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