Friday, December 22, 2017

Why is the business cycle elongating?

First, let me wish all my Econoblog readers a Merry Christmas and a Happy New Year!!

Economists have traditionally put the business cycle at between 3 to 8 years long.  But of the last 4 business cycles 2 out of the last 4 have lasted longer than the 8 year limit that economists typically look at.  In fact counting this business cycle, which officially hits 10 years (or 120 months) in December 2017, 3 out of the last 5 business cycles have had periodicity longer than the 8 year economist "consensus" upper limit.

For those geeky enough to be interested in US business cycles see the table below which is lifted from the NBER website.  The longest expansion we have seen in the US economy was through the 1990s through until the tech stock bubble in 2001, which lasted a full 128 months, 8 months than where we are right now.
Source: NBER website

But this then begs another question.  What are the specific reasons as to why the current cycle would be elongated, and how persistent will these effects be in preventing us from entering the contractionary phase of the business cycle?  Well there are several reasons why I believe economists and economic commentators think that we might have an elongated cycle this time.  I will run through each of these reasons below, but to summarize these reason up front:

1.  We started the expansionary phase from a lower base, as the "great recession" of 2007-09 was more severe than all previous downturns with the exception of the "great depression";  

2.  Quantitative Easing (QE) has provided an additional stimulus which combined with the usual countercyclical fiscal policy, allowed the economy to achieve escape velocity, but QE is only now being unwound;

3.  The tax reform bill just passed by the Trump administration, plus the Infrastructure spending bill that the Trump administration has promised in the first half of 2018, will continue the fiscal stimulus for the economy through at least 2018, and possibly to the end of 2019; and

4.  That the "great moderation" which started in the 1980s, has seen a dramatically lowering in volatility for short term cycles in growth, but due to a couple of reasons, this cyclical volatility has transferred to longer cycles in growth which, for the moment implies that the usual business cycle frequency of 3 to 8 years quoted by economists is now incorrect.

So let's start with the first reason.  The main insight here comes from the Great depression, and the fact that when a macroeconomy experiences a really deep recession, where the financial sector is involved, the recovery will be slow and arduous.  The accompanying chart from an IMF publication shows this quite clearly.  The horizontal axis shows the number of quarters into the recession and the reaction of various economic variables (averaged across countries and across time). So for example, residential investment starts to recover after around 4 quarters for non-financial recessions, but for financial recessions that recovery starts 11 quarters after the beginning of the recession.  As the great recession was caused by both the housing market and the financial markets, the recovery pattern has clearly been slower than for other recent recessions in the US. This is also clearly seen in GDP growth itself, which is shown below.  The most recent recession is the first recession since the Great depression where the economy was recovering from a financial recession and it is clear from the rate of growth coming out of the recent recession that the economy has had difficulty growing above roughly a 2% rate.

Source: BEA and authors calcs
While the logic of this argument appears sound, there are a couple of things to notice about the nature of the reasoning here.  First, the fact that the great recession was a financial recession would tend to suggest that the business cycle elongation will be only relevant for this current recovery rather than for business cycles in general. If this reason is correct, then the macroeconomy should return to its usual 3-8 year cycle after the next recession.  Second, it also flies in the face of business cycle dating that we referenced above - the business cycle has definitely been getting longer, and has not remained within the usual 3-8 year periodicity that economists so often cite.

The second reason as to why the current business cycle will be elongated is monetary policy. The amount of stimulus provided by central banks has continued to rise albeit at a slower pace.  As the graph below shows, the US is now reversing it's massive QE program, and that is one of the reasons why rates are rising in the US relative to rates elsewhere.  If we look at the chart below, we can see that indeed Global QE is still rising, mostly thanks to the ECB, who have still not started to taper.  That in itself is a massive boost to financial companies around the world as central banks have brought large amounts of financial assets off the commercial bank balance sheets, thus freeing up capital to be lent elsewhere, and stabilizing balance sheets.  If we look at this in terms of the rate of change of QE globally, we come up with a different impression, which is given by the chart below ( - please ignore the forecasts of a research group which were made in 2015).  These liquidity injections clearly have largely dissipated for most central banks, but net injections are still reversals have not yet been substantial enough to make an impact on the total, and some central banks are still continuing their QE buying programs.

Note that this reason would also only imply a temporary one-time elongation of the business cycle, and so doesn't explain why the most recent business cycles appear to have been on a elongating trend.

