The reality of real interest rates

With interest rates having been so low for so long in the industrialised world, policymakers are increasingly waking up to the need to take away some of the monetary stimulus put in place almost a decade ago. The Federal Reserve started its tightening process in December 2015 and it was joined last week by the BoE which nudged the benchmark rate above 0.5% for the first time in over nine years. But it is generally recognised that although central banks are beginning to take away some of the monetary stimulus, they are not heading back to pre-2008 levels any time soon.

In a bid to understand how much headroom there is for monetary policy, central bankers are increasingly paying attention to the neutral real interest rate, described by former Fed Chair Janet Yellen as “the level that is neither expansionary nor contractionary and keeps the economy operating on an even keel.” More formally, it can be thought of as the rate which balances desired wealth holdings with desired capital holdings. This is the theoretical framework attributable to the Swedish economist Knut Wicksell in which equilibrium in both the goods and financial assets market is simultaneously derived.

The analysis published last week in the BoE’s Inflation Report explained this framework very nicely (see chart) and noted that we can think of the rate as being driven by long-term secular factors (R*) and a short-term component reflecting cyclical issues (s*). John Williams, recently elevated to the role of President of the New York Fed, noted in a speech earlier this year that in his view the real neutral rate (R*) in the US is around 0.5%. The BoE comes to a similar conclusion for the UK, pointing to R* in the range 0%-1% (with a modal estimate of 0.25%).

These estimates are around 200 bps lower than those prevailing 20 years ago. So what has changed? One of the key secular factors is demographics. As people live longer they have to save more for retirement with the resultant increase in savings putting downward pressure on interest rates (a shift in the red line to the right in the BoE’s chart). Another important factor is the increased demand for safe assets which has driven down returns on government bonds relative to those on riskier assets, and which also has the effect of driving the red curve further to the right. A third factor is the slowdown in productivity which has reduced business demand for capital, thus putting additional downward pressure on the interest rate (the blue line shifts to the left). Finally, a rise in the government debt-to-GDP ratio may depress the real rate via a crowding out effect since this reduces the quantity of capital available to finance an expansion of the business capital stock.

As to how these factors will play out in future, there is general agreement that slower population growth in the western world will not reverse the current trend ageing of the demographic profile. Consequently, retirement saving is likely to remain a key driver putting downward pressure on the equilibrium rate. It is less clear what will happen with regard to productivity. It may recover, or it may not, but we cannot say for sure that it will remain as sluggish as it has over the last decade. In any case, as labour force constraints begin to bite, it is possible that demand for capital will rise which will act to raise the neutral rate. But it is unlikely that government debt-to-GDP ratios will decline rapidly any time soon, which argues for continued downward pressure on the equilibrium rate.

However, some doubt has been cast by the BIS on the link between interest rates and the observable proxies that are conventionally used to measure the savings-investment balance. Part of their argument rests on the fact that much of the analysis is based on data only back to the 1980s and that taking the data back to the late nineteenth century suggests a weaker link between them. That said, the BoE’s analysis is  based on a long-run of data extending back more than 100 years and they come to much the same conclusion as the rest of the academic literature, which weakens the BIS criticisms to some degree.

However, the BIS does raise another important question:  Much of the literature assumes that monetary policy is neutral in the long run and that only real factors influence the real interest rate. But is this necessarily true? For one thing, the expected wealth demand function may be determined by the actions of central banks themselves as interest rate expectations influence portfolio choices. Another objection is that we may underestimate the key channels through which monetary policy exerts a persistent influence over real interest rates (e.g. the inflation process or the interaction between monetary policy and the financial cycle). These are serious criticisms, although the BoE’s framework introduces the short-run variable s* into the framework, and whilst we can estimate R* using conventional measures, the BoE does not try to put a numerical value on s*. However, it does suggest that in the longer-term the s* component will tend towards zero (although it may not be zero at any given time).

What are the takeaways from all this? First off, if we add a 2% inflation rate to estimates of the real neutral rate, we end up with a neutral funds rate in nominal terms of around 2.5%. With the Fed funds target corridor currently set at 1.75%-2.0%, we might only be three 25 bps hikes away from the neutral rate. Similarly, the UK neutral rate is estimated in the range 2%-3% so we do appear to have more headroom. Nonetheless both estimates suggest that interest rates will not get back to the pre-2008 rates of 5%-plus for a long time to come. Welcome to the new normal.

