Article 50: One year on

It is now exactly a year since Theresa May stood before UK parliament and announced that she was triggering the Article 50 mechanism that would sweep the UK out of the EU within two years. Halfway through the mandated two year time period, the UK has made more progress with regard to negotiating a deal than I believed possible at the time. Nonetheless many mistakes have been made along the way, and there is still much work to do before UK is able to arrive at a deal which will minimise the damage caused by what I still consider to be an act of economic self-harm. Perhaps more significantly, the country remains as split as ever on Brexit. The ultras still want it at any price whilst there is still a significant core of Remainers who want to prevent it altogether.

Looking back over the past 12 months, there is certainly a lot less gung-ho from the prime minister. The idea that “no deal is better than a bad deal” has been quietly dropped and some of the more strident rhetoric which was designed to keep the pro-Brexit faction of her party onside has been toned down. Of course, this is in large part the result of the ill-judged election call which cost the Conservatives their parliamentary majority last June, and which has weakened the prime minister’s position. More significantly, parliament has exercised a greater of control over the domestic legislation process than was initially envisaged. The government’s original plan was that it would be the prime driver of Brexit legislation but the Withdrawal Bill has been the subject of numerous amendments during its parliamentary passage and may not be the all-encompassing piece of legislation that was envisaged a year ago.

The toning down of domestic rhetoric is also a consequence of the Realpolitik of dealing with the EU27 across the negotiating table. For example, during her speech to parliament in March 2017, the PM promised to “bring an end to the jurisdiction of the European Court of Justice in Britain.” Earlier this month, she was forced to recognise that “even after we have left the jurisdiction of the ECJ, EU law and the decisions of the ECJ will continue to affect us.” That is a very different message to the one she tried to sell a year ago but it is a recognition that the form of close partnership that the UK wants with the EU27 will necessarily involve compromises that will not please everyone in her party. However, it raises the prospect of ongoing domestic political upheaval as it becomes clear that Brexit simply cannot take place on the no-compromise terms envisaged by many Leavers.

It was evident a year ago that the two year timeframe was never going to be long enough to ensure that the final agreement between the UK and EU27 could be ratified. And so it has proven, with the announcement last week that the two sides will implement a transition deal starting in a year’s time which runs to end-2020. The good news is that this will remove the prospect of a cliff-edge Brexit in March 2019 although does not preclude the possibility that the cliff-edge has merely been postponed to December 2020. Nonetheless, this is good news for financial institutions in particular, who until yesterday were unsure whether the arrangements that allow cross-border transactions in financial services would come to an end in March 2019. However, the Bank of England has now opined that it “considers it reasonable for firms currently carrying on regulated activities in the UK by means of passporting rights … to plan that they will be able to continue undertaking these activities during the implementation period in much the same way as now.” In other words, we now have more time to prepare, and hopefully more information on the future of financial services will be forthcoming in the interim.

As regards the three key issues that formed the basis of phase one of the Brexit negotiations, the UK and EU27 are broadly agreed on guaranteeing citizens’ rights and the final exit bill. However, whilst both sides agree in principle on the issue of maintaining an open border between the Irish Republic and Northern Ireland, the UK has not yet come with a solution which will satisfy the requirements of both sides. It is thus notable that whilst the UK and EU27 agree on 75% of the issues outlined in last week’s joint agreement document, the Irish border issue, and the thorny question of how much jurisdiction the ECJ will be allowed to have, remain to be resolved.

Compared to what was expected on the economy twelve months ago, GDP growth has been broadly in line but unemployment has fallen faster and CPI inflation has picked up more than anticipated. The threat of Brexit has clearly not derailed the economy but it has arguably underperformed relative to what might have occurred in its absence. Indeed, the UK remains at the bottom of the G7 growth league and is the only major economy which registered slower growth in 2017 than in 2016. I thus remain to be convinced that Brexit will prove a net benefit for the UK economy, for reasons that I have outlined numerous times before.

But my biggest issue with Brexit remains the way in which the Leave campaign made their case ahead of the referendum (and allegations of funding impropriety which have surfaced in recent days does nothing to assuage these concerns) and the way in which the result was interpreted as a winner-take-all  event. Leave supporters continue to believe that the “will of the people” justifies Brexit at any price and precludes the option of revisiting the decision. But parliamentary democracy in the UK is founded on the principle that no parliament can take a decision that binds its successors. Yet that is precisely what Brexit implies. It is the imposition of a policy that younger generations – and perhaps those not yet born – will have to contend with. It is in many respects a profoundly undemocratic decision.

