On the Seventh Day ...

… Donald created chaos. In recent days, the Trump Administration has imposed an immigration ban which is generating controversy around the world, whilst today the head of the National Trade Council, Peter Navarro, publicly accused Germany of using a “grossly undervalued” euro to “exploit” the US and its EU partners. Both these issues call into question the underlying principles of the international economic and financial framework. Whilst recent events reveal that the new Administration is not going to play by the old rules, and we are going to have to live with it, they also display a degree of callowness regarding how the world works.

On a wider view, businesses and investors do not like what they have seen and heard. It is potentially the first step towards a more protectionist world which will damage the US as much as its trading partners. Of more concern is that the global financial system has historically worked best when the global superpower acts in its benevolent self-interest by maintaining access to its markets, allowing unrestricted access to its financial markets and generating higher global incomes which benefit everyone – corporate America included. Any sense that the system is to be gamed in favour of the US will not end well for anyone.

Navarro’s comments in particular were worrying on many levels, not the least of which because he is wrong. It is true that Germany is running an excessively large external surplus which, as I have pointed out in a previous post (here), does put undue strain on the workings of EMU. But ironically, a higher surplus ought to put upward pressure on the currency, rather than weaken it. After all, it is not as if the whole of Germany’s surplus is solely generated at the expense of other EMU members. Moreover, the perceived weakness of the euro is due more to ECB asset purchases than to any deliberate action on Germany’s part, something which has been strongly opposed by the German contingent at the ECB (notably Bundesbank President Weidmann, who has been a vociferous critic of QE).

An excellent article in The Economist a couple of weeks ago noted that “there are reasons to be worried about the head of Donald Trump’s new National Trade Council” (here). In particular, The Economist notes that Navarro’s view that unbalanced trade is responsible for a slowdown in US growth since 2000 is simply “dodgy economics.” It goes on to suggest that Navarro “seems to think that once they [China] comply with global trade rules, the trade deficit will close and manufacturing jobs will return to America’s shores … This is a fantasy. When manufacturing production moves overseas and then returns, productivity has usually risen in the interim; so far fewer jobs come back than left.”

Navarro’s views on the EU are equally wrong-headed. He said in a recent FT interview that “The unequal treatment of the US income tax system under biased WTO rules is a grossly unfair subsidy to foreigners exporting to the US and a backdoor tariff on American exports to the world that kills American jobs and drives American factories offshore.” Whatever else it might be doing, Europe is not stealing US manufacturing jobs. It might be getting more of its share of US corporate taxes than the government would like but there is a simple solution to that – cut the corporate tax rate, which is amongst the highest in the industrialised world.

But perhaps what is most worrying of all – and it was highlighted by a number of below the line commentators on the FT website, who are a pretty savvy bunch – is that the US government appears to be trying to drive a wedge between EU nations by highlighting the fact that Germany is “exploiting” other European partners. Certainly, it seems to have a preference for negotiating bilateral deals with the intention of (as one commentator put it) “the destruction of the EU, by peeling one nation at the time from the EU, till the whole thing collapses.” That might be a bit over the top but it is a common theme.

Even more worrying from a UK perspective, as the inestimable Gideon Rachman noted in the FT yesterday, is that “the election of Mr Trump has transformed Brexit from a risky decision into a straightforward disaster (here).” I have long believed that the main risk Trump poses to the UK is that many of his policies may well not be in the UK’s national interest. As Rachman put it, “If Britain had voted to stay inside the EU, the obvious response to the arrival of a pro-Russia protectionist in the Oval Office would be to draw closer to its European allies. Britain could defend free-trade far more effectively with the EU’s bulk behind it …  As it is, Britain has been thrown into the arms of an American president that the UK’s foreign secretary has called a madman”.

When a man who wants to build a wall on the southern US border to keep out Mexicans; who wants to ban immigrants from one of the most tolerant and open societies in the world and who threatened to jail his political opponent, thinks Brexit is a good idea we really need to think again! As the Ancient Greek storyteller Aesop wrote, “A doubtful friend is worse than a certain enemy. Let a man be one thing or the other, and we then know how to meet him.”