The case for a UK rate hike

The Bank of England is widely expected to raise interest rates by 25 bps this week, taking them above 0.5% for the first time since March 2009. The markets seem convinced, pricing such an action with a probability around 90%. It would be a major surprise if the Bank were not to deliver, with the markets so apparently sure. Indeed, if the BoE had a problem with current market pricing it would almost certainly have said something before now to try and nudge expectations. The fact that it has not done so is a strong indication in favour of a policy tightening. (If a rate move is not forthcoming … well, that is another story and we will deal with it if it happens).

There are those who believe that raising rates is a mistake (or at the very least that there is no need to act now). Their argument is sound enough: Price inflation is slowing; wage inflation is not picking up as anticipated and there are sufficient headwinds from Brexit that caution is warranted. If we were talking about an economy in which rates were a little bit higher than those introduced when the economy was about to fall off a cliff in 2009 I would be a bit more receptive to that view. But we’re not! Whilst Bank Rate of 0.5% may have been appropriate for an economy which was expected to contract by more than 3% in real terms, it is hard to make the case that is still the right interest rate 9 years later for an economy expected to grow by 1.5%.

For quite some time, I have believed that the UK rate setting process has taken an overly short-term approach to monetary policy. By looking only at short-term issues (e.g. the latest inflation or growth data) policymakers have been able to defer the need for a policy tightening. But in so doing, they appear to have suffered from what we might term “horizon myopia” without taking account of the fact that all these short terms eventually add up to an extended time horizon.

My argument for raising rates is the same as it has been for the last 3-4 years: The current interest rate is too low for general economic conditions. Those who believe that nominal GDP growth should act as a benchmark for the policy rate – and I am semi-persuaded of the merits of such a policy – argue that UK interest rates have deviated from GDP to an unprecedented degree in recent years (see chart). By itself, that is not proof of anything but it is an indication of the extent to which financial rates of return are out of line with those in the real economy which is likely to lead to economic distortions.

Arguably, excessively low (or high) interest rates distort capital allocation decisions – for example, by propping up zombie firms (though I am not sure that is a problem in the UK right now). However, they do distort savings choices. If returns to saving are low, this is a strong argument in favour of spending rather than saving. This is, of course, precisely what policy was designed to achieve during the depths of the recession but is it really necessary almost a decade on? And as I have pointed out previously, the longer interest rates are held at emergency levels, the bigger the risks to future generations of pensioners whose pension pots will not grow as rapidly as they ought. Indeed as John Authers noted in the FT last week whilst low interest rates prevented an economic meltdown, “it grows ever clearer that risk has been moved, primarily to the pension system.”

In my view, this is another strong argument in favour of modestly tightening monetary policy. At this stage we are not talking about a dramatic stamp on the brakes, but allowing rates to edge upwards by (say) 50 bps per year for the next couple of years would take some of the heat out of the problem. Whether the BoE will be in a position to do that depends, of course, on the extent of any damage that Brexit inflicts on the UK economy.

Self-inflicted wounds

It has become clear over the last twelve months how woefully unprepared the British government is to negotiate an exit from the EU. As the play in the theatre of the absurd continues to unfold, we are faced with the prospect of the British government having to take steps to secure food supplies in the event of a no-deal Brexit, which has lit up social media sites with posts displaying a mix of trepidation and withering scorn. As more than one person has commented, we appear to have gone from “Vote Brexit to save £350 million a week” to “Vote Brexit and we will ensure that the food doesn’t run out.”

Against this backdrop the latest missive from the brains behind the drive to sign new trade deals – none other than trade secretary Liam Fox – arguing that ‘No deal’ is preferable to delaying the Brexit process is beyond stupidity. You may recall a year ago, Fox claimed in a radio interview that “the free trade agreement that we will have to do with the European Union should be one of the easiest in human history.” This is the same Liam Fox who said two years ago that “we're going to replicate the 40 EU free trade agreements that exist before we leave the European Union so we've got no disruption of trade.” With seven months before the UK leaves the EU, let us consider how many of those trade deals Fox has actually signed (clue: It’s an integer less than one). So you will forgive me for not taking Fox’s latest assertion at face value that “extending Article 50 is the definition of failure for the government.”