Of course, the Leave side can reasonably contend that it is undemocratic to be shackled to an institution of which they do not wish to remain part. Thus, one year after triggering Article 50 and almost two years after the referendum, the legal and constitutional implications of the decision are no nearer being resolved. Expect us to be having much the same debate about the (de)merits of Brexit in March 2019 as we did in March 2017 (or even March 2016).

Examining the case for a wealth tax

I have pointed out previously that the huge fiscal tightening imposed on the UK over the past eight years has come about through huge cuts in spending and relatively little by way of additional taxation (most recently here). Now that the balance between current spending and revenue has been restored, there is no serious rationale for further swingeing spending cuts. Undoubtedly this was one of the factors supporting the announcement by Theresa May earlier this week that additional funding will be made available for the NHS.

Whilst this is a welcome development, the pressure on public finances has not suddenly gone away now that the deficit on current spending has been eliminated. If anything, as the population ages, the demands on healthcare and social services will continue to rise. It is not just the health system that is struggling to cope: The benefits system is under pressure too, and there is a huge wedge of people at the lower end of the income scale who are struggling to gain access to the benefits to which they are entitled.

What the government has not outlined is how much additional funding will be provided nor where it will come from. After eight years of grinding austerity, raising existing taxes to fund the additional resource requirements will not be acceptable to taxpayers who would regard it as yet another kick in the teeth for the squeezed middle. Indeed, raising income taxes appears to be a non-starter. In any case, efforts to compensate low-paid workers for the curbing of their benefits via an increase in personal income tax allowances is already estimated to have cost a cumulated £12bn in foregone revenue in FY 2017-18. Having raised VAT to an already-lofty 20%, the scope for raising indirect taxes is also limited. It would thus be sensible to look for alternative revenue sources, and two apparently radical fiscal suggestions have been given more prominence in recent weeks. One is the possibility of some form of wealth tax and the other is to introduce a hypothecated tax to fund such items as the NHS.

In this post I will consider only the option of a wealth tax and will come back to hypothecated taxes another time. The rationale for a wealth tax is that incomes, which form the basis of most direct taxes, have remained stable relative to GDP over the past three decades whereas wealth holdings have significantly increased. Thirty years ago, UK household net financial wealth holdings were a multiple of 1.2 times GDP but today the multiple stands at 2.3. The picture looks even more favourable if we add in wealth held in the form of housing. Financial and housing wealth together amount to around 5 times GDP compared to a multiple of 3 in 1988 (chart).

But why should this windfall gain be subject to tax? One strong argument is that taxes on income do not take into account the claim on overall resources that wealth confers. For example, there is a difference in the ability to pay a bill of (say) £1,000 between someone who earns £20,000 from labour income and someone who earns £20,000 as a return on a wealth stock of £1 million. As a result, a wealth tax will raise the overall progressivity of the tax system by taking account of the additional taxable capacity conferred by wealth. But wealth holdings are already subject to tax in some form or another. For example, liquidating wealth holdings subjects individuals to capital gains tax. Moreover, the flow of income accruing to a stock of financial wealth is liable to income tax. In addition, even if the wealth is untouched and generates no direct financial benefit to the individual, if it is passed on as a bequest to future generations it is subject to inheritance tax.

In any case, there are a huge number of practical difficulties associated with introducing a wealth tax. To name just a few: How much should it raise? On which assets should it be levied? At what rate should it be set? Should it be set at a single or graduated rate? Howmuch (if any) of an individual’s wealth should be exempt? Even if we could agree on these issues, once such a tax has been implemented, two of the biggest ongoing problems are disclosure and valuation. The disclosure problem is obvious: It is easy to hide many forms of wealth (think how simple it is to hide small but precious items such as diamonds). As a result, compliance becomes a problem and even honest taxpayers have an incentive to cheat if their fellow citizens are not playing ball. In addition, the valuation problem is often underestimated, particularly if the absence of a market transaction makes it difficult to establish an appropriate valuation metric. It is for all these reasons that the proportion of OECD countries levying a wealth tax has fallen over the last three decades. In 1990, half of them did so (17) but by 2010 only France, Norway and Switzerland levied them on an ongoing basis.