Donald's rhetoric trumps rationality

I have no axe to grind regarding President Donald Trump. I am not a fan but unlike the Brexit issue I have no skin in the game. So when I say I don't like much of what I heard during Trump's inauguration speech, I say it as an economist and a citizen of the world (which in Theresa May's eyes makes me a citizen of nowhere).

I tuned in just as Trump got into full flow. But I shuddered at the passage which contained the phrases: 

"We have defended other nations' borders while refusing to defend our own ... One by one, the factories shuttered and left our shores with not even a thought about the millions and millions of American workers that were left behind ... From this day forward, it's going to be only America first, America first ... Protection will lead to great prosperity and strength." 

I am critical of British politicians who play the nationalist card and I am not impressed by leaders of other major nations who do the same. Imagine what the reaction in the British press would be if German politicians said similar things. But when an American president takes such a tack, we know that this could be very damaging to the world economic and political order upon which our prosperity has depended for so long.

As an economist, I question the notion that protectionism will make the US economy stronger. My immediate reaction was "has he learned nothing from long dead US politicians Smoot and Hawley?" Standard economics states that raising tariff barriers simply increases the costs to consumers who ultimately have to pay. It's the same reason I am so concerned that the UK will fail to get a deal with the EU and we have to fall back on WTO rules which raises the costs of most imports.

Yet there is an argument that this is conventional thinking and we should be approaching the problem differently. Indeed, a young journalist asked me this week if tariffs are such a bad thing. In effect, he was asking whether the pursuit of economic efficiency really is the be all and end all. Given the times in which we live, it is a question which deserves an answer. I suspect the answer lies in the extent to which they serve the national interest. The national interest in this case is not simply about the economic costs and benefits, because on these grounds there is no case. It is about taking back control – a slogan we heard so often during the Brexit referendum. Ironically, the message from Theresa May was that the UK wants more free trade, rather than less, which seems to contrast with the Trump view. Trump’s appeal is to those who believe that the pace of change has been too rapid, and my guess is that American voters might tolerate higher import tariffs for a while but ultimately realise they are economically self-defeating. But tariffs may simply have to be tried to remind a new generation of why the world has spent 70 years trying to reduce them.

Think of the US auto industry. The area around Detroit declined (as did the British Midlands) because the cars built there were more expensive and technologically inferior to those produced by the foreign competition. Domestic consumers took the view that they got better value for money by looking elsewhere. Imagine they didn't have that choice. Imagine that instead US workers continued producing cars and stayed put in Michigan. This would have reduced the internal migration of skilled workers, with the result that currently-dynamic urban areas would have grown more slowly and there would be fewer resources available to be allocated to higher value-added sectors such as tech or fracking. In short, there would have been less dynamism. If that is what the public wants, that is their choice. But as my friends on the other side of the Atlantic tell me, that is not the American way.

Then there is the problem of retaliation. If the US erects barriers, you can bet its trading partners will respond. American companies have pinned their hopes for many years on the Chinese market – whether those hopes have been realised is another matter. But they will be shut out of the world's most dynamic major market and will lose global market share as a consequence, especially if China were simultaneously to open up to the Europeans. And it is not as if the US does not have world class companies which compete globally. Microsoft, Apple, Google and Amazon have revolutionised the world, and did not arrive in their present incarnation behind tariff barriers. They depend on being able to sell around the world, and rely on global supply chains to stay competitive. Its global banks have survived the financial crisis in far better shape than their European counterparts and still play a huge role in the global financial architecture.

We should also not ignore the soft power which the US enjoys. Netflix is changing the way the world watches TV; Hollywood blockbusters are still the films most people talk about; its universities are ranked as amongst the best in the world. Moreover, the US issues the world's pre-eminent reserve currency. This should not be underestimated: Controlling access to dollar markets gives the US unprecedented economic and financial leverage.