Fox went on to say that “The public have told us, it wasn’t a consultation, to leave the European Union, and the public already wonders why it’s going to take more than four years after the referendum for us to fully remove ourselves from the EU. To attempt to extend our membership even longer, many voters would regard as a complete betrayal by the political class.” So where to start with this one? How about the fact that the referendum was in effect a consultation – it certainly was not legally binding. And why is it taking four years? Because it is a difficult process and one which if rushed will lead to far worse outcomes than are necessary. The biggest betrayal of all would be to sell out the public in order to deliver a Brexit which leaves people worse off. And if he thinks people are angry with the way politicians have handled Brexit so far, wait until it is bungled.

Another of the Brexit-at-any-price brigade, Daniel Hannan, yesterday told readers of the Daily Telegraph “Let’s call the EU’s bluff and prepare for a no-deal.” Hannan’s argument relies on the old nonsense that “they need us more than we need them.” This is simply wrong. Around 47% of UK exports are destined for the EU27 with only 16% of EU exports headed to the UK, and the Telegraph is guilty of peddling fake news by suggesting otherwise. You can argue, as Hannan does, that the EU is being unreasonable in its approach, and we can look at that another day. But all sane commentators knew that the EU held the whip hand in negotiations and expecting it to act in any other way than to look after its members interests denotes irresponsible levels of naivety.

There is nothing new in any of this, of course. I think the Brexit ultras are wrong and they believe me to be a Remoaner, afraid of looking to new horizons. So let’s have a look at some evidence. Over recent months I have been looking at gravity trade models of the UK to assess the impact of a hard Brexit (the final results are likely to be published in a few weeks’ time). On my estimates, a no-deal Brexit will cost around 8% of UK export volumes and impose a hit of 3% on imports. With exports falling more than imports, this implies a one-off reduction of 1.5% in GDP. That may not sound like a lot but if we impose these results on a structural model and run them over a 15 year horizon, we end up reducing real GDP by 4% relative to baseline and real incomes by 3%. As a result unemployment rises and public finances turn out significantly worse than they would otherwise be. I can’t find the Brexit dividend to fund higher NHS spending (neither can the OBR). 

With support for a second referendum apparently mounting, the whole Brexit debate is reaching a tipping point. I have to stress that I am no great fan of this idea although I don’t buy the will of the people nonsense (remember, only 37% of eligible voters opted for Leave). But the decision to leave the Single Market and Customs Union is economically crazy and was certainly not on the ballot paper. However, if Theresa May continues to believe that this is what people voted for, then a second referendum may indeed be required to check whether it really is “the will of the people.”

I do wish there were more important things to write about but Brexit appears to have become an all-consuming part of this blog. However, it is THE economic question of my lifetime – and it is being driven by ideological politics. But as the journalist James O’Brien put it, “The one thing I still can’t quite get my head round: It’s optional. It’s a choice. It’s voluntary.”

You don't know what you've got 'til it's gone

Viewed in a global context Brexit is very much a sideshow. However, it is all part of a global backlash against the status quo which is perceived to have acted against the interests of citizens in the developed world. Nowhere is this more evident than in the actions of the Trump administration which earlier this month imposed higher tariffs on the first $34bn worth of imports from China and threatened to escalate still further, thereby risking Chinese retaliation and a further step on the path towards a global trade war. The biggest danger in all of this is the prospect that the current global economic architecture could well be jeopardised, which may not be perceived to be a problem in Hicksville USA or Smalltown England, but might result in turning our back on the most successful period of prosperity generation in world history.

To put some figures on it we rely on the database put together by the late Angus Maddison which looks at very long runs of GDP data. Measured in real terms, the increase in world GDP between 1950 and 2000 outstripped anything seen in the previous two millennia, rising at an average annual rate of 3.9% versus 0.2% in the preceding 1950 years (chart). The same is also true of the US, although its most rapid growth occurred during the early years of the industrial revolution. Nonetheless, average US growth of around 3.5% per year between 1950 and 2000 compares pretty favourably with the 4.4% rate recorded during the nineteenth century. Growth is not everything, of course. When comparing living standards, what matters is the absolute level of income. Whilst it is true that US per capita income growth has stalled over the last decade, the US still ranks ninth in the world behind three oil-rich Gulf states, four smaller European economies (Norway, Luxembourg, Switzerland, Ireland) and Singapore. For the record, Chinese real income per head is just 23% of US levels.