Despite all the practical difficulties, there is a genuine case for some form of wealth tax on grounds of inter-generational fairness. For example, older generations tend to hold the vast bulk of the wealth whilst benefiting from additional public spending on areas such as the NHS. It is for this reason that the Resolution Foundation recently put forward a series of proposals to reform property taxes, including the introduction of a progressive property tax to replace the existing Council Tax and raising taxes on highest-value properties.

Such measures will clearly not be popular with Conservative voters, and is one reason why they will not be implemented any time soon. But as the fiscal debate increasingly switches away from deficit reduction and focuses more on what the state can reasonably be expected to provide, the issue of inter-generational equity will inevitably rise up the list. We may not want to talk about wealth taxes today but it is an issue that is unlikely to go away.

China crisis

The announcement that the US government plans to impose tariffs of 25% on $50 bn of goods imported from China has set the cat amongst the pigeons, with equity markets turning sharply lower and safe havens such as gold gaining ground. But whilst this may look like a simple application of economic nationalism, led by a president who clearly has no appreciation of the damage that he may be about to unleash, it is worth considering the underlying US grievances. First and foremost, the Administration believes that China has gained from the unfair expropriation of US intellectual property and that some form of recompense is required. But this is not only a US problem: Many western governments are beginning to worry about the asymmetries which their companies face in doing business in China – the US is simply the first to take action.

Three weeks ago The Economist, which has long been a cheerleader for global free trade, expressed reservations about the direction in which China is heading. In its view, “the China of Xi Jinping is a great mercantilist dragon under strict Communist Party control, using the power of its vast markets to cow and co-opt capitalist rivals, to bend and break the rules-based order.” The article went on to point out that “Chinese markets are opened only after they have ceased to matter” whilst regulators “take away computers filled with priceless intellectual property and global client lists.” A week later, the Financial Times ran a story headed “Backlash grows over Chinese deals for Germany’s corporate jewels” following the news that Geely has acquired a 10% stake in Daimler which has raised fears that Daimler’s know-how in the field of electronic vehicles will filter back to China without appropriate compensation.

Industrial espionage is not new, of course, and we should remember that some of the earliest examples of such activity involved the transfer of Chinese technological advantages into western hands. For example, in the 1800s China had a monopoly on tea growing until a British botanist, acting on behalf of the East India Company, smuggled tea plants and seeds to India and established an industry whose output eventually eclipsed that of China. But this does not assuage current western concerns that the heavy-handed techniques employed by the Chinese are backed by the government. Whilst western companies have long been required to hand over technological secrets before being allowed to conduct business in the Chinese market, the fear is now that many of China’s major foreign acquisitions have been funded by state-backed institutions. Indeed, the FT reports that the message conveyed by the Geely chairman to the German media, that the company wanted to cooperate with Daimler, was not the one he gave to his home audience which was that the action was designed to “support the growth of the Chinese auto industry” and “serve our national interests.”

Seen in these terms, it is hardly a surprise that the US feels that it needs to take some form of action. But despite Trump’s rhetoric to the contrary, it is hard to believe that the US really wants to embark on a major trade war. The fact that China responded with tariffs on only $3bn of imports from the US suggests that it is not willing to escalate the problem either. In the grand scheme of things, the US actions will have next to zero impact on Chinese GDP. A 25% tariff on $50bn of exports amounts to a total hit of $12.5bn which is insignificant in a Chinese economy whose output is valued at $12 trillion. But it is what comes next that matters.

In assessing the outcomes, I am indebted to some modelling analysis conducted by Bloomberg analysts using the NiGEM global macro model. In its first scenario, Bloomberg assumed that the $50 bn figure becomes a US revenue target to reflect the estimated damage done to the economy by intellectual property theft. But the impact of such an outcome, which is four times more significant than what we believe likely to happen, only costs 0.2% of Chinese GDP by 2020. Bloomberg thus concluded that China would be better off not retaliating because the economic losses resulting from inflation generated by higher import tariffs would exceed this amount. In a second simulation exercise, Bloomberg tried to assess the impact of a 45% tariff on all Chinese imports – a figure that Trump happened to mention on the campaign trail. This resulted in a 0.7% hit to GDP by 2020 which they concluded would “not be disastrous.”