All told, the US is in a far stronger position than Trump’s supporters believe. Admittedly, we no longer live in a world of unchallenged American power – the rise of China has seen to that. But the US has more to lose than gain if Trump really does set off down the protectionist path. We can only hope his team is less impulsive than he is.

The dawn of fiscal reality?

The week in markets ended on a volatile note as they began to digest the full economic implications of President Donald Trump. Emerging markets took the full brunt as it dawned upon them that the protectionist rhetoric which passed for economic debate during the election campaign was now a step closer to being realised. But bond markets also sold off sharply. The yield on 10-year Treasuries has risen by 30 basis points since Tuesday, dragging other industrialised markets in their wake. This in turn was triggered by fears of higher inflation stoked by a significant expansion of US fiscal policy.

According to analysis by the Tax Policy Center (here), Trump’s tax proposals would boost growth but cut Federal revenues. They include reductions in marginal tax rates; increases in standard deduction amounts; lower personal exemptions; caps on itemised deductions and allowing business to expense investment rather than depreciating it over time, though businesses doing so would not be allowed to deduct interest expenses.

A simple static calculation of the costs suggests this would  cut revenues by $6.2 trillion over the first decade. But a looser fiscal stance would boost output, with simulations indicating an increase in output of between 0.4 and 3.6 percent in 2017, 0.2 and 2.3 percent in 2018, and smaller amounts in later years. The analysis indicates that over the first eight years, higher activity partially offsets the static revenue losses. But in the longer-term higher interest rates resulting from bigger budget deficits begin to crimp investment, thus leading to slower GDP growth and even higher revenue losses. All told, the plan would increase the debt-to-GDP ratio by 25.4% over a ten-year horizon and by 55.5% by 2036. Faced with these kinds of numbers, it is hardly surprising that bond markets are worried.

But just as a Trump presidency raises fears about the long-term prospects for free world trade, so it could also mark a pivotal moment in the mix between fiscal and monetary policy. Although the attacks by politicians on the independence of central banks in recent months have overstepped the mark, both the Brexit and US presidential votes suggest that electorates are fed up with what they are getting from governments. Indeed, households in all industrialised economies are not paying any less tax but they are receiving less back from the state as outlays are cut. With the UK government due to present its Autumn Statement on 23 November, the expectations are that it will adopt a much less aggressive approach to eliminating the public deficit than we have seen over the last six years.

Some of us would say that it is about time governments recognised that fiscal policy has a role to play in helping to get the economy back on its feet. It is certainly one of the key lessons of the 1930s, when the policy of monetary orthodoxy in the wake of the crash of 1929 contributed to the severity of the Great Depression. My own efforts to get this message across have fallen on deaf ears in recent years, with continental European economists particularly hostile to the view. But in a paper in early 2015, I pointed out that IMF research indicated that fiscal tightening could – under certain circumstances – prove to be counterproductive. Everything depends on how high we believe the fiscal multiplier to be. In simple terms, the multiplier measures the proportional change in economic output for a given change in the fiscal stance. Thus, if a fiscal tightening (expansion) of 1% of GDP produces a reduction (increase) of less than 1% in GDP the multiplier is less than unity. This can be used to justify a policy of fiscal austerity to tackle excessive fiscal imbalances.

But if a 1% fiscal tightening produces a decline of more than 1% in GDP, the multiplier is greater than unity and a policy of austerity becomes self-defeating. Prior to the Great Recession, the standard view was the multiplier was less than unity. However, much of the recent academic evidence indicates that pre-recession estimates may have been too low, which should give pause for thought in the fiscal policy debate. I will highlight the empirical analysis resulting from this paper on another occasion, but suffice to say that for countries such as Greece the multipliers appear to have been larger than initially assumed. This in turn has contributed to what can only be described as a Greek economic depression.

Governments and policy makers across Europe woke up this week to the fact that popular resentment is rising. The EU may have been able to dismiss the Brexit vote as a little local difficulty in a country which has never bought into its ideals. But it cannot ignore the message from the US electorate. It may be too late for Italy, which heads to the polls on 4 December.  But the French election next spring now assumes even greater relevance for the future of the EU project.