The third reason is due to the recent US fiscal stimulus in the form of the tax reform and the possible infrastructure package that President Trump has promised next year. This will affect the US, but does come with likely additional public debt implications, which will tend to crowd out investment and in normal circumstances would drive interest rates up.  But the tax reform essentially increases the return on US investment (purchase of plant, machinery and equipment), which will tend to increase private investment, thereby offsetting the crowding out effect.  So on balance, with the individual income tax reductions, these corporate tax changes should further stimulate the US economy, bolstering the monetary policy argument above. Once again, this is a one-time effect, and does not explain the lengthening of the business cycle.

The last reason why we might be seeing an elongation of the business cycle can be explained by recent research that I have been doing with Professor Andrew Hughes Hallett of George Mason University.  The empirical argument is shown in the figure below.

This analysis is called a "multiresolution decomposition" or MRD, and the technique essentially extracts the processes embedded within the series over different frequency ranges which are represented by the series d1 to d5 which are shown in the figure. We have 2 papers, the first of which showed statistically that the longer cycles embedded in real GDP growth (shown by d5 and d6 above (which relate to cyclical activity ranging from above 8 -16 years and from 16 - 32 years respectively) have become more volatile since the early 1980s, while the higher volatility cycles in real GDP (shown by d1 to d4, corresponding to cycles from 2 quarters to 8 years), have become less volatile [see below for academic references].

The second paper, which has been published as a discussion paper by the central bank of Finland (Suomen Pankki) [again see below for academic reference], goes through a lengthy analysis of the theoretical models typically used by macroeconomists to show the factors that could potentially cause this lengthening of the business cycle.  To cut a long story short, the factors that could be shifting volatility in the process that drive economic growth from shorter cycles to longer cycles turn out to be i) an increase in inflation aversion; and ii) a reduction in output stabilization. So let us look at each of these parameters in turn.

Has there been an increase in inflation aversion moving from the pre-mid-1980s period through to the post-mid-1980s period?  I would assert that yes, there has been, and this is due to the fact that many central banks instituted inflation targeting and if he could have done so, we know that ex Fed Chairman Ben Bernanke would have done so.  So has there been a reduction in output stabilization?  That is, has there been a reluctance to fully engage fiscal policy to it's maximum effect during downturns and to offset any rapid growth in the economy?  I think the evidence, once again, is that yes, we are seeing less output stabilization in US fiscal policy for certain, and perhaps a little more emphasis on stabilization by the Fed.  The net effect though would still be for less emphasis on output stabilization.  Now why do I assert that this is the case?  I think the evidence has been on show during the last week in the US.  As we know we are entering the final stages of the business cycle, the Trump administration has effectively announced a tax stimulus package which then will cause a spurt in growth as well as a one time elongation of the business cycle.  This tax reform package is definitely not output stabilization in the classic sense of counter-cyclical fiscal policy.

So note here that this fourth explanation would help to explain a permanent elongation of the business cycle since the mid-1980s.

But what about the markets in all of this?  One of the best visualizations I have seen relating to business cycles and the stock market came in a piece of research out of Goldman Sachs in late November this year (see below).

The figure shows that we are now approaching the 9th year of a bull market, with no signs of any correction coming.  This is not quite the record run yet, but it is fast approaching the 9.1 years of the 1920s bull market.

My own feeling about the financial markets is that we are beginning to move into "borrowed time", and that as soon as these one-time stimulus factors have passed, the downturn will happen. Whether that is in late-2018, 2019 or 2020 I am unsure.  But if there is one thing I am definitely sure of it is that the next downturn is coming sooner or later.


Crowley, P. and Hughes Hallett, A. (2015), "Great moderation or “Will o’ the Wisp”? A time–frequency decomposition of GDP for the US and UK", Journal of Macroeconomics, Vol 44, pp82-97.

Crowley, P. and Hughes Hallett, A. (2014), “Volatility transfers between cycles: A theory of why the "great moderation" was more mirage than moderation”, Bank of Finland Discussion Paper 24/2014.

Wednesday, November 1, 2017

Who will be the next Fed chair?

On the campaign trail, now President Donald Trump made it pretty clear that he wanted Janet Yellen gone as the Chairperson of the Federal Reserve.  Now in a televised speech on Instagram last week (see here), President Trump offered the biggest clue to his intentions by dropping in the word "hopefully" in his wish that "they will do a fantastic job".  That "hopefully" is, in my view, a definite hint that change is on the way, as if he really had another Yellen term in mind he wouldn't have needed that "hopefully" word. As in so many areas with President Trump, he will break precedence if he doesn't reappoint Chairwoman Yellen, as every Fed chair in modern history who has completed a first term has been nominated for a second term.