But the real problem comes when the tariff war goes global and pulls in countries other than China. An across-the-board rise of 10% in US import tariffs which is met with a similar response by all the US’s trading partners results in a 0.5% drop in Chinese output but a 0.9% drop for the US. This highlights the self-defeating nature of tariff wars and results from the fact, as Bloomberg pointed out, “the tariffs affect 100% of US trade, but for China and other countries, [they] only impact bilateral trade with the US.”

On the surface, the optimal Chinese response to higher tariffs which in aggregate terms amount to little more than a gnat’s bite, would be to ignore them. Since it continues to grow faster than the US it will – in the not-too-distant future – overtake the US as the world’s largest economy and will be in a position to retaliate more effectively. In any case, there are other ways to respond. China is also the largest holder of US Treasury securities (chart). It could thus tweak the tail of the US by selling Treasuries and put upward pressure on US longer-term interest rates.

But this issue is about more than just economics. This is a tale of two alpha economies demonstrating their political muscle, which runs the risk of miscalculation. Unlike Japan in the 1980s, when the US tried to exert pressure using similar tactics, China is a much more potent economic and political rival. It is also not politically allied with the US in the way that Japan was. I have never subscribed to the idea that China and the US are doomed to fall into the Thucydides Trap. But this is a time for cool heads and as I noted in late-2016, it is at times like these that we will miss the rationality of an Obama.

Should we continue spending a penny?

One of the policy ideas that was floated in the wake of last week’s UK Spring Statement was the possibility of scrapping the lowest denomination coins (the 1p and 2p piece). According to research cited by the Treasury last week, “surveys suggest that six in ten 1p and 2p coins are used in a transaction once before they leave the cash cycle. They are either saved, or in 8% of cases are thrown away” (see chart). Since the Royal Mint has to produce and issue additional coins to replace those falling out of circulation, and because “the cost of industry processing and distributing low denomination coins is the same as for high denomination coins” this not unreasonably raises the question of whether we need the lowest denomination coins.

I have to confess that I have long wondered the same thing given that over the years I have collected large quantities of pennies in jars, which weigh a lot but have little monetary value. Moreover, the amounts in coin which vendors are legally obliged to accept in the UK are very low. For example, the legally acceptable maximum payment in 1p and 2p coins is a mere 20p (it can be more, depending on the discretion of the payee). For 5p and 10p coins, that limit rises to £5. That is a very arbitrary amount: I can legally only use 20 x 1p coins in one transaction whereas I can use 100 x 5p coins (which are also  irritatingly small). I also recall that the one time many years ago when I wanted to cash in my pile of bronze and took it down to the automatic machine at my local supermarket, the nominal value of the coins was something like £42 but I paid a £2 commission fee, corresponding to almost 5% (and yes, I know I should have taken it to a bank).

So it should be clear that I am not a fan of coinage that clutters up space for little return. And the UK has form when it comes to taking small denomination coins out of circulation. Way back in 1960 the farthing was removed from circulation. For those unfamiliar with UK coinage, the farthing was equivalent to a quarter of a pre-decimal penny – around one-tenth of a modern penny. In 1983, the halfpenny was taken out of circulation and I do not recall any great wailing and gnashing of teeth at the time. Moreover, since 1984 the price level as measured by the CPI has increased by a factor of 2.5, and one penny today is worth less than 0.4p in 1984 prices. In other words, the real value of the penny today is less than the halfpenny in 1984.

One of the arguments which is increasingly used in favour of demonetising the smallest unit is that its face value is often less than the cost of production. In the US, for example, it cost 1.5 cents to mint each penny in 2016, and although the US continues to issue the penny, the Bank of Jamaica recently announced it would phase out the one cent coin on the grounds that it is too expensive to make. The Royal Mint in the UK has not revealed how much it costs to strike a penny in the UK, but so far as we know it is less than its face value.

