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

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

Brexit, two weeks out

As expected, the last two weeks following the UK’s EU referendum have been marked by significant political and economic volatility. Both major English political parties are in a state of upheaval: within Labour, Jeremy Corbyn dramatically lost a vote of confidence, yet refuses to resign (it recently appeared that he would retain popular support in a leadership election, although it is impossible to say how the recent swell in Labour membership registration would impact this; Corbyn assumes it will add to his support); among the Conservatives, Theresa May now appears to be the front runner for David Cameron’s replacement, after enough in-fighting among the Leave campaign’s leaders to make British politics appear to be a modern-day recreation of Game of Thrones. Leave’s wall of false promises came tumbling down remarkably quickly, and all of its most prominent leaders have disappeared from the scene. Scotland has begun to negotiate its status with both the UK and the EU.

Economically, the pound sterling has dropped even farther from its initial post-referendum plunge, hitting lows against the US dollar that have not been seen in three decades. Unsurprisingly, importers (particularly in the tech sector) have begun to increase prices on products sold in the UK. Property prices have dropped, while the Bank of England has been very active in implementing its post-referendum plans (perhaps the only government body to actually have one). One aspect of this has been to loosen regulations covering bank lending, which may promote consumption and investment, but also runs the risk of further weakening the financial positions of the banking sector, reducing resiliency in the face of another shock (such as, say, the actual triggering of Article 50).

Looking ahead, obviously a great deal of uncertainty still remains. What is clear, is that if the British government does begin to move forward on the task of disentangling its laws and regulations from those of the EU, the task will require the hiring of a large number of skilled workers, most of whom will have to come from outside the UK, potentially increasing net immigration.

Two recent political developments are especially noteworthy. First, a lawsuit has been filed with the aim of ensuring the government abides by constitutional rules which would require full Parliamentary debate over triggering Article 50. Most MPs favor remaining in the EU, so many will face the issue of balancing personal ideologies with electoral concerns (particularly in districts with heavy Leave support), along with lobbying interests. Business lobbies are heavily skewed towards remaining in the EU and broadly represent the most internationalised and productive industries in the UK, so while little regulatory oversight applies to these activities, their influence cannot be underestimated. The financial sector can be expected to publicly pursue both voice and exit options, balancing demands to retain access to EU markets with threats (at the very least) to move staff and positions to the continent. It is likely that if Parliament votes against triggering Article 50, it will have to come with policies along the lines of implementing the concept of embedded liberalism: improving the lot of globalisation’s losers through policies aimed at improving job training, infrastructure, and attracting investment to British cities outside of London and Manchester, many of which have experienced significant economic decline over the last several decades. If Parliament does trigger Article 50, then the pound is likely to fall farther, and the British economy will face a very extended period of little or no economic growth.

The second is the emergence of May as potential PM. As a (somewhat tepid) Remain supporter, she is better positioned to negotiate effectively with EU officials than anyone associated with the Leave campaign. This may be partly down to The logic of two-level games in international bargaining may apply here, but the application is a bit messy (or not as set out in the seminal research on the topic). If there is a second referendum (unlikely), the expectation of a slight majority of Leave votes places May in a relatively good position to extract concessions from the EU (Britain’s negotiation position overall is fairly weak). It is more difficult to predict the potential impact of Parliament as a veto player, as the weights placed on constituent support versus overall welfare or lobbying support by individual MPs (or the average of these across Parliament) is something that, for now, can only be guessed.

Brexit, two weeks out

Quick Thoughts on Brexit

My colleague Alan Renwick has a nice post covering the legal logistics surrounding Brexit. What about the economic implications?
The domestic economic implications of Brexit began to play out while votes were still being tallied, as the British pound dropped rapidly in a depreciation reminiscent of Black Friday, eventually settling at a level not seen in three decades. Uncertainty over the exit negotiations with the EU, where the UK holds a fairly weak hand (one fact the Leave campaign conveniently ignored), means that investment and employment will be suppressed; these will, in turn, suppress consumption. The weak pound, at least, will stimulate tourism and exports, but the cost of living within the UK will increase. Perhaps ironically, the regions and groups of voters (typically less educated, older, outside London or Manchester) who were the strongest supporters of the Leave campaign are going to be hit hardest by recessionary forces over the next few years. This should make things interesting for the incoming administration, particularly since Boris Johnson will have to go on TV to apologise for promising no recession (if he keeps to that; Leave has been quickly renouncing the lies and false promises they made prior to the referendum, such as spending £350 million saved on EU transfers on the NHS).
Politically, the distributional effects of the recession will be profound. David Cameron has already resigned as prime minister, and the Tories are far from free of internal strife. Labour faces a massive shake-up as well. Both the Lib Dems and SNP appear to be relatively unscathed, despite the Remain campaign’s failure. Instead, a second Scottish independence referendum looks likely to happen in the next couple of years. There’s similar pressure in London for a city-state-like exit from Britain. The generational divide between Leave and Remain supporters is particularly salient: Baby Boomers denying to Millennials the opportunities from which they themselves benefited; this seems to be a bit of a global phenomenon (there is certainly a lot of room for more research on the political implications of employment life cycles). At the supernational level, there are clear divides between the key Leave voices and EU officials over just about all essential issues, not the least of which is the preferred timing of Britain’s exit. The EU would like Britain’s exit negotiations to begin and end as soon as possible (the official lines read something like ‘GTFO’) to minimize uncertainty and volatility; Leave’s voices would prefer a lengthier timeline.
It will be interesting to watch UK negotiations with the EU over trade, investment, and migrants. All of this will take years to resolve, and the end result will not be the unfettered access to the common market without unrestricted migration that Leave promised. A number of fledgling British industries, like watch manufacturing, will suffer greatly from decreased access to inputs. The financial sector and multinationals with large employment bases in the UK will be watching closely; jobs will probably be lost along the way as risk-averse businesses move to the Continent. There will be a great deal of political pressure on the UK government from these sources, which will counteract the populist, nativist and xenophobic elements that led to Leave’s success.
With respect to UK relations with countries outside the EU, there is actually a bit of a silver lining. Without requiring all EU member states to be party to trade agreements, the UK should have less difficulty successfully navigating negotiations. With the US, this may lead to an alternative to TTIP, which has attracted significant popular criticism (although this seems a bit unlikely for now). With China, the greater flexibility may make agreement on a deal more likely to happen when compared to the delays in resolving issues in the proposed EU-PRC FTA. However, these agreements and others are unlikely to make up for the hit to economic growth that will result from loss of access to the common market.
One thing is for certain: it will be a bumpy ride.
Quick Thoughts on Brexit

Hello world!

In lieu of updating the ‘About’ page, this blog will focus on topics relating to international and comparative political economy. The aim is to emphasize the policy implications of ongoing research and to provide a research-informed perspective to current events as they unfold.¹

International political economy (IPE) explores the inter-relationships between politics and economics, with a particular emphasis into the ways in which institutions – both formal and informal – influence actors’ behaviors. IPE also examines the redistributional impacts of transnational economic flows and the consequences for politics and policy. As a discipline, it straddles the fields of economics and political science, as well as borrowing from others.

Traditionally, IPE has focused on international trade, foreign direct investment (FDI), and monetary policy. Over the past few years, research has increasingly expanded to portfolio investment, international migration, systemic risk, the environment, offshore outsourcing, and a number of other topics.

(1) The former goal is too frequently ignored in academic publications, while the latter is too often rendered a moot point by the length of the peer-review process. In economics, where there are high quality working-paper distribution networks and short-form/policy-oriented journals, but in international relations and political science, these outlets are still lacking.

Hello world!