So now that I believe it is fairly clear that he has signaled that he will replace her, the media has been looking at the candidates that the President has in mind, and focusing on the daily rumors that appear to emanate from the White House about who is in favor.  But the decision is not as easy as you might think, and for two reasons: i) the President has economic growth objectives that many conservative central bankers might see as unlikely and therefore may try and be more hawkish on monetary policy than otherwise would be the case; and ii) the end of the business cycle expansion is approaching, so the President would likely not want a Fed Chair that is inexperienced in the art of central banking.

This is probably the most important appointment that the President will make in his current term of office, as the likelihood of an economic downturn is extremely high, given that we are coming towards the end of the expansionary phase of the business cycle.  Whoever the next Fed chair is will very likely have to cope with a recession, and will have to position the Fed accordingly.

Therefore, in my view, given that Yellen has effectively dropped out of the race, there are really only 3 candidates left in the running. I will deal with each one separately below:

i) Jerome Powell.  Powell is currently on the Fed Board of Governors, so is no stranger to the Fed.  He was appointed to the Board in 2012 and is a card-carrying Republican as well as a multimillionaire having worked at the Carlyle Group.  He is moderate when it comes to monetary policy views but is not an economist, which may be seen by some as a weakness.  Nevertheless he clearly understands monetary policy well, but may not be the right guy for the job if the economy has another severe recession in the next 4 years.

ii) Kevin Warsh.  Warsh was first appointed an economic advisor at the White House in 2002, and then from 2006 to 2011 Warsh served as a Fed governor, but then resigned to join the Hoover Institution where he is currently employed.  He has been a frequent critic of the Fed, and there are already a website that has been established to lobby against his appointment (see here).  He is definitely seen as more of a hawk, and the consensus is that monetary policy would likely be on a tighter trajectory. He was trained as an economist, so that is a plus, but on the other hand many of his predictions when he was previously employed at the Fed (such as higher inflation if the Fed maintained QE) have not transpired, which doesn't give the markets much confidence in his judgment.

iii) Professor John Taylor, is the only distinguished economics professor among the  candidates. He is the author of the so-called "Taylor rule" which was an effort to use a rule-based setting of monetary policy for modelling purposes.  Taylor was at the US Treasury during the George W. Bush administration and served at the White House under Presidents Carter and Ford.  Through his comments on the maintenance of QE, the markets view him as somewhat hawkish, and the media believes that a Taylor appointment would "spook" the markets.

So what is the perception of the odds for each of these candidates?  The website "Predictit" (see here), has odds based on actual bets, and as of Nov 1st at 11.30am, the odds currently are:

So what is my assessment?  For me this comes in 3 parts - i) who will Trump choose and ii) who would be the best choice in my assessment; and iii) who would actually be best for stockmarket gains?  Let's deal with each in turn.

First, who do I think Trump will choose?  It seems that the President has changed his mind almost daily, so although the latest anonymous leak from the White House stating that Powell is the favorite (see here), I doubt this will be sustained until the announcement.  My belief is that Trump will want to go with an economist and someone who will shake things up at the Fed, as he will want to please his base and also impress other Republicans on Capitol Hill.  So my guess is that Trump will go with Taylor as long as he has Taylor's assurances that he will not enact a rules based policy as this would tend to raise rates faster than would be the case with the other candidates and might then derail the so-called "Trump rally" and spook the markets.  Of course if a Taylor appointment is made, then the markets might still be temporarily spooked until they can get reassurance during the Senate confirmation process.

Second, who do I think would be the best choice for the top job at the Fed?  I believe that continuity is important here, and that likely another Yellen term would actually be best for the country as a whole, as Yellen is already acting on "normalizing" Fed policy, but is doing so at a cautious rate that allows for economic growth to be sustained going forward.

Third, who would be the best choice for the markets?  I think the markets, as the polls show, would prefer Powell, as he possesses the element of continuity, but at the same time is a little more "light touch" on financial regulation than Yellen.

What is almost certain though is that whoever takes over at the Fed (unless it is a Yellen reappointment) will change Fed policy going forward, and that will undoubtedly impact the bond markets and perhaps the pace of interest rate hikes and the withdrawal of the QE stimulus, with its attendant effects on economic growth.  

Monday, August 21, 2017

Are "Trump Trade Wars" Inevitable?