But the penny has a strong hold on the UK public imagination and last week’s suggestion was met with such a howl of outrage that the government was forced to back down. It has been around for a thousand years in various guises although it was not until 1714 that it began its transformation from a little-used small silver coin to the bronze item that has become such a staple part of the UK coinage system. Some people are concerned that abolishing the penny would encourage retailers to round up prices – and there may be some truth to that – but a better argument against abolition is that low income households are bigger users of cash and they would likely be hit disproportionately hard by its abolition. Indeed, it is notable that the Treasury’s call for evidence was based on the notion that we are increasingly moving towards electronic cash – but whilst that may be true for most, it is not so for all. The charity sector was also quick to argue that the collection bucket is a useful place to get rid of low denomination coins.

But as much as I value tradition and have no desire to impoverish the less well-off, the arguments in favour of keeping the penny are not strong enough to save it in my view. Inflation has eroded its usefulness – as anyone who has tried to spend a penny in recent years can testify. It ought to go the way of the threepenny bit, the sixpence and the half crown – not to mention the pound note. In any case, there is still the 2p – why keep the penny when you can have two of them in one coin?

UK fiscal update: Counting the Brexit costs

Just four months after the Chancellor presented an autumn budget, and with no new fiscal measures scheduled today, it was rather puzzling why the OBR bothered to churn out the standard 243 page Economic and Fiscal Outlook following today’s Spring Statement. It was, as usual, a thorough and considered analysis of the current situation in the UK and contained an updated forecast, but it all seemed a bit superfluous. So what did we learn?

First, that the OBR’s medium-term forecast remains broadly unchanged compared to November, and second, that the fiscal outlook has improved a bit, with a cumulated reduction in borrowing of around £20bn over the forecast period. In other words, nothing to write home about. With regard to the growth outlook, recall that the OBR cut its medium-term projections in November by reducing the outlook for productivity growth. I did note at the time that this might have been a little premature, primarily because a tightening labour market might be expected to boost capital investment which in turn would lead to a faster pickup in spending relative to labour input. As the OBR acknowledged, “the biggest surprise in the economic data released since November is that productivity growth – measured as output per hour – has been much stronger than expected.” But since this reflected an unanticipated decline in hours worked in H2 2017, which the OBR expects will be reversed, the fiscal watchdog sees no reason to change its view regarding its medium-term productivity assumption. The jury is still very much out.

With regard to fiscal projections, however, it is evident that the UK has now managed to bring current income and outlays back into line. Having reduced the current deficit from 6.5% of GDP in 2009-10 to zero, you might think that now is a good time to pause and rethink the austerity strategy. The bulk of the reduction has fallen on public spending, whose share in GDP has fallen by a whopping 6.3 percentage points over the last eight years whilst the revenue share is only up by 1.4 points. To the extent that the current balance effectively measures the day-to-day cost of running the public sector, it is now clear that services have been reduced to levels which can be covered by tax revenues. In any case, it is possible to stabilise – and even reduce the debt-to-GDP ratio – so long as the primary balance is broadly zero and the rate of nominal GDP growth is higher than the interest rate on government debt. Seeking overall balance on total borrowing, which implies that today’s taxpayers are paying for investment that will be enjoyed by future generations, makes little sense.

I have pointed out many times previously (here, for example) that there is only so much austerity that can be put in place without cutting front line public services beyond the point of no return, and with the strain on health and welfare services unlikely to improve there is a case for raising expenditure in both areas in the near future. Incidentally, I was struck by the French government’s recent suggestion to scrap all jail sentences of less than one month on the grounds that they are both costly and counterproductive. With the UK prison service struggling under the burden of cost cuts, it seems to me that part of the austerity drive in future will not be how to do more with less, but simply how to do less.

One of the key areas of interest in the OBR’s publication was its attempt to quantify the cost of the Brexit divorce bill, which it puts at £37.1bn – 75% of which will be incurred by 2022. Whilst this is at the lower end of the estimates which have been bandied around over the past year, largely because the UK will continue paying into the budget until end-2020, by my reckoning this is about £10bn more than the UK would have otherwise paid to stay in the EU over 2021-22. Moreover, the UK will continue paying off its liabilities until 2064 (chart). The OBR also pointed out that the UK will continue to pay into various EU funds in order to retain access to specific schemes – although the government was unable to suggest how much this will ultimately cost because it has not yet decided in which schemes it wishes to participate.