It might suit some American politicians to claim that their country has never had it so bad, but the US is still a pretty good place to be. The US has attained these lofty heights, thanks to an exceptional period of technical innovation – which it drove – and a huge rise in world trade which allows it to buy products more cheaply from other parts of the world, thus allowing American citizens to spend their excess income on other products. Whilst it is true that China is closing the gap with the US, per capita GDP growth has recently slowed to an annual rate of less than 3%. At current rates, it will take China 55 years to reach current US  levels and assuming China is able to sustain a 2.75% growth rate way out into the future (which is unlikely) and US incomes grow at 1% per year, it will take the better part of a century for China to match US living standards.

Worse still, the US Administration appears to have no concept of the gains from trade. As The Economist put it a few weeks ago, “Trump appears to see the world as he saw the New York property market, a place of screw or be screwed.” China may be stealing US technology and engaging in sharp practices to ensure that the playing field in the Chinese market is far from level, but that does not mean that the US should cut off its own nose to spite its face. Adam Smith – a hero of many on the right – argued in his 1776 publication The Wealth of Nations that all nations would gain simultaneously if they practiced free trade and specialized in accordance with their absolute advantage.

The US may no longer be the world’s primary producer of traditional industrial products such as steel, but it is still the world’s most technically advanced nation which in the past 20 years has given us Facebook, Amazon, Netflix and Google (the so-called FANGs) which also happen to be the largest global companies by market cap. Moreover, many companies rely on outsourcing production to external markets, and retaliation in response to US actions would imperil global value chains and force a rethink of how companies operate across borders with unanticipated consequences.

But rationality is not the order of the day. Western historians will probably look back at the first two decades of the 21^st century as a golden period punctuated by a severe crisis that prompted irrational policy choices. They do say that you don’t know what you’ve lost until it’s gone. I miss the good old days even before they have ended.

Imagine ...

The morning of 24 June 2016 dawned bright and fair as British voters awoke to the news that they had voted by a margin of 52% to 48% to remain in the EU. It was a close run thing but was broadly in line with pre-referendum polling that had given the Remain camp a narrow lead. As the political establishment breathed a sigh of relief, Nigel Farage vowed to fight on to try and extricate the UK from the EU whilst influential Conservative figures such as Justice Secretary Michael Gove and charismatic backbench MP Boris Johnson – both of whom had campaigned for Leave – promised to abide by the result.

But the big story of that Friday was David Cameron’s surprise resignation as prime minister. He  justified his action on the basis that he had prevailed in holding the Union together after the September 2014 Scottish referendum, and had successfully managed to keep the UK in the EU whilst lancing the boil of Euroscepticism within the Conservative Party. As he said in his resignation speech, “I was absolutely clear about my belief that Britain is stronger, safer and better off inside the European Union … and as such I think the country requires fresh leadership to take it in this direction.” The pound soared on the news that the political slate was being wiped clean, giving cover for the BoE to begin the process of raising interest rates that had been postponed during the referendum campaign.

Meanwhile, the process of finding a new Conservative Party leader got underway. Chancellor George Osborne was the runaway favourite but he had made many enemies within his party in the preceding six years. Surprisingly, the parliamentary party began to coalesce around Ken Clarke, the 76-year old Europhile who had stood unsuccessfully for the leadership on three previous occasions and whose time in front line politics was assumed to be over. Clarke and Osborne were the last two candidates standing before Osborne pulled out of the contest, with the result that a ballot of party members became  unnecessary and Ken Clarke walked into Downing Street unopposed as the oldest first-time appointee to the job of prime minister.

Nine years older than opposition leader Jeremy Corbyn, Clarke’s tenure marked a switch towards a more mature style of politics. He reappointed Philip Hammond as Foreign Secretary whilst Home Secretary Theresa May swapped jobs with Chancellor George Osborne, and there were promotions for prominent Remain supporters such as Amber Rudd, Justine Greening and Jeremy Hunt. Admittedly, the Conservatives still had a sizeable minority of MPs who backed Leave but many of them had given up the fight after the referendum, promising to abide by the “will of the people.” But Clarke took the UK in an unexpected direction at the October 2016 Conservative  Party conference, promising a UK application to the Schengen Area and most radically of all, membership of the European single currency. As Clarke said in his conference speech, “we  are all citizens of somewhere and the referendum result has made it clear that the British people have voted categorically to align themselves with the values and institutions of the European Union.”