President Donald Trump, at his joint address to Congress on February 28th 2017 stated: “I believe strongly in free trade, but it also has to be fair trade. It’s been a long time since we had fair trade. The first Republican president, Abraham Lincoln, warned that the abandonment of the protective policy of the American government would create want and ruin in the country… It’s time we heeded his advice and his ways.”
Free trade has been at the cornerstone of capitalist democratic economies now for many years, so this statement from the President of the biggest trading country in the world looks to President Lincoln to justify a return to protectionism and a reversal of the trend to ever freer trade that has been characterized by the post World War II international economic consensus. This has economists somewhat aghast at what is going on with the Trump administration, as after the new President immediately withdrew from the progressive Trans-Pacific Partnership (TPP) agreement, we also know that the Trump administration is now looking to not only renegotiate NAFTA but also has explored the idea of perhaps bypassing World Trade Organization (WTO) rules so as to impose a border adjustment tax (we'll come to what that is below).

So how will this all play out? Well there is already a battle inside the administration about how protectionist the policy pronouncements will be (see here), and it looks like the battle between the two factions will continue for a while yet, despite the fact that Steve Bannon has left the White House staff. In a recent NYT article (see here) there is doubt that President Trump will be able (or want) to follow through on his campaign promises with as much gusto as he suggested he would on the campaign trail. And in an article in the FT (see here) there were signs emerging that the Beijing relationship has now becoming badly frayed as the Trump administration initiates several unfair trade practices investigations. The danger though here is that the "soft-liners", although they might win in the short run, will not hold the upper hand as we approach the mid-term elections in late 2018 and beyond, as the administration realizes they are being punished at the ballot box for not fulfilling on these commitments.
So let's take stock of where we are in terms of President Trump's campaign promises. In not particular order, they were:

1. Withdraw from TPP

2. Halt T-TIP negotiations

3. Renegotiate or scrap NAFTA

4. Institute a border tax (tariffs) with Mexico so as to pay for a wall on the Mexican border

5. Declare China to be a currency manipulator

6. Impose a border adjustment tax (BAT) as part of the tax reform package that should be forthcoming from the administration.

The first 2 on the list have now been completed, but the third is the one that has everyone guessing as to the consequences, so let's look at NAFTA first. 

NAFTA is now embedded into the North American economy, so changing the basis of the Treaty that established NAFTA requires a summit with both Canada and Mexico, and the negotiations for this summit are now taking place. 

President Trump has made it clear that he wants a complete rewrite of NAFTA, and that led to a tense start to the negotiations, which got underway this week (see here). The Canadian foreign minister, Chrystia Freeland, noted that “We pursue trade, free and fair, knowing it is not a zero-sum game”. She added that: “it is worth pointing out that we are the biggest client of the United States. Canada buys more from the U.S. than China, the UK and Japan combined.” 

Perhaps the US team in the negotiations, led by U.S. trade representative Richard Lighthizer, sees trade bilateral deficits ( - and the US does run a small deficit with Canada) as a measure of fairness of trade with that entity.  Any student of international economics understands that this is not the case - it is simply a component of the overall trade balance, and reflects a balance of comparative advantages between the two countries. Also it should be noted that Trump's ire has not been directed at Canada (with the isolated case of the softwood lumber issue) but in the NAFTA context his ire has largely been directed at Mexico. This is because whereas the U.S. ran a goods and services trade surplus with Canada in 2016 of about $12.5bn, the U.S. ran a goods and services trade deficit with Mexico of $55.6bn.  But as we shall see below, the trade deficit with Mexico is dwarfed by the trade deficit with China.

Now although the topics to be discussed are rules of origin, managed trade (read more quotas), and so-called "Chapter 19" dispute resolution, whatever is in NAFTA 2.0 better reduce the U.S.'s trade deficit with Mexico, otherwise this will likely prompt President Trump to threaten withdrawal from NAFTA. But given the fact that much of the trade between the U.S. and Mexico is intermediate goods trade, it does make sense that the biggest part of the cross border trade would be the finished product (for example a vehicle), rather than the sum of all the parts that might be produced in the U.S. that are exported to Mexico (where the vehicle is then assembled). Given then that it is unlikely that trade with Mexico could ever get to close to in balance (or in surplus), I think that President Trump, given that he has made such a big issue of either pulling out of NAFTA or completely rewriting it, may decide to pull out if the Mexicans don't walk out first.  

What I think will possibly transpire is a return to CUFTA, which was the free trade agreement with Canada that formed the original basis for NAFTA. Although other economists might not agree with my assessment, I believe that President Trump will feel that he has to deliver on this particular promise if he is to stand any chance of re-election.  In order for NAFTA 2.0 to eliminate the trade deficit with Mexico would be import quotas.  I think these will be rejected by Canada, as they would also affect Canadian exports to the US. So there is no way forward that would satisfy all 3 parties and therefore this will possibly lead to withdrawal. Since the announcement of Steve Bannon's ouster as a Trump advisor, the probability of withdrawal has gone down, but the trade representative will still have difficulty delivering what the President wants out of a re-write of NAFTA.