It is clear, however, that there will be ongoing EU liabilities above and beyond the divorce bill, which will put further pressure on the budget, and highlights that a “clean Brexit” is virtually impossible. Although the OBR was too polite to say so, the notion that the UK will make savings from no longer having to contribute to the EU budget, which can be used for other purposes such as the NHS, is a complete and utter fiction. Here’s looking at you Boris!

Making sense of social trends

Populism has been at the top of the political agenda for much of the last two years. It is manifest in the Brexit vote; the election of Donald Trump; the rise of the AfD in Germany and last weekend’s election in Italy, which saw the Five Star Movement and Lega Nord perform particularly well gaining almost 50% of the votes. To many people, this backlash against the status quo came out of the blue. In reality, it has been brewing for quite some time.

The economist Simon Wren-Lewis recently wrote in a blogpost that “those who think the UK descended into political madness with Brexit are wrong: the madness started with austerity in 2010.” I would argue that the roots extend even further back, and have long believed that Tony Blair’s decision to participate in the invasion of Iraq in 2003 marked a fundamental erosion of trust in government in the UK. Around the same time, in 2004, the journalist David Goodhart wrote an influential essay in Prospect Magazine, entitled “Too diverse?” in which he argued that tolerant western societies face a “progressive dilemma” as the greater diversity of lifestyles and beliefs make it more difficult to find common issues around which society can coalesce.

Goodhart is no tub-thumping populist – indeed he is very much part of the “liberal elite.” Thus, his argument that “large-scale immigration …  is not just about economics; it is about those less tangible things to do with identity and mutual obligation … It can also create real – as opposed to just imagined – conflicts of interest” saw him vilified in sections of polite society. But as the journalist Jonathan Freedland remarked last year in a review of Goodhart’s latest book “you don’t have to like any part of that argument to recognise that it was prescient.”

Fast forward to the present and the recent book by political theorist Yascha Mounk The People vs. Democracy argues that the glue that has held together the liberal democratic model of the post-war era is becoming unstuck. I suspect that the conclusion is a bit overdone but he does accurately nail some of the governance problems faced by western societies. In his view, “elites are taking hold of the political system and making it increasingly unresponsive: the powerful are less and less willing to cede to the views of the people.” In a highly readable review of this book in The American Interest, Shadi Hamid, a senior fellow at the Brookings Institution, argues that this is primarily the result of a change in the nature of government which has become more technocratic and thus has less room to listen to the people.

In Hamid’s view, “technological progress, scientific advancement, and the necessity of ambitious welfare states to maintain social order” has necessitated this more technocratic approach. The electorate has outsourced issues such as taxation, healthcare and a whole manner of regulatory issues to government – they simply do not have the expertise to deal with them nor the time to become fully informed. Hamid points out that governments made a mistake in treating immigration as just another technocratic problem that could easily be dealt with, but “voters didn’t see it that way and repeatedly tried to get politicians to listen.” Worse still, “governing elites wished to make sensitive conversations … off-limits for polite democratic deliberation. To make matters worse, it was done in a condescending way, with enlightened moral appeals … juxtaposed to the untutored bigotry of the masses.”

This was a particular problem in Europe where the rise of AfD; the Italian election result and the Brexit vote are all related in some degree or another to domestic concerns about immigration which governments were unwilling to confront. It may not be a problem that liberals such as myself are willing to acknowledge, but as a partial explanation of why the populist backlash of recent years has taken place it does fit the facts. This does not make the vast majority of the European population racist or xenophobic. But it does echo Goodhart’s warning that recent changes in western societies could “erode feelings of mutual obligation, reducing willingness to pay tax and even encouraging a retreat from the public domain. In the decades ahead European politics itself may start to shift on this axis, with left and right being eclipsed by value-based culture wars and movements for and against diversity.”

It also suggests that governments across the continent have taken their eye off the ball when it comes to addressing the concerns of their electorates. Obviously, these concerns have been magnified by the aftershocks from the global financial crisis of 2008-09, and perhaps governments were so preoccupied with trying to generate a recovery that they were distracted. But as I pointed out in early 2015, it is “evident that the world is not going to return to a pre-2007 “normality”... and policy makers need to start having honest discussions with their electorates about these issues.” In recognition of the fact that the French electorate has concerns, the government last month put forward a plan to tighten immigration controls. Had Angela Merkel known in February 2016 what she knows now about German voters’ concerns, perhaps the EU would have offered the UK more concessions ahead of the Brexit vote.