The day of fate

In German, 9 November is known as Schicksalstag – the day of fate – for it was on this day in 1848 that the politician Robert Blum was assassinated; in 1923 Hitler launched his first failed attempt at a coup; in 1938 Kristallnacht took place and in 1989 the Berlin Wall was opened. For the record, it was the day in 1921 that the Italian fascist party was formed. It will also be remembered as the day that Donald Trump was elected as the 45^th President of the United States.

At 5.30 am this morning, as the rain was beating down against the window, markets also looked to be taking a beating as the news came through that Donald Trump was on his way to the White House. In the event the markets took the election in their stride. Compared to the chaos which ensued after the Brexit referendum, it was small beer. I can only assume that whatever reservations markets have about Trump’s plans, they know that today is not the day to express them. For one thing, he has to wait another two months before being given the keys to 1600 Pennsylvania Avenue. For another, markets learned a lesson after the Brexit vote that it may pay to digest the wider implications of the vote before making a move.

But as one of my colleagues noted today “if 1989 was the year that the walls came down, 2016 was (metaphorically) the year they went back up again.” Voters in the UK and US have now sent a strong message that their tolerance for globalisation has reached its limit. And with Italian Prime Minister Renzi next month staking his future on a constitutional referendum which he may lose, and general elections next year in Germany and France, the stage is set for a period of extreme uncertainty in western politics – and by extension economics.

Economic fears centre primarily on the new president’s attitude towards foreign trade. Unfortunately, globalisation has been seen as a zero-sum game in which there is one winner and one loser. This is far from the case, though try telling that to the former steel workers in the rust belt. Undoubtedly, manufacturing jobs have been shifted offshore although in the process US consumers are now able to gain access to high quality goods at lower prices than if they were produced locally. Clearly, their utility function is such that they would trade some of their better material prosperity for some of the jobs which have been lost. This does not make their economic argument right, or indeed wrong, though I suspect it tells us something that I have long suspected – namely, that attempts to measure consumer well-being in monetary terms defines too narrowly the problem of economic dislocation in the wake of globalisation. It was a failure of successive UK governments to comprehend this that led to the vote in favour of Brexit.

But where Trump is wrong is to suppose that starting a trade war will alleviate the problems. In a first act, he is likely to kill the Trans-Pacific Partnership, a trade pact involving 12 Pacific Rim nations, which Obama had hoped would be approved by Congress after the election. Indeed a press conference involving representatives from Australia, Japan, New Zealand and Singapore which was scheduled for tomorrow, has now been cancelled. This may be a recognition that progress is unlikely. Admittedly, ending the TPP would not involve any additional costs since it has not been ratified anyway.

But threats to pull out of NAFTA would be more problematic. Trump wants to impose steep tariffs on goods imported from Mexico in order to deter additional jobs from moving south. Economists continue to debate whether NAFTA is beneficial to the US. But it is likely that many of the jobs lost would have gone anyway, and with the US trade deficit with China roughly five times bigger than that with Mexico, around five times as many jobs have been lost to China as Mexico. Moreover, outsourcing some of the lower value added processes to Mexico and reimporting them into the final product has helped to keep US labour costs down. You can argue about it, but it does not seem as though NAFTA has been the killer that Trump has argued.

Threats to impose import tariffs on the likes of China would quite simply be very bad economics. For one thing, we know where that got us in the 1930s, as beggar-thy-neighbour policies depressed world trade. For another, China holds large swathes of the US bond market. Attempts to pick a trade war could have adverse consequences if the Chinese decided to dump their Treasury holdings.

Trump’s fiscal policies don’t add up either for they imply a lot of unfunded promises. We can come back to this at a future date but suffice to say that if you want to expand fiscal policy, it may not be a great idea to antagonise the Chinese too much: They might turn out to be the best customers for your bonds! Finally, and in an echo of the UK debate, relationships between Trump and Fed Chair Yellen are not exactly cordial which has given rise to speculation that Yellen could walk the plank when her term expires in January 2018. It would not be the first time that the White House and the Fed have clashed in this way but it does not send a particularly positive signal to the markets on the conduct of monetary policy.