It was a controversial move, to say the least, and the government’s plan to apply for euro membership without parliamentary approval was only halted by the intervention of James Dyson, the businessman and prominent Leave campaigner, who sought a legal ruling as to whether parliamentary approval was required. In the event, the Supreme Court upheld his challenge prompting the Daily Mail to ask why these “Enemies of the People” should stand in the way of further European integration. But fearful of acting against the “will of the people” parliament voted through the government’s plan despite serious reservations amongst backbench MPs.

In March 2017, the government announced a formal bid for euro membership and appointed Education Minister Nicky Morgan as the lead negotiator, backed up by her new department DEnMU (Department for Entering Monetary Union).  Barely had negotiations begun than Prime Minister Clarke decided to call an election for June 2017 in order to extend his wafer thin majority of 12 seats. It turned out to be a bad call, with the Conservatives falling 9 short of a parliamentary majority and requiring the support of the 12 LibDem MPs in a rerun of the 2010-2015 coalition. It transpired that voters were not quite as enthused about further European integration after all, but the real vote loser turned out to be the ongoing austerity promised by Chancellor Theresa May. Had the Tories won the expected thumping majority, it was widely believed that Clarke would have sacked her but in the event he could not afford more disruptions to his team.

From then on, the going got really tough as the UK began to understand the restrictions which membership of the single currency would entail. More fiscal discipline would be needed in order to reduce the debt-to-GDP ratio, which was now heading towards 90% compared to an entry threshold of 60%. Having raised rates by a  total of 100 bps since summer 2016, the BoE was now under pressure to reduce them in order to converge with ECB levels and thus ensure a smooth transition to EMU membership by 2019 (the ECB’s main policy rate at this point stood at -0.4% versus 1.5% in the UK). There were widespread fears that this would give the economy an undesired boost which would push GDP growth above  3% – way in excess of the estimated trend of 2¼% – and in turn push wage growth above 4%.

Against this backdrop, domestic political opposition to the government’s plans mounted. The Great Integration Bill made its torturous passage through parliament, with backbench MPs trying – and failing – to thwart its progress. Negotiations with the EU also became more tricky as the UK began to ask for more concessions with regard to the EMU fiscal targets whilst calls for a permanent UK representative on the ECB Governing Council met with resistance. By March 2018, it was evident that EMU entry in 2019 was an unrealistic option and a transition period was agreed in principle that would postpone entry until end-2020. The government White Paper of summer 2018, which detailed the logistics of swapping the euro for the pound, was a brave effort but the timetable was far too tight to be realistic and the ECB objected to the five-year transition plan in which sterling and the euro would continue to operate as legal tender in the UK.

As of now, the process is deadlocked with parliament split on the issue of further EU integration. It is evident that the wounds caused by the EU referendum have not healed, whilst the government’s plan to join the single currency is increasingly regarded as unrealistic. As one prominent government minister remarked just ahead of the parliamentary recess, “Clarke’s plan will never fly and he only remains as PM due to a lack of alternative candidates. You know, I sometimes wish Remain had never won the referendum. The Leavers would never have produced an omnishambles of this magnitude.”

The Black Knights of Brexit

The Brexiteers increasingly remind me of The Black Knight in the film Monty Python and the Holy Grail, who, you may recall, refused to let King Arthur pass over a bridge without a fight. In the subsequent skirmish, the knight responds to the loss of one of his arms with the wonderful remark, “’Tis but a scratch.” His response to the removal of his second arm is “It's just a flesh wound!” Only after both legs have also been cut off does the knight suggest “we'll call it a draw.” According to John Cleese, one of the writers of the sketch, the story stems from his schooldays when he supposedly witnessed a wrestling match in which neither contestant would give up. It was only when one wrestler finally pulled away from his opponent that he realised the other man was, in fact, dead and he had effectively won the match posthumously. In Cleese’s telling, the moral of the story was "if you never give up, you can't possibly lose."