But pulling up the drawbridge is not the answer. The idea that limiting immigration makes life better for European voters is based on the notion that there is a fixed amount of work, and reducing immigration reduces the competition for that work. This is clearly wrong, but whatever the economics profession might say, a large body of the electorate does not want to hear that message and in order to get re-elected governments have to take a line which may not be in their best economic interests. I am sure that the prevailing opposition to immigration will eventually change, but perhaps not quite for some time, and governments may not be quite so willing to open their borders for an even longer period for fear of the political backlash this generates. I hope I am wrong when I say we may well look back at the last 20 years as the golden age of the liberal economy.

Steeled for trouble

The announcement last week by Donald Trump that he intends to levy tariffs on US imports of steel and aluminium, of 25% and 10% respectively, was the first indication that the President intends to follow up on his campaign promises. The announcement came a matter of hours after I sat in a client meeting and said something to the effect that Trump had so far not implemented the worst of his campaign promises, thereby demonstrating my great prescience.

It came at a bad time for markets, which were beginning to recover from the wobble at the start of February and the S&P500 is currently around 5.7% below the high achieved in late January. What particularly spooked markets was Trump’s claim that “trade wars are good, and easy to win.” Nothing could be further from the truth, as the experience of the 1930s demonstrated. They are nasty and do not result in any winners – everyone loses. Obviously, the steel tariffs will matter because the US is the world’s largest steel importer (26.9 million tonnes in the first nine months of 2017). But who will pay the price? Initially, it will be US industry which uses the steel as an input but ultimately it will be consumers – primarily in the US but also those elsewhere which buy US products using imported steel as an input.

The initial kneejerk reaction was that this was a way of hitting back at China, which has been the focus of the President’s displeasure for some time. Admittedly, China was accused by the EU of dumping steel on the world market at artificially low prices. Only last April the EU introduced levies ranging from 18.1% to 35.9% on certain types of Chinese rolled-flat steel products for a five year period. But China is not even in the top 10 sources of US steel imports. Canada, Brazil, South Korea, Mexico and Russia (in order of importance) account for 57% of the total – and the irony is that two of these countries are NAFTA partners (see chart). With regard to aluminium imports, Canada alone accounts for 56% of the US total, followed by Russia (8%) and the UAE (7%), with China lagging behind in fourth with a mere 6% share.

Trump also turned his focus on the EU at a press conference yesterday, saying “The European Union has been particularly tough on the United States … They make it almost impossible for the United States to do business with them. And yet they send their cars and everything else …” Spot the EU exporter in the list! In fact, Germany is the only EU country which manages to get on the steel importers list, coming in ninth, accounting for 3% of the US total.

We are still waiting to hear which countries will be affected by the tariffs and it really does look like the President has lashed out without regard for the consequences of his actions (why should we be surprised?). There has been speculation in the media that Trump’s actions were nothing more than an angry reaction following the resignation of communications director Hope Hicks, and a series of other incidents.  If true, it certainly raises a concern about the state of mind of the man with his hand on the nuclear button.

The damage from the trade action is likely to be twofold. On the one hand, there will be some limited form of retaliation from US trade partners, and even though an all-out trade war is unlikely, it is still a very bad sign. Second, it may raise questions about the quality of people prepared to serve in the President’s Administration. Gary Cohn, Trump’s highly rated chief economic adviser, has already resigned in opposition to the plan and a number of other cabinet members are believed to be opposed, including Treasury Secretary Mnuchin and Secretary of State Tillerson.

Perhaps more importantly, it calls into question the rules-based system that underpins the global economic order which has served the western world so well for 70 years. If the US, which has acted as guarantor for so long, no longer appears inclined to play by the rules, why should the likes of China or India, which are set to become major economic powers in the course of the 21st century? It will certainly give China greater moral authority to write a set of trade rules to suit itself. And on this side of the Atlantic, at a time when the UK has decided that it no longer wants to be part of the EU, the customs union or single market, it should give those pushing for trade deals with the rest of the world pause for thought about who our friends are and where our interests lie.