All in all, markets may have dodged a bullet today but there is enough for them to worry about in future to suggest that today could only be the calm before a very big storm.

The best laid plans ...

Economic plans set out by politicians ahead of an election are probably not worth much more than a cursory analysis, but that does not stop people trying. Ahead of the US presidential election, a lot of ink has been spilled trying to figure out the respective merits of the two candidates' plans. As usual, the candidates talk a lot about taxes and how many jobs they will create. But whilst this may be all well and good in a dictatorship where the election winner has carte blanche to act as they please, it certainly does not wash in western democracies where the head of government is beholden to parliament (or Congress in the US case).

Donald Trump has called for lower taxes and a simplification of the tax code, reducing the number of tax brackets from seven to four, and for the top rate of tax to fall from 39.6% to 33%. In his words, "The rich will pay their fair share, but no one will pay so much that it undermines our ability to compete." Analysis by the Tax Foundation of the Republicans’ tax plan, released in June and which is similar to Trump’s, would disproportionately benefit the rich by raising the post-tax income of the top 1% of earners by 5.3%. But the Republican nominee goes much further, by proposing to completely eliminate estate taxes which would clearly benefit those rich enough to be able to pass on more than $5.45 million of assets to an individual (or $10.9 million to a married couple). This does not sound like a policy aimed at the blue collar workers amongst whom Trump is so popular.

Hillary Clinton, meanwhile, proposes to maintain the existing seven brackets but is also in favour of an additional surcharge on those earning more than $5 million per year which would be used to fund programmes such as free education for the less well off. Both candidates favour limiting tax deductions, with Clinton limiting them to a total of 28%. Analysis of their respective tax plans by the Tax Policy Center suggests that the Clinton plan would raise revenues by $1.2 trillion over the next ten years whilst Trump would cut them by $11.2 trillion. On the spending side, the Committee for a Responsible Federal Budget estimates that Clinton's spending increases would broadly match the higher tax take but Trump makes no effort to close the gap, with the result that his plans will result in much higher deficits. His plans thus sound more suited to Europe, which is crying out for stimulus, rather than the US which no longer is.

Where the Trump plans really start to fall apart is in the area of trade, where there are calls for the renegotiation of trade deals to favour the US and to walk away from those deals which are not viewed as favourable. Meanwhile, Trump has also advocated a 35% tariff on goods imported from Mexico and a 45% tariff on Chinese imports. To put it bluntly, a proportion of the income tax savings which US consumers would derive under President Trump would be clawed back in the form of higher goods prices resulting from higher tariffs. Not that Clinton's trade views are that consistent either. In a bid to tap into the Zeitgeist on trade issues, Clinton now suggests that the Trans-Pacific Partnership is not necessarily the best deal for America, even though she was involved in the negotiations.

John Cochrane argues in a blog post that the Clinton plan is not really a plan at all and that it represents little more than a wish list of ideas. Allowing for the fact that he is not particularly well disposed towards Clintonite policies in the first place, he has hit the nail on the head when it comes to describing candidates' plans (and not just in the US). They can only ever be a wish list. For example, whilst both Trump and Clinton suggest that they will boost the US manufacturing sector, the forces determining its fate lie well outside the control of any US president. For better or worse, we live in a globalised economy and we have to accept that for all the material benefits this has brought, there are costs in terms of a redistribution of jobs. Attempts to reverse the process will also impose major costs – particularly in the case of Trump’s plans.

Often, some of the things which candidates promise on the stump turn out to be things they bitterly regret. Take for instance David Cameron's 2010 promise to reduce annual UK immigration to "the tens of thousands" from levels around 250,000 at the time (it has since risen by a third). It made him a hostage to fortune which he could never deliver upon, and was compounded by the ludicrous decision to hold a simple in-out referendum on EU membership. And we all know where that led.