I make this point because reality is coming ever closer to us and still the Brexiteers will not yield. The EU has made it clear what a no-deal Brexit will look like in a 17-page paper released earlier this week. The Commission notes that although “there might be a transition period” running to end-2020 “we need to prepare for all scenarios ... and each scenario has different consequences.” The EU makes it clear that “no deal” will result in the UK becoming a third country, with all the attendant legal consequences that will entail. Amongst other things, airline licences, certain citizen rights and medicine certificates will end overnight.

For this reason, the EU makes a clear distinction between preparedness and contingency in planning for the UK’s withdrawal from the EU. Preparedness is defined as those “measures  that  will  have  to  be  taken  as  a  consequence  of  the withdrawal  of  the  United  Kingdom regardless  of  whether  there  will  be  a  withdrawal agreement” whereas “contingency planning consists of envisaging the measures that would be necessary to mitigate the  effects  of  a  withdrawal  of  the  United  Kingdom  from  the  Union  without  a  withdrawal agreement.” Although we don’t know what contingency measures are being put in place, presumably because the EU does not want to show its hand too early, the fact that it talks about them is a sign that the EU is taking seriously the threat of “no deal” by March 2019.

Meanwhile, the Black Knights of Brexit show their unshakeable faith that all will be well. Without any form of contingency arrangement, aircraft will not fly – despite the blithe protestations of Leavers – because insurers will not cover them to do so without the requisite permissions. In the absence of any form of contingency, ports will clog up. And industrialists repeatedly warn that their businesses will suffer in the event of a “no deal” Brexit. The warnings from Airbus and BMW have been widely reported but Jaguar Land Rover – a business with a long domestic tradition, even though it is now Indian-owned – is increasingly vocal about the risks which stem from the prospect of tariffs and customs delays that would hurt its just-in-time inventory model. However, Conservative MP Owen Paterson knows better: “If we really do leave the Customs Union, Jaguar Land Rover will have access to cheaper parts and components all around the world and the European suppliers will be forced to compete or they will lose Jaguar Land Rover’s business.” After all, who needs experts?

To many of the ultras, it seems as though Brexit is merely a flesh wound to the British economy. But as Anna Soubry MP noted in the House of Commons on Monday, ”If we do not deliver frictionless trade … thousands of jobs will go, and hon. Members sitting on the Government Benches, in private conversations, know that to be the case. What they have said in those private conversations is that the loss of hundreds of thousands of jobs will be worth it to regain our country’s sovereignty – tell that to the people who voted leave in my constituency. Nobody voted to be poorer, and nobody voted leave on the basis that somebody with a gold-plated pension and inherited wealth would take their jobs away from them.”

Brexit has always been about more than about economics, and it has long been clear that using economic arguments to counter the concerns is futile. The arguments simply fall on deaf ears. The debates over the White Paper (and indeed, those leading up to it) have become increasingly ideological. To use the moral of Cleese’s tale, if Brexiteers will not give up they cannot lose. However, they are losing in the remorseless battle against reality. Metaphorically, they have already lost at least one limb and at some point they too will be totally limbless, claiming they fought to a draw. But just to remind you how the scene in The Grail ended, King Arthur simply walked past his defeated opponent with the Black Knight threatening nothing more than to bite his legs off. Fact can be stranger than fiction.

Dealing with Donald

British Prime Minister Benjamin Disraeli is credited with coining the phrase “There are three kinds of lies: lies, damned lies and statistics.” But Disraeli never met anyone like Donald Trump who has created a fourth kind of lie in the form of fake news – a damned lie of a wholly different order of magnitude. Fake news goes well beyond a mere bending of veracity – it reflects an  untruth created with the express purpose of dissemination via various forms of media in order to attract such a huge following that it becomes virtually impossible to counter with the truth.

Trump’s world view both informs and is informed by fake news. His attitudes towards trade, for example, which his Administration views as a zero-sum game, are informed by the dodgy input of Peter Navarro who believes that the US trade deficit is a major drag on American economic prosperity. But as Trump pumps this message to a wider audience, so he gains support for taking measures that defy economic rationality. The idea of engaging in a trade war with China, for example, is an illogical proposition in which there are no winners – only losers. Admittedly, since the US imports much more from China than it exports, it can ratchet up tariffs on a far wider range of goods than China can match and in that sense the US would expect to “win” a trade skirmish. But this is a very short-term way of looking at things. There is little doubt that China will overtake the US as the world’s largest economy before too long and as a result it will write the rules governing world trade. If China takes to heart the lesson that economic nationalism is the way to go, before too long it will be able to throw its weight around in ways that the US may not like.