When campaigning, Donald Trump also mentioned a 35 percent tariff on autos made by U.S. companies in Mexico. This tariff was originally mentioned with regard to also funding construction of the wall. This tariff would currently go against the rules of NAFTA so is unlikely to be implemented while the U.S. remains inside NAFTA. So if the U.S. does leave NAFTA then this idea might get resurrected as a means to deter manufacturing or assembly going south of the border.

On the campaign trail President Trump also promised to name China as a "currency manipulator".  But having met with Premier Xi Jingpin, Trump declared that China had manipulated its currency in the past, but was moving to correct the level of the yuan, and hence it would not be necessary to name China as a "currency manipulator".  So this is now off the table.  President Trump did, however, decide to pursue several probes against China, most notably on intellectual property (see here), but also on steel. Although the U.S. has not imposed steel tariffs yet, it seems that they are likely to do so (see here).  This so-called "section 232" review ( - that was initiated because of fears that threats to the U.S. steel industry from imports would not be in the interests of national security) has to be made public by mid-January. Then President Trump will have 90 days to react, perhaps implementing a steep tariff on steel imports principally from China, but also from all other steel producers.

The Border Adjustment Tax (BAT) has now also been abandoned as a proposition, but just to keep my readers fully informed, I will explain exactly what a BAT is. A BAT is essentially an import tariff coupled with an export subsidy by means of making exports tax free.  

So that is the current state of play on international trade policy and the Trump administration. As mentioned above, the current administration appears to be particularly concerned about turning the overall U.S. trade deficit into a surplus, or at least reducing it.  In the table below from the BEA, the bilateral trade deficit or surplus for the U.S.'s main trading partners is shown, and it can be seen that the majority of the deficit is with China, and this is fairly consistent over time. 

Source: US Census Bureau, Dept of Commerce

Of course what really matters here is the trend in the data, so I thought I would download the data and see exactly how a long term perspective can show that actually China is pretty much the only problem. 

Data source: Dept of Commerce; Graphic by blog author
Now the graphic clearly shows that although there was a deterioration in the trade balance with countries like Japan, Germany and Mexico over the early 2000s, it is the trade deficit with China that really takes off in the early part of the century, and although for countries like Canada the trade balance has actually improved, for China, with only a brief respite during the great recession, the overall trend has been towards a widening of the deficit.

Chinese President Xi Jinping and U.S. President Donald Trump shake hands
So from an economic assessment, if one agrees with this approach, the President should really focus mostly on China, as this is where much of the trade deficit originates from. But what is the best way to tackle this? The U.S. trade representative has a detailed list of objectives which can be found here, but of course these only state objectives and not solutions.  

On a recent trip to China I visited a large container port off the coast of Shanghai ( - in fact it is at present the largest container port in the world), and was surprised to hear that half of the containers travel to China empty, but every single container is full leaving China. So the main problem with trading with China (and this goes for the EU too), is that China's trade with most of the rest of the world is unbalanced.  

This highlights the fact that although half of this problem is the U.S.'s problem, the flip side is that China clearly has a lack of consumption of imports in the sense that savings are high and when the Chinese do consume, much of their urban dwellers consume Chinese goods. The China issue prompted President Trump and President Jinping to set up a "US - China Comprehensive Dialogue", but as reported in the Financial Times last month (see here), this dialogue is a talking shop regarding the issues to be tackled, but nothing concrete to make it happen, and definitely no sign of agreement on the way forward. 

Clearly the Trump administration has changed tack and instead of calling the Chinese currency manipulators, has decided to go after the Chinese on various fronts by launching probes in specific problematic areas. The results of these probes though, if acted upon, will likely prompt reprisals, and perhaps WTO arbitration cases against the U.S. Certainly the Chinese appreciate that although the U.S. is not their largest trading partner ( - the EU is), that there are considerable risks to domestic economic growth if there is a trade war with the U.S.

So is a trade war inevitable with China?  I think that the answer here is still up in the air, but I still think the most likely outcome is narrowly in favor of a trade war. This is the case particularly if we see a degradation in the NAFTA talks appearing over the next few weeks.  A sign pointing in a different direction has also appeared though, and that relates to the earlier probe on steel which the President launched. There has still been no announcement as to the results of this probe, and this is likely because the announcement has been held back as it would be damaging to trade with China. How to handle this will definitely require some diplomacy, as President Trump will not want to make outright enemies of the Chinese.   

