savers, although those heavily invested in stocks tend to benefit (the effects of negative rates are even more pronounced, but the BoE governor has – so far – distanced himself from these). With cash ISAs often making up a disproportionate amount of savers’ investments (particularly among the less well-off), extended periods of very low interest rates exascerbate monetary policy’s distributional and political effects. It is very likely that this is one of the (admittedly many) causes of the pronounced dissatisfaction with the UK government, as well as the divisions within Labour.

The low value of the pound, relative to other currencies, on the other hand, is something that directly factors into the academic literature on central banking. For consumers, the pound’s drop since the Brexit vote has led to a significant increase in the real cost of living (probably 10-20% depending on the basket of goods). When combined with minimal returns to savings and investments, this could be viewed as an important determinant in the testy battle over Labour’s leadership.

And all of this to promote investment? Well, exports respond positively to a weak currency, but I wouldn’t hold my breath over investment doing the same in this case. Because the lack of new investment is driven uncertainty over unresolved issues, much larger economic incentives would be required to persuade risk-averse investors that Britain is safe for further investment. In view of this, avoiding base-rate reductions on the BoE’s part is the right move. What happens next is dependent on how the UK economy responds (probably not much) and how the Brexit negotiations continue to unfold.

Investment and the Bank of England

Post-Brexit Trade

The French president, Francois Hollande, has reiterated what I expect to be a standard line among EU leaders: no common market without free movement, which stands in stark contrast with the Leave campaign’s pipe dream of full common-market access and no movement. Intuitively, the solution to this bargaining game will lie somewhere between these two points.

Patterns in liberalization (or, for that matter, protection) that are likely to emerge will reflect lobbying by groups both within the EU and UK, assuming the Norway solution is out of the picture (it’s not, but other potential outcomes are a bit more interesting at the moment). In most cases, these forces will come from producers, but may also arise from consumers, although for some industries in the UK, consumers may be viewed as having voiced their stances through the Brexit vote (because just about everything is getting read into that; if someone said UK citizens rejected climate change 51-48%, I wouldn’t be surprised).

What might this mean for the topography of trade policy? European products with clear UK substitutes are likely to face trade barriers at the border. For example, much of the British shoe industry is based around Northampton (the county was 58% for Leave), and domestic brands (Joseph Cheaney, Church’s, Crockett & Jones, Loake, John Lob, etc.) can rely on domestic materials while competing with foreign brands (Ferragamo, Gucci, Bruno Magli, Magnanni, Santoni, etc.). There is a fair amount of product differentiation within the industry (UK designs are typically more conservative and chunkier than continental designs), but there will be domestic lobbying efforts for protection on finished shoes within the UK.

This can be contrasted with Britain’s nascent watch industry, which relies heavily on imported movements and movement components from Switzerland and East Asia. Cases, dials, and hands can be manufactured domestically, but investing in highly specialized machinery and materials required for minute components like hairsprings is well beyond the means of most manufacturers (even in Switzerland). Sourcing movements and other key components has become more difficult in recent years simply because of ETA’s (the largest movement producer) restrictive policy towards non-affiliated brands. Rather than worrying about import competition on finished watches, the British industry will focus on maintaining open access to the inputs they need to continue to produce new watches and service existing pieces. Product differentiation again plays a role here, as the most prominent British brands don’t necessarily have a direct substitute from outside the UK, and there tends to be more brand and design awareness in watch-purchasing decisions than with shoes (Bremont creates very rugged watches with classic designs, probably most closely competing with Breitling; Christopher Ward focuses on the value end of luxury watches, competing most directly with Frederique Constant, but with a different design language).

Moving outside manufactures, the financial sector is probably the most directly impacted by potential changes in trade policy (both finance and hospitality will be lobbying for retaining some form of open immigration). UK efforts to retain financial access to continental markets will be bolstered by lobbying from London as well as financial-service providers keen on not having to move existing offices and staff and being able to serve both UK and EU markets from one location. Efforts at introducing protection may be driven by German leaders with aim of building financial clusters in Frankfurt and other cities.

Agricultural negotiations will be interesting to watch, as Britain imports much of its food. Leaving the common market means domestic producers will compete with those supported by the Common Agricultural Policy. A replacement domestic policy would be expensive to implement and maintain (and would not assist a significant portion of the British population). A politically and fiscally more efficient solution would be to implement trade protection on a range of imported agricultural products, but it is difficult to identify exactly which products will receive protection and which won’t. This is, after all, the sort of environment where US apple producers lobbied for import bariers to be imposed on bananas, because ‘cheap bananas could lead people to stop eating apples’.

In any case, any tariffs imposed on European imports to the UK will not exceed the WTO’s most-favored-nations (MFN) rates; the bigger issue is the potential imposition of non-tariff barriers, such as sanitary and phytosanitary measures to restrict food imports. If these become excessive, many UK residents will have to become acquainted with higher bills.

Post-Brexit Trade