Even in the short-term, China can make life difficult for those US firms operating in the Chinese market. For example, Apple’s sales in China (at around $13bn) are only slightly lower than those in Europe ($13.9bn) and are growing at a much faster rate. Over the last six years, Apple’s European sales revenue has grown at an average rate of 2% per annum versus 19% in China. Another way to think of this is that Apple generates sales in China equivalent to the amount that 235,000 workers would generate in terms of salary income. In an accounting sense, these sales compensate for the absence of jobs that would otherwise be located in the US.  It’s all about swings and roundabouts.

Another aspect of Trump’s world view that increasingly disturbs is his ability to ride rough shod over long-standing allies. He has threatened to withdraw from NAFTA and has already imposed duties on European steel imports. Last week’s visit to Europe was hardly a triumph of diplomacy. Before sitting down with Angela Merkel, Trump denounced Germany as a "captive of Russia" and suggested that "Germany is totally controlled by Russia." He further undermined the US commitment to NATO by demanding that every member should reach the agreed threshold on defence spending of 2% of GDP by next year (the current target date is 2024) otherwise he would "go his own way." During his visit to NATO headquarters in Brussels he even demanded a rise in defence spending to 4% of GDP. He does have a point that there has to be a greater degree of burden sharing on defence, but the way to go about it is not to annoy allies because at some point you are likely to need them again.

Similarly, his intervention in the Brexit debate was bizarre. According to The Sun, Theresa May’s soft Brexit approach means that the UK’s “trade deal with the US will probably not be made.” His intervention in a domestic British issue was – to say the least – unusual and his backing for Boris Johnson was highly inflammatory. Trump subsequently backed away from criticisms of Theresa May reported by The Sun, claiming that it was “fake news.” But this fake news was captured on tape. Trump claims to have been similarly misquoted following his meeting with Russian president Putin.  When asked whether it was Russia that interfered in the 2016 presidential election campaign, Trump responded “I don't see any reason why it would be.” He later backtracked saying, “In a key sentence in my remarks, I said the word 'would' instead of 'wouldn't’ … The sentence should have been: 'I don't see any reason why … it wouldn't be Russia.”

What we are faced with is a US President who his allies simply no longer trust – certainly not on trade issues or defence cooperation. Increasingly they cannot take what he says at face value because even he is not prepared to stand by what he says. Martin Wolf in the FT offers a view of Trump based on the fact that the US position at the top of the pyramid is threatened by China and his nationalist kneejerk reaction is what the people want to hear. But he also suggests that the US economy “has recently served the majority of its people so ill” that Trump is the anti-establishment politician who can give “the rich what they desire, while offering the nationalism and protectionism wanted by the Republican base.” As one of the below-the-line reader comments put it, “America is being led by an ignoramus who thinks he's a genius, on behalf of plutocrats who claim to be populists, at the expense of the desperate who will believe anything.” Better perhaps to say “at the expense of the desperate who need something to believe in” but the point is made. 

Trump is the response to a system that failed: He exists because the old guard led the economy over the cliff in 2008 and are perceived to have left ordinary voters to pick up the tab. The reason why many Germans and pro-Remain Brits are scratching their heads at Trump’s behaviour is because they are not the ones who have been left behind. They don’t need to believe in a Trump-like figure and they can see through fake news. But they do not form a majority. Moreover, Trump does not play by the old rules because he gains nothing from doing so. There is thus no point in trying to tackle him on conventional terms.

Quite how we deal with a problem like Donald is hard to work out. Part of me hopes that he is a storm that will blow itself out when his policies are demonstrated to have failed. But I fear that he could be the first in a series of nationalist politicians who decide to tear up the rulebook in order to get things done. We only need look at Erdogan in Turkey or Duterte in the Philippines to see that there is a market for strongman politicians. And if the west becomes similarly infected then the rule-based economic system we have all grown up with will be in serious trouble.