Wednesday, February 8, 2017

A Realistic or Panglossian Brexit? What lies beyond Article 50.

Source: Chicago Showbiz
Pangloss was a character in Voltaire's Candide ( - which was made into a wonderful opera incidentally, by the late Leonard Bernstein), who suffered from unbridled optimism. Obviously with Brexit the Panglossian "best of all possible worlds" (or as a note on a memo that was recently leaked to the UK press said "to have your cake and eat it") is unlikely to come to pass in the difficult negotiations ahead - but to me that is hardly a surprise, as I will explain in this econoblog.  

We now have some clarity on what is going to happen regarding the UK's exit from the EU (otherwise known as Brexit). UK PM Theresa May has determined that the type of Brexit that occur has to be of the "harder" variety, and she made a speech to this effect, and you can read the full version of the speech here.  Also, after the challenge made in the UK High Court (roughly equivalent to the US Supreme Court), the UK Houses of Parliament has had to vote on a bill to take the UK out of the EU, and although many of the MPs themselves wanted to remain, there was a "whip" to ensure that the vote (498 to 114) to start the Brexit process formally by allowing the PM to trigger Article 50 (which then is the official notification to the rest of the EU that the UK is on a 2 year timetable to leave).
Source: Getty Images

Some commentators, such as Martin Wolf of the FT (see here) had already gone on record to say that he thought the only feasible outcome is now a so-called "hard" Brexit. Martin Wolf stressed that the linear (or quadratic) programming problem that satisfies all the political and economic constraints for a deal is essentially an empty set. So Martin Wolf sees this as leading to the hard option, with no soft "squidginess" allowed.  I think that indeed "ceteris paribus", this is certainly the direction of the negotiations, but that the mostly likely outcome will be more nuanced than this.

My reasoning is as follows  "Ceteris" does not have to be "paribus", so although we ulimately need some practicality imposed on all this, clearly EU immigration is the big sticking point that leads to what most economic commentators believe is an "empty set". But I think as the weeks and months have passed since the referendum the general public is now beginning to get it's mind around the tradeoffs involved with the practical steps needed to achieve Brexit, and understands that leaving the single market is the only way forward, but even PM May has already suggested some "squidginess" here, in referring rather mysteriously to what she called "customs agreements".

OK, so let's back up a moment and remind ourselves of the distinction between a customs union and a single market.  A "single market" means you have the "4 freedoms" - free flow of goods and services, workers and capital - in other words free flow of all goods and factors of production.  A "customs union" is different - it is a free trade agreement where the participants agree to a common external tariff (CET). And then of course you have a free trade agreement (FTA) where each country can set it's external tariff separately.  So for example there are countries in Europe that are members of the single market, but not of the customs union ( - Norway and Iceland for example), and countries that are members of the customs union but not of the single market ( - Turkey, Andorra and the Isle of Man).

So how do PM May's "customs agreements" fit into this framework?  I had actually never heard the expression before PM May's talk, so what might it mean?  Remember that PM May has stated that she would like a free trade agreement (FTA) with the EU, which then suggests no CET, so my interpretation of a "customs agreement" is that for trade in certain sectors, the UK would agree to use the EU's CET.  In other words this opens up a "sector by sector" negotiation.  But are these two concepts (FTA and a CET in certain sectors) compatible?

My answer to this question depends on who you are.  I think to the UK, these two concepts are completely compatible, as they just see trade in goods and services continuing as before, except with certain sectors having to have tariffs the same as the EU's tariff levels to ensure that no "trade deflection" occurs ( - companies trading through the UK because for example it has a lower external tariff than other countries).  But to the EU this is not compatible, as the customs union is just not the same as an FTA to the EU, because with FTAs there has to be a geographical distance there (or internal value added thresholds) to permit different external tariff rates.  So for example the EU now is moving towards an FTA with Canada in both goods and services, but this is in a limited number of goods and services (given how small the Canadian economy is compared to the EU's) and so differential external tariffs are not likely to cause a company to set up in Canada in order to export to the EU, or vice versa.  The same cannot be said of the UK though as it is much closer to the rest of the EU, and there is a lot more trade in goods and services between the two entities.  So I think that an FTA with the UK will not be that attractive to the EU, but they will go along with the "customs agreements".  Incidentally a useful map of all the trade agreements that the EU has with the rest of the world is shown below.
Source: HM Government - Alternatives to membership: possible models for the United Kingdom outside the European Union (Annex A) p.45, 2016.
So, the Brexit is likely to be hard, but I think that free trade will only exist with the EU in certain sectors where "customs agreement" have been negotiated.  So, this leads me to further think that the "Swiss model" is still the best model for negotiation between the EU and the UK. And here, by Swiss model I mean the structure of the negotiations, not the exact template that the Swiss have right now, as clearly the free movement of people is not something that will happen.

The Swiss model contains many of the advantages that the UK desires in its post-Brexit relationship with the EU – a bespoke series of bilateral agreements that would minimize the economic damage from Brexit, while allowing the UK and the EU the latitude to tailor these agreements to ensure that the underlying cause of the Brexit vote is honored if not entirely in substance, certainly in spirit, while also pursuing common economic and political interests.  While the "full" Swiss model will take a long time to come to fruition, in my assessment it certainly trumps the other alternatives.  

So what would a Swiss model look like if applied to the UK?  This is difficult to say, as the Swiss agreements are numerous and extensive in their coverage (see for a good summary).  Clearly there are certain bilateral agreements that the Swiss already have on the books which could be simply transferred in template directly to the UK ( - for example research, media, education, civil aviation and pensions), but there are areas of mutual interest where the UK and the EU would have to create new bespoke agreements (areas such as trade in goods, trade in financial services, FDI, and migration), and this will pose significant challenges for both sides. 

For example in migration, mutual interest might be served by instituting a NAFTA-style agreement on movement of qualified labour.  In NAFTA, a degree from a North American institution of higher education together with a job offer gets you a NAFTA visa which allows educated workers from Mexico, the US and Canada to work anywhere within the NAFTA zone.  A similar clause has also been put into the Canada-EU comprehensive economic and trade agreement (CETA), so there is precedent for this already.  Implementing a similar agreement for a bilateral agreement between the UK and the EU would allow free flow of educated workers, while still permitting the UK to institute its own rules on inward migration for unskilled workers. 

On trade, sectoral customs unions (or "customs agreements") would be negotiated for example for automobiles and other vehicles, for pharmaceuticals and for certain agricultural products.  A similar approach could be taken with financial services, with certain types of financial services (such as foreign exchange transactions, banking services and marine insurance) wrapped up in a bilateral agreement.  

The Swiss model is a compromise model, but it is a flexible model that can cater to the requirements of both the EU and the UK, and probably the biggest advantage of this model is that new areas can be added over time, so that the 2 year deadline becomes irrelevant, as the relationship is ongoing and integration becomes dynamic, rather than the static level of integration that is the hallmark of a conventional FTA.  It hopefully offers the best deal (where it exists) for each sector and common interest, so contains elements of both “hard” and “soft” Brexit strategies.  Obviously the biggest hurdles to achieving this model are the set-up costs. These will undoubtedly be significant, and some areas and sectors may end up being excluded at first, so there may also be significant “transition” costs to the eventual new arrangements for some sectors and common interests.

Tuesday, January 24, 2017

Happy New Year for 2017!

(Source: ThinkStock photos)
Happy New Year for 2017 to all my econoblog readers.  And first, one of my resolutions in 2017 will be to "blog" more, as I do enjoy it, and hopefully you all get something out of it too!  I will be honest, and say that 2016 was a hard year for some reason - more teaching than expected, deaths in the family and other issues meant that blogging was not the priority.

Hopefully that can change in 2017. And 2017 will clearly be a pivotal year for the US, as a new administration takes the reins with likely a very different course to be charted, and with likely quite different results.  As an entrepreneur, President-elect Donald Trump has largely kept his views on fiscal and monetary policy to himself, and even in the election he mostly focused on what he would do to change trade policy, which for a country like the US, with only around a 15% dependency on foreign trade, is not going to have that much of an effect.  Of course changes in trade policy will have an effect on the US's other NAFTA partners, the T-TIP and the TPP, the former likely negatively affecting Mexico and Canada, and the latter 2 now dead on arrival.  The TPP is the only new transcontinental trade agreement that could be saved, but it would not be as influential without the US being part of the agreement - on the other hand T-TIP is clearly dead.  In a way it is just as well that Canada recently signed the new CETA deal (see here), which will allow Canada to partially offset any negative impact arising from any renegotiation of what President-elect Trump has called "one of the worst trade deals the US has ever signed".  This in addition to the so-called "Thucydides Trap", where a rising power (China) begins to challenge the hegemony of the existing power (the US) would point to trade war with China, which some commentators (such as Paul Krugman (see here)) think will soon occur.  But more on this "Thucydides Trap" in a future blog.
NYE 2016 in Dubai

But what are the other effects of the tariffs that President-elect Trump has threatened (and presumably will have to go ahead with if he really stands any chance of a second term in the White House)? As any student of international economics will tell you, the first implication is that domestic prices will rise for those goods that are protected from international competition.  So these rising prices will lead to a boost in US inflation, which although not substantial, will have other effects.

To understand US domestic price pressures, we must also include the prospects for oil in our discussion here. Oil prices have been on an upward trajectory lately, and are headed for $60 per barrel based on increased demand for oil with the lower prices as well as more robust demand as we head into the final expansionary growth phase of the international business cycle. There is also a reinforcement effect going on here as well, as higher oil prices means more fracking, which means increased output and wages in the US, which further adds to price pressures.  So it is likely that US inflation pressures will finally start to build.
So unless President Trump turns out to be a complete economic disaster, which is unlikely, then US economic growth will continue to pick up, US inflation will start to accelerate and unemployment will head for 4% and "full employment".  This will lead to perhaps more Fed hikes in 2017 than some economists are expecting, and a continuation towards a normalization of monetary policy in the years ahead.

Sectors that will benefit from this are the financial and construction sectors in the US.  There are considerable uncertainties surrounding the healthcare and biotech sectors though, The financial sector will continue to do well as US banks are in much better shape than their counterparts elsewhere and will also benefit from higher interest rates, and the latter because the millennials will finally start to inherit wealth and get sufficient pay raises to afford their own properties.  More on this in a future blog I am preparing.

Let's now turn our attention to Europe.  The main problems here are i) the political and economic fallout from Brexit; ii) the continuing migration problem; and iii) continued weakness of the financial sector.  On the first problem, I have another blog coming out tomorrow on this topic, so I won't steal my own thunder, but essentially this will create uncertainty and therefore some economic and financial wobbles this year in the markets.  The interactions between the UK and EU negotiating teams on Brexit will inevitably leak and cause considerable volatility, particularly in the UK. I do not foresee other member states following the UK though, as the deal they will likely strike will be tailored specifically to the UK, and the EU will make sure that it is not attractive to other member states, to facilitate cohesion after Brexit.  On the second issue, the migrant problem: this will cause some political problems in Germany, but will also provide significant labor needed to ensure that German labor supply expansion supports economic growth, but the political backlash in both France and Germany may cause more business friendly governments to be elected in those key member states, which are the engines behind the EU, so this might actually not be a bad thing for economic growth (although it might not be so good for political cohesion).  And the third issue, that of the EU financial sector will start to be resolved in 2017 as a more concerned ECB and the EU Banking Authorities take action to ensure the capital adequacy of the European banks.
Source: IMF IFS and authors calculations

So what does all this mean for European growth and stockmarket prospects in 2017.  The chart above gives us some clues.  The chart shows that even with the 3.5% annualized rate of growth reported in the 3rd quarter in the US, the rate of growth for the US will still be below that of the EU.  But Trump's election has changed this equation completely, with the US likely to leapfrog over the EU in the 2017.  That points to outperformance for the US over the EU stockmarkets in 2017, although there still could be some bright spots in the EU, notably once again the banking sector and also the energy sector, depending on where the price of oil goes.
Source: Yahoo Finance

Let's now turn to Japan.  Despite the effots of the Abe government, the Japanese economy still in dangerously close to turning deflationary again, as can be clearly seen from the chart on GDP growth.  This is on top of the exceptional fiscal and monetary stimulus that has already been delivered under Abenomics.  The stockmarket performance of the Japanese Nikkei reflects the reflationary policies adopted since 2012, but the Nikkei is still not performing as well as the US and German stockmarkets.  This can be clearly seen in the stockmarket chart above, which sets the end of 1990 as the base year to show longer term stockmarket returns.

This stockmarket chart is informative as it indicates that in fact on returns basis the DAX (German stockmarket) has given a slightly better return than the S&P500 since 1991, which is not what I would expect, especially when taken in nominal terms. Nevertheless, the return from the stockmarket over these 26 years has been remarkable, with a 7 fold increase in stockmarket value, and this doesn't even include the total return (return including dividends).  Investment in Japan (represented by the Nikkei) has clearly not given a good return (in fact it is still negative), and this reflects Japan's "lost 2 decades" of economic growth and deflation.

So what of other economies and stockmarkets?  My own view is that China is now a riskier bet (given the prospect of a trade war with the US), and so should be avoided.  India, on the other hand, still has good prospects, although the Modi reforms appear to have stalled, which may put the brakes on the good economic growth performance (currently higher than China's) that the country has recently experienced.

For other regions, Australia and New Zealand have performed very well recently, but now appear to be running into some inflationary concerns, and Africa also still has considerable unlocked potential, but does not appear to have gotten past it's political problems quite yet.

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